Macro and Credit - Potemkin village

"Now I believe I can hear the philosophers protesting that it can only be misery to live in folly, illusion, deception and ignorance, but it isn't -it's human." - Desiderius Erasmus

Looking at the CoCo Bond slaughter surrounding the €1 takeover of ailing Spanish banking giant Banco Popular by another giant Santander, while thinking about the much vaunted narrative surrounding a Spanish "recovery", we reminded for our title analogy of Potemkin village. While markets are still racing ahead, on renewed optimism and reduced wall of worries, with credit still in tightening mode, thanks to significant fund inflows, we are already seeing some cracks in the narrative, particular in consumer credit in the US decelerating, which we think warrant close monitoring. On the subject of our title analogy, a Potemkin village is any construction (literal or figurative) built solely to deceive others into thinking that a situation is better than reality (Spain and other subjects come to mind). The term comes from stories of a fake portable village built to impress Empress Catherine II during her journey to Crimea in 1787. In similar fashion the story surrounding the appeal of AT1 bonds aka CoCo bonds and the recovery of some part of the European banking sector is akin to a Potemkin village, with a narrative solely built to deceive others into thinking that the situation is better than reality. On numerous occasions we have voiced our distaste for European banks equities. In this on-going "Japanification" process, we would rather continue to play the credit part, but, we continue to have a profound aversion for CoCo bonds, being short gamma that is and its poor risk/reward "beta" proposal.

In this week's conversation, we would like to look what we think of the second part of 2017 and why we are switching, probably early to "defense" and asking ourselves how long before the cycle turns.

Synopsis:

• Macro and Credit - Credit cycle turning, dude are we there yet?
• Final chart - US Consumer Credit taking a break.

• Macro and Credit - Credit cycle turning, dude are we there yet?

While we have been wise in early 2017 to fade the US long dollar crowd while remaining short term Keynesian and bullish equities and all things credit in the first part of the year, supported by strong fund flows thanks to NIRP still plaguing a significant part of the Fixed Income world, the deflation of the "Trumpflation" narrative could indeed put a spanner into the most recent performances of the various beta trades, one being High Yield. For the much vaunted "reflation" trade to continue to play out we think, you would need higher inflation expectations and higher and steeper yield curve. In both last two instances, no matter how the Potemkin narrative is playing out for some pundits, appearences, unfortunately can be deceptive, particularly when you cannot hide a flattening yield curve. 

With European High Yield yielding a paltry 2.59%, we can always go tighter à la 2007, but, credit wise, the risk-reward appears to us less and less appealing with US 10 year Treasuries yielding 2.21%. The Iboxx HY Corporates cash index dropped to just 2.89%, setting a new record low in the process, which is of course supported by the hunt for yield and significant inflows. While it doesn't mean you need to rush for the bunker and don a kevlar helmet as of yet, it does seems to us that there are already cracks showing up in the narrative such as weakening loan demand and decelerating consumer credit that already warrant close monitoring in this long extended credit cycle.

What appears to us fairly clearly is that, as the Trumpflation narrative is fading, so is the beta narrative. The outperformance in beta at least in credit has been very significant in the first half of 2017 and as well during the second part of 2016. Yet as we posited above, it looks to us increasingly that the second part of 2017 could become more complicated for a continuation in all things beta and we would rather reach for quality at this stage in credit. On the subject of beta in credit, we read with interest Bank of America Merrill Lynch's take on the subject in their Credit Strategy note from the 9th of June entitled "Beta losing its shine":

"Beta is losing its shine
A year ago ECB bought its first corporate bond, as part of the CSPP program. Lots have changed since then. ECB now holds more than €90bn of corporate bonds; an eighth of the eligible bonds universe. The beta trade has been in vogue since.

There is a clear correlation between macro and the performance of different beta trades (HY vs IG, XO vs Main, subs vs seniors, fins vs non-fins). So for the beta trade to continue outperforming we need higher inflation expectations and higher and steeper rates. With inflation expectations lowering in the past months we see risks that the beta trade has less favourable risk-reward profile. The dovish ECB yesterday further supports our view that in relative terms beta will underperform from here.

A key factor that has supported the relative outperformance of high beta over low beta pockets of the market was the rates cycle. Higher inflation expectations and higher and steeper rates were pivotal to see the beta trade performing. With inflation expectations lowering in the past months we see increasing risks that the beta trade has less favourable risk-reward profile. To be clear, we are not saying that high beta parts of the market will stop tightening, just that their relative outperformance will significantly reduce.

We think that the beta trade is linked to the growth outlook and inflation expectations. The stronger the economic data and the subsequent improvement in inflation expectations, the stronger the outperformance of high-spread / high-beta assets vs low-spread/ low-beta ones. As the chart above shows, there is a clear correlation between macroeconomic metrics (5y5y inflation swaps for instance) and the performance of different beta trades (HY vs IG, XO vs Main, subs vs seniors, fins vs non-fins) on a spread ratio basis. 

Till this backdrop improves again, we will favour reducing risk on corporate hybrids, high-yield bonds and senior financials CDS (vs senior bonds, high-grade credit and iTraxx Main, respectively), beta pockets that have performed significantly in the past months." - source Bank of America Merrill Lynch

We do agree with the above and in fact our tool DecisionScreen is telling us the same when it comes to its signal switching to slightly negative for US High Yield:

The current signal is at -0.25. The aggregated rule is made up of the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score) and US GOV 10 year yield (1Y Z-Score). The trading rule statistics from 1986-09-03 to 2017-06-07 delivered a Sharpe Ratio of 2.13 with an annual volatility of 2.40%.

From a low volatility perspective, should we see in coming weeks a renewed bout of volatility, given the strong inflows in fund flows in conjunctions of the return of Bondzilla the NIRP monster made in Japan returning to play with Japanese Lifers and their friends deploying their cash, as pointed out in Bank of America Merrill Lynch, credit outperformed stocks in Europe last month and could continue to prove more resilient in case of some weaknesses in the equities space:

"The beta trade is also a function of investors’ perception about the pace of QE. As credit investors were expecting the ECB to start tapering purchases across the sovereign and the credit program proportionally (more in our Credit Investor Survey from April), they looked to add more beta, riding the reach for yield trade. However, credit investors realised, over the past month, that the ECB is more than happy to up the CSPP program when supply comes and thus provide stronger support for “eligible” assets. Additionally “eligible” assets look cheap vs “non-eligible” assets and thus we think that there is room for a catch up trade, as the ECB is on full-on mode buying “eligible” credit instruments.

We will be looking for two signals for us to become more constructive on beta-assets: (i) a pick-up on inflation expectations and (ii) a slower pace of the CSPP. Till then we expect the relative pace of tightening of high beta pockets like corporate hybrids, high yield bonds and senior financials CDS (vs seniors, high-grade and iTraxx Main, respectively) to slowdown." - source Bank of America Merrill Lynch

Whereas we remain more defensive on High Yield at the moment, tactically speaking, Investment Grade in both Europe and the US should be more resilient in the case of renewed pressure on equities and high beta credit, hence our appetite to reach for quality rather than yield currently. Wednesday will set up the tone for both inflation expectations and the Fed's hiking path as we will get the most recent reading on Core CPI in the US. Yet the deceleration in credit growth seen as of late is a cause for concern and it will be interesting to see the Fed's take on the subject. With the recent weakness seen in US breakevens pointing towards a deflation in the "Trumpflation" narrative, we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 9th of June entitled "Deflation and rate hike":

"Deflation and rate hike

Since 1957 there have been 722 overlapping two-month periods. As core CPI prices almost always go up (Figure 1), in only six of these, or less than 1%, have we seen core CPI deflation – but that includes the most recent March-April period this year (Figure 2).

On Wednesday we get the most recent (May) reading on core CPI as well as the Fed’s rate decision. With the Fed widely expected to hike, and normally not inclined to surprise investors, a rate hike is the baseline. But the inflation data has to be concerning, especially as long term inflation expectations have now completely retraced their post-election increase (Figure 3).

Moreover, as we have consistently pointed out this year, other data is week and suggest everybody is in wait-and-see-mode, including C&I and consumer lending data (see: Situation Room: In wait and see mode 07 February 2017). So the Fed has to be very careful in crafting the statement message and press conference. While the biggest near term risk for spreads remains a correction in equities we remain bullish on HG credit spreads." -source Bank of America Merrill Lynch

As well, if indeed there is a return of the "Japanification" narrative and a continuation in soft data, not only it makes sense to reach for Investment Grade credit but it makes also sense to go for MDGA (Make Duration Great Again). As we stated flow wise, Investment Grade is not losing steam as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 9th of June entitled "Buy what they (ECB) buy":

"Highest inflow into IG in 44 weeks

Tapering? What tapering? CSPP buying numbers have been moving higher in the past month, while PSPP absorbed most of the tapering pressure. IG credit emerges as the winner, as investors are piling on the same ECB trade that worked when CSPP was announced. The “buy what they buy” is hence making the IG market highly resilient. Another reason why inflows have been strong lately, especially for the mid- and long term funds, has been the slowdown and reversal of the trend seen in the previous months of higher and steeper yield curves. As our analysis has shown, the level and trajectory in the rates market is a very strong predictor of flows in credit market.

Over the past week…

High grade funds recorded another week of inflows; the 20th in a row. The latest inflow has been the highest in 44 weeks and the second-highest since EPFR data started. High yield fund flows remained in positive territory for a seventh week. Inflows to European-domiciled HY funds were coming from European and global-focused funds, while US-focused funds recorded outflows. Government bond fund flows were marginally positive last week, recording the first inflow in five weeks. Money market funds recorded their second consecutive weekly inflow. Overall, Fixed Income funds recorded their 12th consecutive weekly inflow and the highest in 45 weeks, thanks to a strong credit inflow.

European equity fund flows were positive for the 11th week in a row. The asset class has seen a positive trend despite the volatility in the size of inflows." - source Bank of America Merrill Lynch

The latest dovish comments from the ECB's supremo Mario Draghi is providing additional support for the fun uphill, the bond market that is. The carry trade in Europe is still the trade du jour thanks to the central bank and its purchases. But, behind the deceitful narrative, we remain very wary of oil prices and its deflationary weigh on "inflation expectations" and the potential for additional sell-off they could trigger in financial assets thanks to some Sovereign funds and oil producing countries under pressure from continuing lower oil receipts. 

Behind the Potemkin village of higher equity prices and tighter credits lies the on-going fight to the death between OPEC countries in general and Saudi Arabia in particular with US shale producers. The strategy of trying to drive US shale producers towards bankruptcy has spectacularly backfired thanks to innovation in 2016. On this subject Bank of America Merrill Lynch again highlighted in their 2016 Breakeven Analysis published on the 9th of June in their report entitled "The Incredible Shrinking US Breakevens" the relentless fall in breakeven prices which spell bad news in the light of recent OPEC cuts trying to offset the stiff competition. 

"2016 Breakeven Prices declined 9%…1-yr B.E. & $43/boe

In 2016, North American investment grade oil & natural gas producers continued to sharply reduce their cost structures with the mean aggregate breakeven (B.E.) price declining 9% to $54.22 per equivalent barrel of oil (/boe). However, when we adjust our methodology to look at B.E.s using reserve replacement costs (RRC) from just 2016, we find that B.E.s are much lower than that with a mean cost of $42.64 per boe with 11 of 17 companies having B.E. cost structures under $50/boe.

In short, this clearly explains why with oil prices trading around $46 per barrel WTI, the U.S. rig count continues to rise. Companies are making attractive (in some cases VERY attractive) returns in the current price environment. With capital still relatively cheap, our analysis suggests that crude prices would need to decline back to $40/bbl to change this behavior.

2016 Breakeven Prices declined 9% over 2015

Operating costs decline but lower realizations offset some of the benefit After the sharp 16% decline in the industry breakeven price among North American investment grade (IG) issuers in 2015, the aggregate breakeven price for the industry declined to $54.22 per barrel of equivalent production, down another 9% from 2015. Total costs for the seventeen companies in our annual breakeven report declined by 11% in 2016, relatively lower than the 15% reduction in unit costs we have calculated last year. Producers continued to cut costs in the first half of the last year and consequently cut production as commodity prices softened. While these cost savings are significant, we believe that it will be difficult to continue to cut costs beyond a point. Added to that, average price realizations relative to the West Texas Intermediate and Henry Hub averages for the year modestly declined to 57% from 58% in the previous year.
As commodity prices declined further, producers adopted different strategies to optimize costs like rationalizing production expense, reducing employee counts, recontracting service terms, asset sales, etc. Our annual review of unit costs and resulting breakeven calculation showed this declining trend clearly with 14 of the 17 companies achieving breakeven cost reductions.

The decrease in revenue due to lower realizations and production cuts more than offset declining costs and as a result, average margins per boe fell 10% y-o-y to a loss of $6.25/boe. In particular, the gassy names saw margins erode or if they did rise, the improvement was at a much slower pace than oil producers." - source Bank of America Merrill Lynch

On a side note, the velocity in the surge of 5 year forward breakeven inflation is what killed Gold post the US elections. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations matters. Both gold and TIPS function as a hedge against unexpected inflation. But returning to the relationship between commodities and rising real rates we also agree with Bank of America Merrill Lynch's take from their Global Liquid Markets note from the 12th of June entitled "Oil is the Fed's canary":

"Commodities perform poorly on rising real rates...

Yet our rates strategists argue that opposite seems to be happening. For starters, as a number of Trump administration initiatives such as tax and health care have stalled, economic growth expectations have fallen. Also, gasoline prices are already down year on year as OPEC production cuts have failed to remove the oil inventory overhang, acting as a drag on inflation (Chart 5).

Moreover, a fast and furious recovery in US shale oil production YTD suggests we are witnessing yet another technology-induced deflationary episode. With expectations already stretched, a less accommodative Fed that accidentally creates a higher real rate environment could further exacerbate the recent drop in commodity prices. We have previously found that rising real rates are associated with negative commodity beta returns, and falling real rates are associated with positive commodity returns (Chart 6).

Moreover, changes in commodity prices can mechanically cause big swings in realized inflation, but can also drive expected inflation near term, exacerbating the Fed's problem.

...so another sell-off may signal a policy mistake

Real rates have a causal impact on commodity prices due to a variety of transmission channels (Chart 7).

Demand for consumed commodities like oil and base metals tends to fall when real rates rise all else equal, as it makes consumption of energy intensive goods harder to finance. Higher real rates also tend to be associated with a stronger USD, which can hurt consumption of energy intensive goods in EM countries. True, periods of high nominal yields have been associated with higher commodity returns during the past 20 years, as economic expansions tend to be characterized by both strong commodity demand and high nominal interest rates. However, periods of ultralow nominal interest rates have been linked to very poor commodity performance since the Global Recession (Chart 8), as commodities need healthy global nominal GDP growth to move higher.

So far, the commodity markets have assumed oil prices are lower because of a supply glut. However, if the Fed hike next week triggers another leg down in commodity prices, the focus may turn on demand conditions. Should the Fed be sleepwalking into a policy mistake next week, commodities may provide some warning signs." - source Bank of America Merrill Lynch

And that's the main issue with the Potemkin village of the GDP recovery story being sold out by many pundits, namely that in reality Global nominal GDP growth is not healthy, yet the Fed is continuing in its hiking path and tells us it is data dependent. 

So to answer the question relating to the credit cycle turning, yes it is slowly but surely turning but, we are not there yet. A burst in inflation and a significant rise in inflation would force the hand of the central banks, and this we think could be the real catalyst for a nasty bear market in various asset classes as discussed recently. We are also data dependent and watching very closely the trend in consumer credit as per our final chart.

• Final chart - US Consumer Credit taking a break.

Back in our conversation "Orchidelirium" at the end of last month we asked ourselves if the US consumer was "maxed out".  We noticed at the time that consumer loan demand, a finding consistent with the weaker spending in Q1 had been cooling. This is a significant indicator to monitor in the coming months we think and our final chart comes from Wells Fargo Economics Group note from the 7th of June and shows that consumer credit was below expectations in April and shows that year-over-year percent change in consumer credit needs to be monitored closely: 

"Consumer Credit Growth Decelerates

• Consumer credit rose by just $8.2 billion in April, the slowest pace since mid-2011. Both nonrevolving and revolving credit growth were soft in the month.

• Revolving and nonrevolving credit growth have continued to move in lockstep on a year-ago basis. This convergence makes sense as student and auto lending cool, while revolving credit plays catch up after an unusually slow recovery." - source Wells Fargo

While it might be premature to pull the curtain on the Potemkin village, if indeed we break the 5% level for nonrevolving credit and continue to see a deteriorating trend in the coming months, then it will be a cause for concern. For credit markets at the moment, it's pretty much "carry on", though we are clearly tactically more cautious with High Yield and high beta in general.

"Everything's fine today, that is our illusion." - Voltaire

Stay tuned!

Credit - The Secondguesser

"Do not try to second-guess or master-mind our military officials. Leave this for established military analysts and experts, who are experienced enough to await the facts before drawing conclusions." - Broadcasting magazine, December 1941

While playing with interest the Hang Seng Index rally game given we have taken some exposure since the 30th of March and enjoying the ride so far, we reminded ourselves the definition of "second-guess" for our title analogy, as it can be of two folds:

1. To criticize and offer advice, with the benefit of hindsight.
2. To foresee the actions of others, before they have come to a decision themselves.

Of course when it comes to our "Asian allocation", we have indeed played number two and decided to "front-run" somewhat the appetite for Chinese investors moving from Shanghai towards Hong-Kong when it comes to their regional "appetite". As far as our title is concern and the choice of allocation, it stems from learning from the wise Charles Gave of Gavekal research for whom we have great respect: 

"if there is more money than fools then market rise, and if there are more fools than money markets fall"

In the case of the HSI, there is indeed more money than fools, whereas when one look at the European government bond markets and in particular the state of the corporate Hybrid debt market we touched on last week, there are indeed more fools than money in Europe. This ties up nicely to definition number 1 for "second-guess" and the benefit of hindsight, given that the "bond" risk in Europe doesn't justify anymore the reward we think.

A commonly used meaning of "to second-guess" is to criticize the actions of others, after the event. On this blog, we try to criticize the actions before the events. When it comes to choosing our title we also reflexionated around the meaning and the origin of the expression as defined by Gary Martin:

The umpire in a baseball game used to be called, rather unkindly, 'the guesser'. People who were continually telling the guesser, the manager or the players what they were doing wrong were known as 'secondguessers' and were so defined in the Sporting News Record Book, 1937:
"Secondguesser, one who is continually criticizing moves of players and manager."

Therefore one could unkindly define us as being "Seconguesser" when it comes to assessing the macro and credit environment and the decisions taken by our brazen central bankers, but we ramble again. Although one could indeed unkindly defined as "Secondguessers" with these few examples:

• we have been short yen since November 2012 when the Japanese yen was trading around 80 as described in our conversation "Cold Turkey" (partly via ETF YCS) guessing that the Bank of Japan had a lot of catch-up to do when it came to QEs and expanding its balance sheet .
• Following the BOJ move, in early 2013 we went long Nikkei but in "Euros" via a quanto ETF (currency hedged).
• Of course our biggest 2014 call has been to go long US duration in January (partially via ETF ZROZ).

As per our January 2013 conversation, "If at first you don't succeed...", we have repeatedly broken our Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions".

So never mind the practices of our "dark sorcerers apprentice", as in this week conversation, while we will briefly touch on the attractiveness of Asia versus Europe, we will look at the supposed end of the European banks/sovereign nexus particularly in the light of the latest Icelandic proposal, namely the Sovereign money proposal which we think is a must read.

Synopsis:

• Yes, for now Asia is a buy and it will continue to be so
• A large number of European banks still destroy value
• Many Southern European banks are still capital impaired
• Don't count on the end of the banks/sovereign nexus in Europe
• Final note: Flows have lagged performance in EM

• Yes, for now Asia is a buy and it will continue to be so

As me mentioned, playing our "Secondguesser" role has meant we have gotten on the HSI exposure since the 30th of March and we do believe in the compelling valuation story in Asia, regardless of the recent parabolic rise in the equity space.

So one might wonder why there has been such a rally in the equity space. It all has to do with the collapse in China money market rates as displayed by Bank of America Merrill Lynch in their recent Liquid Insight note from the 15th of April 2015 entitled "What's driving China rates":

"More to lower rates than just policy easing
The rally in the China stock market since March has been significant and in our view at least partly related to expectations of policy stimulus, as reflected in lower rates (Chart of the Day). In particular, there has been a lot of focus on China’s money market rate – the 7-day repo – which has dropped about 200bp to 3.0%. The decline should come as no surprise as market rates were high relative to inflation, and high real rates were probably the last thing the government wanted to see given the slowdown in investment and economic growth. The market move has been consistent with our view that 7d repo should come off to 3.0-3.5% in the short term.

But a closer analysis suggests banks’ liquidity management also played an important role in the decline of repo rates, over and above the PBoC’s policy guidance. The question is how fast and to what extent can money market rates fall from the current low level, in particular after the latest weaker-than-expected financing and economic data. We argue that the 7d repo rate could fall moderately further to an average of 2.5-3.0% in the coming months, but that the sharp decline of recent months seems unlikely to repeat itself." - Bank of America Merrill Lynch.

We are not the only one thinking about the China "reflation" trade as we see maverick money manager Stanley Druckenmiller recently commenting on this very subject on April 15th in Bloomberg article from Katherine Burton and Stephanie Ruhle entitled "Druckenmiller Bets on Market Surprise With China Boom, Oil Rise":

"Chinese stocks have soared with the Shanghai Composite Index doubling in the last 12 months.
“Whenever I see a stock market explode, six to 12 months later you are in a full blown recovery,” he said.
A recovery in China, the world’s second-biggest economy, would influence securities and commodities prices around the globe, said Druckenmiller. For instance, it would send German government bond prices lower, boost European exporters and lift the price of oil, he said in a separate interview." - source Bloomberg

When it comes to valuation, while the rally in Asia has been epic, when it comes to Europe, we would rather "cash in" given current valuation levels as displayed in the latest note by Louis Capital Markets from the 13th of April entitled "Three For The Price Of One" where one can see in their bonus chart the percentage of Stoxx Europe 600 members trading above their 200-day Moving Average:

 - source Louis Capital Markets

With the liberalization of personal account rules in China and a forward PE around half of the S&P500 and a free cash flow yield or around 20% according to Asia Times, Hong-Kong appears to us a better "value proposition" in these global inflated markets if we would need to second-guess investors' appetite.

• A large number of European banks still destroy value

When it comes to Europe and in particular many points to cheap valuation in the European banking space. As we have argued in our conversation "The Pigou effect" in February this year, we have argued around the "japanification" process of Europe:

"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe."

This "japanification process can be seen with the rapid disappearance of "positive" yields in the European Government space with German Bunds closing on the zero bound.

We have also long argued that regardless of QE, ZIRP and AQR, European banks would be facing continued deleveraging and that both bondholders and shareholders alike would in many instances get punished for their holdings. The reason is that European banks, in many cases still destroy value. On this subject, we read with interest Nomura's EU banks strategy note from the 10th of April entitled "Why European banks still destroy value":

"Why do half Europe's banks not make a 10% cost of equity?
Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where almost all exceed the hurdle.
In this report, we decompose profitability to identify the main drivers. Low ROE banks are mainly a result of higher costs, and to a lesser extent higher provisions and higher taxes. Margins (mix) and leverage together account for less variation between high and low ROE banks. Nordic and Benelux banks show the highest ROEs, while German and Italian banks are lowest, with UK, France and Spain around the 10% hurdle.
How and where can banks improve their profitability?
We show that cutting costs would deliver the biggest improvements in ROE, but given the consistency of national cost/income ratios, much of the differences in costs appear to be structural. Although most banks have some form of cost reduction plan in place, few target an absolute reduction in the cost base, suggesting it will take some time for banks in the least profitable countries to converge their ROEs (hence valuations) with the best in class." - source Nomura

Truth is most European banks offer poor value in terms of returns as shown in Nomura's report:

"Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where the average ROTE of banks in the BKX index is just over 13% and where almost all exceed the10% hurdle."

- source Nomura

As pointed out by Nomura's note we were note surprise to read that US banks higher ROE was driven by fewer lower risk mortgages on balance sheets:

"The higher ROE of US banks is driven by higher revenue margins given fewer low risk mortgages on balance sheet. This (and to a lesser extent a lower cost of risk) helps compensate for a considerably better leverage (equity/assets), as well as a slightly higher cost/income ratio and tax rate."

This is not a surprise for a "secondguesser" as we have highlighted on numerous occasions the very important concept namely the accounting principles of "stocks" versus "flows":

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

After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.

Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE.

The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between US banks versus European banks we think. 

This difference can be ascertained from the difference in return on assets for EU banks versus US banks as displayed in Nomura's recent report:

- source Nomura

Given the amount of deleveraging that still needs to occur in the European banking space, this divergence will continue to grow.

Although European banks have risen 16% YTD, they are still underperforming the market and when it comes to their peers in the global space they do stand out less cheap as indicated by Nomura in their report:

"EU banks stand out less as cheap vs global peers …
With the 16% rise in European banks YTD, the market capitalization weighted SX7P banks index trades at 1.2x 2015E TBV for a consensus 2016E ROTE of 11.7%, which limits aggregate re-rating opportunities (absent a sustained fall in the cost of equity).
At a global level within the banking sector, European valuations generally appear proportionate to forward ROE expectations, with some countries already implying further profitability improvements." 

- source Nomura

When it comes to a better "value" proposal, China stands out as having much better 12m forward ROE. It is also not a surprise for a "Secondguesser" to see Chinese banks listed on the Hang Seng China entreprises index rallying hard as well as indicated by Asia Times in their article from the 15th of April entitled "Chinese bank soar on valuations":

"Industrial and Commercial Bank of China led gains on the Hang Sang China Enterprises Index overnight, up 4.86%, followed by China Construction Bank (+4.39%), Bank of Communications (+4.31%), China Minsheng Bank (+3.93%), Bank of China (+3.56%) and Agricultural Bank of China (+3.50%). Banks rallied after ICBC reported mediocre 4th quarter earnings, with a big pop in loan loss provisions and a modest decline in YOY net revenue.
Mediocre is beautiful when stocks are cheap. Chinese banks non-performing loans were a mystery wrapped in an enigma wrapped in plastic explosive, and the market bid down bank stocks because of uncertainty about future write-offs. A year ago, ICBC traded at a multiple of just 4 to earnings. Now investors are convinced that banks can earn their way out their bad loss positions over time, and bank multiples have recovered–to just one-third their pre-2008 levels.
At the peak of the 2007 China equity boom ICBC traded at 21 times earnings, or three times its present valuation. The bank stock recovery reflects greater confidence in regulatory transparency under the ongoing financial reform regime. The banks have gone from distressed valuations to merely low valuations.
As global managers pile into the China trade, moreover, bank stocks are among the few vehicles with enough market capitalization and liquidity to meet the requirements of large portfolio managers." - source Asia Times

From a "second-guesser" perspective, there is indeed better value in Asia at the moment and particularly in the banking space we think whereas European banks doesn't offer that much value particularly when one takes into account the quality of capital in Southern European banks. This brings us to our next item

• Many Southern European banks are still capital impaired

Many Southern European banks' capital basis are made up for a large part of Deferred Tax Assets (DTAs) as reported by Nomura in their Southern European Banks report of the 7th of April entitled "Quality of Capital":

"Deferred tax assets (DTAs) under the microscope
European authorities are reported to be considering whether or not the legislation and guarantees on DTAs in southern Europe can be considered state aid (FT, 7 April 2015). This is in addition to the ECB looking for greater harmonisation of European capital ratios by attempting to correct for some of the different national definitions.

How big an issue are DTAs for southern Europe?
DTAs have increased significantly in southern Europe over the past few years (generated by the significant losses incurred by many of the banks). However, under Basel III’s definition, the bulk of the DTAs will be deducted from capital ratios (a change vs the previous regulatory environment). To minimise the impact of this regulatory treatment, many countries in southern Europe enacted legislation to limit the impact of this deduction. DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios.

Raise capital or improve quality over time? 

Given the extent and the size of the DTAs in southern Europe, and taking into account political considerations, we think it unlikely that the banks will be forced to raise capital specifically to address this issue. However, with the ECB increasingly looking to harmonise capital ratios, the banks could be required to continue to build and strengthen capital ratios over time. This issue could also be a hurdle to those banks looking to significantly increase dividends or payout ratios. For the moment though, the majority of dividend policies for southern European banks target moderate payout ratios of c40%- 50% (with Intesa the one major exception – targeting a payout ratio of c70% in 2015 and c82% in 2016)." - source Nomura

Hence our negative stance on European Banks and Southern European Banks in particular given the additional "real capital" that is needed to compensate for the "favorable" DTA treatment offered by the local regulators.

The exposure to DTAs while often overlooked when it comes to the quality of capital is not trivial as per the same report and is very significant in the Spanish banking system as indicated by Nomura in their report:

"Exposure to DTAs
As we can see from Fig. 1 banks in southern Europe have built up significant amounts of DTAs. In Spain alone total DTAs reached cEUR 77bn in 2013, although net DTAs (ie, net of tax liabilities) were cEUR 68bn. Low levels of profitability have meant that for the moment the amount of DTAs continues to increase.
Under Basel III, the treatment of DTAs is harsher vs the previous regulatory regime. However, in an effort to minimise the negative impact on capital from holding large levels of DTAs, governments in southern Europe have enacted legislation to reduce some, if not most, of this impact. In Spain, for example, the value of the DTAs is underwritten by the Spanish government. The DTAs that are not used up within 18 years are considered a credit against the Spanish government and exchangeable for Spanish public debt. Of the total amount of net DTAs in Spain, the government has guaranteed c 60% or cEUR 40bn. As we can see in Fig. 2, DTAs account for a significant part of the current capital ratios for the banks.

Our base-case scenario is that the banks do not have to raise capital to specifically address this issue. However, we do believe capital ratios could be raised to higher levels. The level of DTAs could also affect banks looking to raise payout ratios to high levels or significantly increase dividends, although most dividend policies are targeting a moderate payout ratio of c40%-50% (which we believe is achievable)." - source Nomura

When it comes to "capital", what matters therefore is the "quality" of the capital. In the case of some Spanish banks, the capital levels made up mostly by DTAs are not sufficient regardless of the AQR. Given in the case of Spain, these DTAs constitute a "credit" against the Spanish government and are exchangeable for Spanish public debt we doubt this marks the end of the banks/sovereign nexus discussed in our next bullet point.

• Don't count on the end of the banks/sovereign nexus in Europe

As highlighted by the DTAs issue in our last bullet point, the last couple of years have seen the banks/sovereign nexus increasing thanks to the "carry trade" financed by cheap LTROs allowing Peripheral banks to gorge on the domestic debt of their country (Italy and Spain). On the subject of the banks/sovereign loop in Europe we read with interest Bank of America's take on the subject in their Euro Area Economic Viewpoint from the 13th of April entitled "Towards the end of the banks/sovereign nexus":

"Banks/sovereign loop in the EA was worse, absent QEIn the Euro area, the impact of the banks/sovereign negative feedback loop was even more acute than in the rest of the developed world, given the tardiness in addressing the structural issues of the banking sector and more fundamentally because, in the absence of QE, banks played the role of marginal lender to the government - thanks to the ECB's generous liquidity policy - at the expense of funding the private sector.

But things are improvingHowever, thanks to progress in the capital position of banks and the new "presumption of bail-in" - which in our view could only come after the most acute systemic banking risks were actually alleviated thanks to government support (e.g. in Spain) - member states' exposure to the financial sector has now fallen. This liberates more room for manoeuvre for counter-cyclical fiscal policy. The recent shift, in the Euro area, from all-out austerity to a neutral, or even slightly stimulative, fiscal stance would not be sustainable, in our view, if government faced massive contingent liabilities.

And QE will help reduce the loop even further
At the same time, to wean banks off lending to the governments at the expense of the private sector without jeopardizing the governments' funding capacity - which would be equally detrimental to economic growth - the Euro area needed to find an alternative marginal lender. This is achieved by QE. In a nutshell, QE is the necessary complement to banking union and the Single Resolution Mechanism to break the banks/sovereign nexus. This is another, indirect, transmission mechanism of QE to the real economy. Under cover of QE, we think that the regulatory authorities will try to incentivize banks to reduce their exposure to sovereigns. This is the message that Daniele Nouy, head of SSM, sent in a recent interview in the Handelsblatt, in which she opined that holdings of government bonds should be limited to a quarter of banks' equity." - source Bank of America Merrill Lynch

We disagree with the aforementioned progress made in the capital position of banks, particularly in the light of the DTAs for Southern European banks. While QE will certainly try to incentivize banks to reduce somewhat their exposure to sovereigns, we have a hard time seeing most of these banks part with some of their highly collateral such as German government bonds due to bond scarcity with the German budget being balanced and the reduction in their debt to GDP level.

In the US the problem were dealt swiftly and differently as highlighted by Bank of America Merrill Lynch's note:

"In the US, vigorous monetary policy action - in the form of early QE - managed to offset much of the fiscal drag. To put things simply, if fiscal support is unavailable and sensitivity to interest rates is lower, then monetary policy needs to "go an extra-mile'. In our view, QE in the US has been instrumental in making sure the economy remained on the recovery track in spite of a i) effective fiscal drag and ii) unprecedented threats of "catastrophic withdrawals" in public spending, with the various "debt ceiling" and sequester episodes. The UK is another example of a country which managed to control the impact of a major fiscal drag - after a just as major public bailout of the financial system - thanks to extraordinary monetary support.

In the Euro area, in our view, the "banks/sovereign" nexus played a more acute role than in the US and the UK, not simply because monetary policy did not offer as much support, at least until very recently, but more fundamentally because the "banking issue" had a more durable, complex and pervasive effect on the economy and policy-making.

The banks/sovereign nexus is bad everywhere, but it's even worse in Europe
The reaction of the US authorities - after the initial "bail in" temptation on Lehman Brothers - was remarkably swift. Forcing a recapitalisation and imposing management decisions on banks complemented state support on liquidity. In Europe, while support came very quickly, there was comparatively little attempt at dealing with the structural issues surrounding the national banking systems. Probably to some extent because European policy-makers considered that this was primarily an "Anglo-Saxon crisis", the onus was on dampening the contagion effects of a New York born financial meltdown, without necessarily a clear awareness of the depth of the local difficulties.

This timing difference is plain to see in banks’ capital to asset ratio across the regions (see Table 3).

For simplicity of analysis, we look here at total assets, not risk weighted assets. This measure, which we take from the IMF’s financial stability report, is therefore close to a leverage ratio. Before the Great Recession, the ratio was already much higher in the US than in Europe (roughly twice as large), but what is striking is that within only three years, it had already improved by more than 2 percentage points. The best European performer during this period (France) managed an increase of only 1.2 pp, from a very low starting point.
The irony, then, is that the Europeans ended up spending slightly more government money on their banks than the Americans (4.9% of GDP instead of 4.5% of GDP for on-balance sheet expenditure alone) while triggering a much smaller improvement in their banks' capital position. To some extent, this mechanically reflects the difference in size between the two banking systems - the same public spending in % of GDP has a much lower impact on the financial position of the much larger European banking sector - but we also consider that, at least at the onset of the crisis, European governments failed to emulate their US counterpart in making public support conditional on significant and rapid efforts from banks under their jurisdiction to deal with their underlying problems.
Europe’s tardiness in dealing with the structural issues of the banking sector proved particularly toxic given the much more central role it plays in funding the economy, relative to the US. Indeed, in the US bank loans accounted for only 20% of the total liabilities of the corporate sector before the Great Recession, roughly half the proportion found in the Euro area (see Chart 2). 

It was not only a matter of quantities but also, as suggested above, of price. As we have argued before (see EEW), the health of the demand and particularly the supply of credit are key to understand the broken transmission of monetary policy, the very limited sensitivity of lending rates to policy rates in most of the periphery for most of the post-crisis period and the increased sensitivity of lending rates to sovereign yields.

Another consequence of the belated reaction of the European public sector was, that by the time the banking sector was blatantly on the brink of collapse in number of countries, the governments there had already lost market access – or at the very least was already paying crippling interest rates – precisely on account of the market’s anticipation of the bailout costs. Spain probably is the best example of this type of behaviour. Exactly at the time public sector support became crucial, its cost was impossible to shoulder.
This gets us to the second significant difference between the US and the Euro area as far as the "banks/sovereign nexus" is concerned: the "imperfect mutualization issue". In the US, even if various bodies compete in the regulation of the banking industry, two centers of decision matter: the White House and Congress, as it is ultimately a federal issue. In the Euro area, a major difficulty arose from a discrepancy, across member states, between banks' need for funds and fiscal capabilities. Ireland is the best example of this. As it can be seen in Table 2, the total of approved support to the financial sector there - on and offbalance sheet potential liabilities - amounted to 500% of GDP, while the effective cost of support exceeded twice local GDP."

   - source Bank of America Merrill Lynch

In the US QE was more effective for a simple reason: stocks vs flows as highlighted earlier. The problems facing Europe and Japan are driven by a demographic not financial cycle. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment. As shown above in our post in Nomura's chart,  the difference in return on assets for EU banks versus US banks improved much faster in the US thanks to the swift approach by the US in dealing with the crisis as well as their existing resolution framework absent in Europe at the time.

The main reason we had recession and credit crunch in Europe was the ill-fated decision of the EBA to impose banks to reach a core tier one level of 9% by June 2012.

Of course the 2011 debacle was avoided by LTRO 1 and 2 but what the "geniuses" at the EBA did not understand was that European banks were "capital" constrained hence the speed of the deleveraging and the epic credit crunch (Italy/Spain) that followed which led to a fall in "Aggregate Demand" a point which we agree with Bank of America Merrill Lynch:

"The political balance within the central bank - compounded by, until recently, the absence of clear deflationary pressure at the aggregate regional level - made it impossible to break this negative feedback loop via direct purchases of government bonds, which at the very least would have isolated sovereign funding costs from the consequences of the banking crisis.
Instead, the ECB approach - understandable from an emergency management point of view - added another layer to the banks/sovereign nexus by turning the banks into the lender of last resort of their local sovereign. Indeed, the ECB, by allowing access to long term cheap liquidity, through the LTROs, allowed banks to engage in safe carry-trade, parking liquidity into government bonds at a time when non-residents were leaving the periphery in droves.

Banks always tend to skew their asset allocation towards government bonds in bad cyclical times, as the demand for credit from the private sector diminishes while the quality of the banks' loan books deteriorates. Still, the ECB's generous approach to liquidity clearly was a facilitator. Italy in our view managed to avoid a recourse to the EFSF/ESM only because banks, which in 2009 held only 14% of the stock of public debt, ended up absorbing 75% of the increase in public debt between 2009 and 2014.

This was probably an acceptable "second best" to QE in terms of maintaining some funding capacity for embattled governments, as well as keeping the banking sector alive in the absence of clear progress on recapitalisation and balance sheet clean-up, but such approach presented the major risk of keeping the real economy into a recessive regime. Indeed, in this configuration, peripheral banks could make a more than decent living purely on the carry-trade, with little incentives for them to try to re-start lending to the private sector." - Bank of America Merrill Lynch

And of course the above approach, for any reasonable "Secondguesser" led the real economy into recessive regime thanks to the "crowding-out" effect mentioned in numerous conversations.

Where we slightly disagree with Bank of America Merrill Lynch is that while QE seems to be a necessary condition to alleviate the distortion created on Peripheral banks' balance sheet when it comes to their overall exposure to their sovereign, it is creating yet another distortion in "valuations" triggering in effect financial instability on a grand scale:

"Beyond institutional progress on banking union, QE is the necessary condition for breaking the banks/sovereign nexus
The two key institutional elements allowing the Euro area to deal with the banks/sovereign nexus are i) the Single Resolution Fund, funded by the banks and ii) the possibility, finally adopted on 8 December 2014, for the ESM to recapitalize banks directly, i.e. without leaving the financial cost, ultimately, on the balance sheet of the sovereign in the concerned banks' jurisdiction. These two instruments' capability is limited (1% of insured deposits for the first one and EUR 60bn for the second) but this is a first, important step towards a mutualization of the banking risk across the Euro area, which is in our view made possible by the federalization of banking supervision under the SSM framework.
In both cases, however, in principle mutualized support can be triggered only after a bail-in of the private creditors. This leaves the "financial stability" issue unanswered. Indeed, if the Euro area was faced with a major banking incident in which "burning" private shareholders and bondholders would trigger an unstoppable, generalized crisis, it remains unclear how a collective response would be organized." - source Bank of America Merrill Lynch

QE on its owned as we have argued recently is not enough to put Europe on the right track as we pointed out in our conversation "Chekhov's gun":

"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?" - source Macronomics, November 2014 

QE without private demand for funds only generates bubbles. The liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. From our take, as "secondguessers" the Icelandic proposal of Sovereign money would break this toxic nexus between banks and sovereigns. To explain further why the Icelandic proposal is very appealing we would like to re-quote Dr Jochen Felsenheimer from asset management XIAI we used in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" in September 2011:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy." - Dr Jochen Felsenheimer

Looking at the current stalemate surrounding Greece in particular and Europe in general nothing has really changed from our "secondguesser" perspective.

• Final note: Flows have lagged performance in EM

While some EM markets have continued to post on stellar performances, there is indeed a disconnect between EM equity flows and EM equity performance as displayed in Bank of America Merrill Lynch's recent Flow Show note from the 9th of April entitled "EM Disconnect":

"Europe hogs the spotlight: $3.9bn inflows this week, extending inflow streak to 13…
…meanwhile EM can’t catch a bid: flows have lagged performance (Chart 3); 8 straight weeks of outflows from China equity funds (despite her being the best performing global market past 12 months) and LatAm equity funds only see a tiny $37mn after 9 straight weeks of outflows" - source Bank of America Merrill Lynch

As "secondguessers", we would expect flows to resume in the coming weeks/months.

"Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation." - Warren Buffett

Stay tuned!

Credit - Operation Mincemeat

"The greatest trick central bankers ever pulled was to convince the investing world that default risk didn't exist" - Macronomics.

Watching with interest government yields making new record lows (Spanish 10-year yields at 2.63%, the least since 1993, and Italian 10-year yields at 2.723%, an all-time low), with the Itraxx Crossover index, the CDS 5 year risk gauge for European High Yield falling 8 basis points to 229 basis, the lowest level since June 2007, we thought we had to adapt our quote above to reflect the "greatness" of our central bankers magic tricks and deceptive actions which is of course a reference to Usual Suspects' "Verbal Kint (when it comes to "Cantillon" effect and creating excessive risk taking mentality) and to great text from the French poet Charles Baudelaire: "My God! Lord, my God! Please make the devil keep his word!"

One may therefore wonder why our chosen title. Given this week saw the 70th anniversary of the D-Day landing in Normandy, we reminded ourselves of one of the greatest disinformation plans of World War II, namely Operation Mincemeat. It was a widespread deception plan intended to cover the invasion of Italy from North Africa. Operation Mincemeat helped convinced the German high command the allied would land in Greece and Sardinia in 1943 rather than the actual objective of Sicily. The glaring success of Operation Mincemeat, caused the Germans to disregard later genuine documents finds such as documents found 2 days after D-Day landings detailing future military targets and disregard similar documents found during Operation Market-Garden in the Netherlands in September 1944. 

In similar fashion the successful concerted action from our "Generous Gambler" aka Mario Draghi, with this week's new decisions from the ECB following his 2012 "whatever it takes" moment have had similar effects on keeping at bay the "feral bond hogs" and leading investors to completely disregard default risk.

Without the prior success of Operation Mincemeat, D-Day landings could not have been successful. In similar fashion the disappearance of "default risk" in Europe and the ensuring "Japonification" process of yields would not have been successful without the prior deceptive plan of the "OMT" ("believe me it will be enough" moment). On a side note for those who want to read great accounts of the D-Day landings in Normandy we recommend you read Max Hastings' masterpiece "Overlord" and "Decision in Normandy" by Carlo d'Este. For those of you who enjoy human's ability in practicing deception, like ourselves, we recommend the site "deceptology.com" dealing with its various forms.

But, moving back to this week's conversation, we would like this week to look at the on-going "Japonification" process and what it entails in terms of risk taking mentality and credit compression as well as the "deception" process at play when it comes to the new measures being set up by the ECB which are in fact once again supportive of the deleveraging and recapitalisation process of the European banking sector as a whole.

A good illustration of the "Japonification" process in the credit space can be seen in the below graph illustrating the degree of tightening of the Itraxx Crossover 5 year CDS index indicative of the risk gauge for European High Yield (based on 50 European entities) - graph source Bloomberg:

The spread is closing towards the lowest point encountered back in 2006 and 2007.

More worrinyingly, liquidity wise, as we have pointed out on numerous occasions on this blog, the degree of liquidity that can be provided by market makers is nothing comparable to what could be provided back then. Dealers simply do not have the inventories or the risk appetite to absorb a large sell-off should it occur in the market place. For instance, from a discussion with a large interdealer broker in the CDS space, it appears that only two banks are providing large enough liquidity in the High Yield CDS single name space in decent clip size (20-30 million of notional amount) whereas most of the time ticket size in the CDS single name space would be around 2-3 million per name in the CDS space. Markets have become indeed more defensive than in 2006-2007, particularly so when CDS dealers have a hard time recycling CDS bids being hit continuously with spread compression with no large loan books hedging taking place lifting protection in the process given the on-going deleveraging taking place in the European banking sector.

The latest move from the ECB has as well closed the gap between Investment Grade in Europe as seen in the credit index Itraxx Main Europe 5 year with its US counterpart CDX IG as illustrated recently by Bank of America Merrill Lynch's graph from their recent Credit Strategist note from the 6th of June entitled "Return to Order":

"Most measures - including the discussion of potential future ABS based QE - are clearly positive for credit as investors are crowded out of yield opportunities. Obviously most directly positive for European credit, but also indirectly for US credit as relative value improves. Hence US investment grade and high yield tightened 1.7bps and 0.26pts, while European IG tightened as much as 3.8bps (iTraxx). It should not be long before Main trades inside IG (Figure 9), especially as with the ECB out of the way US interest rates can better reflect the strength of the US economy." - source Bank of America Merrill Lynch

What of course the continuous tightening has done to Investment Grade Credit has been to increase the instability to sudden shock in rising rates, making the asset class increasingly more vulnerable than High Yield which from a convexity point of view is less sensitive to rates movements as indicated in the same report from Bank of America Merrill Lynch:
"The emerging June seasonal in rates
For the second consecutive year financial markets are working hard to establish a very bearish June seasonal for Treasuries, as 10-year interest rates two business days into the month have risen already 12bps. That represents the biggest 2-day increase in interest rates in more than six months (since 11/20/2013), but ranks only 15th since rates began to increase in May last year (Figure 21). 

However a representative IG ETF (long term) has declined 1.29% over the last two days – a move not seen since 7/5/2013, and the 6th biggest move since May last year. A benchmark HY ETF is down 0.76% over the same period, a move we have seen earlier this year, and only the 23rd biggest decline since May last year. Clearly this recent increase in rates is disproportionally adverse to IG returns compared with anything we have seen recently. The main reason is that, as credit spreads have rallied significantly, there is very little spread cushion available to offset the increase in interest rates. Clearly high yield has more capacity, and thus returns are faring better.
The past two days compare with the period 10/29/2013-12/31/2013, where the same representative IG ETF declined similarly (1.21% negative price return). However, that was on a 50bps move higher in 10-year interest rates (from 2.5% to 3.0%). One of the big differences is that back then credit spreads started at 144bps compared with just 112bps currently, and thus could play a bigger role in offsetting the rates move (Figure 22). 

We continue to expect some spread tightening initially as rates go back up, although this time much more modestly. This especially as retail flows – that tends to be driven primarily by past returns – are still driven in the short term by this year’s stellar performance through May. However, the experience the past two days shows just how fast returns erode this time when interest rate increase.
Thus eventually retail inflows end, which should more than offset the increase in institutional demand and lead to less favorable liquidity conditions and higher spread volatility." - source Bank of America Merrill Lynch

To illustrate further more interest sensitivity in conjunction with lack of liquidity, we discussed recently this very subject with our cross-asset friend and fellow blogger "Sormiou". For instance there are some new issues in investment grade in the primary market in the 300/400 million euro range size coming to the market. They are obviously smaller than the traditional 500 million benchmark size deals being generally placed and bought by mutual funds. They come with 10 year maturities with spread comprised between 70 and 90 bps. The problem is that on the secondary space these bonds are being priced by market makers with 10 bps bid/offer spread meaning that with a duration sensitivity of around 7/8 you lose 1 year of carry in the secondary space should you decide to part with your recently acquired bonds. So dear Investment Grade investors welcome to "Japonification" and "buy and hold" for the next 10 years...

The recent ECB decisions will of course reinforce the technical bid for credit even more and compressing even further already very tight spreads in the market place. In this environment, no doubt European High Yield will continue to perform as the "hunt for yield" will intensify in true "Cantillon Effects" fashion. We therefore expect financials to outperform significantly non-financials, and in particular Italian financials credit and equities to be as well the big beneficiaries from the latest generosity from our "Generous Gambler" aka Mario Draghi. Let's face it, when your central bank offers you 400 billion 4 year loans at 25 bps, it is hardly an offer you can refuse to play the "carry" game even further. While the ECB is hoping that banks will use to pass it on to corporate via increase lending, the deception in "Operation Mincemeat" is that it will be used rather as yet another source of cheap funding given the real constraint face by the European financial sector has more to do with capital issues rather than liquidity issues. 
What seems to be happening as well with the recent additional help of "Operation Mincemeat" by the ECB, is that investors are indeed pushed out even further out on the risk curve as confirmed by Morgan Stanley's Leveraged Finance Insights note from the 6th of June entitled "Here What You Own":

"We find that HY funds have gradually allocated away from high quality in recent history. In December 2012, the allocation to BBs stood at 36% (very much in line with the overall market, at 37%). The allocation to Bs was also close to the broader market, at 49%. Over the last five quarters, BBs have increased as a percentage of the overall market by 7%. However, BBs increased as a percentage of total mutual fund holdings by only 3.4% from 4Q12 to 4Q13 and remained flat from 4Q13 to 1Q14. Funds are now 5% underweight BBs compared to the overall market, showing that rising rates have likely surprised investors this year. To some extent though, we have seen moderation in risk-taking by funds quarter over quarter. For example, funds have moved from 1% overweight CCCs to 1% underweight, at the same time increasing their overw eight to Bs." - source Morgan Stanley

The latest round of central bank generosity will further trigger additional yield seeking investment and boost no doubt asset prices further up as illustrated by the performance of European High Yield versus Equities since 2009 as displayed by Bank of America Merrill Lynch in their latest Thundering Word report entitled "So it begins":

In true Japanese fashion, credit in a deflationary environment does indeed tend to outperform as we have previously discussed in our conversation from April 2012 entitled "Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"

We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior  financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4%  these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great magicians. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:

On a final note and to illustrate further our "deception" analogy from our chosen title as well as our gently twisted starting quote from above, Mario Draghi is truly a great magician when it comes to deception tricks as indicated by the below Bank of America Merrill Lynch graph from their latest Thundering Word note entitled "So it begins" given that Italy now appears more creditworthy than the US:
"From ZIRP to NIRP
ECB policy ease induced a phenomenal rally in European credit markets. 5-year Italian bonds yielded 700bps more than US 5-year bonds less than 3 years ago; now they trade 25bps below (Chart 2)."

- source Bank of America Merrill Lynch.

For us it seems we are indeed moving from ZIRP to NIRP, to ZILCH, when it comes to yield levels and no doubt the last leg of the rally has some more room to "overshoot" on the way up rest assured.

"Profit is sweet, even if it comes from deception." - Sophocles

Stay tuned!