Credit - Blue Monday

"As long as the world is turning and spinning, we're gonna be dizzy and we're gonna make mistakes." - Mel Brooks

Watching with interest the dizzying gyrations in various markets on Monday following the Greek referendum "shocker", which no doubt has put additional pressure on already "stressed" VaR models, we reminded ourselves for our chosen title of a double analogy this time around, a musical one. Given Blue Monday is often associated to the most depressing day of the year in January (typically the third monday of the month), for us it as well a reference to the single released in 1983 by British band New Order, later remixed in 1988 and 1995, the biggest-selling 12" single of all time.

As far as our analogy goes, it was interesting to note the indiscriminate "selling" that occurred on Monday, particularly at the open of the credit markets where at some point the CDS High Yield European risk gauge 5 year CDS index Itraxx Crossover was wider by around 50 bps, which was reminiscent in earnest of the moves we saw back during the supposedly "dull" summer of 2007, which was indeed much warmer than usual, fo us credit guys at the time.

From the starting lyrics and with the on-going Greek situation, we think that our chosen title is indeed more than appropriate again, this time around:

"How does it feel to treat me like you do?
When you've laid your hands upon me and told me who you are.
I thought I was mistaken, I thought I heard your words.
Tell me how do I feel. Tell me now, how do I feel.
Those who came before me lived through their vocations
from the past until completion, they'll turn away no more.
And still I find it so hard to say what I need to say." - Blue Monday, New Order 1983

Indeed, we could even have gone one title better and select yet another song from our beloved great New Wave group "New Order". We could have selected another of their seminal tracks "Confusion" and some of its lyrics when it comes to relating to the Greek situation:

"You cause me confusion, you told me you cared

He's calling these changes that last to the end

Ask me no questions, I'll tell you no lies

The past is your present, the future is mine

You just can't believe me

When I show you what you mean to me

You just can't believe me" -  Confusion, New Order, 1983

But we ramble again...

Again, rather than focusing solely on the "Blue Monday" effect on asset prices thanks to the continuation of the Greek tragedy, in this week's conversation we want to focus our attention on the deteriorating trend in credit and the recent moves in Inverstment Grade Credit particularly in Europe which somewhat have validated our recent take from our conversation "Eternal Return":

"As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower will be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!
So, should the volatility in the bond space continue in conjunction with a materialisation of a GREXIT, you could indeed face Poincaré's "recurrence theorem" and a vicious risk-reversal in illiquid secondary markets." - Macronomics, Eternal Return, 9th of June 2015

Synopsis:

• Convexity has no doubt started to "bite" credit, in particular Investment Grade Credit in Europe
• How to cheaply hedge a potential Greece related sell-off using credit
• The credit channel clock is ticking for High Yield
• Balanced funds getting "unbalanced"
• Final note: Cash holdings as a % of AUM is at the lowest since 2008

• Convexity has no doubt started to "bite" credit, in particular Investment Grade Credit in Europe

While we mused on the 9th of June on the convexity issues surrounding Investment Grade credit and in particular Europe and warned about its rising "unattractiveness", we were not surprised to read from a recent Bank of America Merrill Lynch note Euro Excess Returns from the 1st of July 2015 entitled "Worse than the Taper Tantrum" that indeed the convexity issue we discussed a month ago has started to "bite" returns in earnest:

Worse than the Taper Tantrum
Euro credit had an unpleasant June. IG spreads widened 21bp as a series of events unfolded. 

At the start of the month, the confusing ECB message on “volatility” caused 10yr bund yields to surge higher (after having already moved materially higher in April). Rate volatility surged and this instigated a strong risk off move across markets. Later in the month, the tensions in Greece added to market weakness and drove a strong bid for protection. Throw in concerns over US rate increases, and a perfect storm brewed last month.

Heightened outflows
On top of all of this, the poor total return performance of credit over the last few months has been the catalyst for retail outflows to start. Euro high-grade credit total returns in Q2 were -2.8%. This is the worst quarterly performance in our index history (since 1996). Retail investors have withdrawn $6.4bn from Euro IG credit over the last 3 weeks, which is a bigger dollar outflow than seen during the June 2013 Taper Tantrum (see below chart).

Tantrums: then vs. now
In terms of comparisons with the 2013 Tantrum, the side table shows total return comparisons, split by maturity.

What’s interesting is that this time around, front end total returns have not been too bad, and certainly a lot less severe than in 2013. The ECB’s pledge to do more QE if necessary has anchored front-end yields. Yet, at the longer-end of the curve, total returns this time have been more painful that in 2013. 7-10yr total returns in June 15 were -3.37% vs. -2.75% in June 2013.

Ugly XS returns
High-grade excess returns were -1% last month, the worst performance since May 2012 (just before the OMT was announced). High-yield excess returns were -1.4%, which feels a bit of an outperformance by high-yield. In fact, the superior spreads and improving growth outlook have been somewhat of a cushion for high-yield over the last month. Note that single-B excess returns were better than BB excess returns (-1.2% vs. -1.4%) last month.
In high-grade, no sector posted positive excess returns last month. Insurance was the worst, despite the paradox that higher yields benefit life insurers. Nonetheless, the sector’s excess returns were -2.1%. Media lost 1.2%, which in part reflected the strengthening of the Euro lately (and thus not good for dollar revenues of media companies). Utilities and telecoms suffered because of the prevalence of long-dated debt. The “least bad” performers last month were leisure, capital goods and financial services (see the tables on the next page).

Year-to-date: equities way ahead of bonds now 

Year-to-date, Euro IG credit is down 1.4% in total return terms (83bp in excess return terms), Euro HY credit is up 2% in total return terms and Euro government debt is down 41bp in total returns. But stocks are eclipsing fixed-income now, even with the recent Greece related sell-off. The SX5E is up 11.5%, banks are up 15% and the Dax is up 14%.

If the Greece referendum returns a Yes vote at the weekend and tensions begin to ease, we think 2015 will begin to cement itself as the year of stocks over bonds (Table 2). 

- source Bank of America Merrill Lynch

No surprise there, we did warn about the end of the "goldilocks" period for Investment Grade credit in our conversation "Eternal Return":

"Should the volatility continue in the Government bond space, it will in the near term put upward pressure on credit spreads for both cash and synthetic indices such as the Itraxx Crossover (High Yield) 5 year CDS index taking the brunt of the widening stance we think as long as the GREXIT is "avoided".
Should the GREXIT materialise, given the Itraxx Main Europe 5 year CDS index is the proxy for investment grade and includes 21 banks out of 125 names, it would then face "harmonic oscillations" in the process." - Macronomics, Eternal return, 9th of June 2015

We also indicated in our conversation that the Itraxx Main Europe 5 year CDS index was a good proxy "macro" hedge in case of Greek turmoils:

"Should the GREXIT materialise, given the Itraxx Main Europe 5 year CDS index is the proxy for investment grade and includes 21 banks out of 125 names, it would then face "harmonic oscillations" in the process.
On a side note, the Itraxx Crossover 5 year CDS index, the "proxy" for High Yield, does includes two Greek companies, OTE and Hellenic Petroleum out of 75 entities within the Series 23 index which was implemented in March this year and rolls every 6 months. Also the US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to a potential GREXIT scenario playing out à la Poincaré..." - Macronomics, Eternal return, 9th of June 2015

iTraxx Europe is the benchmark investment grade CDS index in Europe and comprises CDS on 125 names. A new series begins to trade every six months (on 20 March and September). The current “on-therun” series is S23.

This brings us to the second point of our conversation,  namely how to benefit from "convexity" and on-going dislocation between equities and credit using credit as a good "macro" hedge for a potential "Grexit" in case of a new "Blue Monday" event.

• How to cheaply hedge a potential Greece related sell-off using credit

We pointed out on numerous occasions the importance of CDS indices for credit investors and "macro" players. CDS indices plays an extremely important role in terms of index trading and price discovery, and is often actively used as a hedge for bond portfolios by investors because of its greater liquidity.

Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:

"Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays"

As a reminder:
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

We concluded at the time:

"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment and also by the fact that some dealers have pulled out of CDS trading in the single name space, reducing even more the liquidity. Large market maker Deutsche Bank pulled out altogether from this business, due to the high cost of capital of this fixed income activity.

So how does one cheaply hedge a potential Greece related sell-off using credit you might rightly ask? On that very subject we read with interest Deutsche Bank Cross Market Insights note from the 2nd of July 2015 entitled "Funding protection with Credit":

"Euro STOXX 50 (SX5E) is about 8% rich vs. iTraxx Europe S23 five-year spread SX5E price reflects the positive impact of ECB QE and is ~4% above pre-QE levels in spite of recent Greece-related sell-off. In contrast, iTraxx Europe spread is 8bp higher than pre-QE levels. (Figure 1) 

The dislocation provides an opportunity to cheaply hedge a potential Greece related sell-off.
Trade: buy SX5E 3000 strike Dec-15 expiry put (notional 1x) funded by selling protection on the iTraxx Europe S23 five-year index (notional 2.4x).

• The gain in the iTraxx Europe position offsets the option premium in a benign environment.

• The trade provides potential upside in a sell-off in which the SX5E reverses its recent outperformance vs. iTraxx Europe; it also provides significant upside in historic sell-off scenarios.

• The trade is expected to have (small) positive P&L if markets rally between now and option expiry due to gain in the long risk iTraxx Europe position.

North American CDX.NA.IG also appears cheap vs. SX5E Investors looking for payout in USD can buy the put option above quantoed into USD, and sell protection on CDX.NA.IG.24 five-year index. 

Main risks
(1) Breakdown of the SX5E and CDS index relationships so that realised betas in a sell-off are materially lower than anticipated or credit experiences a sell-off while SX5E remains firm, (2) sell-off in equity implied vol, and (3) FX spot and vol fluctuations (for the USD trade). - source Deutsche Bank

Of course the story is one of rising convexity and on-going dislocation in the relationship between credit versus equities.

In their note, Deutsche Bank goes into more details on the on-going dislocations (linked for us, to the rise in "positive correlations" thanks to central banks "meddling"):

 "Euro STOXX 50 and iTraxx Europe prices dislocated
Uncertainty regarding Greece, ECB QE and core rates re-pricing have been the three major, and often conflicting, themes that have driven markets in 2015.
ECB QE, which should run until September 2016, is expected to provide long term support to risky assets (like equities, and credit spreads). The sharp move higher in core rates is seen as a more transient phenomenon with the most volatile periods likely behind us. Most market participants expect the Greek crisis to be contained and not lead to contagion like we saw in 2011. However, concern remains that material sell-offs can occur due to unexpected events in the saga, or due to policy missteps. 

Risk asset markets have not priced these factors in a consistent manner, especially in recent weeks. Figure 2 shows the evolution of the price of the Euro STOXX 50 (SX5E) equity index and the spread of the iTraxx Europe S23 CDS five-year index.

We also show equity and CDS index pricing at the time QE was announced. We see that the SX5E rallied 15% over its level at the time of QE announcement, and remains above that level in spite of the recent Greece-driven sell-off. iTraxx Europe S23, on the other hand, is now 8bp higher than before QE announcement. SX5E still remains buoyed by the QE effect, while iTraxx Europe seems to be discounting it.

Figure 3 and Figure 4 show the relationship in a different way. Figure 3 shows the beta of SX5E return to iTraxx Europe mark-to-market.

We see that the beta has steadily increased as risky asset markets have rallied over the past three years. This is to be expected. As markets rally, credit spreads get closer to their floor and so respond progressively less to bullish signals. Equities have no ceiling, and so can rise unabated. As a result, the equity-credit beta should rise over the course of a long rally. We see exactly that in Figure 3.

The beta links price changes between the two asset classes. Consequently, an increase in this beta in rising markets transforms into a convex relationship at the price level (Figure 4). The chart also shows that the iTraxx Europe S23 spread is too wide compared to SX5E, even after taking this convexity into account. In fact, the convex relationship shown in the chart implies that SX5E should be about 280pt (or ~8%) lower to price in line with its credit counterpart.

This observation is interesting but does not in itself mean that SX5E and iTraxx Europe S23 should re-price to fair levels over the next few weeks. However, it does give us confidence that SX5E will likely suffer more should markets selloff in the coming weeks – say due to unexpected events in Greece, or due to policy missteps (or miscommunication by policymakers), or if market participants begin to think that firewalls against contagion are inadequate.
Equity implied vol has already risen but not in a manner similar to what we saw in 2010-12 due to the formal mechanisms that have been constructed to minimize the danger of contagion. Given this background, investors see implied vol as already being quite high, and are considering strategies such as put spreads and ratios, and hybrid options to cheapen the cost of buying protection. Here, we utilise the richness of SX5E vs. iTraxx Europe to suggest a cheap hedging strategy." - source Deutsche Bank.

Of course, and always, regardless of the final melt up in asset prices, credit prices are indeed giving us clues for a stock market correction. And when it comes to credit and "Blue Monday", nothing last forever, particular when one takes into account the stellar performance of the asset class since 2009 and the fast rising leverage in the High Yield space, that warrants close monitoring we think which brings us to our the third point of our conversation.

• The credit channel clock is ticking for High Yield

As we posited in our May conversation "Cushing's syndrome", "overmedication" by central bankers have created an abnormally long credit cycle:

"What credit investors forget is that in a deflationary environment, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield. But, due to the "overmedication" thanks to our central bankers "market health" practitioners, the long credit cycle has indeed been extended into "overtime".
Investment Grade credit is a more interest rate volatility sensitive asset, High Yield is a more default sensitive asset. What warrant caution for both we think are, the risk of rising interest rates for the former as per our previous bullet point and the risk of rising default rates for the latter. For more on credit returns we suggest reading our March 2013 guest post from our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"

In terms of the credit channel clock ticking, the first quarter has recently shown that, indeed, when it comes to High Yield, it has been ticking much faster as indicated by Bank of America Merrill Lynch in their High Yield Credit Chartbook from the 2nd of July 2015 entitled "Stay tuned":

"June swoon
June came and brought with it setbacks for HY from all angles- geopolitical, fundamental and technical. Situation in the Eurozone deteriorated as a Greek deal proved elusive and trouble in Munis land brewed as Puerto Rico’s debt woes came to the fore once again. At the same time fundamentals in US HY continued on their negative trajectory with three more defaults pushing the US default rate to over 2% for the first time since 2013. These adverse changes prompted retail outflows, as we had envisioned and warned against, totaling $7bn in June. In what proved to be an unsurmountable climb for the asset class, HY spreads widened 50bps, and YTW jumped to 6.6%, most of the sell-off taking place in the last three days of the month alone as the cash cushion evaporated and pressure built up in the secondary to meet redemptions.
All asset classes we track declined; equity and rate volatility surged. Global equities took the worst hit in light of the negative news out of Europe, with EM equities returning -3.2% and SPX at -2.1%. EU HY took the next worst hit at -1.9%, while US HY returned -1.5%. Best performing asset classes, though still negative, were treasuries and mortgages. Within HY, belly of the curve outperformed the ends, as was also the case in IG. We have been recommending positioning in Bs, and believe the belly will continue to outperform in the 2H15. Stay tuned.

Tuning our HY earnings
HY market leverage increased dramatically in Q1 jumping 0.6 turns to 4.8x due to plunging EBITDAs, while coverage levels dropped. The main culprit being the Energy sector where EBITDAs declined by 130% YoY on an issuer-matched basis eroding $13bn in profits and sending leverages to new highs.

However, since most of these declines were a direct result of asset impairment charges, we found it necessary to tune HY earnings and strip out non-cash charges, in order to view the true trajectory of corporate health. In this month’s report, we introduce our Adjusted Leverage and Coverage metrics which we calculate using earnings adjusted forone-time items.
We find levels of leverage and coverage based on adjusted earnings to be markedly different compared to when using GAAP earnings. While headline HY leverage jumped from 4x to 4.7x over the last 2 quarters, adjusted leverage has increased only 0.3x from 3.5x to 3.8x. Similarly adjusted coverage shows a lesser decline (4.4x to 4.1x) vs 3.8x to 3.2x when using GAAP. Not only are the levels different but the pace of change of the two metrics has also diverged significantly since 2013.

This is because companies have consistently been reporting a net negative effect from on-time adjustments every quarter, amounting to 2%-4% of their cash earnings on an LTM basis. This disparity reached its peak in Q1, when a staggering 11% ($23bn) of LTM earnings were lost to non-cash charges. However, what hasn’t changed is that leverage is ticking up and has reached the unadjusted levels at the height of the last credit cycle. Adjusted coverage, while not as impacted mainly because of a conducive rates environment, too is heading in the wrong direction." - source Bank of America Merrill Lynch

What is of course of interest is that looking at the current default rate doesn't tell you much about the direction of High Yield, as aptly explained by our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"  in their very interesting previous note:

"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube

Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space. On that call we agree with Bank of America Merrill Lynch from their recent High Yield Wired note from the 29th of June entitled "Nothing last forever":

"HY market seems complacent about Greece risks
We have expressed concern over the last several weeks about the risk of the situation around Greece getting worse and the HY market’s reaction to such an event. In our view, most high yield investors seem complacent about events in Europe, instead concentrating on the low-yield, low-default environment as reason enough to continue to fund the asset class. In fact, many investors we have spoken with believe that Greece defaulting would be good for US high yield, as bunds collapse and treasury yields plummet towards 2% once again. We disagree; every time risk-free yields have fallen due to a flight to safety, HY has sold off meaningfully. In our view, this time will be no different. 

Issuance likely to increase over summer, as will HY spreads
After what has been a relatively slow June, we think issuance is likely to pick up this summer thanks to previously sidelined M&A transactions and more importantly, in anticipation of the Sep rate hike. The well-telegraphed nature of this hike and the absolute low level of current yields are likely to create a rush of deal volume.

Even outside of supply technicals, we have likely come close to a floor in spreads this year. Although it wouldn’t shock us to see OAS approach 430bp again, we think the trend will be higher. Investors are demanding a higher liquidity premium than in the past and with rates and geopolitical uncertainty on the rise and a backdrop of weak fundamentals, our anticipation is that we reach 500bp spreads before 400bp. 

Flows: US HY returns to inflows
US HY retail funds returned to inflows this week as optimism over Greece took hold in the earlier part of the week. US HY funds reported an inflow of +$790mn after posting two successive weeks of $2bn+ outflows. Non-US HY investors didn’t reflect the same level of optimism and pulled -$850mn from retail funds, putting the global total near zero. ETFs led the recovery within US HY with +$1.2bn of inflows. 

Issuance: moving along
DM high yield issuance was decent this week as 10 deals for a total of $5.5bn came to market. $4.5bn came from the US and $1.0bn came from Europe. Month-to-date, we have seen a total of $25.8bn come to market in June, while year-to-date we now stand at $215.6bn, about $10bn ahead of last year’s pace. Global loan issuance slowed down as $4.2bn was priced vs a strong $7.4 last week. Month-to-date, stand at $29.7bn while year-to-date we have seen a total of $141.5bn. Last year at this
time, we had already seen $233.2bn of new supply." - source Bank of America Merrill Lynch 

You can indeed expect additional "Blue Mondays" in the credit space, given we have been indeed moving into overtime in the credit cycle thanks to central banks' overmedication.

Also, as we mentioned earlier on in our conversation, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger.

In their High Yield note Bank of America Merrill Lynch confirms this risk to the downside for High Yield prices:

"Asymmetric credit returnsChart 4 shows that the relationship between spread levels and subsequent returns is negatively sloping. 

This isn’t all that surprising for seasoned credit investors. Over the last 3.5 years, when spreads were at or below the current level (442bp), HY has widened 56% of the time over the next three months. More importantly, the average spread widening in those scenarios was about 11% (~48bp at current spread), while the average tightening was in the 7% (~29bp) range in the 44% of the time that the market rallied. So that’s not only a slightly higher likelihood of widening than tightening, but the scale of the sell-off is also likelier to be larger than the scale of any rally. " - source Bank of America Merrill Lynch

With positive correlations on the rise and convexity effects, we indeed do expect significant price movements over the coming months given the spillover from bonds volatility in the credit space. As we posited in our May conversation "Cushing's syndrome" expect as well lower liquidity particularly during the supposedly "summer lull":

"One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. " - source Macronomics, Cushing's syndrome, May 2015.

This brings us to our fourth point in our credit note, namely that with the ongoing volatility in the bond space, VaR has finally taken its toll leading to significant outflows in government bond funds or when "balanced funds" are finally getting "unbalanced"

• Balanced funds getting "unbalanced"

As we indicated in our May conversation "Cushing's syndrome":

"The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.
The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking"." - source Macronomics, May 2015

Indeed, this rise in bond volatility has led to significant outflows in government bond funds as indicated by Bank of America Merrill Lynch's Follow the Flow note from the 3rd of July 2015 entitled "Not so safe assets":

" $3bn of government bond outflows
High grade credit flows moved back to positive during the last week, although only marginally ($65mn inflow). High yield on the other hand continued with the outflow trend at -$716mn, the fourth week of outflows in a row.
But the largest withdrawal was from government bond funds, where outflows were the highest ever last week at -$2.85bn.

The shock from the Greek referendum announcement pushed sovereign yields higher, adding more pressure to an already tense outlook. During the last five weeks, outflows from government bond funds have totalled $8.5bn. Money market funds also felt the heat of the Greek story: last week’s outflows were -$20bn, the highest this year.
The only significant inflow was recorded in equities, where inflows were $1.5bn, mainly from ETF funds. This brings the year-to-date inflow to $67bn, which is already the highest yearly inflow into European equity funds on record. " - source Bank of America Merrill Lynch

 This is indeed a materialization of the risk we discussed back in May when it comes to "Balanced funds":

"In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out." - source Macronomics, May 2015

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle.The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are indeed facing an uphill struggle in maintaining their stellar records in this environment. And if indeed, cash is currently king, particularly in US dollar terms in the ongoing "Blue Monday" markets, you will indeed have interest in our final note for this week's conversation.

• Final note: Cash holdings as a % of AUM is at the lowest since 2008

We read with great interest Citi's recent Globaliser Chartpack from the 29th of October. In terms of complacency, we find of great interest that the cash level in % of AUM dropped to 4.3%, which is indeed the lowest point since 2008, indicating that when it comes to equities, investors are indeed piling much more in equities, giving more ammunition to the "Great Rotation" crowd:

"Citi’s June poll: what do US investors think?

Our June poll results suggest the investment community seems fairly upbeat, with the current weighted average year-end S&P 500 objective of 2,177; 2015 earnings are expected to climb 4.5% on the Buy Side

‘The results of a late June poll suggest that investment community seems fairly upbeat’, declares US Strategist Tobias Levkovich, ‘and while investors have not shifted their expected year-end target for the S&P 500 much in the past two surveys, with a current weighted average objective of 2,177, more now anticipate a higher chance of a 20% rally vs a 20% pullback. The more striking result was the decline in cash holdings as a % of AUM. On average, the cash proportion dropped to 4.3%, the lowest figure we’ve seen since we began asking this specific question in 2008, indicating that money has been put to work, with 80% saying that they would allocate more funds to equities. Europe and Japan still lead the US as most favored equity markets for outperformance in 2015. Earnings are expected to climb 4.5% on the Buy Side for 2015, a tad below Citi’s 5.6% forecast, but still above the bottom-up and top-down Street consensus. Investors expect a Fed rate hike in 3Q15, underscoring a growing consensus around a September move’." - source CITI

Are investors suffering yet again from "Optimism bias"? We wonder...

"Hindsight bias makes surprises vanish." - Daniel Kahneman, psychologist

Stay tuned! 

Credit - While My Guitar Gently Weeps

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." - Mark Twain

Looking with interest at the latest surge in the US 10 year yield to 1.94% in conjunction with the "improved" employment picture in the US as well as the fall to record low level of 1986 for the Baltic Dry index to 559, we remembered one of our favorite song from the Beatles "While My Guitar Gently Weeps" recorded in 1968 for our title analogy. "While My Guitar Gently Weeps" was ranked no. 136 on Rolling Stone '​s list of "The 500 Greatest Songs of All Time", no. 7 on their list of the 100 Greatest Guitar Songs of All Time, and no. 10 on their list of The Beatles 100 Greatest Songs.

As far as the above Mark Twain quote goes, it's indeed what we know for sure when it comes to global economic growth which is of concern to us, regardless of the supposedly "deflation escape velocity" reached by the US economy and its latest Nonfarm Payroll figures. We still sit tightly in the deflationary camp for the time being and remain extremely cautious about the risk posed by the velocity in the rise of the US dollar.

The Baltic Dry Index indicative that all is not good in global economic growth - graph source Bloomberg:

"Baltic Dry Index down to levels not seen since 1986" - source Bloomberg

You might therefore be wondering why we have used such a title as an analogy. Georges Harrison's musical masterpiece had an initial incantation, which we think, resonates well with the current investment environment and global central banks meddling in asset prices:

"I look at the trouble and see that it's raging,
While my guitar gently weeps.
As I'm sitting here, doing nothing but ageing,
Still, my guitar gently weeps."

There was as well an unused line in the very beginning of his initial writing which was eventually omitted:

"The problems you sow, are the troubles you're reaping,
Still, my guitar gently weeps."

And when it comes to QE and Central Banks, an early acoustic guitar and organ demo of the famous song had a slightly different third verse which we find interesting for the sake of our analogy with our central banks "money" games:

"I look from the wings at the play you are staging,
While my guitar gently weeps.
As I'm sitting here, doing nothing but ageing,
Still, my guitar gently weeps."

In 2004, Harrison was inducted posthumously into the Rock and Roll Hall of Fame as a solo artist. "While My Guitar Gently Weeps" was played in tribute by Tom Petty, Jeff Lynne, Steve Winwood, Steve Ferrone, Marc Mann, and Dhani Harrison, and concluding with arguably one of the most  memorable guitar solo by fellow inductee Prince but we ramble again.

In this conversation we will re-assess current trends and "rotations" and "look at the trouble" to see if it is indeed "raging" while our guitar gently weeps as well as musing around the impact QE has had in Europe so far.

Synopsis:

• Lower expected returns and higher expected volatility
• "Great rotation" not from bonds to equities but, from US equities to European equities in early 2015
• European equities lift-off akin to the move seen on the Nikkei  (hedged) in 2013but with less firepower!
• Rising divergence between volatility and credit spreads in Europe

• Lower expected returns and higher expected volatility

When it comes to the outlook for returns, we agree with Nomura's latest Strategic Outlook note from the 6th of February 2015, namely that we are going to see lower expected returns and higher expected volatility. We also share their concern on the US economy. We think it is more fragile than currently assumed:

"A common view is that the US economy is in good shape – effectively immobile against a stronger USD or lower energy prices or low productivity. With most of the rest of the world (ex Brazil) loosening monetary conditions (FX and rates) another view is emerging that EM growth will recover. And the ECB’s QE announcement should, it is argued, hedge downside inflation and hence growth risks in the euro area. These views rest squarely on the assumption that the US will not and never has slowed down from above trend growth without the intervention of the Fed via tight monetary policy. In contrast we see increasing evidence that the US profit cycle is in fact maturing rapidly and that profit growth is likely to disappoint through H1. If this is the case then slower capex and employment follow – regardless of the Fed. This would constitute a major surprise to global forecasts that are more clustered than they have been since 2007.

Given the starting point for inflation this scenario would generate further upside pressure on real yields across the curve. How risk aversion would respond is critical to predicting the outcomes for returns. By contrast the bullish growth scenario would, we think, lead to a rapid repricing of Fed hikes back toward June given the stage of the US cycle. Our unpalatable strategic conclusions are that growth estimates for H2 will probably need to come down, that real yields or nominal yields are going back up under most scenarios, and that risk aversion will continue to trend higher." - source Nomura

While we have taken the proverbial "beating" on our ETF ZROZ long duration exposure losing 7% since the 30th of January, we are sticking with our position, given our lower entry level in the trade (we have also exposure to a long term macro short term trade offsetting the short term pain via ETF YCS, being short JPY for disclosing purposes...). The recent widening in US Treasuries make a good entry point for those who missed out, we indeed, expect, the data in the US, from a contrarian perspective to be weaker than previously expected, regardless of the most recent NFP.

On that specific point we would like to point out to Reorient Group's latest note on a US premature rate hike from the 8th of February 2015:

"Individual components of the employment report are at odds with other data. One of the fastest-growing components of employment, for example, was construction, with total head-counts up 5.5% year-on-year as of January. Construction spending adjusted for the construction Producer Price Index was flat year-on-year. Either the spending numbers were wrong (but unlikely because construction activity is easily counted) or the employment numbers are suspect."

 - source Reorient Group

We agree with the above, that all is not what it seems and it demands a more inquisitive mind when it comes to taking the data at "face value".

• "Great rotation not from bonds to equities but, from US equities to European equities in early 2015

From an allocation point of view, what we find of great interest has been the continued inflows into the bond sphere (59 straight weeks of inflows to Investment grade bond funds with $8.7bn) as indicated by Bank of America Merrill Lynch's Follow the Flow note from the 5th of February entitled "The Bond Capitulation":

"On Flows and Markets
Bond is Back: massive inflows to bond funds ($21bn – 7th largest weekly inflow on record – Chart 1); outflows from equity funds ($7bn).

Gold is Back: largest 3-week inflows ($3.8bn) to precious metals funds since
Aug’11 (Chart 2).

Europe is Back: 4th consecutive week of equity inflows to Europe (Chart 5); contrasts with outflows from US/EM/Japan.

EM Debt is Back (at least for a week): 1st inflows in 9 weeks to EM debt funds ($0.9bn).
Risk Resilience: best explained by ECB & Sentiment (risk has rallied since BAML Bull and Bear Index flashed "buy" on Jan 7th…US HY 1.8%, SPX 3.0%, ACWI 5.4%, WTI 5.5%, SX5E 9.1% (all $-terms).
Risk Resilience: note also significant weekly inflows to bonds and/or gold in past 15 years (i.e. moments of “fear”) have unsurprisingly proved decent entry points into stocks (Chart 4).

- source Bank of America Merrill Lynch

In relation to Bank of America Merrill Lynch and its "Great Rotation" story, it seems that, courtesy of the ECB unleashing a QE of its own, the great rotation has clearly been from US equities into European equities it seems with $4.3bn of inflows for a 4 straight week, whereas the US saw $9.9bn of outflows for a 5 straight week. European assets seems to be a large beneficiary from the ECB's promises to deliver a QE of its own as indicated once more by Bank of America Merrill Lynch's Follow the Flow note from the 6th of February 2015 entitled "Income mania":

"Biggest inflows ever into European assets
Fund flows highlight the chronic shortage of yield in Europe. Last week saw the greatest ever total inflow into European assets (chart 2). 

The reach for yield was in full effect across high-grade and high-yield credit, government bonds, money market funds, equities and commodity funds, according to EPFR. In terms of notable trends:
• Money-market inflows were the 4th highest ever.
• European equity inflows were the 6th biggest ever.
• Inflows into government bond funds were the 3rd largest ever.
• Inflows into all fixed-income funds were the 2nd biggest ever.
• High-grade credit flows were the 8th largest, since data began.
All in all, aggregate risk-on flows in to European assets were huge: almost $40bn!" - source Bank of America Merrill Lynch

At the same time and on a monthly basis, the S and P 500 saw during the month of January $28bn of outflows and equating to 15% of AUM according to Morgan Stanley. In fact, the biggest monthly outflow ever:

- graph source Bloomberg / Morgan Stanley


Also, investors continue to pile into the yield trade as the search for income runs unabated.

For instance IYR (REITS) had its largest daily inflow ever on the 2nd of February ($900 mln or 12% of AUM) according to Morgan Stanley:

- graph source Bloomberg / Morgan Stanley

We believe the great rotation story in 2015 currently playing out is indeed from US equities towards European equities for the time being and we agree with the following comments from Morgan Stanley:

• "US investors are loaded up on US risk:  50% of the entire industry ETF flows since 2009 has gone into US equities ($300 bln).
• The peak in global growth might very well have come in Q1 (US printed 5% GDP in Q3 and Q4 GDP came in 2.6% below the 3% consensus forecast).  Now we have a strong dollar and we are starting to see countries implementing policy stimulus to close the gap in growth." - source Morgan Stanley

So indeed while our guitar is gently weeping, US risk is indeed much less appealing than European risk (Grexit avoided of course...).

Therefore, when it comes to allocation to European equities it is definitely on the "menu du jour" as displayed in Louis Capital Markets Cross Asset Weekly report from the 2nd of January:

"Run Forrest!
No client meeting we have conducted has passed without a question on the relative performance of European equities compared to US equities being posed. European investors are well loaded with European equities as they suffer the classic “home bias”, well known in academic literature. US investors are similarly biased, but the letters Q and E, that recently reared their head in Europe, have broadened their investment universe and a flow of money has poured into European equities. The US ETFs that hedge the currency impact have benefited strongly from this trend as we show in the chart below.

This re-balancing has happened in a context where Wall Street has started to show some signs of weaknesses. We have recently discussed this hypothesis and it seems that US indices have lost their upward momentum (at least, in the short term).
The reversal of the profit trend could be the reason for this weakness. Or perhaps this is simply a profit taking phase, because as we all know these are a regular occurrence in equity markets.
Sarcasm aside, the fact that European equities recorded new highs in this less than favourable context is therefore heroic, because on the profit side there is absolutely nothing new. The charts below illustrate this. We can understand that the impact of the EUR/USD is positive for European companies and negative for US companies, but in the earnings forecasts of analysts there is no change. 

The 2015 EPS of the Eurostoxx50 has been revised down by 2.2% for the sole month of January. 

Although we share the consensual view that the decline of the EUR/USD will support profits of the European index later this year, this 2.2% negative revision is a reminder that on an index level the macroeconomic developments that appear obvious to many investors are not so straightforward when it matters due to its composition/structure.

By sector, the message is consistent with the “currency advantage” as consumer stocks that are quite global have done better than more domestic sectors like utilities or financials. The telecoms sector, with its very strong performance, is the exception in Europe.
However, the difference in performance between the Eurostoxx and the S&P500 since the beginning of the year is broad based and not related to a specific sector. The underperformance of US financials compared to European financials sends a key message here: this is not only a matter of exchange rates.

The herd mentality is strong on equity markets with this run against time to chase European equities that keep a potential for a catch-up if we look at prices. If we look at valuation (without discussing the impact of possible different profit cycles and different profit trend growth) the potential for a catch-up is exhausted. We have updated our table on the valuation of the MSCI EMU if we apply to it the sector composition of the US index. Here, we find a mere 2.2% discount in terms of forward PER.

Last week we started mentioning the valuation aspect of the Europe/US question. To be clear, we stress that profits have to improve significantly to think that European indices can outperform on a sustainable basis its US peers." - source Louis Capital Markets

• European equities lift-off akin to the move seen on the Nikkei  (hedged) in 2013but with less firepower!

This European lift-off in equities hedged is akin to the move seen in 2013 on the Nikkei hedged complex which provided solid performances for "wise" investors. (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro). We have repeatedly highlighted the weakness in aggregate demand in the Eurozone. We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions. Unless there is a significant sustained improvement in credit conditions in Europe, we don't think Europe can deliver more stellar returns than Japan did in 2013 while our guitar gently weeps.

• Rising divergence between volatility and credit spreads in Europe

From an equity to credit perspective, one of the major impact from the ECB's QE has been the rising divergence between Eurostoxx 50 Put/Volatility versus Credit Spreads. This has been for us quite logical for Investment Grade, less so for High Yield. According to Goldman Sachs the spread between Out of the Money Put options on the Eurostoxx 50 and CDS spreads is at its highest level since 2010, and the yield that can be obtained by selling 70% put on the Eurostoxx 50 is 3 times higher than the Itraxx Main Europe CDS 5 year index (Investment Grade proxy for risk with 125 entities):

- source Goldman Sachs

Furthermore, as we indicated in our conversation relating to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid..."), it is all about Stocks versus Flows:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

This major difference can already be seen, we think from the behavior of credit versus equities as discussed by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 6th of February entitled "Catch the basis if you can":

"Central Banks liquidity primarily provides a strong back-stop against funding risks; rather than support earnings, which usually come further down the line. When the Fed announced the first QE program, credit spreads outperformed equities.

On the flip side, the ECB QE announcement has not ignited the same response. This time around credit lagged equities.

One could argue that European credit spreads are already close to the tightest levels in years, and thus should lag post an ECB QE announcement, especially when growth outlook is coming off the lows. At the end of the day the ECB QE is meant to boost growth rather than to reduce funding/default risks, and equity markets have started pricing that.

However, we expected Crossover to follow suit on the strong reaction from equity markets, being a growth proxy in the credit market. We were expecting Main to underperform Crossover in a QE event, also reflecting the same strong growth potential the equity markets are pricing.
However, XO has lagged the risk on move tighter. We think that this was not driven by the lack of yield in credit markets – as government bond yields have continued to rally – but mainly due to the rise of geopolitical risks and the resurfacing of funding risks." - source Bank of America Merrill Lynch

End of the day, it doesn't matter that European stocks have been racing ahead of fundamentals, from a "quality" and "japanification" perspective, it is still a goldilocks period for Investment Grade credit, particularly in a shift towards a new regime of higher volatility.

On a final note we leave you with Nomura's forecast of stock of assets purchased by central banks as a % of national GDP from their Economics Insights note of the 28th of January 2015 entitled "Comparing ECB QE with BOJ, Fed and BOE programmes:

"• BOJ holdings of JGBs are expected to increase from the equivalent of around 40% of Japanese GDP at the end of 2014 to around 60% of GDP by the end of this year. This compares with “only” 14% of GDP in the case of the Fed and just over 20% of GDP for the BoE.
• ECB purchases of sovereign bonds (just over €40bn a month, allocated according to the capital key) will be equivalent to around 4% of GDP by end-2015. These will have grown to about 7.5% of GDP by end-September 2016 (or around 13% of the total stock or 17% of the targeted stock; the latter referring to the maturity parameters of a remaining maturity of 2 years and a maximum remaining maturity of 30 years at the time of purchase).
• Only the Fed has engaged in macroeconomically significant (measured as a share of GDP) purchases of assets other than Treasuries, buying the equivalent of 10% of US GDP of Agency MBS. We estimate the ECB will maintain private sector asset purchases at around €10bn a month, resulting in purchases equivalent to just 1% of GDP by the end of this year and reaching 2% of GDP by the end of September 2016.
• In conclusion, if one believes in the effectiveness of QE (we don’t), then size probably matters. In this context, there are two considerations: (i) the increase in the stock of purchases is going to be gradual, which implies it is going to take some time for the cumulated size to become meaningful, and (ii) the cumulated expected size of the programme by the end of this year will still be only a third of the size of the Fed and BoE programmes, suggesting that, if you believe in the effectiveness of QE, the ECB’s programme will need to grow much more significantly before it has a macroeconomic impact." - source Nomura

 “It's not the size of the dog in the fight, it's the size of the fight in the dog.” - Mark Twain

Stay tuned!