Macro and Credit - Alprazolam

"Anxiety does not empty tomorrow of its sorrows, but only empties today of its strength." - Charles Spurgeon British clergyman

Watching with interest the historical defeat of Prime Minister Theresa May relating to Brexit, in conjunction with the Chinese central bank injecting a net 560 billion yuan ($83 billion) into the Chinese banking system, the highest ever recorded for a single day given the weakening tone of the economy, when it came to selecting our title analogy we decided to go for a medical reference to "Alprazolam". "Alprazolam", also the trade name for Xanax among others, is the most commonly used benzodiazepine in short term management of anxiety disorders, specifically panic disorder or generalized anxiety disorder. It seems to us that the Chinese authorities have decided to act decisively on the very weak tone taken on their economy and the slowdown in global trade and its impact. Due to concern about "misuse", some strategists like us would not recommend "Aprazolam" as an initial treatment for panic disorder such as the MSCI China index down 23% over the past year. With the University of Michigan’s consumer confidence index falling to a more than two-year low of 90.7 in January, down from 98.3 in December, and well below expectations of 97.5, we wonder if our quote above is correct in asserting that anxiety does indeed empties today of its strength, namely consumer confidence. After all, clinical studies have shown that the effectiveness of Alprazolam is limited to 4 months for anxiety disorders but we ramble again...

In this week's conversation, we would like to look at the rising cost of attrition on the global economy, with the continuation of the stalemate in Brexit, US vs China trade/tech war, yellow jackets in France and of course the government shutdown in the United States. While Alprazolam has brought some solace to the December angst for investors, it remains to be seen how long the effect will last on the recovering "patients".

Synopsis:

• Macro and Credit - Does A for attrition equate R for recession?
• Final charts -  Mind the liquidity shock...

• Macro and Credit - Does A for attrition equate R for recession?

As we indicated in our previous conversations, "Bad News" has been the new "Good News" at least for asset prices in general and high beta in particular, the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture. 

We indicated more downside risk at least from a European perspective and we continue to have a very negative view on France given the continuation of the unrest and the "yellow jackets" movement not giving any respite to president Macron. 

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

In the AFTE latest survey, there is now a clear trend in the deterioration in their operating cash situation showing up:

- source AFTE

The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average).

On this "attrition" subject we read with interest Bank of America Merrill Lynch's take from their Cause and Effect note from the 18th of January entitled "Investing in the age of the attrition game":

"Attrition bites in Europe

The “yellow vest” protest in France, which has resulted in the “worst riots since 1968” is now its 9th week. Not only it has shown no sign of ending, the number of demonstrators rebounded sharply over the past two weeks (Chart 6).

What began as a protest against fuel hikes has morphed into a broader movement of discontent with the government. President Macron has so far has refused to restore the wealth tax, one of the key demands of the protesters. This could turn into another war of attrition, especially with the fast approach of the EU parliamentary elections (May 23-26). French consumer confidence has tumbled sharply and is approaching levels reached during the Eurozone crisis (Chart 7).

The slowdown within the Eurozone is spreading. Both Italy and Germany are already in a recession (“the “R” club is recruiting”, January 11). For Italy, despite the passage of the 2019 budget bill, our European economics team has observed that the busy electoral calendar and decrees (not least those implementing pension reform and an income support scheme) could challenge the current ruling majority in the first half of the year. In Spain, a new far right party is emerging and the government lacks parliamentary support to pass a 2019 budget. The latest manufacturing PMI surveys show that new orders for Germany, France, Italy and Spain, the four largest economies in the Eurozone, were all below 50 (contractionary) in December, the first time in four years (Chart 8).

In our view, the greatest risk facing Europe is that the slowing economy fuels further populist discontent, creating a vicious circle." - source Bank of America Merrill Lynch

The numerous "attrition wars" being fought on a global scale are indeed clear headwinds regardless of the latest injection of "Alprazolam". As we indicated in our previous conversation "Respite",

"As we stated in various conversations including our last, we tend to behave like any good behavioral psychologist in the sense that we would rather focus on the flows than on the stock. On that note we continue to monitor very closely fund flows when it comes to the validation of the recent "Respite" seen in the market and it is not a case of confirmation bias from our side. 

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian". 

A flattening curve in our book is not positive for banks and cyclicals such as housing and autos have already turned.  Also as briefly pointed out, a sustained shutdown is likely to be another drag on US growth which will therefore push the Fed's hand further into "dovish" territory". In that context, and if inflows return into credit markets, then high beta credit as well as Investment Grade could continue to thrive in the near term given Fed Chair Powell indicated in the latest FOMC minutes a willingness to be patient with future rate hikes. 4Q US GDP might disappoint we think." - source Macronomics, January 2019

We also discussed in our conversation the importance of the return of "macro" and the need to "monitor" fund flows for any signs of stabilization in "credit markets" as well as the need to track oil prices relative to US High Yield given its exposure.

Flow wise, Bank of America Merrill Lynch in their Follow The Flow note from the 18th of January entitled "Just a bounce?" question the most recent positive tone in financial markets given the weakening mood coming out from the macro data:

"Light positioning and known-unknowns

This year started on a positive note. Despite further weakness on the macroeconomic data front across the globe (more here), risk assets have staged a strong bounce higher. This is not because everything is in the price and we already know that macro is slowing and that the synchronised recovery has turned to a synchronized slowdown. It is the fact that positioning has been very light at the end of last year and thus cash balances have been put to work in January. With slower primary and tighter spreads last week it feels that the outflow trend is slowing down. However we are skeptical for how long markets can keep ignoring the continuing deterioration in macro. We feel this rally will not last, and thus we would use this bounce higher to reduce risk.

Over the past week…

High grade funds suffered another outflow, making this the 23rd week of outflows over the past 24 weeks. However, this week’s outflow is the smallest observed over that period. High yield funds recorded another outflow, the 16th in a row, but also the smallest in a while. Looking into the domicile breakdown, Globally-focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Actually Europe-focused funds have recorded small inflow, the first in 15wks.

Government bond funds recorded a small outflow this week. Meanwhile, Money Market funds recorded an outflow as risk assets moved higher. All in all, Fixed Income funds recorded an inflow, the second in a row.

European equity funds recorded another outflow this week, the 19th consecutive one. During the past 45 weeks, equity funds experienced 44 weeks of outflows.

Global EM debt funds continued to record inflows, the second weekly one. This confirms the improving trend observed recently as a dovish Fed has weakened the dollar. Commodity funds recorded another (albeit marginal) inflow, the 6th in a row.

On the duration front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while long-term funds experienced a decent inflow, continuing the recent trend of strength on the back-end of the curve." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch that, the significant rally in high beta should entice you to become more "defensive" and favor "quality" (rating) over "quantity" (yield). In the ongoing attrition game, it is more a question of capital preservation than capital appreciation we think.

Moving back to the "attrition game" and Bank of America Merrill Lynch's note from their Cause and Effect from the 18th of January entitled "Investing in the age of the attrition game", regardless of the positive liquidity injection from the PBOC and dovish tilt of the Fed, earnings as well are slowing down and there is more risk to US consumer confidence with the shutdown:

"Shutdown raises trade war risk

What does a destabilizing gridlock in Washington mean for the US-China trade war? Given the peril of fighting two battles at the same time, it seems reasonable to assume that the incentive for Trump to close a deal with China sooner than later has gone up. The fact that he has been talking up the prospect of a deal with China in recent weeks (“I think we’re going to be able to do a deal with China,” January 14) is consistent with this hypothesis. The market has taken these upbeat remarks at face value and has been driving up EM assets, the main casualties of the US-China trade war last year.

However, it takes two to tango. Trump’s loss of full control of Congress may be viewed by Beijing as justifying a less conciliatory stance. With the shutdown in Washington and growing expectations that the Mueller report will be out soon, Beijing may decide that it is not in a hurry to close a deal. Trump set a precedent by agreeing to a 3-month extension for the next round of US tariff. Beijing might think that the Americans could be forced into giving another extension if there is no deal by March 1.

The recent US slowdown could be giving China another reason to wait. Despite the reductions in reserve requirements to decade lows (Chart 3), Chinese credit growth has so far shown no signs of picking up (Chart 4).

Beijing might have eased monetary policy even more aggressively last year if it weren’t for the fact that rate hikes by the Fed was pushing down the renminbi (Chart 5).

A much weaker renminbi might have further complicated the US-China negotiation. The fact that the Washington shutdown is increasing the chance of a Fed pause, giving China a wider window to ease policy, could also reduce the urgency for Beijing to close a deal with Trump." - source Bank of America Merrill Lynch

Unless there is a rapid resolution between the United States and China on the trade/tech war narrative which has led to a significant rally in Emerging Markets so far this year on the back of a weaker US dollar, then indeed there is a high probability that the effect of the "Alprazolam" will fade and the bounce experienced so far could end rapidly and abruptly.

Bank of America Merrill Lynch added the following in their report:

"Market implications

Developments over the past two months suggest to us that political risks are rising.
This puts us at odds with current market consensus.

The contrast between our views and those of consensus is giving us confidence in our investment thesis for 2019:

The USD is vulnerable. We view the escalation of the gridlock risk in Washington as posing the greatest risk to the decoupling trade and to the USD. We are soon approaching a key support level that, if broken, will usher in further USD weakness (USD topped and target reached, but is this it? January 16). We like selling the USD especially against the JPY and the CHF. The EUR has been unable to capitalize on the USD’s retracement this year, reflecting concerns about the growth outlook for the Eurozone. If Eurozone political tension continues unabated, we may have to revisit our bullish EUR/USD forecasts.

EM rally won’t last forever. EM is rallying on Trump’s upbeat comments on the prospect of a trade deal with China. We think the risk of a no deal by March 1 is higher than expected. We also think that the inability of the EUR to gain against the USD will limit the room for further gains in commodity prices and EM. We think EM investors should not wait too long before taking some money off the table. We continue to believe that in 2019 investors need to think strategically but act tactically.

US rates vol looks cheap. Rates vol has fallen sharply year-to-date as risky assets stabilized (Chart 9).

We see the sell-off as possibly overdone given the binary nature of the political risks we highlighted in this report and the increasingly binary decision the Fed is facing. The worsening supply-demand dynamics as we head into possibly debt ceiling crisis #2 will likely provide strong support to rates vol." - source Bank of America Merrill Lynch

Any spike in rates volatility would obviously be negative for asset prices given carry players, risk-parity investors and other pundits love one thing, and that's low rates volatility. Any return of volatility on the aforementioned would definitely trigger another bout in "risk-off" rest assured.

How convinced are we with the strong rally seen so far from the December "oversold" situation? Not very much, we would argue. Sure, we have seen a welcome respite with the central banking cavalry arriving late, once again to an already damaged macro situation. Given the amount of known "unknowns" and the weaker tone in the overall macro picture, yes bad news are good news again for asset prices, but, we do think that buying some protection to the downside with potential bouts of volatility is a wise move.

Remember 2018 has marked the return of "cash" in your allocation toolbox and it should be used more extensively in 2019 given the risk for even more volatility events than in 2018. Bank of America Merrill Lynch in their High Yield Strategy note from the 18th of January entitled "When Cash Becomes King" makes some compelling arguments about the current tactical rally we are seeing:

"Low-risk yields appear compelling in this macro setup

The rally in leveraged credit has taken a pause in recent sessions, with our DM USD HY index oscillating around 450bps, more or less where it stood a week ago. The same could be said of rates as well, where the 10yr remained range-bound over the past week, spending most of its time around 2.70-2.75%. Even equities exhibited low volatility, by recent standards, with S&P500 moving 10-20pts in most sessions, a sea-change from 80-100pt sessions around year-end.

So, can this be considered an all-clear signal? Perhaps. It undoubtedly adds one reason to think so, although it is hard to make it sound convincing in and of itself. We prefer to rely on more tangible events, something that would not be forgotten tomorrow if volatility were to return.

Among such new developments, we counted the following:

• China: has responded strongly to apparent signs of weakness in its economy by cutting bank reserve requirements, policy rates, and business taxes. The extent of cuts in reserve requirements now exceeds those witnessed in 2008 and 2015. Business taxes were cut to the tune of $30bn/year; for some perspective US corporate tax cuts of 2017 amounted to $600bn/10yrs, or $60bn/yr for an economy that is 1.5x larger. In other words, very meaningful policy actions out of China.
• Earnings: banks opened the reporting season with a bang despite notable shortfalls in FICC results; their other businesses appeared to be doing well. Tax-reform bump is likely to begin coming out of numbers only next quarter, and will potentially reach its peak in Q2-Q3 of 2019. So US earnings could stay artificially elevated for a couple more quarters, in our view.
• Sectors: financials led, while utilities and staples trailed in the whole S&P500 round-trip between Dec 14-Jan 15. The argument goes that financials underperform and defensives outperform into a downturn. And yet the fact that utilities underperformed through a potential PCG bankruptcy does not help the case of this not being a cyclical turn.

On the other side of the ledger, the following reasons support continued caution:

• China: would probably not be throwing this much stimulus if its economy was performing in an acceptable way. The leadership there must know something we don’t know, in our view.
• Earnings: our model for US EPS has experienced further deceleration in recent weeks, and points to +6% growth over the next year. While this is not a level consistent with a cyclical downturn, we note that earnings went from 20%+ actual yoy growth rate in Q3, to earlier estimates around +10-12% to +6% today (Figure 1). So the trajectory and the remaining cushion are a concern.

• Wide IG: with spreads elevated in the IG space, HY looks tight. BBs offer only 100bps premium over BBBs (Figure 2). While not unheard of, we think this is too tight in today’s market environment given the shift in risk sentiment that has occurred over the past several months. Historical relationship between BBBs and BBs implies the latter should be 60bps wider given where the former is, ex PCG.

• Illiquidity gap: while liquid bonds have rallied and retraced a good chunk of Dec losses, illiquid paper remains marked at discounted levels (Figure 3 and Figure 4). This behavior is inconsistent with a sustainable turn in market sentiment, i.e. investors must become comfortable bidding for illiquid stuff to demonstrate their conviction. Buying HYG does not cut it.

• High dispersion: only 1/4 of all HY bonds trade within +/-100bps of overall index level; under normal circumstances, 40-50% of them trade this way. High degree of dispersion could be a function of illiquidity gap described above. Regardless of its origin, dispersion tends to increase (percent trading at index levels drops) at times of market downturns. The current levels of dispersion are consistent with 500- 525bps HY spreads and 1,300-1,400bps CCC spreads.
• Default estimates: With most factors now fully refreshed with Dec levels, the model continues to point towards 5.5% issuer-weighted and 4.25% par-weighted default rates. Such credit losses, if materialized, imply meaningful pickup over realized levels (2.8%) and point towards wider HY spreads (500bp as a risk-neutral level).

While these data points are not yet known, and could change our thinking as they come in, we remain mindful of a scenario where this episode eventually proves itself to be a cyclical turn. As such, we find current HY valuations to be somewhat out of balance, in terms of likely ranges going forward, i.e. we think probability is higher to see spreads in high-500s rather than low-300s; these two are otherwise equal distance away from here. Given this view, we are reducing our model portfolio beta to a modest underweight at this point, which we intend to move towards a more substantial underweight if  spreads continue to grind tighter from current levels.

Think about what you believe are reasonable return expectations from here, and compare them to low-risk alternatives: Libor is at 2.75%, short-duration IG is at 3.70% yield, and short duration BBs are at 5.20%.

In the environment where the next few months carry a reasonable chance of marking the turning point in this credit cycle, we find such yields increasingly attractive. Even if the cycle overcomes all obstacles and rolls on, you can blend-average the above into 3.5-4% portfolio, with a strong likelihood of actually realizing this return, in our view.

So we are probably entering a period of time when cash is becoming king again. HY may end up showing bouts of strong performance during this time, just as it did in early January, and we remain open-minded to tactically shifting our views when opportunities present themselves. We just struggle to see how it could happen from 450bps overall index levels or from 100bps BBs-BBBs differential." - source Bank of America Merrill Lynch

Being underweight high beta is we think indeed a good recommendation at this stage. Stay nimble and get tactical. Buying HYG might not cut it for Bank of America Merrill Lynch from a "liquidity" perspective, but, from our side and as a useful "macro" defensive tool for credit exposure "hedging", we believe synthetic exposure through credit indices such as Itraxx Main Europe 5 year and CDX IG for the lucky few of you benefiting from an ISDA agreement provide sufficient liquidity to sidestep any Investment Grade liquidity concerns. The US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks as a reminder. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to more turmoil with "European" banks, though we do not expect Mario Draghi to rock the ECB boat before his departure and it is highly likely the ECB will provide additional LTRO funding to the ailing banks in the European banking system, some more "Alprazolam", one would opine.

On that note, if indeed we are back into a "macro" world when it comes to "trading" then, using the rights "macro" instruments such as synthetic credit indices and options on credit indices might provide mitigation to heightened volatility over the course of 2019 and sufficient liquidity if indeed there is a "liquidity shock" when the "Alprazolam" effect will truly fade.

• Final charts -  Mind the liquidity shock...

While as we pointed out like many pundits that "liquidity" is a concern given how credit markets have swollen in recent years thanks to buybacks supported by very large issuance levels, then looking at the CDS market as a proxy for risk ahead is again warranted as pointed out by Bank of America Merrill Lynch in their Credit Derivatives note from the 16th of January entitled "The basis for a correction" with the below chart pointing out to the underperformance of bonds relative to the CDS market:

"Macro data continue to disappoint; we remain cautious

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to the year for risk assets, we think that volatility will remain a key theme for another year. Large swings and lack of clarity underpin our bearish stance on spreads and beta in the following months; we continue to advise a defensive positioning. The deterioration in macro indicators will keep market sentiment fragile, in our view.

It feels like 2015-16

2018 is likely to be remembered as the worst year since the 2008 crisis. Performance was poor and funds suffered outflows. The performance over the past 12 months resembles that of 2015-16. However, this year started on a much more upbeat note than. 2016. Nonetheless, we are concerned that several factors are reminiscent of the drivers that pushed spreads wider in January and the early part of February 2016. A macro slowdown, lack of inflation in Europe and tightening conditions that risk assets were dealing with back then are still adversely affecting markets.

Gap risks and basis

We also think that CDS is too tight to cash bond spreads and negative basis is supportive for more downside risk in the synthetics space. The “gap” wider risk for the CDS market makes us less comfortable at current levels and, as we see fewer catalysts to reverse this market weakness we would use the recent move tighter as reason to reset shorts, especially by selling receivers to own payers. We also screen for negative basis opportunities.

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to this year, we think that volatility will remain a key theme in 2019 too. Large swings and lack of clarity underpin our stance to remain bearish spreads and beta in the coming months; we continue to advocate defensive positioning. We expect the deterioration of macro indicators to keep markets sentiment fragile, and until we see the cycle trough, we remain skeptical on how well higher risk/beta pockets will perform." - source Bank of America Merrill Lynch.

So enjoy "Alprazolam" effects while they last as we concluded in similar fashion our previous conversation. Remember that those taking more than 4 mg per day of Alprazolam have an increased potential for dependence. This medication may cause withdrawal symptoms upon abrupt withdrawal or rapid tapering, which in some cases have been known to cause seizures, as well as marked delirium.  The physical dependence and withdrawal syndrome of Alprazolam also add to its addictive nature. Alprazolam is one of the most commonly prescribed and misused benzodiazepines in the United States, benzodiazepines are recreationally the most frequently used pharmaceuticals due to their widespread availability. Alprazolam, along with other benzodiazepines, is often used with other recreational drugs such as QEs but we ramble again...

"A crust eaten in peace is better than a banquet partaken in anxiety." - Aesop

Stay tuned !

Credit and Macro - Fluctuat nec mergitur

"The human race's prospects of survival were considerably better when we were defenceless against tigers than they are today when we have become defenceless against ourselves." - Arnold J. Toynbee, British historian.

While still reeling from the outrageous Paris attacks (one of us being a "born and bred" Parisian), and, looking at the continuous rally in risky assets, for our chosen title and in homage to the numerous victims of this senseless act, we decided that our chosen title should reflect Paris, hence our election for Paris coat of arms' motto "Fluctuat nec mergitur". It was officially established on the 23rd of November 1853 but dated back from at least 1358, a coincidental "number anagram". This motto could be translated as follows for Paris: "Paris is tossed by the waves but does not sink". 

When it comes to our analogy, Paris is like credit, resilient, it is tossed by waves but does not sink as reflected in the below graph from RBS The Revolver note from the 17th of November:

- source RBS

As we move towards the end of 2015, when it comes to credit European High Yield in the credit space has clearly outperformed US High Yield and even US Investment Grade. In this week's conversation, we would like to look at the prospects for credit for 2016 as well as pointing out some additional signs of credit cycle exhaustions as of late which, we think, warrants further monitoring.

Synopsis:

• LBO fatigue - yet another additional "caution" sign of the "credit cycle"
• The US High Yield Market continues to be heading "South"
• What to expect in 2016 - Will it be "Fluctuat nec mergitur" again for credit?
• Final chart - Q4 US consensus profits growth is already forecast to be negative

• LBO fatigue - yet another additional "caution" sign of the "credit cycle"

Whereas in recent weeks/months we mused around our favorite credit indicator for the lateness in the "credit cycle" being the "CCC Credit Canary" and its issuance issues, we also recently questioned ourselves in our conversation "Liebig's law of the minimum":

"Looking at the acceleration in M&A activity in recent days (DELL, AB InBev, etc.), which amounts to us, as yet another indication of us being in the last inning in the credit cycle, it appears evident that while credit corporate bond markets remain wide open, the last two months have shown clear signs of some form of "exhaustion" in the cycle, particularly for High Yield. It remains to be seen which next M&A deal or LBO will fall through." - Macronomics, October 2015

Indeed, whereas we have seen an acceleration in large M&A transactions, the continuous struggle of the "CCC Credit Canary" and the rise in the "cost of capital" have finally taken their toll and translated into the LBO market as shown in the  recent comments below from SG US derivatives desk highlighting that once again "weak feeling" we have on US HY credit markets, following a quickly erased October rebound:

"This week surprisingly weak demand for financing of the LBO of Veritas caught banks by surprise. The consortium led by Bank of America and Morgan Stanley ended upstuck with $5.6bl of the debt as they were forced to postpone the offering, even after they offered a discount to investors and a yield as high as 11%. The consortium of banks will now have to the debt on their books and wait for a more opportune time to sell the high yield debt. Earlier this year a group of Private Equity investors led by Carlyle agreed to buy Veritas from Symantec (SYMC) in an $8bl Leveraged Buy Out, the largest LBO of 2015.
The high yield debt market has seen stress from the energy sector, where default rates have risen to 8.2% last month from <1 beginning="" in="" nbsp="" of="" span="" style="color: red; line-height: 20.8267px;" the="" year.="">The stress seems to spread to other segments of the high yield market, as demonstrated by the failure to place debt of a tech company and a overall widening of spreads of risk free rates.

 

We launched an High Yield Thematic basket (SGUSHY Index) last week that replicates the HYG, but holds the stocks instead of the corporate bonds of the issuers in the Markit iBoxx High Yield index. The basket therefore offers a much more attractive transaction costs (1mL – 30 financing costs vs. 90bp borrowing rates for HYG (indicative prices))." - source Société Générale

For us, it was interesting to see the difficulties of the Veritas LBO refinancing deal, far away from the struggling oil sector. Different times, different situations, but some 2007 memories came to our mind, particularly when the first signs of the credit market peak came from a few struggling LBO refinancing deals at the time.

Within the general High Yield market tone of nervousness we also noticed on the US Convertible markets in the last few day some several "massive" spread widening moves, especially on the High Y iled "renewable energy" segment:  SUNE, SCTY…

 SPX vs US HY ETF HYG - source Bloomberg:

- graph source Bloomberg.

Also, we are also wondering about the increasing number of cash M&A deals met with market skepticism (with acquirers shares selling off on the announcement: ON Semi/Fairchild and Air Liquide/Airgas yesterday, Mylan/Perrigo and Dialog/Atmel situations in the last few weeks…). Are we seeing some signs of fatigue? It certainly looks like it to us.

In conjunction with LBOs losing their "mojo", flows have well have finally shown some signs of pause after the significant inflows we described in October. For instance, as shown in Bank of America Merrill Lynch High Yield Flow report from the 12th of November entitled "The pendulum swings for HY ETFs",  the rally experienced throughout October in terms of inflows have come to an end:

"High yield fund flows reverse trendUS high yield saw its first week of outflows (-$1.61bn) in 6 weeks with both ETFs and non-ETFs ending up in the red. HY ETFs saw a massive $3.91bn WoW swing with a- $1.37bn (-3.5%) outflow this week, while non-ETFs saw a less volatile $242mn (-0.1%) net outflow. These outflows from ETFs are not surprising given the nearly 17% AUM growth the asset class has seen over the previous 5 weeks. Additionally, as we have previously discussed, investors likely grasped at the opportunity to sell into the recent rally and lock in October’s impressive 2.73% return.Meanwhile, non-US high yield funds saw $1.08bn (+0.4%) in net inflows. Outside of high yield, high grade funds continued to grow their asset base with an $828mn (+0.1%) net inflow, their 5th consecutive weekly inflow. Loans posted yet another outflow ($347mn, - 0.4%), to bring their YTD %NAV to an even -11%. EM debt saw net outflows of -$1.2bn (-0.8%), likely suffering from the ever-increasing probability of a December rate hike. As a whole, fixed income funds saw -$3.30bn (-0.2%) in net outflows, their first weekly outflow in 6 weeks. Equities saw little change with a minor $2.41bn (+0.0%) inflow.

- source Bank of America Merrill Lynch

Whereas for US Investment Grade, we still believe in a "Fluctuat nec mergitur scenario for 2016, where a rising US dollar and "external" allocations (such as Japan's GPIF) to US credit should continue to be supportive of the asset class, we are getting more and more concerned on US High Yield with the accumulations of warning signs we are seeing. This brings us to our next bullet point.

• The US High Yield Market continues to be heading "South"

More concerning to us as (apart from "inflows" and "outflows in High Yield) has been the flattening of the US High Yield CDS curve as shown below from CMA part of S&P Capital IQ for the CDX HY Series 25:

As of per the 19th of November 2015:

As of per the 1st of October 2015:

- source CMA part of S&P Capital IQ

This, for us is yet another clear sign of deterioration whereas Investment Grade continues so far to benefit from a steeper credit curve despite market expectations of a rate rise in December by the Fed.

We are not alone to have a "negative stance" on US High Yield, we also share the same concerns as Bank of America Merrill Lynch from their HY Wire note from the 16th of November entitled "Bonds to underperform loans again in 2016":

"Fool’s gold
Several weeks ago we mentioned that taking part in the October rally was a fool’s errand, and that the inflow of cash to primarily ETFs was responsible for the bottom fishing that occurred in the first two weeks of the month. In our view, selling into the strength, despite high cash balances was the prudent move- a position we continue to like today headed into year end.
The payrolls number from two weeks ago coupled with further weakness in fundamentals and commodities, disappointing retail sales and relatively hawkish comments from Chairwoman Yellen have created a perfect storm of worry among high yield investors, as our index has retraced almost 50% of the gain from last month (Chart 1). 

And for good reason too. Our house view is for the Fed to raise rates in December and it appears as though the divergence of the US economy from high yield fundamentals isn't changing anytime soon as Q3 earnings mark a 5th consecutive quarter of weakness. EBITDA growth for a third of the HY universe that has reported so far is still negative, and adjusted EBITDA growth is near zero (Chart 2).

And unfortunately, it’s getting increasingly harder to push the blame for dismal HY earnings on the strength of the dollar.

Furthermore, geopolitical headwinds still exist, and, liquidity (or perhaps the better word is "reality" as in the reality of the real prices in which bonds can trade) continues to present challenges. To make matters worse, we can't say we love quality here either though clearly given our disposition leaves us the least ill when thinking about positioning in a must invest world. Meanwhile triple Cs and single Bs are not the place to hide with just a few trading weeks left in the year. As such, expect next to no bid on any new deals with hair on them and for higher quality new issue to be the place to hide and put cash. Finally, despite loans holding up so well to bonds this year, we continue to like loans heading into 2016, and discuss below in detail some analysis that draws us towards that conclusion. " - Bank of America Merrill Lynch

Exactly. Going higher into the quality spectrum in US High Yield is a imperious necessity as we are witnessing a clear deteriorating trend in the "credit cycle". 

What interesting is that investors (or "yield hogs") seems to continue in many instances to disregard "safety" for "yield "as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 13th of November entitled "Yield is king":

"More in yield, less in “safety”Investors continue to embrace yield over “safety” for a fifth week in a row. Both high-yield and equity funds continued to see more inflows last week. On the contrary, flows into high-grade slipped back into negative territory. Likewise for government bond funds.
Optimism on the back of the previous week’s high grade inflow did not last long as the latest data shows; flows dipped back to negative. Nevertheless, note that high grade ETF fund flows remained positive for a fifth week in a row.

Looking at high-grade duration, both short and long-term fund flows turned negative during the previous week, while mid-term fund flows remained positive but only marginally.
A positive trend however continues in high yield, with the third consecutive week of $1bn+ inflows; the fifth inflow in a row. Last week’s flow also brought the year to date inflow for the asset class back into positive territory.
Government bond fund flows, on the other hand, moved deeply into negative territory suffering the biggest outflow in 19 weeks. Money market funds followed a similar path, but less extreme.
The week in fixed income flows therefore finished in negative territory, marking the first outflow in five weeks. YTD flows into FI funds are now negative.
 Looking at equity fund flows, the trend remains strongly on the positive side for the sixth consecutive week. YTD flows are now at $110bn+." - source Bank of America Merrill Lynch

Whereas, 2014 was not the year of "Great Rotation" from bonds to equities, 2015 was clearly supported by flows particularly in Europe thanks to the "divine" intervention and meddling of central bankers. This is leading us to our third point, namely what to expect in 2016, will it be "Fluctuat nec mergitur" again for credit?

• What to expect in 2016 - Will it be "Fluctuat nec mergitur" again for credit?

This is particular true in Europe which, performance wise, was clearly supported by the actions of "Le Chiffre" aka Mario Draghi as indicated in Société Générale in their note from the 12th of November entitled "Risk Premium in Pictures ":

"Digging into corporate bond valuationsAt a time when the US Fed is expected to embark on the journey of normalising its monetary policy, we analyse the relative valuation of equity, corporate credit and government bonds.
With the exception of eurozone equities, most asset classes have delivered lacklustre returns in 2015. Rich valuations, a potential Fed rate hike and a slowdown in Chinese growth has weighed on asset prices this year. However, consistent with our constructive stance on eurozone equities, 2015 has indeed proved to be a fine vintage for eurozone equities.

Be ready for lower returns going forward. 

In the left-hand chart below, we plot the total return investors should expect across asset classes. Our proprietary risk-premium model suggests that most asset classes will deliver single-digit sub-par return going forward. 

However, it is clear that equities are expected to do well relative to fixed income assets. Within equities, we expect the euro area to perform best as growth expectations improve from the current bearish level." - source Société Générale

While we continue to expect Europe to outperform High Yield wise the US from a "relative value perspective", the actions of the ECB continues overall to be supportive of credit in Europ particularly in the light of continuous "financial repression", rising amount of short term negative yields in the continuation of the "Japanification" process. 

Credit wise, we are moving from a story of convergence, to a story of divergence, some would point out this is very "2011ish" in credit, but it is the reality, as the Fed and the ECB are set up for different courses. This was clearly indicated by the latest post from DataGrapple:

"The FOMC minutes released yesterday confirmed that the Fed are still on course to raise rates in December. Specifically, it was noted that “while no decision has been made, it may well become appropriate to initiate the normalization process at the next meeting”. Based on the Fed fund future market, the probability of a hike stands at 68%, but hardly anyone doubts that will go ahead. That is in stark contrast with expectations regarding the ECB next course of action. QE expectations in Europe are as high as they have ever been and investors are bracing themselves for a salvo of new easing measures mid-December. It will be the first time in a long long while that central banks in Europe and in the US embark on radically diverging paths. These contrasting environments are being played by credit investors, and some today were buying protection on CDXHY in the US while selling protection on iTraxx Crossover. Generally speaking, relative values are being played and it is obvious for all to see on the above grapple. While CDXIG and iTraxx Main (ITXEB) were trading 1bp apart at the beginning of October (at 96bps and 95bps respectively), they were trading 7bps apart early November (at 78bps and 71bps respectively) and stand 12bps apart at the close (at 84bps and 72bps respectively)." - source DataGrapple

This divergence, we think, will continue to play out in credit, from compression and convergence to decompression and divergence. Please find below our illustration on this subject - CDX Investment Grade US versus Itraxx Main Investment Grade Europe (roll adjusted) - data source Bloomberg:

- source Bloomberg - Macronomics

In this "beta" chasing game, some pundits would point out to the attractive "valuations" level of European banks. We continue to dislike the sector as the deleveraging and low profitability of the sector makes us prefer to play it through credit instruments à la "Japan". 

Equities wise, we believe the banking sector will continue to underperform "high beta financial credit", regardless of the bullish and overweight stance of Société Générale's Equities team and the below graph from their report European banks from the 13th of November entitled "A wake-up call":

"Top picks 

We are Overweight European Banks. There is value, with over half the sector (and €600bn of market cap) now trading below TBV. The earnings momentum has stalled post Q3, and banks need to wake up to the new reality of revenue stagnation. Restructuring and a focus on isolated areas of revenue growth will help. This can be supported by increasing capital strength. Our Top 5 list outlines the banks that can best benefit from these themes: Barclays, Erste Group, ING, Lloyds and UBS. We remain cautious on BBVA, CS, DBK and Nordea.

- source Société Générale - SX7P = Eurostoxx 600 Financials vs Eurostoxx 600 = SX7E

No "offense" to the equities guys but here are some facts about the banking system in Europe still being "capital impaired" as indicated by Linklaters on the 2nd of November:

• Estimated €826bn of NPLs are currently sitting on the balance sheets of European banks that are supervised by the SSM

• NPL volumes still remain close to levels revealed at the ECB’s comprehensive assessment in 2014

• Significant differences between NPLs across different countries with high volumes in place across Italy, Spain, France and Greece

• Greek, Austrian, Portuguese, Italian and Cypriot banks likely to be challenged further in future stress test

New analysis from Linklaters estimates that since the ECB’s Single Supervisory Mechanism (‘SSM’) was implemented on 4 November 2014, non-performing loan (‘NPL’) volumes across the banks it supervises remain high, reducing marginally from €841bn* to €826bn**. 

The NPL to Asset Ratio of these banks has also only slightly decreased from 4.13% (end of 2013) to 3.92% (H1 2015). 

Banks have been announcing plans to offload NPL portfolios and demand continues to be significant from investors with at least €40bn*** of distressed funds raised to buy these portfolios. But the research suggests that NPLs in certain countries are steadily increasing, causing a drag on banks’ profitabilities and market confidence. Tackling these credit risks will be a key supervisory priority for the SSM in 2016." - source Linklaters

No matter how our "equities friends" want to "spin it", we are not "buying it" and we will stick to "credit" when it comes to banking exposure in this "japanification" on-going process. There is much more "deleveraging" to go in Europe, in 2016 as well as shown in the never ending earnings revision in the sector as displayed in the same Société Générale report:

- source Société Générale.

So if you want "Fluctuat nec mergitur", when it comes to "banks" exposure in Europe, stick to credit.

In the end for credit, and markets, leverage matters, financial credit conditions matter and so does earnings for any rally to be sustained.

• Final chart - Q4 US consensus profits growth is already forecast to be negative

Whereas during most part of the summer we have been musing around the credit cycle, leverage, defaults and indicators, more recently we have touched on the deteriorating picture and risk of "peak profitability in the US", earnings, regardless of the surge in the US dollar are facing "headwinds" and this, we think is linked to global financial conditions tightening. For our final chart, we would like to point out the fundamental problems facing equity investors given the weakening earnings picture. This is clearly illustrated by the below chart from Société Générale Global Equity Market Arithmetic report from the 16th of November entitled "US profits facing numerous headwinds":

"Equity investors face a variety of fundamental problems, including higher levels of debt, expensive valuations and weakening profits. And whilst earnings momentum has turned up recently, as it typically does during the reporting season (and from very low levels), the proportion of downgrades coming through remains elevated and is only likely to increase in preparation for Q4 reporting. Notably Q4 US consensus profits growth is already forecast to be negative even once financials and energy are excluded.

US dollar strength is clearly already a problem for US corporates and weak US import prices are taking its toll on industrial profitability. However a strong US dollar is not necessarily a given post the first interest rate rise. A quick back of the envelope calculation shows that whilst the US dollar typically appreciates in the 3 months leading up to the first rate rise, in 9 out of the last 10 interest rate cycles the US dollar was weaker in the 3 months thereafter." - source Société Générale

Remember when everyone is thinking alike, no one is really thinking...

"We cannot solve our problems with the same thinking we used when we created them." - Albert Einstein

Stay tuned!

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!