Credit - The Departed

"Faithless is he that says farewell when the road darkens." -  J. R. R. Tolkien 

We have long posited that by suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns. This week's chosen title is not only a reference to departing Fed chairman Ben Bernanke, but as well a reference to Martin Scorsese movie masterpiece "The Departed". In the final scene, a rat is seen on the window ledge, symbolizing according to Scorsese "the quest for the rat", which we can ascertain today in the strong sense of distrust towards the actions of the US central bank and in relation to our chosen analogy. We could ramble further and quote Don Delillo's 2003 Cosmopolis: "A rat became the unit of currency".

Under Ben Bernanke's guidance, there has been a growing disconnect between Wall Street and Main Street as displayed by Bank of America Merrill Lynch graph displaying the evolution of Wall Street versus Main Street:

From its 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion.

No doubt to us that the 2013 performance of the US stock market has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks thanks to increase leverage given many corporates have issued bonds to finance their buybacks program as displayed by the graph below displaying the growing divergence between the S&P 500 and trailing PE since January 2012  - graph source Bloomberg:

 The S&P 500 trades at 25x cyclically adjusted PE ratio (CAPE), exceeding the highs reached in 1901 and 1966. In 1929 CAPE reached 33x and in 2000 44x. 

Our "Departed" strategy has relied heavily on the "Cantillon Effects". The rise of the Fed's Balance sheet coincided with the rise of the S&P 500, and boosted as well by the rise of buybacks. The greatest failure of "the Departed" can be clearly seen in the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

What the "Departed" aka Ben Bernanke as achieved is as follows:

More liquidity = greater economic instability once QE ends

No surprise therefore that the $4 trillion of flows which have been going towards Emerging Markets have been impacted by the return of US rates into positive real yields territory as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment."

Of course, what we are seeing right now in Emerging Markets is the continuation of "reverse osmosis".

So in this week's conversation, we will look at the growing downside risk posed by some Emerging Markets, the implication for European stocks, and our growing uneasiness with the credit risks being taken and the deflation build-up we are seeing.

We already discussed EM troubles brewing in our conversation "Misstra Know-it-all" relating to the great work from Ben Bernanke aka "The Departed":

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

And as posited by Nomura at the time of our September 2013, the risk of the situation turning nasty for lack of liquidity is significant:

"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

We also added at the time:

"Misstra Know-it'all has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets"

In the same conversation we also indicated an interesting trade we particularly like and enjoy today:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up." - David Goldman's article about Gold and Treasuries and bonds in general written in August 2011 (the former global head of fixed income research for Bank of America)

This is exactly what is happening at the moment from a tactical point of view we think and at least the gold leg of the put-call parity, has indeed been performing in this fashion year to date while Emerging Markets currencies have been on the receiving end of the sell-off - graph source Bloomberg:

Interestingly, when it comes to Japan and the crowded trade in JPY (which we have been playing since late 2012) appears to us overly crowded and the risk of a strong reversal cannot be ignored anymore, making as well the Nikkei vulnerable in the short-term (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro). The USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

When it comes to credit and spread tightening, the above significant correlation between rising equities and tighter credit spreads is clearly explained by the wealth effect induced by the Japanese QE.

But, the recent rise in the Nikkei 3 month 100% Moneyness Implied Volatility could indicate a potential near term rise in the Itraxx Japan, representative of the credit risk perception for corporate Japan. It has stayed at record low levels for many months and could easily climb back towards the 100 bps level we think - graph source Bloomberg:

Given the recent bout of volatility, which has been caused from the "Great Rotation" from Emerging Markets aka the "Tourist Trap" (a tourist trap being an establishment, that has been created or re-purposed with the aim of "attracting tourists" and their money), when it comes to playing "defense", Consumer staples offer partial crash protection. On that subject see our April 2013 post - "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option".  From a contrarian stand-point, Consumer Staples, as displayed by Bank of America Merrill Lynch January 2014 Long & Shorts summary, appears extremely underweight:

When it comes to equities and credit sensitivity to Emerging Markets turmoil, Europe is more sensitive to China/EM weakness as indicated by the below chart from Bank of America Merrill Lynch from their note from the 25th of January entitled "Love EM or Hate EM" displaying the massive underperformance in Europe main investment grade risk perception indicator namely Itraxx Main (125 European investment grade entities):

We already touched on the sensitivity of equity index earnings versus FX sensitivity on the 21st of March 2013 in our conversation "Have Emerging Equities been the victim of currency wars?":
"For some countries, the major equity indices can be much more heavily affected by foreign earnings than by domestic earnings." - source BNP Paribas

No wonder the IBEX is on clearly on the receiving end of the latest sell-off. In similar fashion peripheral issuers such as Santander, Mapfre and BBVA in the credit space have not been spared either. The underperformance of the IBEX - graph source - stockcharts.com:

Credit wise, "The Departed" has indeed pushed "mis-allocation" to deep instability level, you would have thought the prime role of a central bank was financial stability, but then again, looking at the recent developments, one might wonder about the "unintended consequences" which increased the instability of the system were worth the efforts put on in over-reflating financial markets.

Recent examples abound to show the increasing risks taken by brazen investors moving clearly outside there comfort zone.

For instance investors are dipping their toes back into illiquid investments as reported by Lisa Abramowicz in Bloomberg on the 23rd of January 2013 in her article "Hard-To-Sell Junk Debt Lure Oaktree to JP Morgan":
"Bond investors are losing their aversion to difficult-to-trade corporate debt that handed them some of the biggest losses in the credit crisis.
The extra yield note buyers demand to own older, smaller junk bonds that trade infrequently has shrunk to an average 0.25 percentage point this month from more than 1 percentage point a year ago, according to Barclays Plc data. JPMorgan Chase & Co. money manager Jim Shanahan said he’s preferring “good credit quality and less liquidity” when picking bonds, while Howard Marks, the head of distressed debt investor Oaktree Capital Group LLC, said he’s finding bigger potential gains in private, less-traded debt.
The evaporating premium for illiquid assets is showing the depths to which money managers are reaching to boost returns after a five-year rally that pushed relative yields on junk bonds to the least since August 2007. With Federal Reserve monetary policies suppressing interest-rate benchmarks for a sixth year, credit buyers are showing more concern that they’ll miss out on a continued rally than get stuck with debt that lost 26 percent during the market seizure in 2008.
“For the past several years, people have been concerned about liquidity,” said Eric Gross, a credit strategist at Barclays in New York. “Now we’re hearing more about people seeking out illiquid bonds.”

Fragile Market

Such debt tends to be more vulnerable to price swings when market sentiment deteriorates, because there are fewer buyers to bid on it when investor withdrawals force money managers to sell. Those risks intensified after stricter banking rules accelerated a pullback by Wall Street dealers that used their own money to facilitate trading.
Primary dealers that trade directly with the Fed cut their holdings of corporate bonds by 76 percent to $56 billion after peaking at $235 billion in 2007, Fed data through March show. After the central bank changed the way it reported the holdings in April, net speculative-grade bond holdings fell as much as 24 percent to a low of $5.63 billion in May before rising to $7.7 billion on Jan. 8.
Investors are demanding an average yield of 5.94 percent to own bonds sold at least 18 months ago in batches of less than $250 million, Barclays data show. That compares with an average 5.7 percent for newer debt offerings of at least $500 million.
The gap, which averaged 0.5 percentage point last year and 0.92 percentage point in 2012, reached as much as 1.95 percentage points at the peak of the financial crisis in March 2009."  - source Bloomberg.

Just a thought for our confident credit investors:
"Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth - - they trust, instead, on their supposed ability to exit."
Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” - "Corzine Forgot Lessons of Long-Term Capital"

Another example as well to the extreme the "Departed" has pushed investors is the return of the old credit binge instruments such as "PIKs" bonds (Payment in Kind) as discussed by Sarika Gangar in Bloomberg on the 24th of January in her article "No-interest Junk Bonds Make Comeback With Twist":
"The riskiest types of corporate bonds are getting a makeover, providing more protection for investors while showing the limits of a rally in junk-rated debt that pushed yields to a record low.
Issuers from Neiman Marcus Group Ltd., which sold $600 million of notes in October that allow it to make interest payments in more debt instead of cash, to Jacksonville, Florida-based Bi-Lo Holdings LLC led $14.8 billion of payment-in-kind offerings in the U.S. last year, the most since 2008, according to data compiled by Bloomberg and Fitch Ratings. The 36 issues were a record.
While the bonds became popular during the last credit boom before the downturn, the new generation of securities are smaller in size, come from companies with less leverage and some compel borrowers to pay interest in cash unless they violate certain financial targets. These protections show that investors are treading carefully even as they search for additional yield amid unprecedented central bank stimulus measures that pushed interest rates to all-time lows.
“The issuance of PIK tends to move the same way as the credit cycle and credit has been loosening,” Sharon Bonelli, a managing director at Fitch in New York, said in a telephone interview. Still, “the market is not as aggressive as it was.” Sales of PIK-bonds were the third most on record last year, behind the $16.2 billion in 2007 and $14.9 billion in 2008." - source Bloomberg.

Kuddos to the "Departed", the Fed's ZIRP since 2008 has forced investors into riskier securities to get extra payouts. But, there is a catch we have repeatedly pointed out:
Definition of Credit Market insanity - "Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

When it comes to credit risk and luck, recently some investors in hybrid securities learned the hard way when ArcelorMittal called early some subordinated bonds at 101 when they had been trading recently around 108.96 cents, a good sucker punch for some unwary investors as indicated by Alastair March in Bloomberg on the 21st of January in his article entitled "Arcelor Mittal's Hybrid Bonds Slump on Early Redemption Call":
"ArcelorMittal’s $650 million of hybrid bonds slumped 6.8 percent after the steelmaker said it would redeem the notes early because of changes to the way the securities are treated by Moody’s Investors Service.
ArcelorMittal will buy back the subordinated securities on Feb. 20 and pay investors 101 percent of their principal, the Luxembourg-based company said in a statement. The notes, which combine elements of debt and equity, were trading at 101.55 cents on the dollar at 11:05 a.m. in London after closing on Friday at 108.96 cents. Moody’s said on July 31 that it would consider hybrids of speculative-grade companies to be entirely debt, rather than half equity as is now the case for all issuers. ArcelorMittal’s move to call the securities early “shocked the market” and highlights the vulnerability of hybrid bonds to ratings changes, ING Groep NV analysts led by Mark Harmer wrote in a note to investors." - source Bloomberg

When the facts change, which they did in July last year, as a credit investor, change your facts or face the consequences.

We are nearing a top in the gentle credit cycle and no doubt there will be a second distressed wave in the not so distant future, rest assured.

This is what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, wrote back in 2011 - Corporate Subprime - The default crisis that never happened:
"Armageddon never arrived. The Federal Reserve slashed interest rates, helping to spark a huge rebound in the price of risky debt. According to S&P, during the past five years cov-lite debt returned a total of 33 percent, versus 31 percent for standard loans with covenants. Companies that were running into trouble were able to raise more money in the markets. Corporate default rates stayed very low. And it all happened so quickly that the protection afforded by the covenants, or the lack thereof, never seriously got tested." - Bethany McLean - The default crisis that never happened.

She also added in her 2011article:
"The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with."

Another interesting development in the desperate search for yields at any risk by credit investors, has been in the the speculative loan space as indicated by Sridhar Natarajan in Bloomberg on the 22nd of January in his article "Loan Surge Above Par Putting Investors at Risk":
"More speculative-grade U.S. loans are trading above par than at any time since May, exposing investors who are funneling record amounts of cash into the debt to greater risks as rising prices encourage borrowers to refinance at lower interest rates. 
Spanish-language broadcaster Univision Communications Inc. and KKR & Co.-controlled First Data Corp. are among at least 30 companies seeking to reduce rates on $31 billion of bank debt as more than 80 percent of leveraged-loan prices exceed 100 cents on the dollar, according to JPMorgan Chase & Co. That’s up from 40 percent at the beginning of October, according to a report from the New York-based lender last week. “Loans are trading well above their call prices because the investor community is reaching out for existing loans, "Jonathan Kitei, head of U.S. loan distribution at Barclays Plc in New York, said in a telephone interview. “You will see more loans getting repriced.”
Investors last year deposited about $63 billion into loan funds that invest in debt with rates that rise with benchmarks and have limited restrictions on early repayment. Banks from Barclays Plc to JPMorgan and Citigroup Inc. expect loans to underperform compared with 2013 as the Federal Reserve begins to taper its bond purchases, paving the way for an increase in rates that have been kept near zero for the last five years.

Limited ‘Protection’

“Whenever loans are trading above par, you introduce an additional risk element as there is limited call protection,” David Breazzano, president of DDJ Capital Management LLC, which manages more than $7 billion in high yield assets, said in a telephone interview. “Value in loans has dissipated a bit in the last couple of months.” Companies reduced borrowing costs on $281 billion of speculative-grade loans last year, or almost 4 times more than 2012, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data." - source Bloomberg.

The divergence of growth between the US economy and the European economy has been indeed reflected in credit prices such as the US leveraged loan cash price index versus its European peer. - source Bloomberg:

While both the PMIs and Leveraged loan prices cratered in 2008, you can see the impressive rebound in 2009, leading in the rapid surge in cash prices for leveraged loans and the increasing divergence in cash prices as indicated by the growing spread between US leveraged loan prices and European leveraged loan prices now at only 3 points apart.

The divergence of loan growth has indeed explained the divergence of economic expansion between Europe and the US. The divergence between US and European PMI indexes - source Bloomberg:

The growth differential between both economies is due to credit conditions. You can clearly notice the uncanning similarity with leveraged loans prices in both regions.

Moving on to the growing deflationary risk we have been warning about for some time, Europe seems indeed to be sleepwalking into a deflationary trap as pointed at recently by Christopher Woods from CLSA in his recent Greed & Fear note:
"At some point the equity market must surely focus on the reality that this market action reflects an increasingly deflationary environment in the Eurozone which is fundamentally equity negative. In this respect it is worth noting that 20% of the items in the Eurozone’s CPI inflation basket are now in deflation, with an average 2.2%YoY decline in December, contributing a negative 45bps to the Eurozone CPI inflation." - CLSA, Christopher Woods

Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going down again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg

Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully.

Another sign of the many failures of the "Departed": Inflation is nowhere to be seen but in rising asset prices, which are more and more grossly disconnected from reality. QE was supposed to create inflation. It hasn't been the kind of inflation the "Departed" was hoping for.

On a final note, of course one of the main culprits in 2013 which we have discussed at length has been Japan which has been exporting deflation on a large scale and the US has not been immune. It is still the "D" world (Deflation - Deleveraging). On that point we agree with Albert Edwards from Société Générale on the deflation risk, as displayed in a recent Chart of the Day graph from Bloomberg:

"The CHART OF THE DAY shows annual rates of inflation excluding food and energy, based on indicators that Edwards cited in a similar chart two days ago. It tracks the monthly changes in a consumer-spending deflator compiled by the U.S. Commerce Department and a price index from Eurostat.
The U.S. deflator rose 1.1 percent for the 12 months ended in November. The increase was smaller than the 1.7 percent gain for the core consumer price index that month, which was matched in December. Last month’s reading for the euro-region gauge was 0.7 percent, the lowest on record.
“Investors have yet to react to the deflationary threat,” wrote Edwards, a London-based strategist who says stocks are in a multiyear bear market that he calls the Ice Age. “They simply do not believe a recession that would trigger outright deflation is on the horizon.”
International Monetary Fund Managing Director Christine Lagarde highlighted the risk of falling prices two days ago during a speech in Washington. She urged policy makers in the U.S. and other advanced economies to avert deflation, which would hamper a “feeble” economic recovery.
“If U.S. growth in 2014 proves as disappointing as in previous years, then there should be a large market reaction as inflation expectations get pegged back closer to euro-zone levels,” Edwards wrote.
Economists expect gross domestic product to rise this year by 2.8 percent, exceeding last year’s 1.9 percent, according to the average estimate in a Bloomberg survey. They also expect a bigger increase in the deflator for core consumer spending, to 1.6 percent from 1.3 percent." - source Bloomberg.

To conclude on Ben Bernanke's legacy, we quite enjoyed Doug Noland recent take on the subject in his column entitled "The Departing Bernanke on Macro-Prudential":
Q&A from the National Association of Business Economics conference, Philadelphia, January 3, 2014: William Nordhaus, Yale University economics professor and chairman of the Federal Reserve Bank of Boston: “I asked my students if they had a question for [Bernanke]. And there were a number of them, one which I won’t ask is ‘what about bitcoin?’ – which I know he knows about. But I thought a really interesting one was this: ‘If you knew in 2006 what you know now, what step or steps would you have taken then to prevent or ameliorate the financial crisis and subsequent severe downturn?’” 

Bernanke: “Well that’s a really unfair question. I mean, the reality is that everybody – every policymaker has to make – this is the nature of policy – it has to be made in very, very foggy conditions with very imperfect information – a lot of uncertainty. So, in order to do anything, I think I would not only have to know everything in advance, everyone else would have to know I knew everything in advance. In other words, if I went out and started saying – all of the sudden I’m arbitrarily raising capital requirements by five percentage points, the banks would say ‘What!’ and it would be very difficult to get Congress and the other regulators and so on and so on to agree. I mean I think the crisis was very complex, involved many many issues. One of the concerns, I want to respond indirectly to a point…, the usefulness of macro-prudential-type measures. I think one of the practical questions is, even if you think you’ve got macro-prudential measures that work, can you put them in place quickly enough and responsibly enough, preemptively enough.

"To know and not to act is not to know." - Cosmopolis - Don Delillo

So long "Departed".

Stay tuned!

Credit - Third time's a charm‏

"Luck is a matter of preparation meeting opportunity." - Lucius Annaeus Seneca 

As we move into 2014, our chosen title reflects the third time strategists put forward the case for a weaker euro. So could indeed 2014 see finally the much anticipated weaker euro forecasted by so many pundits?

In terms of our prognosis in both 2012 and 2013, we did not believe in a weakening of the Euro versus the dollar and we reiterated our stance in numerous occasions such as in our conversation from April 2013 "Big in Japan":

"In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."

When it comes to Europe, we will not change our stance in 2014 either. As we pointed in a "Tale of Two Central banks", we would like to repeat our friend Martin Sibileau's view we indicated back in October 2011 when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

Unless Mario Draghi unleashes in Europe QE to fight off the growing deflationary risks we have been tracking and warning about, we do not see a weakening of the Euro in 2014. Therefore we do not fully agree with Bank of America Merrill Lynch's recent take on the subject in their note entitled "Will the Euro stop defying gravity in 2014?" published on the 9th of January:

"Our case for a weaker Euro in 2014...

We argue that real economic indicators, inflation differentials, rate differentials, technicals and quant analysis, all point towards a weaker EURUSD in 2014. Indeed, we project EURUSD at 1.25 by the end of the year. Our analysis suggests that the strength of the Euro in 2013 was because of forces that are either losing steam, or will be absent in 2014, including: the Fed’s much more dovish monetary policy stance, the substantial adjustment from short Eurozone positions in FX and in European assets more broadly, and an improving current account balance in the Eurozone.

..and the case against us

The risks to our thesis for a weaker EUR in 2014 include: a slowing in US growth, a reduction in the inflation differential between the Eurozone and the US and an increase in the Euro share of global central bank reserves. We argue that these are low probability risks." - source Bank of America Merrill Lynch.

But, where we agree with Bank of America Merrill Lynch's take on the subject is no doubt on the importance of central bank policies, which are indeed the driving force behind many markets:

"In our view, one of the key forces supporting the Euro is relative monetary policies. Although both the Fed and the ECB loosened policies last year, the Fed remains much more accommodative. Indeed, the Fed has been reluctant to exit quantitative easing too early, while the ECB has been avoiding quantitative easing all along (see Global Rates & Currencies Year Ahead).

Relative central bank policies would actually justify an even stronger Euro. The strengthening of the EUR/USD during 2013 is consistent with the expansion of the Fed's balance sheet compared with that of the ECB (Chart 16).

Indeed, this correlation would be consistent with EUR/USD at 1.45. A comparison of the monetary policy stance between the Fed and the ECB based on a Taylor rule would justify a similarly strong EUR/USD (Chart 17).

We expect the ECB to continue being reactive rather than pre-emptive in 2014. We believe that the ECB will deviate from its current stance and loosen policies further only in risk scenarios, primarily linked to disinflation and deflation risks, such as:

-If liquidity conditions were to tighten further and for a larger number of banks in the wake of uncertainty generated by the bank asset quality review and the stress test that will follow. In this case, we expect the ECB to introduce a new LTRO, for more than a year and with fixed rate (possible within H1);

-If inflation was to stay below 1% for more than a quarter and 2015 projections were to decline towards 1%. We would then expect the ECB to cut by a small amount its refi and possibly its deposit rate (unlikely before Q2);

-If the euro zone was to show outright signs of deflation. Only in this case we would expect the ECB to move to asset purchases (most likely government bonds), a tail risk scenario in our view."

 After all, the "Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows. Yes, we ramble again in 2014:

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

When it comes to depreciation of liabilities and deflationary forces, credit conditions in Europe have yet to improve, as bank credit to companies and households in the euro area has shrank for the 19th month in November even after the ECB rates cut in 2013 while euro inflation has been below the 2% target for the last 11 months.

We have argued that improving credit conditions and severing the link between banks and sovereigns would amount to "squaring the circle". European Banking Union or not, we do not see it happening. Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 0.8% inflation rate is telling you. It is still the "D" world (Deflation - Deleveraging). As illustrated by Bank of America Merrill Lynch's graph from their note from the 6th of January entitled "The mixed blessings of better markets", we have yet to see any meaningful loan growth in the euro area and with the upcoming AQR in 2014 with continued deleveraging, don't expect improvements anytime soon:

And when it comes to the deflationary trajectory and continued deleveraging pressure the evolution of nonperforming loans in peripheral countries are clearly indicate of ECB liabilities having to depreciate further. The graph below from the previously quoted Bank of America Merrill Lynch note clearly underlines the issues faced by the ECB, which cannot sustain both the demand for sovereign government bonds and credit availability for the private sector, something will have to give unless Mario Draghi comes up with new "unconventional" tricks in 2014:

"That largest pool of problem credit is in Spain, where there is as yet no sign of NPLs slowing up in Spain: the last three months saw a €12.2 billion rise in system NPLs, compared with €11.6bn in the prior quarter" - source Bank of America Merrill Lynch

In relation to government bonds holdings, as we posited in our last 2013 conversation, it is after all, all about the carry which remains attractive for peripheral banks which have been soaking up on their domestic bonds at a rapid pace for the last couple of years. Third time's a charm as well when it comes to the carry trade.

The European bond picture, some convergence as of late, with Italy and Spanish continuing to perform and providing carry and earnings to their respective financial institutions - graph source Bloomberg:

Some additional convergence as well can be seen credit wise in the evolution between the spread of the 5 year CDS index Itraxx Main Europe (Investment Grade risk gauge based on 125 European entities) and the 5 year Itraxx Financial Senior index which has been trending towards zero - graph source Bloomberg:

With so much "Greed" and no "Fear", risky assets have rallied hard at year end, particularly in December, as displayed in the rally seen in High Yield and the continuous rally in the S&P 500, but increasingly the performances for credit  investment grade is being capped  - graph source Bloomberg:

The correlation between the US, High Yield and equities (S&P 500) is back thanks to "yield hunting". US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG.

The surge in risky assets has been of course driven by the fall in volatility as a whole in various asset classes as displayed in the below Bloomberg graph although the recent announcement of "tapering" in December has led to a surge in 1 month Treasury options volatility as of late:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

Of course, credit has not been the shining star of 2013 as it was the shining star of 2012. In 2013 the S&P500 delivered its best return since 1997.

The rise of the S&P 500 a story of growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

Of course 2014 is already a continuation of 2013 in terms of multiple expansions when one looks at the recent announcement of FedEx which will issue $2 billion of bonds to speed up stock buybacks. While shareholders have been celebrating, bondholders have no doubt been licking their wounds given that FedEx’s  $500 million, 4.1 percent portion due April 2043 and issued last year traded Dec. 18 at 86.2 cents on the dollar to yield 5 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority and as reported by Bloomberg. For Apple's long bond issued last year it is a similar story of bond losses.

The "Cantillon Effects" at play, the rise of the Fed's Balance sheet, the rise of the S&P 500, the rise of buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

As we posited in our conversation "Misstra Know-it-all":

"By suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns."

In terms of the "dash for trash", it can be illustrated we think by looking at the performance of Small-Cap, Utility Stocks versus the S&P 500 since December 2012 - graph source Bloomberg:

Or by looking at  the S&P500 index versus High, Low Quality Stocks since March 2009 - graph source Bloomberg:

Looking at the S&P 500 against Margin Debt at NYSE members firms and the estimated annual interest cost for margin debt at broker call rate, we wonder at what point this rally induced more and more by leverage players will come to an abrupt end - graph source Bloomberg:

After all it is the third time central bank induced asset bubble does indeed seem to be working like a charm as our title goes.

And looking at the success by the Fed in "bending" the velocity curve and curbing the fall in the labor participation rate, we wonder if playing the "wealth effect" via asset prices inflation is worth the risk being taken - graph source Bloomberg:

Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3%. Now at 62.8% the US is back to 1981 and velocity is still cratering (1.54), even lower than in the 1960s.

What investors fail to assess is the growing global deflationary risk which, we agree with CLSA Strategist Russell Napier, is significant:

“Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt. In a market where such bad news has been seen as good news (as it leads to more QE), the reality of QE’s failure will become bad news as we head towards deflation ….. The failure of monetary policy to defeat deflation is about to become apparent, with dire consequences for equity prices”. - CLSA Strategist, Russell Napier

Just note that the ThomsonReuters/Jefferies Commodities Index is now back to where it was at the end of 2009 and 25% below its early peak in 2011. Of course Gold's 28% decline in 2013 has been the worse since 1981.

Of course one of the principal culprit in exporting deflation on a global scale, has no doubt been Japan, as we have posited back in 2013. For the first time since 1992, as reported by Bloomberg, prices in Japan's consumer durables are indicating somewhat a tentative escape from the deflationary forces which have been plaguing for decades Japan - graph source Bloomberg:

"Prices in Japan of consumer durables such as computers and mobile phones rose for the first time since 1992, signaling progress in the nation’s campaign to defeat deflation.
The CHART OF THE DAY shows a 0.3 percent gain in November from a year earlier, after a 21-year slide, boosted by price increases for desktop and notebook computers. The gauge has a weighting of about 7 percent in the overall consumer-price index, which rose 1.5 percent.
The increase came seven months after the Bank of Japan unveiled record monetary easing in pursuit of a 2 percent inflation target. The jump defies a trend of technological improvements leading to lower prices and shows manufacturers are moving away from aggressively competing on cost, according to economist Yoshiki Shinke.
“Inflation is spilling across a whole range of products,” said Shinke, chief economist at Dai-ichi Life Research Institute in Tokyo. “The weakening yen has contributed to higher prices for these products as Japan is importing many final goods given that production is shifting overseas.”
Declines in the Japanese currency, which fell last month to its lowest against the dollar since 2008, led companies such as Apple Inc. to raise prices last year of computers and smartphones. Increases of 24 percent and 12 percent for desktop and notebook computers, respectively, in the November consumer- durables data outweighed a 0.3 percent fall in auto prices.
The narrower household durables index, which includes refrigerators and washing machines, fell 0.9 percent. Technological advances for such appliances lag behind those for gadgets, holding back demand and price gains, according to Naoki Murakami, chief economist at Monex Inc. in Tokyo." - source Bloomberg.

On a final note, as we posited in our conversation from December 2013 "All that glitters ain't gold", we still believe the following:
"2014 will also see Europe still facing the pressure from two tectonic deflationary plaques, which have been the US QE but more importantly in 2013 the outpacing of the Fed led by "Abenomics" which is indeed sending a tremendous deflationary force around the world which means that even the US is not immune to, hence our repeated doubts in seeing a "tapering" in 2014." 

Therefore unless, the ECB starts another round of QE or some additional "unconventional" policies, with Japan exporting deflation on a global scale, and the recent lackluster US nonfarm payroll numbers, we have a hard time seeing a much lower EUR/USD for the time being.

"Faith consists in believing when it is beyond the power of reason to believe." - Voltaire

Stay tuned!

Guest post - When is "good news" "bad news"?

"Bad news sells because the amygdala is always looking for something to fear." - Peter Diamandis 

Please find below a great guest post from our good friends at Rcube Global Macro Asset Management. In this post our friends go through a quick and easy method to identify time periods during which "good news is bad news.

Since last May and the sudden addition of the word “tapering” to the financial lexicon, we have observed quite a few better‐than‐expected US economic releases resulting in short‐term market corrections, and vice versa.

The underlying reason for this market behavior is quite obvious: nowadays, when an economic release indicates a strong US economy, investors fear that this will incite the Fed to prematurely reduce the dosage of morphine it injects into the economy through QEs and ultra‐low rates.

In this paper, we will present a quick and easy method to identify time periods during which “good news is bad news”. We won’t use the vast mathematical toolbox aimed at this kind of task (regime‐switching models such as HMM). Instead, we’ll keep things simple, visual and intuitive.

We’ll use Citigroup’s US Economic Surprise Index (CESIUSD Index) as an indicator of economic momentum. CESI indicators reflect how recent economic releases have fared compared to expectations. As far as we know, they are never revised (unlike the vast majority of economic indicators) and as a result, they reflect the surprise factor in real‐time. Their main shortcoming resides in their rather short history (around 11 years). For stocks, we’ll simply use the S&P 500.

A casual look at both time series’ levels doesn’t yield many interesting insights:

Even when we attempt to “stationarize” the S&P 500 by applying a momentum transform, it is still

quite difficult to visually distinguish between periods where economic momentum and equities move

in opposite directions from periods where they move together.

One popular solution to identify regime switches is to perform a rolling regression between time series differentials. What follows is a 6‐month exponentially‐weighted regression* between daily changes in economic momentum and daily equity returns:

                                                                

*By using an exponentially‐weighted regression, we avoid the “cut‐off” effect that is inherent to rolling windows (in which the disappearance of past observations from the rolling window arbitrarily changes our assessment of the current correlation level).

Due to outliers, the regression time series is very noisy and difficult to interpret. Moreover, the regression level is an inherently lagging indicator of regime switches.

As an alternative to rolling regressions, we therefore propose the following time series, which we will call the “Cumulative Surprise Impact” (on the S&P 500, in our case):

Cumulative Surprise Impact: 

Cumulative Sum of [ (CESI daily differential) x sign (S&P daily Change) ]

The Cumulative Surprise Impact increases (by the amount of the CESI daily differential) when the CESI daily differential and the S&P go in the same direction, and decreases when they go in opposite

directions. The goal is not to predict anything, but to analyze the S&P’s short‐term response to positive (or negative) surprises.

The level of the Cumulative Surprise Impact is not directly interpretable (CESI daily differentials represent the intensity of surprises released during each day, but their value do not represent anything). What matters is the direction of the Cumulative Surprise Impact:

‐ The slope is positive when equity investors yearn for positive economic news (“good news is good news”).

‐ The slope is negative when investors fear that the Fed’s proverbial “punch bowl” is going to be removed (“good news is bad news”).

As illustrated by the following graph, there is a clear relationship between the Cumulative Surprise

Impact and the Fed’s monetary policy:

‐ Before mid‐2004, as long as the Greenspan Fed stubbornly kept its rates at 1%, good news was generally good news.

‐ From mid‐2004 to mid‐2007, a period which started with the Fed hiking rates by 25bp at every meeting, good news became bad news.

‐ From mid‐2007 until mid‐2013, as we entered the “Great Recession,” rates were eased and we switched back to a “good news is good news” mode. Although we reached the zero‐bound for

rates in late 2008, the massive QE programs that followed acted as a substitute for rate decreases (the rate equivalent of 1 additional Tn$ in the Fed’s balance sheet is anyone’s guess, here we arbitrarily displayed 1 Tn$ as 1%).

‐ Last May, as soon as Bernanke hinted that the Fed might contemplate reducing the amount of monthly bond purchases (under the right set of circumstances), good news became bad news again.

At the risk of stating what might be obvious, we can formulate the following rule:

‐ When the Fed is in easing mode, good news is generally good news.

‐ When the Fed is in tightening mode, good news is generally bad news.

We now seem to be at the onset of a new “good news is bad news” period. As we have seen, these periods can last for several years. We therefore believe that bulls should be careful what they wish for regarding future US economic releases.

"He who laughs has not yet heard the bad news." - Bertolt Brecht 

Stay tuned!

Credit - All that glitters ain't gold

"Ah, lives of men! When prosperous they glitter - Like a fair picture; when misfortune comes - A wet sponge at one blow has blurred the painting." - Aeschylus

Hearing recently Alan Greenspan in the footsteps of Janet Yellen talking about the surge in equity markets not being a manifestation of "Cantillon Effects",  namely bubbles, we reminded ourselves of our post "Cold Turkey", which in retrospect should have been called "three wise monkeys" given, including Ben Bernanke, these three "wise" central bankers cannot see, hear or speak no evil. By that point, you are probably wondering therefore why this week's chosen title. 

Like many investors we have been "Singin' in the Rain", blessed by the Fed's liquidity "rain" for the last couple of years.

We have no doubt reaped some of the benefits of our "Generous Gambler", such as buying Junior Financial Subordinated bonds paying 12.5% coupon at 94.5 in cash price in 2011, seeing them soar past the 130 mark in cash price recently or buying Nikkei exposure hedged in Euro in 2013, and as we mused in our conversation the "Coffin Corner" we 've been indeed "singing":

"Like our credit friends, we keep dancing, but close to the door, knowing well enough, at some point the music will stop, and given the poor liquidity in the secondary space, the feeding frenzy on any new issues coming to the market, even with a miserable yield (Nestlé 7 year bond at mid-swaps +25 bps), when it will, it will no doubt be messy, like a NF104 Lockheed Starfighter falling from the sky."

So this week's chosen title is a musical reference to 1995 hit song "Gold" by Prince. When ones looks at some of the deals being thrown in the market, for instance in the convertible space, no wonder we think that some parts of Prince's lyrics are appropriate as our chosen title:

"Everybody wants to sell what's already been sold

Everybody wants to tell what's already been told

What's the use of money if you ain't gonna break the mold?

Even at the center of fire there is cold

All that glitters ain't gold" - Prince - Gold Lyrics

When we mention the convertible space there is a good reason. There is a surge in demand for bonds that converts into equities with zero interest, as reported in the Financial Times by Arash Massoudi in his article "Clamour for stocks sets "no-no" debt deal loose":

"A clamour for fresh opportunities to jump on board the equity market rally is providing some companies with cheap financing alternatives in the $200bn US convertible bond market. The most coveted of these are known  as “no-no” bonds. Convertible bonds allow issuers to offer debt that pays investors a low monthly coupon and gives them the option to convert the security into the issuer’s stock if it climbs to a preset premium over the bond’s tenure. But as new issuance of the hybrid securities roars back to life after a multi-year slowdown, a number of companies are taking advantage of pent-up demand to pull off no-no deals that offer no monthly interest payments or discount to face value. 

For investors, however, the return of these aggressively priced hybrid securities are the latest sign that issuers are exploiting a corner of the US capital markets for favourable terms. This month Yahoo and ServiceNow raised $1.25bn and $575m respectively by issuing no-nos, the first such deals since a $1.25bn Microsoft convertible bond in 2010. In the case of Yahoo, a conversion premium of 50 per cent means that investors need its stock to climb to above $53 a share to exercise the option of converting debt into equity. 

David Puritz, who runs the convertible bond trading desk at BlueMountain, a $13bn hedge fund, says the recent deals leave investors with little margin for error. He says: “A no-no bond may look perfectly fine in a convertible model with interest rates and credit spreads at current levels . . . but given their longer duration, low or zero coupon securities are by definition more vulnerable to a move in rates or spreads.” Still, investors say the fact the deals were able to price with such favourable terms is a reflection of optimism over the state of the US equity markets and the attractiveness of indirect equity ownership. The conversion feature of the bond means that its value increases as the issuer’s share price goes higher, making deals for companies that have more volatile share prices such as technology stocks more attractive. 

The Barclays US Composite Convertible index is up 21.6 per cent so far this year, not too far off the 26.4 per cent gains for the S&P 500. That compares with the Barclays High-Yield index, which is up 6.5 per cent, and a 2 per cent decline in the Barclays US Investment Grade index. But the resurgence of no-no bonds reflects just how distorted supply and demand in the convertible bond market has become, as the Federal Reserve’s stimulus efforts since the financial crisis have driven down interest rates. Lawrence McDonald, senior director at Newedge, says: “We see these types of deals when chief financial officers have more control over the capital markets and can dictate deal terms. That’s a trend across capital markets all year and it can be a very early indicator of an overheated market. It was in 2007 and it was in the dotcom bubble.” 

The central bank’s efforts have allowed companies to borrow from traditional bond markets at historically low rates, leaving the overall size of the US convertible bond market to contract as new issuance has failed to keep pace with maturing securities over the past five years. Analysts at Barclays say the face value of outstanding US convertible bonds has shrunk by $120bn to $175bn since 2009, as some bonds matured and others were redeemed. But companies are once again turning to convertible bonds as investors and issuers brace for a possible rise in interest rates next year as the Fed looks to wind down its stimulus. This year companies are issuing convertible bonds at their fastest clip since 2009 and the pace has continued into November, which is set to be the most active for new issues this year. Companies have raised $42.75bn from offering 158 convertible bonds this year, according to Ipreo. 

Joseph Hall, partner at Davis Polk, says: “When stock prices are as high as they are, the convertible bonds become a lot more attractive instruments for issuers. Companies are taking advantage of the opportunity to lock in financing in some cases at zero per cent.” Some warn, however, that the new deals could carry substantial risk if interest rates rise, especially for no-no bonds. Venu Krishna, head of equity-linked origination at Barclays, says: “Investors need to be cautious, especially if interest rates start rising, since these securities will be negatively impacted by heightened duration risk from having no coupon. “On the other hand, assuming no change in credit risk, if interest rates rise 100 basis points but the stock goes up say 30 per cent, investors will participate in the upside.” " - source FT.com - Arash Massoudi 

Of course many will argue that until the music stops 'in true Chuck Prince fashion as an investor, you have to keep dancing: "As long as the music is playing, you've got to get up and dance" - Chuck Prince, CITI ex CEO.

So in this week's conversation we will look at these "glitters" we are seeing which definitely ain't gold and warrant caution as we move into 2014 which could mark the final innings of the long rally initiated in 2009 courtesy of central banks generosity.

The "Cantillon Effects" at play, the rise of the Fed's Balance sheet, the rise of the S&P 500, the rise of buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

“This does not have the characteristics, as far as I’m concerned, of a stock market bubble” - Alan Greenspan

A recent good illustration of the issuance of convertibles for buy-back purchases was NVIDIA's announcement on the 25th of November of an offering of $1.3 billion convertible senior notes to use the proceeds of the offering to fund capital return to shareholders via the repurchase of shares of the Company's common stock and for quarterly dividend payments pursuant to the Company's recently announced $1 billion fiscal 2015 capital return program.

Multiple expansion through share buybacks have been driving indeed the stock market higher greater than earnings have. The S&P 500 has risen 26.7% YTD versus 16% for the trailing PE from 16.4x to 19.1x. Buybacks rose by 18% QoQ to $118 billion in 2013, up 11% YoY to $218 billion in 1H13. The S&P 500 trades at 25x cyclically adjusted PE ratio (CAPE), exceeding the highs reached in 1901 and 1966. In 129 CAPE reached 33x and in 2000 44x. The growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

All that glitters ain't gold...

And it cannot be truer if either one looks into the rise of the S&P500 between High and Low Quality Stocks - graph source Bloomberg:

Or if one looks into the outperformance of the Small-Cap ratio versus the underperformance of the S&P 500 Utilities index - graph source Bloomberg:

Another sign of the real "Great Rotation" has been the continuous selling from Institutional clients while private clients have been stepping in as reported by Bank of America Merrill Lynch in their recent equity client flow trends report from the 26th of November entitled - "Little confidence in equities' new high":
"Institutional clients lead selling; retail clients return to buying
Last week, during which the S&P 500 climbed 0.4% to reach another new all-time high above 1800, BofAML clients were net sellers of US stocks for the fifth consecutive week, in the amount of $2.3bn. Net sales were led by institutional clients, who returned to net selling following a week of muted buying. Institutional clients remain the biggest net sellers year-to-date (Chart 1),  with cumulative net sales of over $23bn—larger than in either 2008 or 2010. 

As we noted last week, while much of institutional clients’ net sales post-crisis were likely due to redemptions, some outflows year-to-date could suggest a rotation out of US stocks and into global equities. Hedge funds were also net sellers for the second consecutive week, while private clients returned to net buying after a week of selling. This group has been a net buyer for 23 of the past 26 weeks. Large, mid and small caps all saw net selling last week." - source Bank of America Merrill Lynch

Another illustration of this "Great Rotation" comes from the same Bank of America Merrill Lynch report which displays BofAML institutional client cumulative net buys of US equities: pension funds and institutional ex. pension funds since 2008:

Of course, the credit markets have been also indicative of  not only investors dipping their toes outside of their comfort zone but most of all the on-going "japonification" such as in the loan market as indicated by Christine Idzelis in her Bloomberg article from the 21st of November entitled "Loan Faults Seen in $250 Billion of Refinancings":
"The demand has helped companies issue $581 billion of loans to non-bank lenders such as hedge funds and collateralized loan obligations, up from $366.4 billion in all of 2012, Bloomberg data show. At the current rate, the record of $581.5 billion in 2007 may be broken as soon as today.
“I don’t think there’s much of a resemblance between now and 2007 other than it’s a borrower’s market,” A.J. Murphy, global co-head of leveraged finance at Bank of America Corp., the largest underwriter of leveraged-loans in the U.S., said in a telephone interview. Leveraged buyouts are smaller than they were six years ago, she said.
The top five LBOs this year averaged about $12 billion, compared with $30 billion in 2007, Bloomberg data show." - source Bloomberg.

We must say we have been quite amused by the above quote, we all know "this time it's different. One thing for sure, 2013 has been the biggest year since 2007 for CLOs as indicated by Kristen Haunss from Bloomberg in her article from the 26th of November entitled "Wall Street Props CLO Boom as Rules Lift Costs":
"The biggest year for collateralized loan obligations since 2007 is being propped by deals managed by Blackstone Group LP and Carlyle Group LP, which started funds that pledge to boost interest rates on the debt.
While $87 billion of CLOs have been issued globally this year based on JPMorgan Chase & Co. data, coupons on the highest-rated portions have risen to as much as 1.5 percentage points over the benchmark from at least a three-year low of 1.1 percentage points in May. Yields rose as GSO Capital Partners LP, the credit arm of Blackstone, Carlyle and other money managers sold at least $4.5 billion of CLOs with the promise of higher interest payments, typically after 18 months.
Money managers and banks are finding new ways to ensure investors keep buying CLOs -- which bundle junk-rated loans used to back buyouts -- after the Federal Deposit Insurance Corp. asked lenders in April to designate AAA rated portions of the notes as “higher-risk” assets. Regulators are now considering more rules targeting the funds, which helped push issuance of leveraged loans this year to a record $277.1 billion, according to data compiled by Bloomberg.
“AAAs continue to be the hardest to sell and banks have become creative in order to distribute the debt,” Ken Kroszner, a Stamford, Connecticut-based CLO analyst at Royal Bank of Scotland Group Plc, said in a telephone interview. At least 10 CLOs sold since June offered a so-called step-up coupon, where rates increase over the life of the deal, according to Kroszner." - source Bloomberg

If you think 2013 was a record year, wait for 2014. 2014 for us points towards the last inning of the game being played thanks to "easy money". Why so? You might rightly ask.

2014 will see the return of big LBOs so as a credit investor, you should switch on your LBO screeners we think. Anne-Sylvaine Chassany from the Financial Times in her article entitled "Private equity's dry powder' raises overcapacity concerns":
"Private equity groups are holding more cash for acquisitions than they had at the height of the leveraged buyout boom, in spite of a fall in the volume of deals being done – raising concerns about overcapacity in the industry.  Data compiled by Preqin, the research group, show that the value of unspent commitments to private equity funds, known as dry powder, has surged to $789bn this year – an increase of 12 per cent since December 2012, after four years of decline. This compares with $769bn of unspent cash in 2007 – when the volume of private equity deals reached a peak – and the $829bn that went unspent in 2008, when deal volumes plunged 70 per cent as the financial crisis unfolded. 

In 2007, private-equity houses led $776bn of deals, but the comparable figure stands at just $310bn in 2013, according to Thomson Reuters. Research by Hamilton Lane, a private equity investor that tracks 2,000 funds, says this combination of increased fundraising and decreased deals could lead to a record level of dry powder by the year end. 

Buyout groups’ rising cash piles reflect the fact that they have taken longer to invest their funds since the crisis, as they have found fewer good opportunities. But the increase in the capital overhang has been largely fuelled by a renewed appetite for private funds from yield-starved investors.

After a steep contraction in the aftermath of the crash, buyout groups have been able to raise more money from investors, partly because they have found ways to return cash from previous vehicles – mostly through refinancings and initial public offerings. This has helped Advent International, Warburg Pincus, CVC Capital Partners, Carlyle and Silver Lake raise more than $10bn each for new funds. 

According to Mario Giannini, Hamilton Lane’s chief executive, 2013 is on course to become “the fourth biggest fundraising year” of all time for the private equity industry, as investors are lured by its higher returns. 


Private equity funds have attracted $279bn this year, more than the whole of last year, Preqin has found. Some industry participants warn that the cash overhang will drive asset prices up as groups feel the pressure to invest the money before the commitments expire, typically after five years." - source Financial Times - Anne-Sylvaine Chassany

What we found very amusing is that part of this "dry powder" is finding its way into shipping. There is a wave of private equity money flowing into shipping, which for us is yet another manifestation of "mis-allocation" and "Cantillon Effects".

We have long argued that "Shipping is a leading credit indicator", as well as a "leading deflationary indicator". We have also discussed at length the link between consumer spending, housing, credit and shipping back in August 2012.

The latest manifestation of the consequences of "cheap credit" and record cash is leading outside players such as private equity investors to dip into the structured finance shipping business as reported by Mark Odell and Aja Makan in the Financial Times on the 27th of October in their article "Wave of private equity money flows into shipping":
"Private equity has been drawn to the sector as asset valuations for both new-build and second-hand ships have hit rock-bottom.
As a highly-fragmented industry with few large players, the need for capital could hardly have been greater. Traditional lenders such as Germany’s Commerzbank and HSH Nordbank and the UK’s Lloyds and Royal Bank of Scotland are either exiting the market or looking to reduce exposure, stung by heavy losses on loans made before the downturn.
Ship owners looking for fresh funds have found private equity groups willing to listen as they struggle to allocate capital in their more traditional markets.
Oaktree Capital Management, for example, last year took a large stake in Floatel, which owns and operates offshore construction support vessels, and injected equity into General Maritime, a crude and petroleum product tanker company.
Other groups are investing directly in ships. This summer Carlyle committed more than $100m to InterLink Maritime, allowing it to order ten bulk carrier ships, while in September Apollo Global Management committed to a joint venture with German freight line Rickmers Group to invest up to $500m initially in second hand ships.
Before that York Capital linked up with New York-listed Costamare, a container ship owner, in another $500m joint venture. “The reason they are here is high expectations about returns as they are entering at the low-part of the cycle,” says Greg Zikos, chief financial officer of Costamare.
These expectations have so far this year attracted more than $2.7bn, a quarter of the total investment in ships led by private equity since 2008, according to data compiled by Marine Money, a US-based consultancy.
Bankers and analysts say the money has targeted specific “hot” sectors of the market, especially product tankers, which carry refined products, and vessels to carry liquefied petroleum gas and liquefied natural gas. There has also been a renewal of orders for dry bulk carriers. 
On top of the $11.2bn invested in ships and indirectly in shipowners since the start of 2008, private equity groups have also been investing in terminals, ship charterers and shipping containers. In August, KKR led $580m in funding for a specialist shipping bank." - source Financial Times, 27th of October - "Wave of private equity money flows into shipping"

Of course the investor profile in the shipping business has indeed changed with the arrival of dry powder and the buccaneers from the Private Equity business as indicated in the same article from the FT:
"But the presence of the “new” money has been noted. At a shipping industry conference in New York this summer a Greek shipowner, whose family had been in the industry for generations, took one look at the audience dotted with private equity executives, before asking the organiser: “Where are all the shipowners?” 
His question was only part in jest, says Jim Lawrence, chairman of Marine Money, who organised the conference. Private equity executives not only look different – the Greek shipowner was shocked by the number of dark suits facing him – they act differently. 
Whereas traditional shipowners tend to hold vessels for at least 20 years, private equity groups hope to turn a quick profit by listing companies or selling their vessels once charter rates and ship valuations recover." - source Financial Times, 27th of October - "Wave of private equity money flows into shipping"

The issue of course for our private equity friends that they will soon discover is that if quick profits depend on valuations, they also depend on "recovery". We think they are bound for some disappointment as overcapacity is still plaguing the industry.

The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fuelling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008  at 11,440;  with the index touching a low point of 680 in January 2012  -  Evolution of Baltic Dry Index from 1990 until today - source Bloomberg:

Shipping has been our favorite deflationary indicator, so we give you the latest reading of the Drewry-Hong-Los Angeles container rate benchmark. The container rate has been increased by $400 USD on the 15th of November on all US destinations with no impact so far for the "recovery" desired by Private Equity - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 in the week ended Nov. 27, declining after last week's $400 general rate increase on containers from Asia to all U.S. destinations, which had boosted rates 14.4%. This marks the 20th week this year that rates are below $2,000. Even with seven increases in 2013, rates are 13.4% lower yoy and down 14.8% ytd, as slack capacity continues to pressure pricing."  - source Bloomberg

While Private Equity's dry powder has indeed led the order book higher for shipping no doubt - source Bloomberg:

Creative destruction in the shipping industry is still slowly digesting the past excesses as illustrated by the number of bulk carrier scrapped vessels still rising - graph source Bloomberg:

Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by around 550% since June 2005.

The overcapacity is still heavily weighting on Asia-Originated Rates lower - graph source Bloomberg:

"The Shanghai Export Containerized Freight Index (SCFI) fell 4% yoy in the week ending Nov. 15. The SCFI is 27% below its May 2012 peak as excess capacity pressures rates, yet has risen 24% from its mid-October low. Similarly, the China Export Containerized Freight Index is 9.5% lower yoy and 22% below its peak, also in May 2012. Containerized traffic is driven by consumers, with changes in spending having a direct effect on global traffic volumes." - source Bloomberg

So we are sorry for Private Equity investors in the shipping space because the deflationary forces at play are alive and kicking as indicated by the 20% drop in Asia-to-Europe FEU Rates after three weekly declines - table source Bloomberg:

"Shipping rates for 40-foot containers (FEU) fell 7.6% sequentially to $1,765 for the week ending Nov. 28, the third straight decline, according to World Container Index data. Asia-Europe trade lanes continue to be the weakest. Rates between Shanghai-to-Genoa fell 14.7% sequentially, driven by a 12% decline in Shanghai-to-Rotterdam trade lanes. Asia-Europe rates have fallen 20.1% since carriers implemented a rates increase the week ending Nov. 7."  - source Bloomberg.

Finally on shipping, deflationary forces and lack of shipping "velocity" in similar fashion to the impact QEs have had on velocity, higher costs have prompted shipping lines to slow vessels 18% over the past three years to an average speed of around 10.4 knots. Reducing the speed of container ships by 10 percent can pare fuel consumption by as much as 30 percent - graph source Bloomberg:

In similar fashion, companies have not invested in CAPEX due to ZIRP and weakening demand, preferring using "cheap credit" for buy backs purposes and shareholder friendly endeavors. Another manifestation of "japonification" in container shipping velocity? We wonder.

All that glitters in shipping ain't gold...

Apart from rising LBOs and increasing investment in shipping in 2014, you can expect another wave of M&A given companies in Europe have amassed almost $1 trillion through earnings, bond sales and by refinancing credit lines as reported by Stephen Morris in Bloomberg on the 28th of November in his article entitled "Record $1 Trillion Cash Haul to Spur Euro Growth":

"Companies in Europe have amassed almost $1 trillion through earnings, bond sales and by refinancing credit lines, foreshadowing a potential surge in acquisitions and investment.

Glencore Xstrata Plc, Siemens AG and Daimler AG are among at least 50 companies in the region that refinanced 143 billion euros ($194 billion) of credit facilities this year paying an average interest margin of 0.59 percentage point, the lowest since 2007, according to data compiled by Bloomberg. Lower debt costs have helped Stoxx Europe 600 Index members accumulate more than 600 billion euros in cash, adding an extra 200 billion euros since 2008, as companies hoarded profits and shied away from takeovers during the region’s longest recession.

Europe’s biggest firms now have ammunition for growth after almost five years of central bank stimulus measures and suppressed borrowing costs. Almost 70 percent of executives expect company mergers and acquisitions to increase in the next 12 months and more than half said growth is their primary focus, according to an October survey of 1,600 decision makers by EY, formerly known as Ernst & Young." - source Bloomberg.

Unfortunately consolidation does not amount to "job creation". It might be equity friendly but definitely not credit friendly if it means releveraging, so probably credit negative overall. While takeovers announced by western European companies have risen by 6 percent to $716 billion this year compared with 2012, according to Bloomberg data, it is still less than half the record $1.5 trillion of deals completed in 2007. It looks like credit wise, 2013 is more like 2006 and 2014 might end up looking a lot like 2007 we think. As noted by Matt Levine in his column from the 27th of October entitled "Welcome Back, Leveraged Super Senior Synthetic CDOs", the "fun" products from the past in this game of yield hunting are staging a come-back:

"You can tell that leveraged super senior synthetic collateralized debt obligation tranches are fun because they are called leveraged super senior synthetic collateralized debt obligation tranches, and anything with that many words in its name is up to something. And in fact LSS CDOs were popular prior to the financial crisis, got various people in various kinds of trouble, and more or less vanished.

But now Euromoney is reporting that Citigroup is trying to market them again, with a slight modification that might get people into less or at least different kinds of trouble, though it is far from clear that anyone will be interested." - source Bloomberg.

We believe 2014 will set another stage for the "japonification" of the credit markets as illustrated in the below chart from BNP Paribas, next year might indeed be "The big easy" as 2007:

We also agree with Peter Tchir from TF Market Advisors, namely that the spread between the 5 year CDS index Itraxx Main Europe (Investment Grade risk gauge based on 125 European entities) and the 5 year Itraxx Financial Senior index is moving towards zero - graph source Bloomberg:

2014 will also see Europe still facing the pressure from two tectonic deflationary plaques, which have been the US QE but more importantly in 2013 the outpacing of the Fed led by "Abenomics" which is indeed sending a tremendous deflationary force around the world which means that even the US is not immune to, hence our repeated doubts in seeing a "tapering" in 2014. 

Make no mistakes the Bank of Japan's actions are highly deflationary. On that sense we agree with the recent note from Russell Napier - Solid Ground - entitled "An ill wind":

"The collapse of the yen from ¥115 to ¥143 to the US dollar from 1997 to 1998 played a key role in the Asian economic crisis as Japanese competitiveness surged. The YoY percentage change in the yen-dollar rate currently outstrips the peak decline of 1998 which cause so much pain for Japan’s competitors." - source CLSA - Russell Napier - "An ill wind".

You should focus on Japan and the pain which is already being inflicted to some Emerging Markets due to the Japanese deflationary "tsunami".

On the subject of the power of this Japanese "tsunami" we agree with the following comments from a head of derivatives trading at Bank of America Merrill Lynch:

"One lesson of Japanese culture: we are always hesitant to be the first one to take action but if one does, everyone will follow in the same direction. 

DO NOT underestimate when all domestic are acting together! 

As far as I know, there "was" only one big domestic winner in this year's equity market until Q3. 

-What if the rally over last two weeks was mainly caused by domestics? 

-What if Nochu is buying equities? 

-What if other mega banks are buying? 

-What if regional banks have started buying equities? 

-What if Japan Post bank (Yucho) has been buying equities? 

-What if Japan Post bank somehow shows up as "foreigner investor" on TSE's "Investment Trends by Investor Category" statistic?

-What if GPIF starts buying from next year? 

-What if retail starts buying through NISA next year? 

-What if lifers start considering "unwinding currency hedge" or "buying foreign asset without currency hedge"? 

-What if US real money will start buying? 

-Do you know how big Nochu is? 

-What if Okinawa situation is settled soon? 

-What if PM Abe leverages Okinawa settlement to settle TPP? 

I heard that BoJ governor held a meeting on Tuesday to invite 25 investors. I heard the content was just repeating what he said before, but what was the subcontent of the meeting? Why did he hold the meeting in front of investors, though I don't think previous BoJ governor has ever done so?" - source Bank of America Merrill Lynch

Because we do not underestimate the Japanese "tsunami", we have been adding to our existing long Nikkei exposure hedged in Euro as well as our short Japanese yen stance.

In addition to Bank of America's comments, you should take into account the following article from Mayumi Otsuma and Keiko Ujikane from the 28th of November entitled "Japan's Tax-Free Granny Gifts Unlocking Retiree Savings":

"Shoko Iwasaki looked for years for a tax-free way to pass down a lifetime of savings to her grandson. Prime Minister Shinzo Abe has offered the 71-year-old an answer with a program now helping unlock pensioners’ hoarded wealth.

“I’m so grateful for this tax measure, which enables me to hand over my money all at once,” said Iwasaki, who lives alone in Ashiya, about 300 miles west of Tokyo. She plans to endow 15 million yen ($147,000) for the education of her grandson under an initiative introduced this year exempting tax on lump-sum gifts to children for schooling expenses.

Potential transferable assets to the younger generation under the program that lasts through 2015 amount to 117 trillion yen, according to estimates by Goldman Sachs Group Inc. Gifts of just 10 percent of the total could see 4 trillion yen a year trickling down -- an amount equivalent to 1.7 percent of annual consumer spending in the world’s third-largest economy.

With a shrinking and aging population leaving Japan’s companies reluctant to invest at home, added impetus to consumption would help Abe’s campaign to strengthen domestic demand. Any bump in spending resulting from the act also could diminish the blow from sales-tax increases that start in April.

“This tax exemption is a significant idea in terms of tapping seniors’ money -- which is mostly in a dormant state,”said Yuichi Kodama, chief economist at Meiji Yasuda Life Insurance Co. in Tokyo. “This is one policy that will support the success of Abenomics.” "- source Bloomberg

So forget the US "tapering" and focus on Japanese "tapping". There is a Japanese "tsunami" coming your way and it represents $8.5 trillion in savings as indicated by Masaki Kondo and Hiroko Komiya in Bloomberg on the 19th of November in their article entitled "Yen Bears Return as Japan Taps $8.5 Trillion Savings":

"The Nippon Individual Savings Account program will allow individuals to invest in stocks and mutual funds starting Jan. 1 without facing taxes on profits, freeing up savings that exceed China’s gross domestic product and complementing the Bank of Japan’s $70 billion of monthly bond purchases. Strategists say low domestic interest rates may force part of the new money offshore, helping weaken the yen and end deflation.

“The NISA will spice up yen-bear sentiment,” Daisaku Ueno, the chief currency strategist at Mitsubishi UFJ Morgan Stanley Securities Co. in Tokyo, a unit of Japan’s biggest financial group by market value, said by phone Nov. 15" - source Bloomberg.

As we said back in our conversation "Cold Turkey" regarding Japan on the 17th of November:

"While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket"

We also added:

"As we posited in the "Coffin Corner" back in Europe, the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe and we think the US will as well withhold its tapering stance, spelling more trouble ahead".

On a final note, the link between Japan's stocks and yen is the strongest on record as displayed in Bloomberg's Chart of the Day from the 27th of November:

"The link between Japan’s stocks and yen is the strongest on record as its central bank stands ready to ease monetary policy while the U.S. Federal Reserve prepares to pare stimulus, according to SMBC Nikko Capital Markets Ltd.

The CHART OF THE DAY shows that the correlation between the U.S. dollar's strength against the Japanese currency and the Nikkei 225 Stock Average rose on Nov. 26 to the highest on  record, based on data compiled by Bloomberg since January 1978. 

This indicates a growing tendency for equities to rise when the  yen weakens, and vice versa. The Japanese currency fell 1.1 percent against the dollar last week, while the Nikkei 225 

gained 1.4 percent.

“Japan’s monetary base is expanding and the expansion in the U.S. monetary base is slowing, which would tend to suggest, all things being equal, that the dollar will strengthen against the yen,” Jonathan Allum, London-based strategist at SMBC Nikko said in a telephone interview. “That’s a reason to think the stock market in Japan will go up.” Prime Minister Shinzo Abe and the Bank of Japan have signaled they’re willing to add to unprecedented easing measures to reach a 2 percent inflation target, while the U.S. Federal Reserve is contemplating reducing its record $85 billion in monthly asset purchases as the world’s largest economy rebounds.

The policy divergence helped the yen lose 15 percent against the greenback this year as the Nikkei 225 surged 49 percent to rank first among major developed markets.

The 130-day correlation coefficient between the yen and Nikkei 225 rose to 0.49 on Nov. 26, from as low as 0.28 on March 21. A weaker local currency boosts earnings for Japanese exporters such as Toyota Motor Corp. and Panasonic Corp., while increasing the cost of imported goods, adding to price pressures.

“The other possibility why the correlation is suddenly so strong is because there is a correlation between a weak yen and inflation,” Allum said. “If Japan gets into a more self-sustaining inflationary mode and people expect it to continue to rise, then perhaps you won’t need the currency to stimulate stocks.”" - source Bloomberg

Houston, we have lift-off...

"Fortune is like glass - the brighter the glitter, the more easily broken." - Publilius Syrus 

Stay tuned!