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 - Information cascade

"Every market is in transition." - Kenneth Lay, former CEO of Enron

Watching with interest the impressive melt up in European equities during the month of February (with French index CAC40 up close 14% since the beginning of the year), in conjunction with continuous credit and rates compression, marking the return of leverage structured credit as the hunt of yield runs unabated, we reminded ourselves of the "information cascade" model when choosing our title analogy:

"An information (or informational) cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts. A cascade develops, then, when people “abandon their own information in favor of inferences based on earlier people’s actions”." - source Wikipedia

In the specific case of the current equity melt-up helped recently in Europe supported as well by "better" economic data, no doubt that some investors have abandoned their own information in favor of inferences based on earlier central bankers actions when it comes to implementing QE, with Europe on the verge of launching a program of its own.

When it comes to assessing the on-going lift-off in European equities, it follows the lift-off we have seen in the US as well as in Japan, following the various rounds of QEs. 

In the "Information cascade model", there are four key conditions:

"1. Agents make decisions sequentially
2. Agents make decisions rationally based on the information they have
3. Agents do not have access to the private information of others
4. A limited action space exists (e.g. an adopt/reject decision).
One assumption of Information Cascades which has been challenged is the concept that agents always make rational decisions. More social perspectives of cascades, which suggest that agents may act irrationally (e.g., against what they think is optimal) when social pressures are great, exist as complements to the concept of Information Cascades." - source Wikipedia

Of course we agree with point number 2. When it comes to financial markets, agents often seems to act "irrationally", and display what former Fed Chairman Alan Greenspan called "Irrational exuberance" but then again, as we posited in our conversation "Pascal's Wager" investors are indeed making a "rational" decision based on the premises that central bankers are "deities":

"In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not."

Obviously investors that believed that the SNB's had a "godly' status met their makers when the SNB finally pulled the plug on the Euro peg but we ramble again...

When it comes to markets and the choice of our specific title, no doubt that the current "euphoric" environment is a clear display of "Information cascades being at work:

"Information cascades have become one of the topics of behavioral economics, as they are often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...) or a specific asset, like a stock that becomes overly popular among investors." - source Wikipedia

What we also find of interest is that marketers also use the idea of cascades to attempt to get a buying cascade started for a new product:

"If they can induce an initial set of people to adopt the new product, then those who make purchasing decisions later on may also adopt the product even if it is no better than, or perhaps even worse than, competing products. This is most effective if these later consumers are able to observe the adoption decisions, but not how satisfied the early customers actually were with the choice. This is consistent with the idea that cascades arise naturally when people can see what others do but not what they know." - source Wikipedia

In similar fashion, central bankers around the world have done the same "marketing" exercise. They have induced other central bankers to adopt QE, although it is fairly clear that the real economic benefits of QE are dubious at best.

Therefore this week will review the current "risk-on" information cascade environment given, we think it is entirely flow driven with one of the main culprit being Japan's GPIF and we will also muse around the utility of a European QE in the current context.

Synopsis

• Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently
• In the equity space, it's "party on" with a caveat
• We have moved from a low volatility regime to a higher volatility regime
• QE + Austerity = road to growth disillusion/social tensions but road for heaven for financial assets
• 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
• Final note: Why European banks deleveraging has much further to go and why it means more pain for shareholders and bondholders

• Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently. 

The current European "melt-up" in European equities is driven by investors' flows and in particular by Japan's GPIF allocations. As reported by Nomura in their 2nd of March note entitled "GPIF Q3 FY14 investment results", there has been significant progress in portfolio rebalancing from the GPIF:

"The Government Pension Investment Fund (GPIF) released its investment results for Q3FY14 and reported that investment income totalled JPY6,623.3bn for a total return of
5.16%.
Beginning this quarter, the GPIF adopted a new method for announcing the amount of its investment assets – it no longer discloses investment assets by asset.
By making certain assumptions, we estimate the GPIF reduced its domestic bond holdings by JPY6.4trn, added JPY1.9trn in domestic stocks and shed JPY0.8trn short term investment. It increased its investments in international bonds and international stocks by JPY0.7trn and JPY1.9trn, respectively.
Compared with the JPY3.3trn reduction in Q2, the GPIF accelerated its domestic bond selling significantly in Q3 (JPY6.4trn reduction including matured investments). This is consistent with October-December JSDA data showing that trust banks were net sellers of yen bonds by a total of JPY3.1trn (vs. JPY0.5trn net buying in July-September).
By comparing the asset mix at end-December and the new Basic Portfolio, we have estimated how much GPIF assets need to increase or decrease to achieve the target median weightings. According to our calculations, GPIF should shed JPY13.3trn in domestic bonds, and increase domestic stocks by JPY5.7trn, international bonds by JPY1.7trn and international stocks by JPY5.9trn.
Assuming the GPIF reduces domestic bonds at a similar pace to Q3, it could achieve the target weighting in six months. Similarly, it would achieve the target weighting in 12 months if the reduction continues at a pace on par with Q2, and eight months if it proceeds at the Q2-Q3 average pace (Case [1] in Figure 2). The amount of portfolio shift necessary would be smaller if we reflect mark-to-market changes since end-December (i.e., higher stock prices, etc.; Case [2] in Figure 2). We will monitor how market movements affect the GPIF’s portfolio shift.
Looking at supply and demand factors alone, the GPIF’s portfolio shift should cause stock prices and yen bond rates to rise and JPY to weaken further. In our view, however, JGB investors may highlight the fact that the GPIF has made significant progress in its yen bond selling, and gradually shift their focus to when it is completed, as well as subsequent supply and demand dynamics.
We also note that public pensions other than the GPIF appear to have lagged in their portfolio shifts, and may begin to accelerate yen bond selling. In this case, the portfolio shift by public pension funds as a whole would be a longer process. However, we believe the market will begin to wonder if the BOJ can continue QQE2 purchases as it heads toward end-FY15, when the GPIF is likely to complete its rebalancing." - source Nomura

And as we posited in our post "The Vortex Ring", the re-allocation process from Japanese behemoth GPIF, has continued to put additional downward pressure on core government bonds:

"It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998". - source Macronomics, 26th of May 2014

Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets.

When it comes to Toshin funds, as reported as well by Nomura in their 4th of March note entitled "Toshin momentum remains strong", retail investors are also piling in international markets:

"Retail investors accelerated their investment in foreign assets via toshins last week, according to NRI (Figure 1). They bought JPY136bn ($1.1bn) of foreign securities, the highest pace in three weeks. This was the 14th week in a row of net purchases, and retail investors' cumulative foreign security buying via toshins this year has reached JPY1.2trn ($10bn), about JPY856bn ($7.2bn) bigger than for the same period in 2014
(Figure 2). 

Toshin momentum remains relatively strong, as risk sentiment among retail investors has improved gradually.
Retail investors continue to prefer foreign equities to other asset classes. They are estimated to have purchased JPY56bn ($0.5bn) of foreign equities via toshins, while purchasing JPY27bn ($0.2bn) of foreign bonds and JPY52bn ($0.4bn) of foreign hybrid securities. They continued to sell domestic assets via toshins for the third week in a row, while the pace of selling slowed to JPY60bn ($0.5bn) from JPY98bn the previous week. Japanese equity prices have been performing well since mid-January, and this likely encourages retail investors to book profits. Retail investors’ expectations for USDJPY appreciation have also led to stronger investment in foreign equities than in domestic assets via toshins (see "Retail investors still see USD/JPY upside", 12 February 2015). Lower yields globally may reduce the appeal of foreign bonds to retail investors. We expect toshin momentum to remain strong, because of better risk sentiment and expectations for JPY weakness, while their preference for foreign equities relative to bonds will remain strong for the time being." - source Nomura

Arguably, the GPIF has not been the only game in town with the pending European QE which, in terms of flows has driven them into overdrive when it comes to European markets as indicated by Bank of America Merrill Lynch Flow Show note from the 5th of March entitled "Carry On Risk":

"Risk-On: cash down for 3rd straight week to fund $7bn into equity funds and $6bn into bond funds Europe the Consensus Darling: euphoric 99th percentile inflows over past 8 weeks ($31bn)…heaviest since Dec'08 (Chart 1)

Retail loves Income: chunky $2.8bn inflows to equity income funds this week; note BofAML private clients have significantly raised allocation to equity income ETF’s past 24 months (Chart 2)

Carry On Risk: incessant central bank rate cuts + rising macro optimism = risk taking on the rise...our Bull and Bear Index (flashed contrarian “buy” in Jan) up to 4.3 (Chart 3); 

big payroll/strong avg hourly earnings would cause risk to pause but Feb small biz hiring intentions today was not strong." - source Bank of America Merrill Lynch

The sentiment of bullishness in February has run unabated but, once again the "strong" NFP data in the US came back to spoil somewhat the party in the US equity space has "good" news once again meant "bad" news and increasing the possibility of a rate hike by the Fed in the near future (we still very much doubt about this).

• In the equity space, it's "party on" with a caveat, 

Not only have foreign flows and the ECB QE path pushed equities into overdrive, but the renewed appetite for buybacks in conjunction with a rise in M&aA operations have also been supportive of the aforementioned rally. But there is indeed a caveat, because while the party is going strong, earnings have reverted in the US and remain flat in Europe. On that note we agree with Louis Capital Markets Cross Asset Strategy note from the 2nd of March, that fundamentals do not seem to matter in this market cycle when it comes to equities behavior to say the least:

"The reading of financial markets has been an understandable process when regarding the bond, the currency and the commodity markets. The equity market however has been a real enigma and its recent behaviour has not helped to better our comprehension of it. What is the driver of equity indices??? We thought that the expected stream of companies’ earnings was the main driver however this market cycle has demonstrated that this assumption is a false one. Subsequently, we are having significant difficulty in identifying the main drivers of the market.

Equity indices are reaching new highs in this cycle contrary to earnings that have reverted in the US and that remain flat in Europe. The P/E expansion has been very strong as a consequence and its limit is unknown. The current level of investor confidence is amazingly high and it contrasts strongly with the business climate in the real sphere that has not shown similar signs of overheating.
This kind of context is obviously very positive for equity investors. Some will say “it’s crazy, it’s going to crash”. However, history has repeatedly proven that high-levels of hubris often take a while before inevitably ending in tears. We did not expect to live through another mania in our life after the one experienced at the end of the 90’s, but we were wrong. This cycle is even more impressive that the one at the end of the 90’s, because it has come from nowhere and has so far lasted longer.

These days many commentators are explaining that, contrary to the TMT bubble, as profits are rising on this occasion current circumstances cannot be diagnosed as a “bubble”. We do not believe the current context constitutes a bubble. However, we were more comfortable in paying Cisco 100x expected earnings in 2000 than paying today 18x the earnings for Endesa or 20x for Belgacom. In the 2000’s the story was a strong one. A sort of revolution was taking place and it was consistent from a market perspective to dream of a new world emerging. Today, we are failing to find a similar story for Endesa and Belgacom, and our dreams are not stimulated when listening to the IR’s presentation of Belgacom.
The “low interest rates environment” are the words that can be found in every mouth during this cycle. The argument appears so obvious that everybody embraces the idea that the influence of central banks on the bond market also impacts the equity market through the discount factor mechanism. If profits of Belgacom remain flat for the next 20 years, paying the stock 20x current earnings roughly implies the recovery of its investment in 20 years. This is a long period of time, but the 20-year government bond yield of Belgium is close to 1%, thus implying a 100 year time horizon needed to recover its investment. 20 years vs. 100 years would represent the “equity risk premium”.
We fully disagree with this rationale, because it implies a “by default” investment. The pricing of equities is not driven by the pricing of bonds. Their underlying drivers are too different to think there are spill-over effects that inflate “naturally” equities. The Japanese experience has been crystal clear on this subject: long term bond yields have oscillated between 1% and 2% between 1998 and 2008, and despite this low remuneration of the bond asset class, the performance of the Nikkei was null during this period of time.We do not want harp-on regarding this subject as it one of weak importance for many PMs. The long only PMs are fighting against a benchmark regardless of the global mood of the equity market, whilst macro traders focus on relative value trades. The main beneficiaries of this equity mania are diversified PMs, because they have the choice between two asset classes that have been in a bullish mood for 6 years now. So even if they are wrong in their assets’ selection, they have not lost money in absolute terms." - source Louis Capital Markets

For us, and as per our title, the "Information cascade is at play and feeding speculation and create cumulative and excessive price moves on a grand scale for the whole market (market bubble...).

• We have moved from a low volatility regime to a higher volatility regime

As per our title analogy, the more central banks meddle with asset prices, the more disconnected and unstable markets are becoming.

On the subject of a higher volatility regime which was discussed in our previous conversation by our friends at Rcube Global Asset Management , European equities have started 2015 on very strong note as highlighted above by the amount of flows in the asset class, but implied volatility have risen across financial markets as depicted by Louis Capital Markets in their monthly report entitled "Europe In Sight":

"The European equity market has been very strong since the beginning of the year, outpacing most equity indices. It is difficult to find a tangible and credible reason behind this move because nothing has really changed in the real economy. It seems it is first of all “sentiment driven” and that the perspective of an aggressive central bank has helped to lift this sentiment.We are surprised by this reaction because the “central bank” argument remains by nature fragile and because we had previously signs of cautiousness with the rising implied volatility across financial markets (see chart below).

In the previous cycle, the 2002-2007 cycle, the rising volatility coincided with the end of the bull market. Although we do not call for the end of this bull market, we thought that the rising volatility since last summer would have prevented an “upward crash” like we got in January/February (15%+ for the Eurostoxx50 in less than 2 months). The chart below shows to what extent this move is unusual.

The sector hierarchy shows that this move corresponds to a pure re-rating as all sectors, with a small dispersion, benefited from this euphoria. The consumer segment has led a little thanks to the decline of oil prices but this is not the whole story. The median 12m Fwd PER of the Stoxx Europe 600 universe stands now at 16.8 and it is well above the top of 2007. That’s the most important story because it questions the valuation regime of European equities. Is this level exaggerated or will we see a median PER at 20 before the end of the year (implying an additional upside potential of 20%+)??? This context is perturbing for investors because it blurs the notion of “cheap” and “expensive” stocks, and lowers in the end, the relevance of the valuation factor." - source Louis Capital Markets

As far as the Information cascade is concerned and the on-going "melt-up" we would repeat what we indicated back in January 2012 in our conversation "Bayesian thoughts" when we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

Bayesian learning today is indeed leading towards an acceleration in the rise in asset prices, while the end of the low volatility regime in conjunction with the rise in the US dollar (meaning a global tightening from a pure "macro" perspective) indicate we are indeed in the final innings of the game we think.

• QE + Austerity = road to growth disillusion/social tensions but road for heaven for financial assets

In our November 12 2014 conversation "Chekhov's gun" we put forward our take on QE in Europe:

"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 12th of November 2014

We also indicated at the time:

"Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)"

Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term.

This brings us to a subject we have already tackled when it comes to differentiating QE in Europe versus QE in the US. It is all about Stocks versus Flows:

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

"Credit growth is a stock variable and domestic demand is a flow variable" as indicated by Michael Biggs and Thomas Mayer in voxeu.org entitled - How central banks contributed to the financial crisis.

On that essential difference we came across a very interesting note from BNP Paribas from the 6th of March entitled "The ECB wants to buy but who wants to sell?"where they highlight 3 main differences between QE in Europe versus QE in the US which we summarized below:

1. Size matters: the corporate credit market/ABS market in Europe is not as deep as in the US. It is very difficult for institutional investors in Europe to switch from holding government bonds to corporate credit/ABS.
2. Timing: QE 1,2,3 in the US were done when the amount of US Treasuries issued was rising due to the US budget deficit! In Europe, QE is being launched when there is a very weak net issuance level due to austerity measures being implemented.
3. Liquidity constraints for Banks and Insurers are much more harsher than in 2010/20111, meaning that these institutions will hang onto their holdings, negative yields or not.

Stocks versus Flows, is for us a key element in terms of the macro understanding of the ECB's position versus the Fed as highlighted in BNP Paribas's note:

"The stock of bonds versus the flow
Over the past few weeks, much has been written about the risk that the ECB may not be able to find all the bonds it is intending to buy. This seems a strange predicament, since not so long ago many people were worried about the eurozone having too much debt. Before we go into more detail, it is worth remembering that someone’s debt is somebody else’s asset, so saying that there is too much debt would be equivalent to saying that there are too many assets, which we never hear (and for good reason). The main focus should rather be more on the quality of the debt (and how it would be repaid) instead of the size.
Why is there such a worry about the execution of QE? As we have pointed out several times, the size of the buying is relative to the size of bonds for sale. We show in Table 1, that the net issuance for 2015 is negative by EUR 200bn after taking into account the bonds bought under QE. This is the major difference with the US and the UK, as QE in those countries were done at a time of greater budget deficit, therefore limiting the concern about supply.

Other differences and specific points about European QE
When the FED was buying T-Notes, sellers had the opportunity to re-invest in the US fixed
income markets. They could also re-invest the proceeds into corporate bonds or in the mortgage markets, where the liquidity was enough to absorb part of the money that used to be in US government bonds. Investors could also choose lower quality bonds, investing some proceeds into municipal bonds for example. Obviously, it is unlikely that holders of AAA-rated US government bonds bought a lot of lower quality US paper (but some spillover must have taken place as we can see in Chart 1 and chart 2), and at the very least they were not penalised by negative deposit rates if the cash was not re-deployed immediately. So if they were not able to extend the duration or go lower into credit quality, they always had the choice to park (at least momentarily) some of the cash into very short-dated bonds at zero.

This is not the case in Europe today. When holders of a government bond from a eurozone country sell a bond, they do not have much of an alternative in the fixed income markets for reinvestment. The European corporate bond market is not liquid enough, the ABS market is too small and the ECB also has a programme to buy covered bonds. So unlike in the US, once a bond is sold to the ECB, the buyer is likely to look for another … government bond. So in the context where the offer of bonds is less (because deficits are lower) and there is a large marginal buyer, there is upward pressure on prices.
There are other differences. QE in the US and UK was done when the rules for liquidity constraints were easier. As regulation pushes banks to hold large amounts of collateral in order to comply with stricter liquidity rules, there is a natural extra bid for short-dated bonds. These bonds are also supported by the fact that the overnight rate is negative (unlike in the US) and as large investment funds do not have access to the deposit facility of the ECB, they have no choice but to buy short-dated bonds. This is why there are so many bonds with negative yields (up to 25% of the outstanding bond market size) – another significant difference with the US.

A word of caution
We should keep in mind that the ECB is officially trying hard to create inflation in line with its mandate. In that context the very long-dated bonds remain particularly vulnerable if CPI inflation numbers start to pick up. Nobody is expecting a bounce anytime soon, but when the base effect of oil fades (towards the end of 2015) and the weaker euro eventually lets some imported inflation in the eurozone, the picture could be very different. Also when QE started in the US, the economic situation was deteriorating following the 2008 crisis, which is not the case in Europe, where some early signs are that the situation is at the very least stabilising or getting slightly better. Forward inflation expectations in the eurozone have already corrected higher at 1.77% (5-year, 5 years forward implied inflation expectations) and are not far off from the ECB’s target, hinting that QE will be successful over the medium term, (Chart 6). 

Such high inflation anticipations combined with the suppression of nominal yields means that investors going into the long end are forced to accept very negative real returns (Chart 7). 

This is a highly unusual situation, which cannot be sustained over the medium term, hinting that at some stage the long end of bond prices will drop." - source BNP Paribas

Caveat creditor...as we posited in our September 2014 conversation "Sympathy for the Devil":

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

"Investors have indeed Sympathy for the Devil we think, as they continue to pile up with much abandon and more and more getting "carried away" in their insatiable hunt for yield. In that sense Baudelaire's 1869 poem rings eerily familiar with the current investment situation in the sense that investors have been giving our "Generous Gambler" the benefit of the doubt (OMT - and now full blown QE) and shown their sympathy and their blind beliefs in "implicit" guarantees, rather than "explicit" (such as the German Constitution as we argued in various conversations)" - source Macronomics, September 2014

As we indicated in our conversation "Eastern promises" on the 9th of June 2012 we continue to think Germany could be the prime suspect in triggering a breakup (Greece being the perfect scapegoat):
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

Keep in mind that Angela Merkel while only appearing to be making material sacrifices has managed to keep Germany's liabilities unchanged so far.

• 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"

We will never understand why the European QE is not made alongside some form of New Deal with massive infrastructures in Europe, which would put people back to work and improve the odds of a self-sustaining economic model with better preservation of social cohesion.

On a side note, if you are fans of the US TV series "House of Cards", you will have noted that in season 3, Frank Underwood (Kevin Spacey) now president of the United States is fighting against an hostile US Congress. In terms of his proposed economic policies, President Underwood wants a hostile Congress to cut Social Security and appropriate $500 billion on public spending to boost jobs in infrastructure, government and the private sector.

In the "real world", as reported by Bloomberg  on the 4th of March, "U.S. Companies Are Stashing $2.1 Trillion Overseas to Avoid Taxes":

"Obama earlier this year proposed applying a 14 percent mandatory tax on the stockpiled profits and a 19 percent minimum tax on foreign earnings going forward.
The one-time tax would generate $268 billion over six years, which Obama wants to use for infrastructure." - source Bloomberg

We find this interesting particularly around the discussions about "Biotechs" current valuations, which for us are clearly representative of their "tax advantage" compared to the "Utilities" sector for example. We touched on this subject in our October conversation "A Descent into the Maelström":

"We think that the "too much liquidity" popular trades of biotech, internet, gaming and small cap are up for more pain in the future. Technology and Health Care Companies in the S&P 500 index are both heavy users of adjusted earnings measures in their financial statements: Of 69 technology companies in the index, 56 use non-GAAP earnings, of 56 Health Care companies, 45 use them. (source "Earnings, but Without the Bad Stuff", Gretchen Morgenson, November 9 2013 - New-York Times). The vast majority of public biotech companies in the U.S. (87%) do not pay taxes because they lose money as they pursue breakthrough therapies and cures as well as using non-GAAP metrics to boast are more "positive" accounting picture. Young high tech companies often end up paying less than 10% of income in taxes whereas old railroads and utilities often pay more than 25% and cannot easily "jump" countries using M&A for tax inversion purposes"

Should the US administration decide to "close the tax gap", rest assured that your "Biotech Bubble" would burst in an instant, but, that's another subject...

• Final note: Why European banks deleveraging has much further to go and why it means more pain for shareholders and bondholders

While the Hypo Alpe Aldria drama is unfolding in Austria with additional losses of €5.1bn to €8.7bn meaning more pain to come for bondholders  (€9.8bn senior and sub, €1.2bn Pfandbriefe), we leave you with Louis Capital Market chart displaying the relative performance of the the STOXX Banks sector (SX7P) versus SXXP:

- source Louis Capital Market

As a reminder, US banks have increased their capital basis by 57% since 2007 until 2012 while Western European banks by only 37% on the same period as per our conversation "Sympathy for the Devil". So keep on playing the "Dead Cat Bounce" game in European banks stocks the on-going "Information Cascade", rest assured that when it comes to European banks, the trend is indeed your friend...

Sic transit gloria mundi -  "Thus passes the glory of the world." 

Stay tuned!

Credit - Quality Street

"Quality is not an act, it is a habit."- Aristotle

While mesmerizing at the velocity in the fall in core government bonds including our beloved US 30 year exposure, and the aforementioned flight to "quality", we reminded ourselves of the individual sweets first produced by Mackintosh's in Halifax, West Yorkshire, England in 1936:

"In the early 1930s only the wealthy could afford boxed chocolates made from exotic ingredients from around the world with elaborate packaging that often cost as much as the chocolates themselves. Harold Mackintosh set out to produce boxes of chocolates that could be sold at a reasonable price and would, therefore, be available to working families. His idea was to cover the different toffees with chocolate and present them in low-cost yet attractive boxes. Rather than having each piece separated in the box, which would require more costly packaging, Mackintosh decided to have each piece individually wrapped in colored paper and put into a decorative tin. He also introduced new technology, the world’s first twist-wrapping machine, to wrap each chocolate in a distinctive wrapper. By using a tin, instead of a cardboard box, Mackintosh ensured the chocolate aroma burst out as soon as it was opened and the different textures, colors, shapes and sizes of the sweets made opening the tin and consuming its contents a noisy, vibrant experience that the whole family could enjoy." - source Wikipedia

In similar fashion, our title is a reference to the rapid surge in ETF inflows in 2014 which broke numerous records in terms of inflows as reported by the Financial Times in their article entitled "ETF industry booms in record-breaking year":

"Numerous records for ETF inflows were set in 2014 by providers, and across asset classes and geographies. This was helped by a massive surge in December, when investors allocated $61.5bn of new cash, a monthly record.  The December surge pushed 2014’s net inflows for ETFs (funds and products), to $338.3bn, up 36.1 per cent on the previous year and surpassing the $272.2bn record for inflows set in 2008, according to ETFGI, the consultancy. Deborah Fuhr, founding partner at ETFGI, called 2014 a “truly amazing” year for the industry.
 BlackRock, the world’s biggest fund manager, cemented its position as the leading ETF provider globally after gathering record inflows of $103.6bn, two-thirds more than in 2013.  Mark Wiedman, global head of iShares, the ETF arm of BlackRock, says more investors around the world are embracing the versatility of ETFs, whether for strategic buy-and-hold investments or as precision exposures to express views on virtually any market. Vanguard, the third-largest ETF provider by assets, also enjoyed a record-breaking year, with inflows of $88.7bn in 2014, up almost 47 per cent on the previous year. A variety of other providers including Amundi, Lyxor, FirstTrust, Charles Schwab, UBS and BMO of Canada also had record-breaking inflows." source Financial Times

It is no surprise to read from the same article that when it comes to "Quality Street", investment grade matters:

"Two BlackRock ETFs linked to investment-grade corporate debt were among the best-selling products in Europe, gathering a combined $5bn." - source Financial Times 

One could indeed infer when it comes to our analogy that, in similar fashion to Harold Mackintosh's boxes of chocolates, when it comes to the investment world the surge of the ETF complex is akin to the rapid success of "Quality Street" sweets but we ramble again.

When it comes to credit, one may just look at the latest EPFR data to see that in our "Quality Street", Investment Grade is leading with 56 straight weeks of inflows as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 16th of January 2015 entitled "Positioning for ECB QE":

"Credit flows (week ending 16th January)
HG: +$1.7bn (+0.3%) over the last week, ETF: +$440mn w-o-w
HY: -$755mn (-0.3%) over the last week, ETF: +$132mn w-o-w
Loans: +$9mn (+0.1%) over the last week
Inflows strengthened into high-grade funds, with the strongest pace in 7 weeks, and the 56th consecutive week of inflows. High-yield registered another outflow, marking a continuation of the flight to perceived relatively safe assets amid an eventful previous couple of months. ETF fund flows into credit remained buoyant for another week in IG space, while flows in high-yield through the ETF door were the highest in 11 weeks, perhaps suggesting that ECB QE could reverse the recent negative
momentum.
Looking at duration, the trend is back to what it was at the end of last year; with unloved short-term funds seeing outflows while mid-term funds continue to remain popular with an inflow of +$1.6bn. Long-term funds are not attracting much attention thus far but the flows are still positive - albeit marginal." - source Bank of America Merrill Lynch

As we were typing our new market musing, came, not the proverbial "sucker punch" which we discussed in August 2012 in our conversation "Sting like a bee - The European fight of the century", but more akin to a nuclear strike on the market with the removal of the Swiss peg.

The SNB punch, EUR/CHF's 30% intraday range picture following the nuclear 10 sigma strike - graph source Bloomberg:

Of course it is of no surprise to hear that after such a massive shock and awe move the demise of some small fishes which are already turning belly-up, in the likes of some FX retail brokers meeting their maker.

"Boxing is the only sport you can get your brain shook, your money took and your name in the undertaker book." - Joe Frazier

No offense to the memory of boxing legend Joe Frazier, but, there is another "leisure" activity that seems to fulfill the above quote we used back in August 2012 we think: "FX Retail brokerage is an activity where you can get your brain shook, your money took and your name in the undertaker book".

So while we are already seeing the small dead fishes resurfacing, we wonder when a big whale will turn up. Rest assured that the SNB's brutal move has had some major financial impact somewhere apart from the FX retail broker space.

In this week's conversation, we will therefore muse around the notion of "Quality".

As a starter, in relation to the Swiss move and the lack of reaction of gold in the process, we read with interest Deutsche Bank's take from their Behavioral Finance Daily Metals Outlook entitled "Gold is still a currency without central bank":

"There are some sections of the gold market where observers are puzzled by the rally in gold prices yesterday. The surge in the value of the Swiss franc, after the SNB abandoned the euro peg, confirmed for them that it was the relatively safer haven, not gold. However, one might also question at what price will come the SNB’s attempt to dissuade safe-haven seekers from coming to Switzerland. Already deposit rates stand at minus 0.75 percent. Ten-year yields, which had halved since the start of the year, halved again yesterday to stand at just 7bp. International competiveness has been eroded and disinflation looks set to be the country’s largest import. Of course, the alternatives might have been worse: after the ECJ backed the principle of ECB sovereign bond purchases, the SNB might have been faced with having to print francs in order to buy many of the euros the ECB might print. This would have proved unsustainable and carried huge economic risks. It is precisely this convoluted relationship that is proving so worrying. Global central banks have continued to set key prices in the financial system, some six years after the crisis – zero benchmark rates, low bond yields, competitive FX rates, and buoyant stock prices. The effort has now become so expansive that the policy of one central bank has undone that of the other. For investors who yearn for a market with less official intervention, gold is once again entering the discussion." - source Deutsche Bank

Exactly, what we posited in our previous conversation when we looked at the "Global Credit Channel Clock". Not only long vol, long government bonds have been rewarding in the early days of 2015, but, gold again is surging again.

What we find of interest is that, for some pundits, the SNB has lost some of its credibility. On the contrary, we think the SNB has in fact regained some credibility by removing the peg and let the market drive freely the level of the CHF currency. As we mused in our November conversation "Chekhov's gun", there are indeed different types of central banks:

"Indeed, when it comes to the ECB we have a case of "Chekhov's gun, whereas when it comes to the Fed and the Bank of Japan it is more akin to Tuco's philosophy: "When you have to shoot, shoot. Don't talk"

In the case of the SNB, we remind ourselves also the points made by Richard Koo quoted in our November conversation:
"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.
Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).
Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members."- source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but the fastest gunslinger is no doubt the SNB. The move of the SNB clearly shows a shift towards the mid-1980s kind of monetary policy described by Richard Koo. Some pundits have deemed unacceptable for the SNB to openly-lie in the lead-up to the decision of the removal of the peg, calling in question its credibility. Obviously the violence of the movement should be a stark reminder for "complacent" investors of what to expect when markets cease to be "financially repressed" and manipulated by our central bank deities. What has actually happened, we think, is that the SNB has decided to "defect" from the central banks cartel of "money printers". The SNB has indeed broke rank with the "easy money" gang and decided to shift back to a more 80s orthodox view of conducting monetary affairs. Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. One might therefore wonder if the SNB has not indeed decided intentionally to shift towards "Quality Street" regardless of the deflationary environment rather than continue to embrace the lax monetary policies embraced by many, preferring therefore the short term pains for long term gains.


We concluded our November conversation with the following remarks at the time:

"While it has been easy to somewhat front-run the QE cowboys thanks to "Pascal's Wager", the end of QE in the US coincide with a renewed period of weaker global trade, historically high asset price levels and record low bond yields making it more likely we will see a return of higher volatilities regime in the near future making future equities return questionable and long bond US Treasuries enticing (we are keeping on our very long duration exposure via ETF ZROZ)."

No doubt, that we have indeed seen a return to a higher volatility regime in 2015 but when it comes to future equities return, they are indeed questionable, particularly in the light of Société Générale's recent report on Risk Premium from the 13th of January entitled "High is not always better":

"US equity risk premium – High is not always better
The US equity risk premium (4.3%) is still in attractive territory (above its long-term average of 3.9%) relative to government bonds. However, the internal rate of return on US equities (6.4%) has continued to fall and is now materially below the long-term average (8.9%). This means that US equities are likely to deliver below-average returns going forward. Furthermore, US equities have limited capacity to absorb higher bond yield:

Internal rate of return on US equities is near its lowest level since 1990 The internal rate of return on US equities currently stands at 6.4%, i.e. materially below its historical average of 8.9%. Clearly, the high US equity risk premium is largely due to stubbornly low government bond yields. Our analysis indicates that a 10-year US government bond yield of above 2.55% would make switching from equity to government bonds attractive from a valuation perspective

US long-term growth (3.7%) is also near multi-decade lows. Any recovery in the long-term growth prospects of the US should have a positive impact on US equities. However, our analysis indicates that part of the growth recovery is already reflected in the current valuation." - source Société Générale

When it comes to equities and their performance relative to credit risk in the European space, no doubt "Quality Street" has played out and will continue to perform has indicated by Kepler Cheuvreux in their latest Cross Asset Research note entitled "Crisis and Continuity":

"Higher quality equity continues to outperform. Stocks with high sensitivity to credit continue to under-perform."

The defensive bias in stock behaviour is still apparent. Higher quality equity continues to out-perform. Stocks with high sensitivity to credit continue to under-perform. In particular, we would like to point out two aspects of the recent behaviour of European equity that are especially significant. The first is the differentiation within Europe’s universe of higher quality, lower risk stocks. The second is the under-performance of Europe’s banks and of the compartment of large cap value since last October. The recent improvement in the relative performance of smaller caps is largely the consequence of the weakness of Europe’s category of large cap value stocks" - source Kepler Cheuvreux

Kepler Cheuvreux made also some very interesting remarks when it comes to our "Quality Street" analogy in their report:

"The benefit that Europe’s lower risk equity has derived from the bull market in high quality duration has declined quite notably, indicating the emergence of a deflation risk premium.
In the second place, only the portfolio of lower risk quality stocks out-performed in 2014. The lower risk growth portfolio did not out-perform. The difference relates to two criteria: debt and growth. Stocks with low debt and low expected growth performed best in 2014.
Generally speaking, low risk stocks with high expected growth and comparatively high debt did not perform well. Moreover, the divergence in question has become more apparent in recent months.
The decline in expectations of nominal growth in Europe produced a premium for balance sheet quality in the course of 2014, with particular reference to indebtedness. It also gave rise to the expectation of Central Bank intervention, accelerated by the effects of the collapse of oil prices. The consequence in the credit space since last October is a premium for the liquidity of the IG and quasi-IG beneficiaries of Central Bank intervention.
The behaviour of Europe’s banks is a barometer of the balance of advantage between the forces of deflation and reflation because bank balance sheets are evaluated by reference to the incentive to leverage or deleverage. The investment consensus tends to assume that all forms of Central Bank intervention are good for Banks. However, excess liquidity does not necessarily ensure the expectation of reflation. Precisely, the contradiction of the investment consensus is the conviction that the ECB must engage in GB-QE but that it will fail to raise the rate of nominal growth in the euro zone. The relative performance of Europe’s banking sector, especially that of the cheaper, lower quality EZ banks, has deteriorated since last October even though Central Bank liquidity is driving down bank funding costs and their lending rates.
The equity investor should take note of the message delivered by divergences within the credit space since last October. A collapse in the value of an asset as strategically important as oil produces the expectation of credit stress in the commodity-emerging space which translates into a risk premium for the banking system. There is a link between the under-performance of the banks and of energy stocks. We cannot yet say that the price of oil has bottomed. There is no sense yet of genuine capitulation with respect to oil within the commodity investment community.
The under-performance of large cap value in Europe identifies a crucial weakness of the bullish consensus. In current circumstances the premium for liquidity and for quality benefit lower risk, non-bank equity, including many of Europe’s insurers. We cannot say that the reflation trade in Europe is effective until Europe’s banks begin to out-perform bond proxies in the equity space (see chart 11). 

The performance of Europe’s banks will improve when expectations of the rate of nominal growth in the region begin to revive. We have no yet reached that point." - source Kepler Cheuvreux

This validates our long standing view that a bank is the second derivative to the growth of the economy. A bank is a leverage play on the economy. This is why it is so important to track economic activity, as banks are at the heart of the economic system when it comes to providing the means to its development.

Furthermore, since the European financial sector stress of 2011 which first started in the credit space, financials senior and particularly low beta credit have clearly outperformed financial equities in Europe. This can be ascertained by looking at the Eurostoxx Banks vs Itraxx Senior Financial index (roll adjusted) particularly since late 2013 whereas European banks stocks have been trading sideways - graph source Bloomberg:

- source Bloomberg

We continue to view European Investment Grade credit particularly in the financial space to be more appealing than equities (QE might change this view and boost banks equities). We expect further earning headwinds and surprises with additional goodwill writedowns particularly for European banks having significant Eastern Europe exposure. US banks earnings have erred so far on the weak side. We expect a similar picture in Europe.

The underperformance of equities versus credit in Europe for the banking sector is not surprising given the deleveraging and continued consolidation of the bloated sector as highlighted by Société Générale in their European Banks note from the 9th of January:

"€600bn of lost corporate lending
The European corporate loan book has shrunk by €600bn since 2009, the point at which corporate credit volumes began to retreat. Around €450bn of this shrinkage has taken place in the last three years – the period of austere governments and regulators. Almost all of this correction is down to three banking systems: Spain (€400bn lost from peak), Italy (€100bn lost) and Greece (€30bn lost).

Over this same period, outstanding debt securities issued by non-financial institutions have increased by c.€200bn, from €850bn to €1,050bn. This has plugged some of the gap, but of course it has been more geared to the core eurozone markets. The periphery has seen less replacement of the banking balance sheet by debt markets.
Corporate credit levels have been in decline. They also remain in decline in 9 out of 18 of the eurozone lending markets we outline below.

However, it is not all gloom. In Germany and France, corporate loan books have actually been growing very modestly since 2013. The volume increase is still slight (1-2%), but the cycle has at least turned.
€7tn of lost assets and 800 lost banks
Shifting up from loans to overall balance sheet, the trend is just as clear. The total euro area banking system has shed €7tn in assets since 2008. The first chunk of assets fell away in 2008-09 (typically non-lending assets – subprime, etc.). The second chunk of assets has been falling away since 2011.
At the total balance sheet level, it is actually Germany that has seen the lion’s share of the balance sheet decline. This is largely linked to the non-lending assets that fell away in 2008-09.

As well as the €7tn in lost assets, the banking system has lost 800 banking institutions. Obviously this takes us well into the tail of banks, with the 150 banks lost in Germany (to 1,734 institutions in 2013) generating few headlines. 

However, consolidation is a theme that cannot be overlooked." - source Société Générale

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth.

Indeed, consolidation will carry on and pain will be inflicted on subordinated bondholders in the European banking space. On a side note we have yet to hear about the fate of Italian fallen giant Banca Monte dei Paschi di Siena which fell today another 2.4% to 45.25 cents. MPS has fallen around 66% in the past six months, leaving the third Italian bank with a market value of just 2.35 billion euros.

It is not surprising to see that there has indeed been a correlation with the severity of the contraction of credit with the rise of unemployment and economic disarray in peripheral countries, which was precipitated by the stupidity of European regulators as we discussed on numerous occasions in our posts when relating to the fateful decision of the EBA:

"What accelerated the "credit crunch" was the EBA's decision for banks to reach a certain capital threshold by June 2012 (for the EBA June 2012 core tier one capital target of 9%, banks needed to raise at least 106 billion euros according to the EBA's calculations)

On a final note, to conclude our note, we would recommend you stay on "Quality Street" (your are less likely to be mugged...) as indicated by this chart coming from the Kepler Cheuvreux report quoted above indicating the evolution of the premium for Quality and Liquidity in particular since October:

"We emphasise the reinforcement of the premium for quality and for liquidity in both the credit and equity space since last October." - source Kepler Cheuvreux

 "Quality is never an accident. It is always the result of intelligent effort." - John Ruskin, English writer

Stay tuned!