Macro and Credit - The overconfidence effect

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong, American astronaut

Watching with interest the increasing pressure on Emerging Markets and various asset markets alike with Brazil getting Pink Floyded as "all in all it was just a BRIC in the wall", and with VW being taken to the proverbial woodshed with its market cap decimated thanks to another "Bayesian" movement on both its stock and CDS prices, and us as well, like many pundits, being wrong footed on our Fed 25 bps hike call, we reminded ourselves for this week's title analogy of a well-established bias namely the "Overconfidence effect". 

With this "bias" a person or market pundit's confidence in his judgement is reliably greater than the objective accuracy of those judgements, especially when confidence is relatively high.

Overconfidence effect is indeed a good illustration of "miscalibrating" subjective probabilities (hence a Bayesian outcome in many asset prices as of late...). Truly, last week, our confidence in the Fed exceeded clearly our "accuracy" meaning we were more "sure" than "correct" to say the least.

When it comes to "overconfidence" distinctions, and in relation to the Fed and other "generous gamblers" aka central bankers, one specific "overconfidence" distinction comes to our mind, namely the "illusion of control" which describe the tendency for central bankers to behave as if they might have some control when it fact they have none. 

"Overconfidence" has also been called the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim. It has been blamed for lawsuits, strikes, wars, and stock market bubbles and crashes but, guess we are rambling again...

In this week's conversation we are going to revisit once more how the credit clock has been ticking faster this time around courtesy of the Fed, meaning we are indeed very late in the credit cycle with a Fed losing credibility facing weaker global growth and lacking ammunitions apart from launching another round of QE.

Synopsis:

• Default risk is rising, spreads are widening and the price action is becoming "Bayesian" in some High Yield names
• US corporate leverage is in full gear while US corporate earnings are weakening - not a good recipe
• Emerging Markets have also been plagued by the "overconfidence effect"
• Final chart - Annual change in US 12 month forward S&P500 EPS expectations points towards recession

• Default risk is rising, spreads are widening and the price action is becoming "Bayesian" in some High Yield names

Back in July 2015 in our conversation "A Cadmean victory", we already indicated that the credit channel clock was ticking faster and not only for High Yield:

"Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space. We keep repeating this but in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger."

This of course was not a case of "overconfidence effect" but, from our point of view understanding the "overmedication" in the credit markets.

We also indicated at the time:

"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters as per our previous conversation when it comes to High Yield."

Of course when it comes to High Yield, perception of default risk matters and when it comes to the Energy sector currently in the eye of the storm given the significant fall in energy prices with European coal slumping below $50 and having declined 26 percent so far in 2015, default risk no doubt is rising as indicated by Fitch on the 21st of September in the summary of their latest report:

"Energy TTM Default Rate Approaches 5%; Highest Level Since 1999

•Fitch Ratings’ trailing 12-month (TTM) U.S. high yield par-weighted default rate climbed to 2.8% in August from 2.5% in July.

•Default volume exceeded $4 billion for the second consecutive month, an event not seen since June 2009.

•90% of third-quarter default volume is in the energy and metals/mining sectors following the September distressed debt exchange for Halcon Resources and chapter 11 filing for Samson Resources.

•September TTM energy and exploration/production rates will approach 5% and 8.5%, respectively, assuming no additional defaults this month.

•Second-quarter leverage (debt/EBITDA) rose to 5.4x from 5.1x in the first quarter, while coverage (EBITDA/interest expense) dropped to 3.3x from 3.5x.

•Leverage and coverage remained essentially unchanged from the prior period, removing the 87 energy and metals/mining companies from the sample." - source Fitch

 As a reminder from our conversation "Blue Monday":

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

So all in all, looking at default rates on their own is akin to looking at the rear view mirror for too long while driving on the narrow credit road.

When it comes to convexity and price movement, in our August conversation "The Battle of Berezina", we indicated that we were following with interest the situation of Abengoa SA (ABGSM) the Spanish company involved in the Renewable Energy sector which is particularly exposed to Brazil and that S&P had a recovery value of just 30%. As indicated on the 21st of September by Bloomberg, bonds due March 2021 tumble to 27.7 cents on the euro and the CDS now signals 93 percent probability of default within five years in their article "Abengoa Bonds Fall to Records After Report HSBC Withdrew Support":

"Abengoa SA’s bonds fell to records after a report that HSBC Holdings Plc withdrew support for the company’s planned capital increase.

The Spanish renewable energy company’s 500 million euros ($564 million) of 6 percent notes due March 2021 fell 12.6 cents on the euro to 27.7 cents, pushing the yield to 38.5 percent, according to data compiled by Bloomberg. Credit-default swaps insuring Abengoa’s debt signal a 93 percent probability of default within five years, CMA prices show.

HSBC retracted an agreement to back 120 million euros of the Seville-based company’s 650 million-euro share sale last week, Spanish news website El Confidencial reported today without saying where it got the information. HSBC, Banco Santander SA and Credit Agricole SA had agreed to be standby underwriters of the increase last month, according to people familiar with the matter." - source Bloomberg

A good illustration of the price action can be seen in the below chart from S&P Capital IQ displaying Abengoa SA 8.875% 2017 bond price moves:

- source S&P Capital IQ

Getting closer to "recovery" value...30% that is.

This clearly illustrates our thoughts from August 2013 in our conversation "Alive and Kicking" where we argued the following when it comes to convexity and bonds:

"In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..." - source Macronomics, August 2013.

Of course when it comes to the "overconfidence effect", "overmedication"  and credit market in terms of issuance on "steroids" courtesy of the Fed, it can be ascertained from the below chart from Bank of America Merrill Lynch's European Credit Strategist note from the 17th of September entitled "Fed for thought":

"Goodbye to ZIRP…
We think the end of zero rates in the US means the end of credit market “excesses” in the US. During the post-Lehman era, the Fed’s zero interest rate policy was a boon for US corporations. Many took advantage of low rates to releverage balance sheets, fund share buybacks and reward shareholders. The behaviour was reflected in the rapid growth of the US credit market."

 - source Bank of America Merrill Lynch

This is particularly of interest given the potential "outflows" risk and "overconfidence" in market participants in avoiding a disorderly "exit" from their investors given there has been a rising share of funds holding the bulk of corporate bonds over the years as illustrated by Bank of America Merrill Lynch Credit Strategist note from the 18th of September  entitled "Long for longer":

"Forensic flow analysis for 2Q 2015

According to the Federal Reserve Flow of Funds data released today foreigners ($172bn) and mutual funds ($116bn) remained the biggest purchasers of corporate bonds in 2Q 2015, followed by life insurance companies ($14bn) and pension funds ($9bn). Notably purchases by foreigners rose significantly from $80bn in 1Q. Households – a residual category that also includes hedge funds and non-profits - sold $122bn of corporate bonds in 2Q compared to selling a more modest $24bn in 1Q (Figure 16). 

Thus the corporate bond market continued to grow largely based on demand from just two types of investors, both of which to some extent are not long term investors - foreign investors and mutual funds/ETFs. As result mutual funds/ETFs now hold 26.5% of the IG+HY corporate bond market (Figure 17).

 - source Bank of America Merrill Lynch.

As per our previous musings, rising defaults could lead to "availability heuristic" which would entail "overconfidence" failure and disorderly exit and significant outflows in the asset class.

It was therefore not a surprise to read in Bloomberg on the 22nd of September that Mutual funds are facing new rules for preventing investor runs as reported by David Michaels:

• "SEC commissioners vote 5-0 to propose liquidity protections
•   Regulation allows bond funds to penalize investors who exit

A hallmark of the $18 trillion mutual-fund industry is that it promises easy entry and exit for investors. U.S. regulators now want new protections to ensure that pledge can be met due to concerns that firms have loaded up on hard-to-sell assets.

The five-member Securities and Exchange Commission voted unanimously to pass a measure Tuesday that addresses criticisms that its rules haven’t kept pace with the evolution of the fund industry. The SEC’s proposal follows warnings from the Federal Reserve and International Monetary Fund that some funds could struggle to meet investor redemptions during a market rout.

Under the proposal, funds would have to maintain a minimum cushion of cash or cash-like investments that can be sold within three days. Funds also could charge investors who pull their money on days of elevated withdrawals.

Protecting Investors

“Changes in the modern asset management industry call on us to now look anew at liquidity management in funds and propose reforms that will better protect investors and maintain market integrity,” SEC Chair Mary Jo White said.

Mutual funds, which are held by 53 percent of all U.S. households, already face a legal requirement to return cash to investors within seven days. In search of higher returns, many fixed-income funds have migrated into riskier debt that doesn’t trade often and could be difficult to sell at fair value during a period of market stress.

A key concern is that any problems will be exacerbated when the Fed raises interest rates, causing bond prices to plunge and prompting fund investors to run for the exits.

The SEC’s plan would force funds, including exchange traded funds, to adopt liquidity-management plans and classify how long it would take to convert positions to cash. Funds would have to hold a minimum amount of cash or cash equivalents, meaning the assets could be sold within three days. A fund’s board of directors would decide what percentage of a portfolio must be easily liquidated." - source Bloomberg.

Welcome to Hotel California Bond funds:

"you can check out anytime you like, but you can never leave"

Of course this is the result of our "sorcerer's apprentices" aka central bankers and their taste for markets meddling on a "grand scale" leading to rising positive correlations (hence the on-going volatility) as well as instability as indicated by "Bayesian" price movements.

The issue this time around is that the US "releveraging" (not yet the case in European credit!) has been on "steroids" and the earnings picture is slowly but surely deteriorating. This leads to our second point about "overconfidence" in leverage and a weakening earnings picture. Caveat creditor...

• US corporate leverage is in full gear while US corporate earnings are weakening - not a good recipe

On the subject of rising corporate leverage which we previously discussed during this summer, we read with interest UBS take on the subject from their 22nd of September Global Credit Comment entitled "Late Cycle Re-Leveraging: No End in Sight?":

"Late Cycle Re-Leveraging: No End in Sight?

The corporate leverage cycle continues to kick into full gear as late cycle dynamics become more evident. Friday’s data release from the Federal Reserve’s Flow of Funds estimated total Q2 ’15 US Non-Financial Corporate Liabilities at $7.94tn, an 8% Y/Y increase. This increase is starting to close in on growth rates seen in the latter stages of prior credit cycles (10-11% Y/Y in late 90s, 11-12% Y/Y in 2007). This level of debt growth has historically been dangerous, but it wouldn’t necessarily be so if corporate earnings were sufficient to match it. However, US non-financial corporate earnings aren’t just lagging, they are actually contracting, albeit marginally, at -0.16% Y/Y. (Figure 1) 

Weak global growth is a major driver; US non-financial profits earned from abroad (which nearly total 25% of total profits) are now falling at a 5% Y/Y pace. Profits earned domestically also are muted, but they still remain in positive territory, growing 1% Y/Y (Figure 2). 

Further headwinds from a stronger dollar and/or renewed problems out of China/EM would likely exacerbate the situation, though an improving European economy could still act as an offset.

While it may seem surprising that debt growth is accelerating when earnings growth is tepid, this is actually the norm historically. What is not surprising is the impact on credit spreads. Weakening corporate fundamentals will eventually place credit spreads under pressure and this cycle is no exception. We find a strong relationship between the excess of debt growth over earnings growth (Y/Y) and BBB credit spreads over time, including in recent months (Figure 3).

The re-leveraging cycle for now will be dictated primarily by the evolution of M&A activity, which our equity colleagues believe will remain robust. Sluggish earnings will not be enough to upset this trend, in our view; indeed this predicament may even encourage more M&A activity. As earnings struggle and margins reside tenuously at peak levels, we think firms are unlikely to aggressively raise dividends, and buying back stock at more expensive levels is becoming less attractive. With growth opportunities low, the one option left is M&A activity, and shareholders are indeed rewarding companies with higher share prices (both the acquirer and the target). Empirically, we see this as well; M&A cycles generally correspond with either falling and/or weak earnings growth, including in the present environment (Figure 4).

Also, as we wrote in Animal Spirits: M&A Feasting on US Credit, S.Caprio, Aug 2015, we think the Fed is highly unlikely to slow the cycle. Higher interest rates have not impeded past M&A cycles; to the contrary, M&A volume has generally moved in lockstep with higher Fed Funds rates. Last Thursday’s FOMC decision also suggests to us that the Fed will be quite gradual and cautious when it does tighten monetary policy, only responding to very tangible signs of improved growth and rising asset prices, in our view. Hence, the emergence of a more hawkish than expected Fed that chills risk appetite is not probable, in our view. Increased market volatility from events abroad may take froth off the pace of M&A issuance, as they did in late August, but even here, recent large M&A announcements indicate the demand for acquisitions is still there.

All told, US corporate leverage will likely increase further in coming months as the usual dynamics of a late stage credit cycle unfold. We believe this will continue to juice non-financial IG corporate issuance and keep non-financial IG credit spreads at elevated levels for the foreseeable future." - source UBS

Exactly!

It is getting late in the game, when it comes to US credit! This is exactly what we concluded relating to M&A in our June conversation "Eternal Return":

"Most acquisitions are often over-valued as they are often made at the top of the cycle, when valuations are excessive and when stocks already include hefty premiums. When companies have access to plentiful and historically cheap funding there is a risk that they use it in ways that support shareholders while making their credit profiles more risky. This is the case today." - Macronomics, June 2015

Once again, the trends that are occurring in the US credit markets have historically been associated with a credit cycle that is reaching maturity.

Also in our June 2015 "Chart of the Day - S&P500 - Leverage and performance", we mused around the "spicy" cocktail of buybacks/M&A at the high of the cycle financed by debt in true "Eternal Return' fashion.

This was indeed a sign for us that the Investment Grade rally of the last few years was getting exhausted particularly in the US (as a reminder):

• significant bond issuance
• low spreads 
• weakening of covenants, 
• declining credit ratings, 
• increase in M&A activity, 
• less favorable use of proceeds from issuance

The continuation of this M&A wave is clearly indicating that we are moving into the final inning  of the credit cycle. The lack of investment in CAPEX means that corporate CEOs are now using M&A following multiple expansions through buybacks, which are now slowing down. M&A is indeed the last US corporate CEOs' "gameplay".

When corporate balance sheet leverage rises, default probability increases down the line, period.

High Yield earnings are also weakening and so is the global economy outlook. On this specific subject we could not agree more with Bank of America Merrill Lynch's take from their High Yield note from the 17th of September entitled "Global growth concerns spread from us to Fed":

"A slow moving train wreck

Today’s Fed decision was the second worst outcome for risk markets, in our view. We have written on numerous occasions that if the Fed didn’t hike rates today initially markets would rally modestly before selling off. The realization that global growth concerns are not only real, but very dangerous right now should cause a risk off environment. And with no room to cut rates, we question the Fed’s ability to manage any further slowdown through what would have to be QE4. However, we can’t see how additional quantitative easing will help, as the goals of QE have already played out: the banking system has recovered, rates are low, investors have driven debt issuance and asset prices to uncomfortable levels, and the housing market has recovered enough to not be a concern.

Furthermore, lower rates don’t help high yield at this point. Whether the 10y is at 2.20% or 2.0%, does the asset class really look all that more compelling? Not in the slightest. In fact, outside of hiking while sounding very hawkish, not hiking and sounding very dovish while expressing concern about the global economy may be the worst thing that could have happened today.

We have been saying for months that the global economy is weak and the Fed’s dovish disposition today only bolsters our view. Europe is about to enter QE2 as inflation and growth remains poor. Japan and Brazil were just downgraded. Commodities remain under pressure and we think, at some point, the narrative could turn from a supply driven story to a demand driven one. Domestically it becomes harder to argue that a strong dollar and the lack of inflation can be viewed as transitory and this headwind is continuing to hurt high yield corporates. Manufacturing is uneven, consumer spending hasn’t improved in a year, and 2014 real median income was down 6.5% versus 8 years ago (and down 7.2% from the 1999 level). Although auto sales remain strong, we would expect as much given low gas prices, an aging fleet and the fact that auto loans are one of the few places in the economy where it’s easy to obtain credit.

Additionally, high yield corporate earnings remain incredibly weak, with yoy earnings growth negative for the first time since the recession (even ex: commodities EBITDA growth is only slightly positive). Leverage is at all-time highs (again, even excommodities) and the High Yield index is more globally exposed than it has ever been (35% of the market generates 45% of its revenue from outside of the United States, and that doesn’t include Energy, which is globally exposed despite not realizing significant direct sales abroad).

Not only are earnings weak, but there has been next to no capex investment, debt issuance has been massive, and buybacks and dividends have driven equity valuations as CEOs and CFOs, afraid to invest in organic growth, have chosen to buy growth instead. And as a result, recovery rates are 10-15ppt below historical norms and defaults and downgrades are creeping into the market. Although we understand many will say its just commodities, is it really? What started as coal weakness 18 months ago became coal and energy weakness. But it wasn’t really just the commodity sectors, as retail was also already weak. Now it’s the commodity sectors, retail and wireline (but definitely not all of telecom). The situation almost seems unbelievable, as everything that seems to go wrong is explained as being isolated (AMD, well, of course semiconductors are in a secular decline) and treated as a surprise (Sprint)." - source Bank of America Merrill Lynch

If that's not a case of "overconfidence" effect taking place in US High Yield credit markets thanks to the Fed's "overmedication", then we don't know what is!

When it comes to credit spreads and default risks and leverage, end of the day, earnings matter!

Back in November 2012 in our conversation "The Omnipotence Paradox" which is in effect, yet another manifestation of "overconfidence" by our central bankers, we argued the following:

"We believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook" - Macronomics, November 2012

US corporate leverage would be less worrying from an historical context if indeed there wasn't a picture of deteriorating operating profits in the background as illustrated in the below chart from Société Générale's Credit Strategy weekly note from the 18th of September entitled "Turning Point":

"Operating profits for the universe were flat year on year in Q2 and contract slightly in Q1, and when the impact of falling oil prices and the stronger dollar is fully felt, perhaps the numbers will be even worse.

However, here again there are reasons to be cautious. The year on year decline in operating profits in 2008-2009 were clearly much bigger than the recent falls. And weak profit data in 2011-2012 proved to be misleading, with the market soon turning around and recovering.
Our suspicion, then, is that global credit markets are discounting a lot of bad news in the Q4 earnings season which starts in mid-October, and they may be pleasantly surprised. This is one of the strong reasons why, at the start of the month, we called for spreads to peak in late September." - Société Générale

Perhaps? Place your bets accordingly.

Furthermore, when it comes to "overconfidence effect", hot money flows and Emerging Markets, they have as well been plagued by this truly toxic cognitive bias as per our third point.

• Emerging Markets have also been plagued by the "overconfidence effect"

While we recently touched on the "stock" and "flow" approach to assess Emerging Markets vulnerability from a balance of payments point of view, the hot money flows thanks to the Fed's easing policies, not only have led to a faster increase in corporate issuance and leverage in the US, but also had some significant impact on EM external borrowings in recent years (see our prior reverse Macro osmosis theory).

We believe than even with the Fed's recent dovish stance, EM assets will continue to be under pressure for the time being.

Thanks to "overmedication" and "overconfidence" EM's vulnerability to external shocks has increased. On that note we agree with Barclays's take from their FX Themes note from the 22nd of September entitled "EM FX: Not cheap given China and Fed risks":

"EM vulnerability to external financing shocks has increased
On the flipside, EM external borrowings have increased substantially in recent years, reflecting cheap financing in DMs and weak growth outcomes/low real rates in DM versus EM. Indeed, external borrowings were crucial in boosting domestic credit across the EM space (Figure 4). 

As the Fed leads the DM out of the low rates environment and with external borrowings by EMs being primarily USD denominated (eg, 87% of external issuance is in USDs), we believe a Fed tightening represents a liquidity shock that would lead to weaker EM FX and higher EM rates.

As Figure 5 shows, the correlation of short-term EM real rates with the US is low, but it is substantially higher for long-term real rates.

Nonetheless, a Fed hike of short-term rates is likely to lead to a move lower in EM FX as real rate differentials narrow. Weaker EM FX is likely to increase the repayment of external borrowings and increase refinancing in local markets – pressuring domestic interest rates higher. A Fed delay will likely be seen as temporary as the Fed seeks to ensure a recovery, which would leave long-term real rates in EM vulnerable. Hence, we do not see either scenario as supportive of a constructive view on EM assets, especially those local-currency denominated.

…and reserves have not kept pace with increased leverage

EM reserves have been declining since peaking in 2010 (Figure 6). 

It is striking that EM reserve growth has not kept pace with the increase in total external debt and has been significantly slower than the growth in short-term debt. In both cases the decline of reserve cover has been significant as EMs have increased leverage in the domestic economy.

In EM FX/Local Markets – Assessing FX reserves adequacy in EM, 19 January 2015, we used an alternative approach to assess FX reserves adequacy in EM economies. Essentially, we conducted a stress test on the capacity of EM central banks to intervene directly in the FX market to protect their currencies should capital outflows accelerate. Our updated ranking is shown in Figure 7.

Our results suggest that the TRY, ZAR, ARS and MYR are likely most vulnerable should EM risk aversion and external financing conditions deteriorate further. It also means that central banks in these countries would likely be constrained in limiting currency weakness through direct market intervention. They would likely be forced to tolerate more currency weakness, or rely on capital control measures.

At the other end of the spectrum, Asian currencies such as the PHP, KRW, THB and the CNY have FX reserves levels high enough for central banks to intervene comfortably in FX to limit the extent of currency depreciation from capital outflows. That said, given our view of further CNY depreciation and broad USD strength going into 2016, we do not think these countries would resist currency depreciation. In fact, authorities in Korea and Thailand are relaxing overseas investment measures to encourage resident outflows to offset the pressure from their large current account surpluses." - source Barclays

When it comes to China and its CNY current stability issues, as we pointed out in our part 2 of our long conversation "Availability heuristic", something will have to give:

"Without further flexibility in its CNY currency in terms of "flows", its large "stock" of FX reserves could be viewed as a Maginot line, playing useless defense in the FX market without widening the yuan's trading band. This will further weaken Asian currencies in the process we think (hence our recent HKD short post)." - source Macronomics, 

This is as well confirmed by Barclays in their FX Themes CNY note from the 22nd of September entitled "CNY: Unsustainable stability":

"Rising cost of maintaining currency stabilityAlthough we were surprised by the way that China moved to allow its currency to weaken (we expected a widening of the daily trading band), we were not surprised by the direction of the CNY move after the policy change. In our view, China’s move on 11 August to adjust the fixing mechanism for USDCNY is likely to open the door to further CNY depreciation in the months ahead. While we do not see the policy change as a panicked move towards a devaluation strategy in order to boost growth, nor as a signal of a loss of control (as discussed in Asia Themes: China: Consequences of a New FX Regime, 14 August 2015), we think the policy change will allow for more flexible adjustments in USDCNY. While China assured the G20 that it is not pursuing competitive depreciation, this does not mean stability in USDCNY will continue indefinitely, especially given the risk of a sharper drawdown in FX reserves if the Chinese authorities continue to aggressively defend the CNY.

Success at a cost
Amid growing capital outflows and pressures on the exchange rate, Chinese authorities have been using FX reserves to hold up the CNY. As we discussed in EM Asia Strategy: China: The heavy cost of intervention, 3 September 2015, FX intervention in recent weeks has been sizeable according to our estimates, which has had a major cost in the form of domestic liquidity tightening and a consequent need to provide liquidity to sterilize FX intervention. China reported a sharp drop of USD94bn in official FX reserves in August, or closer to USD104bn after accounting for valuation effects of exchange rate changes on the composition of FX reserves. This marks a step up in FX intervention from about USD50bn in July and an estimated USD140bn from December 2014 to March 2015, which underscores the significant pressure from capital outflows. This also suggests that the recent relative stability of spot USDCNY could be misleading and coming at a cost.
Although China’s FX reserves appear to be relatively healthy at USD3.65trn, continued FX intervention at the current rate would result in a swift drawdown in reserves. If the current pace of FX intervention continues, we estimate that the PBoC could lose up to ~14% of its FX reserves (ex-valuation adjustments) during June-December 2015. Moreover, we estimate that China’s central bank would have to reduce the reserve requirement ratio by ~40bp/month just to offset the impact of its FX operations on domestic liquidity.

Illicit outflowsAnother way to look at the sustainability of current exchange rate policy is by examining illicit capital outflows. Although China’s capital account is closed, several illicit channels of capital outflows have made the capital account rather leaky. We discuss these and their impact in China: Leaky capital account: estimating outflows and policy implications. We estimate that capital outflows from China could rise from the current 8-10% of GDP, driven by slowing growth, financial market volatility, policy uncertainty and currency overvaluation. In an adverse scenario, total outflows on the capital account could rise to a significant ~15% of GDP. Since these outflows are much larger than current account inflows of 5% of GDP, they will pressure China’s FX reserves and/or the CNY exchange rate. If China absorbs the balance of these outflows (USD1trn) completely by selling reserves and meeting hedging demand (in forward markets), this implies a drawdown of 28% of the current reserve portfolio. We believe this is a significant amount, especially if authorities are unable to slow capital outflows. We expect a weaker CNY over the medium term and significant jump risk for USDCNY as sustained intervention of such a size is unlikely given the uncertainty of success.
How much further does the CNY need to fall to stabilize capital flows?With our valuation models suggesting that the CNY is about 5-10% overvalued, and with China’s growth prospects deteriorating, we see risks of capital outflows and CNY depreciation pressure persisting. Indeed we think a 10% fall in the CNY versus the USD is needed to stabilize the REER and capital outflows. China’s challenging backdrop calls for a more flexible currency regime, and we maintain our forecast of USDCNY 6.80 by year-end. The deterioration in growth prospects have led us to downgrade our China 2015 and 2016 GDP forecasts to 6.6% and 6.0%, respectively (see China: Lowering 2015-16 growth forecasts following recent soft data, 13 September 2015). That said, we estimate that 10% CNY REER depreciation would add only between 30bp and 40bp to growth. However, we believe a much larger depreciation against the USD could pose serious risks to financial stability that government officials may prefer to avoid." - source Barclays

There you go, regardless of the "stock" of FX reserves put forward by many pundits, what matters in the case of China and the "overconfidence" effect are flows and particularly "outflows" in the form of a leaking capital account akin to "negative FCF". Remember financial crisis are always triggered by "liquidity" issues and in the case of sovereigns "over leaking" capital accounts.

So there you go, there are indeed evident signs of "overconfidence" effects in both  the credit and macro  pictures. When it comes to US equities and economic outlook, the annual change in US 12 month forward EPS is a harbinger for weaker earnings, therefore wider credit spreads thanks to weaker balance sheet due to cheap credit binge releveraging triggered by the Fed.

• Final chart - Annual change in US 12 month forward S&P500 EPS expectations points towards recession

Earnings matters as we clearly indicated in our conversation when it comes to leverage, rising defaults and wider credit spreads. While the Fed has indicated its concern about global growth, there is cause for concern when it comes to the global earnings momentum.

The final chart comes from Société Générale Global Equity Arithmetic note entitled "US profits growth has never been this weak outside of a recession published on the 21st of September:

"That the US Federal Reserve is only now declaring itself worried about global economic growth is perhaps the only real surprise of last week. After all, global earnings momentum (the ratio of analyst upgrades to estimate changes) has plummeted from a respectable 47% in May this year to a recessionary 32% last week. Even once the weak Energy sector is excluded, global EPS momentum has still dropped to 35%, also from around 47% in May.

The chart below shows the annual change in 12-month forward S&P 500 EPS expectations. This series is based on forward consensus expectations and therefore excludes many of the write-downs and exceptional items that are currently pushing down actual reported profits. It is more akin to operational profits and has never been this negative outside of a recession!"

 - source Société Générale

Is the "overconfidence effect" warning out? Looking at the recent "price-action" it's certainly looks like central bankers are losing their "Chutzpah"!

"Without the compassionate understanding of the fear and trepidation that lie behind courageous speech, we are bound only to our arrogance." - David Whyte, English poet

Stay tuned!

Guest Post - China’s Devaluation, EM Corporates and Rising Risk Aversion.

"Living at risk is jumping off the cliff and building your wings on the way down."- Ray Bradbury

Please find below a great guest post from our good friends at Rcube Global Asset Management written on the 20th of August. In this post our friends go through the numerous risks pointing towards a Chinese devaluation, EM Corporate credit risks and rising risk aversion:

Since Q4 2014, we have been explaining why China had little option but to devalue its currency (Rcube Macro Portfolio 20/11/2014). Last week’s move is just the early step of a much more meaningful devaluation. Authorities always choose to devalue as opposed to reforms when a crisis hits. China is currently dealing with deflating housing and equity bubbles, but also debt and economic restructurings all at the same time. The odds that in such difficult environment they choose reform over devaluation are extremely low in our opinion.

On a trade weighted basis,August devaluation puts the yuan only back to where it was in May. Since mid‐2011, the real effective exchange trade weighted yuan has appreciated by 43%. It is no coincidence that it is precisely since then that economic conditions have started to worsen. The Yuan needs to weaken much more.

Chinese equities will keep plunging as long as the currency is not devalued more meaningfully.

Capital outflows are intensifying.

Authorities are tapping reserves which have fallen by $350bln to prevent the yuan from falling sharply, which de facto tightens financial conditions. FX reserves as % of M2 is crashing.

Authorities had to cut reserve requirements to offset the unintended monetary tightening. As the inflation rate is falling faster than the PBOC can ease, monetary policy easing is hard to achieve.

The China Momentum Indicator (CMI) weights together information on electricity consumption, rail freight volumes and credit growth. Based on those three 'easy to measure' indicators preferred by Premier Li, the indicator tells us where growth is heading over the next year or so. Based on the indicator, Chinese GDP is estimated to be below 3% and still falling.

As a result, the Chinese government could be facing both a crashing equity market and a weaker currency in the medium term. The perception by Chinese people that the government advertised so strongly investing in equities creates a political risk if the market were to crash. This could be the catalyst for a more meaningful currency move.
The MSCI emerging market has finally broken below its key support (900). An acceleration is underway. 2008 low is our target.

EM corporate bond spreads do not reflect current risks properly, they have barely started to widen. EM financial conditions are tightening, EM corporations have borrowed almost 5trn of US dollars, and their currencies are plunging together with their cash flows (commodity crash). At the same time because the US twin deficits are shrinking, there are less dollars in circulation. This is a recipe for disaster. It is now unfolding.

EM corporate bonds have massively outperformed equities over the last 5 years, we think this is unsustainable given the EM credit channel tightening, weakening cash flows, capital outflows, and the substantial refinancing needs coming to maturity.

The current disconnect between credit risk and equities in the US (Rcube Macro Portfolio 27/07/2015) relies on the belief that there will be no contagion from the energy sector credit risk to the overall market. We believe otherwise.

Furthermore, deteriorating corporate credit health is visible across all sectors. US financing needs are going through the roof. As a result, corporate credit spreads remain extremely mispriced. The energy story only adds risk to this phenomenon by intensifying outflows. Equity volatility will spike higher and close the gap with credit risks soon.

Additionally, bullish sentiment is falling from historical highs as fast as in 2007. This is a major new development since we strongly believe that it is a prerequisite condition for risky assets to fall further. As John Hussmann regularly says, “the difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes has little to do with the level of valuation and everything to do with the attitude of investors toward risk.”

Diminishing risk seeking attitude visible through sentiment measures, widening credit spreads, and negative market internals represent clear warning signs for global equities.

EM assets have entered a panic/liquidation phase that will end when EM corporate bonds will have priced in correctly the risks facing the asset class. We are still far away in terms of valuations.

Investors should watch carefully EM corporate bond spreads as well as US high yield ones for clues about potential risk aversion contagion. A break below 2040 on the SPX will confirm a medium term top is in.

"Only those who will risk going too far can possibly find out how far one can go." - T. S. Eliot

Stay tuned!

Credit - Magical thinking

"Once to every person and nation come the moment to decide. In the conflict of truth with falsehood, for the good or evil side." - James Russell Lowell, American poet

Watching with interest the rising tremors in the markets current fault lines with the fragility in credit markets now spilling into the equities space, we reminded ourselves of the definition of Magical thinking for our chosen title analogy. In clinical psychology, magical thinking can cause a patient to experience fear of performing certain acts or having certain thoughts because of an assumed correlation between doing so and threatening calamities. Of course, magical thinking is creating fear in our "omnipotent" central bankers, who have indeed gone a little bit too far in their sorcerer's apprentice experience with their buckets of liquidity and their beliefs in real economy recovery with their numerous QE "healing rituals", but, we ramble again...

Whereas "Magical thinking" is most dominantly present in children between age 2 to 7 years old, it is interesting to see that according to developmental psychologist Jean Piaget's theory of four developmental stages, children during the stage of his Preoperational Stage of development are not able to use logical thinking. And, according to Piaget, children within this age group are often "egocentric", believing that what they feel and experience is the same as everyone else's feelings and experiences. In similar fashion our central bankers believe that what they feel and experience when it comes to the much vaunted "economic recovery" is the same as everyone else's feelings and experiences. We beg to see it differently. To paraphrase Star Wars, Jedi mind trick only works on the weak minded, same goes with central bankers talk.
 

In this week's conversation we would like to point out again the worrying deterioration in the overall global demand picture with the continuation of EM FX onslaught, deterioration in credit metrics with rising leverage in the US as well as outflows in credit funds in conjunction with significant widening in credit spreads, which explains why in the recent conversations we have indicated why we did put our deflation hat back on, meaning an increase in our US long duration exposure (partly via ETF ZROZ).

Synopsis:

• In US credit, net debt continues to rise at an unsustainable rate
• End of the day when it comes to credit and default, what matters is "leverage"
• The deepening "commodity rout" is a cause for concern credit wise
• Final chart: LatAm FX weakening with commodity prices

• In US credit, net debt continues to rise at an unsustainable rate

In this conversation, once again we have decided to focus on the credit cycle and where we stand when it comes to the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

In early 2014 we indicated our long duration exposure, which we partly played via ETF ZROZ as an illustration of us playing and understanding the "macro" game. Given we think the US is moving firmly into the higher quadrant, we have increased our exposure once more to US long government bonds. 

Also in September 2014 we indicated the following in our conversation "Sympathy for the Devil":

"Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day." - Macronomics, 9th of September 2014

We have long argued that in the US the credit channel clock has been ticking at a faster pace, as indicated in our October 2014 conversation "Actus Tragicus":

"The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is likely coming to an end as we move in the US towards the upper quadrant of the "Global Credit Channel Clock".
Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...)." - source Macronomics, October 2014

What we are seeing recently is indeed we think a clear move towards in the upper quadrant with a flatter yield curves, a widening in credit spreads and a very weak tone in the carry players space, namely Emerging Markets (EM). When it comes to the previously discussed "releveraging" taking place in the US corporate credit space, we read with interest Société Générale Global Equity Market Arithmetic note from the 17th of August entitled "Above the results din, US corporates continue to pile on the debt": 

"Despite all the excitement surrounding the Chinese currency devaluation overall global developed equity markets finished the week only 0.2% down. The real volatility however was to be seen in Asia ex Japan and more broadly Emerging Market equities and currencies. The MSCI EM Index fell 2.4% during the week and is now down over 20% from last August’s high.
It would appear then that US investors in particular are reasonably sanguine about the risks associated with a slowing China and declining commodity prices. However as we have highlighted before, counter-cyclical positioning is not confined to EM and commodities. The Global Semiconductors index, for example, has fallen in lockstep with Global Energy sector over the last three months and tellingly high yield corporate bond spreads have been markedly wider over the last couple of months – see chart below.

With the US reporting season largely complete, we have taken a quick look at what has been going on under the hood. These numbers all exclude financials. Net Income growth has fallen by just over 10% YoY largely as a function of the weakness in the energy sector , it is only slightly down once energy is excluded. However ex-energy profit momentum is weakening when you compare 12 months trailing profits growth in Q2 versus Q1.
Revenue growth is up a robust 5% ex-energy, driven by strong sales growth in the likes of Apple and Amazon. However it is also heavily affected by M&A, primarily among healthcare stocks. Meanwhile dividend growth is up a robust 12% per annum (including or excluding energy) – and while net buybacks are slowing once you include energy, they continue to rise when you don’t. More worrying though is that net debt continued to rise at around 20% pa." - source Société Générale

 A 20% rising rate for net debt is clearly "unstainable" unless you are affected by "Magical thinking". We believe the on-going widening in credit spreads warrants close monitoring.

We note as well the arguments made by Bank of America Merrill Lynch in their Relative Value Strategist note from the 20th of August entitled "Stocks, HG, HY: Unhappy in their own way" where they make the point that credit does not always portend doom for stocks:

"Unhappy in their own wayHappy families are all alike; every unhappy family is unhappy in its own way. The opening lines of Anna Karenina provide an apt metaphor for markets today. Credit has undoubtedly had a very difficult year. Within the asset though, high grade and high yield have each had to deal with their own unique issues. For the former it’s been about immense bond supply (our HG Strategists expect $1.1 trillion for 2015) meeting little demand and the upcoming rate hike cycle. For HY cash, it’s been about the sizable exposure to commodity related sectors and poor fundamentals including increasing leverage and stagnant earnings growth. Equities on the other hand have been frustratingly range-bound. Within the S&P 500, more than 80% of mega-caps delivered earnings beats for Q2, easily offsetting any bad news from smaller companies. On a related note, our Equity Derivatives team has shown how equity inter-sector correlations have been very low, thereby dampening the overall volatility of SPX.
As a matter of fact, it is this relatively low volatility in stocks that there has been much hand-wringing about, standing as it does in sharp contrast to the steady leak wider in credit spreads. And we’ve been fielding many questions on what that ultimately portends for stocks. Our contention so far has been that portfolio matters. We analyzed the seeming divergence between CDX IG and VIX, adjusted for the outliers in IG that aren’t part of SPX, and the gap didn’t look as wide as at first glance. The underperformance of HY relative to SPX seems to be largely Energy driven and HY returns appear to be in line when compared to Russell 2000.
Credit does not always portend doom for stocksThe anxiety among equity investors regarding signals from the credit market is understandable. The most recent memory of a meaningful divergence is from 2008 and that did not end well. But times are different now and we thought we’d look at relative moves between spreads and equity volatility over a longer period. Over the three months to 17-Aug-2015, our HG cash index is 31bp or about 23% wider, the HY index is 104bp wider, also 23%, while the VIX is 1pt higher. The shaded regions in Chart 1 show past periods with similar HG vs. VIX changes, specifically 3m windows over which HG spreads widened by 20% or more and VIX did not increase. 

For HY, we used a lower threshold of 15% in Chart 2 to account for recent Energy underperformance (exEnergy HY is 17% wider over 3m).

Over the last 25 years there have been a number of occasions where spreads have widened substantially without affecting equity volatility. More importantly though, these divergences did not always result in an equity sell-off; equities were up the following month more often than not (Chart 3 and Chart 4).

The S&P 500 return in the month following a HG-VIX divergence was positive 60% of the time and the median return for the index was 0.8%. In the month following a HY-VIX divergence, SPX return was positive 53% of the time and the median was 0.3%. So credit does not always portend doom for stocks. Other than 2007-08 sizable and sustained equity corrections are observed in the late-‘90s/early ‘2000s following a divergence.

It is well possible that the VIX goes up over the next 2-3 months or the S&P 500 sees a meaningful correction. We’d caution against expecting either of these as necessary simply because credit is weak. Credit has been mired in its own problems including dreadful bond liquidity, high supply volumes (HG), sizable exposure to commodities (HY) and uncertainty around what the upcoming hiking cycle means for yields and investor risk appetite. The Fed, China, USD and commodities all remain the inter-connected common catalysts affecting both assets. These factors are more likely to directly determine the fate of stocks in the near-term, than a transmission mechanism through credit." - source Bank of America Merrill Lynch.

We believe that, if indeed, the Fed is not able to use logical thinking and continues with its "Magical thinking" then indeed, regardless of the weaker tone in credit we have been indicating in recent conversations, equities will be in the receiving end and both assets will continue to reprice accordingly.

Of course, for a more severe equity sell-off to materialize you need three deteriorating factors :

1. Corporate balance sheet leverage, 
2. Credit availability, 
3. Earnings revisions.

From the same Bank of America Merrill Lynch note, one can indeed see that so far this year the widening in credit spreads in both Investment Grade credit and High Yield have been significant:

The opposite risk, that of a melt-up on no hike or a hike + very dovish Fed, seems more plausible now. This house is far from constructive on credit, but given valuations and underperformance versus equities there is some chance of a snapback in Q4. CDX option flows, which have had a somewhat bullish tilt even as the indices themselves sold-off, hint that this is the risk that hedges are being set against. Indeed, option implied volatility has been remarkably subdued despite wider spreads (Chart 7 and Chart 8).

 - source Bank of America Merrill Lynch.

Of course a more "dovish" fed could indeed spell some sort of rebound but, this is not the main scenario we are buying and we expect further weakness in the coming weeks when it comes to credit spreads.

We continue to believe that we are coming towards the end of the credit cycle and credit investors have indeed played well into overtime thanks to central bankers' generosity and overmedication. 

This brings us to our second point, namely that "instability" in credit is brewing thanks to the increase in leverage hence the move in the higher quadrant of the "Global Credit Channel Clock". 

• End of the day when it comes to credit and default, what matters is "leverage"

On this specific matter of rising leverage in the US credit markets, which has been one of recurring theme on this blog, we read with interest Bank of America Merrill Lynch's take on the subject in their Situation Room note from the 17th of August entitled "2Q HG Fundamentals":

"2Q HG fundamentals: Leverage peakingWith the 2Q earnings reporting season mostly over, our estimates show that credit fundamentals of public US high grade non-financial issuers continued to deteriorate during the quarter1. Leverage increased, including outside of the troubled Energy and Basics sectors. This was simply the result of a brisk pace of borrowing outpacing weak earnings growth. Hence net and gross leverage in 2Q increased to 2.15 and 2.62x, respectively, from 2.07 and 2.51x in 1Q-15 (Figure 1). 

After having risen since the end of 4Q-2013, we expect leverage in the high grade market to peak in 2Q or 3Q this year and then decline next year. This the result of more challenging conditions in the high grade market and strong US economic growth.

Cash balances (relative to assets) increased in 2Q while the pace of capex growth declined, suggesting that companies pulled forward borrowing to the second quarter, which likely continued during the summer given the record supply volumes. For issuers outside of Energy, Basics and Utilities YoY gross debt rose 4.0% in 2Q – the highest increase since 3Q-11 – while net debt was up just 1.6% YoY. For the same set of issuers median YoY revenue (0.0%) and EBITDA (0.2%) growth were close to flat, thus pushing leverage higher (Figure 2).

Coverage for the high grade market declined in 2Q to 9.18x from 9.34x in 1Q and 9.78x in 4Q-2014 (Figure 3). 

Liquidity metrics improved, with the cash rising to 4.05% of assets in 2Q from 3.80% in 1Q and the share of long-term debt increasing to 93.5% from 92.9% in 1Q. Revenues declined 2.4% YoY in 2Q while EBITDA rose 0.7% YoY. Gross and net debt increased 4.5 and 4.6%, respectively, over the same quarter last year.

Leverage

Both net and gross leverage increased in 2Q, rising to 2.15x and 2.62x from 2.07 and 2.51x in 1Q-15. This is notably above the peak 1.98x and 2.46x net and gross leverage during credit crisis in 2009 (Figure 1). Leverage also increased for our control group that excludes Energy, Materials and Utilities. There net and gross leverage were 1.26x and 2.06x in 2Q-15, up from 1.22x and 1.94x in 1Q." - source Bank of America Merrill Lynch

Where we beg to differ with Bank of America Merrill Lynch is that we believe that the strong US economic growth story is more akin to "Magical thinking" hence our current negative stance on US credit. We continue to believe that, in the near term, US rates will outperform US credit. After all flows from the asset class seem to validate our position as indicated in another Bank of America Merrill Lynch High Yield Wire note from the 17th of August entitled "Death by a thousand cuts":

"Flows: Outflows galore
Credit funds reported outflows last week: US HY at -$1.1bn driven by ETFs (-$960mn), Loan funds at -$350mn, while IG funds also came in negative at -$1.1bn. Other fixed income asset classes also experienced outflows with EM bond funds, non-US domiciled HY funds and Municipal funds, all posting outflows. Equities experienced a small rebound reporting +$890mn and commodities also breathed a sigh of relief coming in at +$450mn after a month of consecutive outflows." - source Bank of America Merrill Lynch.

Also, the note indicates that defaults are on the rise which will continue to impact the High Yield asset class as a whole:

"The best of times are behind the market
The basis for our relatively bearish outlook for 2015 stemmed from the realization that the best of times are now behind the market and, with rising defaults and a higher premium demanded for liquidity, that high yield would struggle to maintain any significant traction following a seasonally strong first quarter. 

Headed into the fall, we maintain our view that the best of times are in the market’s rearview mirror and continue to believe that the end of this credit cycle is now upon us. Although it sounds disastrous, we think the end is likely to play out over a long time, characterized by an increase in defaults, likely dominated by commodity names at first, and a slow unwind of crowded trades.

In many ways, this could be more painful than the alternative: a steep cathartic move that cleanses the market. We think the remainder of the year likely experiences further weakness as poor energy performance leaks into the rest of the market, and lackluster global growth and a strong dollar weighs on fundamentals." - source Bank of America Merrill Lynch

As it seems they are indeed different views within Bank of America Merrill Lynch, for choice, we would side with the above given we strongly believe that the ear of "selling" "beta" as "alpha" is coming to an end. When it comes to "Magical thinking" which causes a patient to experience fear of performing certain acts, investors in this case, should rethink their "collective mindset" as aptly described in Bank of America Merrill Lynch's High Yield note:

"The era of indiscriminate beta compression is over
We have had a long-standing view that accounts have shifted their collective mindset from one where they were scared to sell bonds for fear of not being able to buy them back to one where they want to sell positions they don’t view as core long-term holdings for fear of not being able to sell them later. As such, we wrote, the bond market would struggle in 2015 to surpass 2-3% total returns and that there would be more disparity between winners and losers.
Again, we continue to like this theme going into the end of the year as we expect continued bifurcation between credits and sectors. With underwhelming fundamentals serving as a backdrop for higher leverage and increasing scrutiny on earnings (see Telecom recently), we believe those companies that manage to avoid big earning misses or being swept up in the weak global growth and strong dollar environment will fare better than those which are exposed to non-domestic forces or have questionable balance sheets and future growth prospects." - source Bank of America Merrill Lynch

In our September 2014 conversation "Sympathy for the Devil"we argued:

"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters."

To repeat ourselves, leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). Now in EM, our "reverse macro osmosis" theory is clearly playing out. 

Forget your "Magical thinking", the credit cycle has reached "maturity" in the US. Meanwhile the continuation of the commodity carnage is a cause for concern credit wise.

• The deepening "commodity rout" is a cause for concern credit wise

The continuation of the EM FX massacre thanks to commodities tanking and rising US dollar is a cause for concerned for some EM corporates which are directly exposed to these serious headwinds. The recent devaluation of the Yuan has indeed added the proverbial fuel to the fire. The credit impact on over exposed countries will be significant, particularly credit wise with the significant risk of defaults for some. The impact of the Yuan devaluation was indicated in another Bank of America Merrill Lynch note from the 18th of August entitled "Adding Fuel to the Fire":

"CNY devaluation adds fuel to the fireThe extent to which the CNY devaluation last week negatively affects the EM credit market will depend largely on the impact it has on EM currencies and commodity prices. The devaluation will negatively impact countries that have large export exposure to China through their terms of trade, and will most negatively affect commodities that China holds a dominant consumer position in (platinum, iron ore & copper).
Our commodities team expects very different outcomes for commodity prices depending on the size of the CNY devaluation. A small CNY devaluation could actually be positive for commodities (negative impact on USD commodity prices outweighed by stronger domestic demand), while a large CNY devaluation (not the base case) that comes as a result of worsening domestic demand in China, would be much more disruptive to commodity prices. Our estimates are that a 10% depreciation of the CNY could translate to as much as 6% downside to commodity prices. Breaking it down by commodity, a 10% CNY depreciation could imply 5% downside to Brent crude oil prices but as much as 12% downside to copper prices.
From a macro perspective, our EEMEA team expects commodity exporters (Russia & South Africa) to be hit hardest as does our team in LatAm, which see’s Chile and Peru as most exposed given their high level of commodity exports specifically to China. In Asia, activity cycles are highly correlated to China, and Hong Kong, Indonesia, Malaysia and Korea specifically should be the most negatively affected as the CNY devalues.
Last week’s performance showcased that the broad impact the CNY devaluation will have on EM. Chart 3 below shows performance on a country level from 8/10 (deval announcement) through 8/14 for EM FX relative (1wk % spot change, vertical axis) to EM credit (1wk % spread change, horizontal axis). 

Chart 4 below shows commodity exposure of corporate credit markets by country. The most noteworthy take-aways from Chart 3 below are the markets that stand out as highly exposed to China/Commodities, but where credit markets did not react very negatively. South Korea and Chile specifically saw FX depreciation of roughly 1.5%, while credit spreads were nearly unchanged."

 - source Bank of America Merrill Lynch

What is of interest is that not only we have the usual suspects high beta countries in the above chart, but looking at the recent devaluation wave in EM FX land with Kazakhstan recently joining the party, you can expect an additional weaker tone in FX which will lead as well for some to a continuation in spreads widening.

You should monitor the sovereign CDS space as another indicator of more trouble ahead.

Activity in some sovereign names (South Korea, Malaysia, Indonesia and China) is picking up as displayed in the below table from S&P Capital IQ:

- source S&P Capital IQ

Even Saudi Arabia is not spared with its CDS now above 102 bps up on the 20th of August by 22 bps as reported by S&P Capital IQ.

The significant moves in the Sovereign CDS space can be ascertained from the following chart from Bank of America Merrill Lynch Asia Fixed Income and FX Strategy Watch from the 20th of August entitled "Fears Higher than Taper Tantrums":

"In CDS, ASEAN is clearly widened the most (see Chart 6). In the case of Indonesia, the widening of the CDS has been the result of Malaysia CDS widening as well as some spillover from Brazil CDS and outlook downgrade. On the other hand, SBI CDS (proxy to India) has moved little. This also means that if risk off moves were to amplify and correlations start approaching 1, SBI CDS has considerable distance to cover." - source Bank of America Merrill Lynch.

In the coming weeks the Sovereign CDS market in the EM space will have to be watched more closely particularly if indeed there is a Fed hike coming due in September.

This brings us to our final chart showing the relationship between LatAm FX and commodity prices.

• Final chart: LatAm FX weakening with commodity prices

Whereas Asian countries from a sovereign external debt perspective not in the same situation as in 1998, the vulnerability of certain LatAm countries and default probability (think Venezuela) goes hand in hand with commodity prices as displayed in Bank of America Merrill Lynch Liquid Insight note from the 20th of August entitled "LatAm currency drivers":

"LatAm currency drivers
We estimate how currency drivers have changed in recent years. Commodity prices are important drivers for BRL, COP and CLP, but not MXN. The explanatory power of US interest rates has increased for BRL and MXN. We remain bearish BRL and COP as commodity prices are still plunging. We stay neutral CLP and MXN – we believe they are undervalued based on fundamentals, but exposed to lower copper prices and higher US rates.

Changing currency factors in Latin America
We estimate the main driving factors for Latin American currencies and how they have evolved from 2012 to 2015. The explanatory power of global factors (the US dollar, the VIX index. 10y US rates and commodity prices) has increased significantly for the Brazilian real and Colombian peso. It has reduced modestly for the Mexican and Chilean pesos.
In particular, commodity prices are more important drivers for BRL and COP now than they were two years ago. Their importance for CLP has remained high and stable, while they are not a significant driver for MXN. Our analysis also shows the explanatory power of US interest rates has increased for BRL and MXN, but decreased for COP and CLP." - source Bank of America Merrill Lynch

When it comes to "Magical thinking", we hope our omnipotent central bankers will to use logical thinking as the upcoming rate hike and with our "reverse macro osmosis" theory playing out, it sures look for EM as a US dollar margin call from hell...

"Petroleum is a more likely cause of international conflict than wheat." - Simone Weil, French philosopher.

Stay tuned!