Macro and Credit - The spun-glass theory of the mind

"Success consists of going from failure to failure without loss of enthusiasm." - Winston Churchill

Looking at the results stemming from the Italian referendum in conjunction with the continued gyrations in financial markets on the back of rising FX volatility thanks to "Mack the Knife" aka King Dollar + positive real US interest rates, when it came to selecting our title analogy for this week's musing, we reminded ourselves of "The spun-glass theory of the mind" which is the belief that the human organism is so fragile that minor negative events, such as criticism, rejection, or failure, are bound to cause major trauma to the system (think Brexit, Trump's election). "The spun-glass theory of the mind" is essentially not giving humans, and sometimes patients, enough credit for their resilience and ability to recover, like central banks have been doing, dealing with economic woes with their "overmedication" programs (ZIRP, QE, NIRP, etc). In 1973, the brilliant University of Minnesota clinical psychologist Paul Meehl poked fun at what he called the “spun glass theory” of the mind which is the false notion that most of us are delicate, fragile, and easily damaged creatures that need to be handled with kid gloves. Since then, many researchers have shown that most people are surprisingly resilient even in the face of extreme trauma. Economies are similar, such as the United Kingdom which showed it was more than tremendously resilient while many pundits were predicting "trauma" and disaster should Brexit happens. In similar fashion, Nassim Nicholas Taleb in his book "Antifragile" showed that there's an entire class of other things that do not simply resist stress but actually grow, strengthen, or otherwise gain from unforeseen and otherwise unwelcome stimuli (Iceland). The main underlying concepts of both "The spun-glass theory of the mind" and "Antifragile" is that the majority of causal relationships are nonlinear and so are market movements (hence the relative ineffectiveness of VaR models - Value At Risk we discussed in February in our conversation "The disappearance of MS München"). Typically both have a convex section where the curve rises exponentially upward and is associated with a positive effect (antifragile) and a concave section that declines exponentially downward and has a negative effect (fragile). Think of the dose of a prescription drug. At first, as central banks increase the dose, the health benefits improve (convexity) for financial assets. But, beyond a certain dose side effects and toxicity cause harm (concavity), such as Debt-fueled economies given debt has no flexibility. Therefore highly leveraged economies cannot stand even a slowdown without risking implosion like our current situation, but we ramble again. 

How do you "hedge" in such a nonlinear world? The way to do it, we think, is to use a barbell strategy that positively captures the optionality of the variable (being long in the convex area and short in the concave area).  If indeed, we live in a nonlinear world and given correlations are less and less static and change more and more frequently, leading to larger and larger standard deviation moves such as typically going way up during downturns, it therefore eliminates Markowitz portfolio theory of diversification benefit. Just when you think your diversification will render your portfolio "antifragile" it brings instability and "fragility" to it. A barbell strategy should render your portfolio more "antifragile". Why is so? Markowitz portfolio theory causes investors to "over allocate" to risky asset classes such as "High Yield" and/or Emerging Markets and play the same crowded "beta" game. In similar fashion, "The spun-glass theory of the mind" cause central bankers to "overmedicate". One could conclude that "Overmedication" leads to "Over allocation". 

In this week's conversation we would like to look again at the importance of flows versus stocks from a macro and credit perspective, taking into account "overmedication" and "over allocation".

Synopsis:

• Macro and Credit -  It's a question of flows versus stocks
• Final chart - Could Japanese equities be antifragile in 2017?

• Macro and Credit -  It's a question of flows versus stocks

Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":

"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."

Before we delve more into the nitty-gritty, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 

"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 

We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org

We have always wondered in relation to the global rounds of quantitative easings the following:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy at least in Europe has been in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE in Europe is not sufficient enough on its own to offset the lack of Aggregate Demand (AD) we think.

As a reminder, in our part 2 conversation "Availability heuristic" from September 2015, the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade. With a rising US dollar, what has been playing out is a reverse of these imbalances hence our "macro reverse osmosis" discussed again recently relating to violent rotations in flows. 

From that perspective, we read with interest Citi Research note from November entitled "How does active fund management survive in 2017?" where as well they tackle the very important point of stock versus flows:

"Is it the stock or the flow of QE that matters?

Essentially, central banks tend to think in "stock" terms

 “Reduce the quantity available to investors & prices will lift permanently”

 To us, QE flows seem very important empirically

Reduce the QE flow by just ~1/3 & markets are quite likely to fall

That makes an asset not priced to fundamentals but to policy …

… prone to non-linear reactions when perceptions of policy change" - source CITI

As we have seen in recent weeks, and as we have remarked in our conversation  "Critical threshold", higher yields leads to material fund outflows in the short-term as indicated by Bank of America Merrill Lynch Follow the Flow note from the 2nd of December entitled "Where's the money going?":

"High grade funds had their fourth week of outflows, and the third that exceeds the $1bn mark. High yield funds recorded their fifth week of outflows in a row; so far this year they have lost more than $10bn. As chart 13 below shows, the outflows this time came mainly from European and global funds, where on the other hand US high yield funds recorded an inflow.

Government bond funds had yet another outflow, the eighth in a row, reflecting rising QE-tapering risks. Money market weekly fund flows were relatively subdued recording a negative flow. Overall, fixed income funds flows remain largely negative, and over the past four weeks almost $20bn has flown out of European domiciled funds.

European equity funds flows switched aggressively to the negative side again, post a short stint of inflows. Last week the asset class had its biggest outflow in eleven weeks. Outflows so far this year are just shy of $100bn.

Global EM debt fund flows remained negative for the fourth week in a row; nonetheless we note a significant improvement in the trend, with the latest outflow being significantly smaller than that of the previous two weeks. Commodities funds also were in negative territory for a third week, as higher inflation expectations support reflation trades.
On the duration front, short-term IG funds flows remained negative for a second week. Mid-term funds had their fourth outflow in a row but riding an improving trend; while long-term funds recorded a marginal inflow." source Bank of America Merrill Lynch

Whereas central banks tend to focus their attention on "stocks", we'd rather focus ours on "flows", from a macro perspective as well as from a fund perspective. Evidently the consequences of "Mack the Knife" aka King Dollar + positive real US interest rates can also be seen in the "Great Rotation" from Europe and Emerging Markets towards the US hence validating our "macro osmosis process":

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

As a reminder, more liquidity = greater economic instability once QE ends for Emerging Markets. Now if indeed "flows" matter, we took a keen interest in reading the impact  "Mack the Knife" has had on Emerging Markets as indicated by Bank of America Merrill Lynch in their GEMs Flow Talk note from the 1st of December 2016 entitled "Reported foreign holdings of local debt dropped 6% in November so far":

"EPFR weekly fund flows
• EPFR measures mutual funds and ETFs (AUM about $225bn)
• This week’s outflows were less than last week which was less than the prior week.
• EPFR outflows in the 3 weeks since the election were:
-4.0% for EXD
-3.7% for LDM
• Part of that is ETFs, whose outflows since the election as a % of ETF AUM were:
-8.1% for EXD
-7.3% for LDM

2013 lessons were learned well, take fast action
• Outflows have been faster than in 2013 (Chart 1)

• Largest 3 week outflow in 2013 was only -4.2% for all currency funds.

Foreign holdings of local debt sharp drop – $40bn implied
• We track $640bn of foreign holdings of local debt
• We observed 6.2% outflows for the month of November in 4 countries (India,
Indonesia, Hungary and Turkey) with foreign holdings of $107bn.
• If all countries had the same average outflow of 6.2%, then applied to the $640bn
of foreign holdings, this implies we could have had a $40bn total outflow in Nov.
Since the election – $35bn potential outflow
• We observed 5.5% outflow since the election.
• If we apply this rate to the $640bn foreign holdings, it implies a $35bn total
outflow in the few weeks since the election." - source Bank of America Merrill Lynch

We recently pointed out that "macro tourists" and levered carry players alike did play the second half of 2016 more aggressively hence the extension of their credit risk and duration risk leading to faster deleveraging and consequently outflows and pain inflicted. Obviously we guess that your next question is going to be how much more additional outflows could be expected particularly from the impact of a rising US dollar is having on Asia for example given capital outflows matter and matter a lot, so does a US dollar shortage as well although Stanley Fischer from the Fed thinks as of late there is no liquidity issue. Regarding this matter we read yet another Bank of America Merrill Lynch note from their Connecting Asia series entitled "Flow and flight":

"We examine two of the most pressing issues facing Asia investors in the Post-Trump election victory world.
The first, is how much capital reversal and outflow in Asia is yet to run amid USD strength, rising yield differential with the US and CNY depreciation. Thus far, some USD24bn in foreign bond and equity portfolio flows are being unwound and compares with the maximum drawdown of USD55bn during the GFC – see front page chart.

The countries that we find are at the sharp end of this outflow are Korea, India, Indonesia and Malaysia.
The second is how investors should evaluate Asia FX and rates vulnerability to the tail risk of rising trade protectionism and confrontation. The brief answer to this is that China, Korea, Taiwan and Thailand appear most vulnerable, while Indonesia and India may be the least.
Ultimately, the combination of capital outflows and rising trade protectionism discussed in this report, suggests that FX risk premiums and volatility for CNY and KRW will rise. From an FX hedging strategy perspective, we continue to recommend low delta 6M USD call, CNH puts such as our year-ahead top trade recommendation for USD/CNH 7.60 strikes.

Portfolio drawdowns – how much more to go?We highlight the maximum drawdown Asian markets have previously seen in terms of outflows. This gives us a sense of the worst case scenario as far as outflows are concerned relative to FX reserves. The bottom line is:
• The largest outflow Asia saw on a cumulative basis was ~USD 55bn during 2008. In comparison to this, Asia has seen about USD 24bn of outflows since October 2016 (see Chart 1 for cumulative outflows during other risk off periods).
• Equity outflows so far have been around 9.9bn USD since October 2016, led by. India, Taiwan and Thailand. When compared to historical drawdowns, the larger equity markets of Korea, Taiwan and India stand to lose the most, although only in Korea’s case does the worst case scenario account for a substantial portion of FX reserves (19%, see Table 1).

• Bond outflows, so far have been about 14bn USD since October 2016, with most seeing outflows of at least 2bn USD. When compared to historical drawdowns, Malaysia stands to lose the most, with the worst case scenario representing about 6.3% of current FX reserves (see Table 2).

- source Bank of America Merrill Lynch

While obviously the biggest "known unknown" lies in the foreign trade policies which will be adopted by the new US administration. As we pointed out in our last musing, measures that would restrict global trade would no doubt be bullish for gold in that particular case. For now, in relation to gold we still remain neutral.

But moving back to credit and nonlinearity, one way of "mitigating" dwindling policy support given recent talks from the ECB in tapering its stance would be to "embrace" a barbell strategy as pointed out by Citi Research note from November entitled "How does active fund management survive in 2017?":

"Barbell when repression is at risk of being wound down

Belly of the credit curve holds disproportionate amount of unpaid β" - source CITI

What would be an interesting barbell credit wise in our opinion? We would favor US credit markets obviously from a flow and currency perspective. We would go long US investment grade credit than European investment grade and even selectively long European non-financial High Yield issuers due to lower leverage than their US peers. But should you want to play the beta game from a "barbell" perspective, then again US High Yield via its derivatives US CDX High Yield, given that it is less sensitive to convexity and interest rate risks and less exposed to CCCs (10% versus 16% weight in cash index), should the risk-on environment persist on the back of favorable macro data. 

From an allocation perspective, we are already seeing once again decoupling between US credit and Europe, because, as we stated on many occasions, the Fed tackled earlier one "stocks" issues on banks balance sheet, which in effect, enabled a stronger credit income and better economic growth relative to Europe, whereas the ECB has in no way alleviated the burden of "stocks" plaguing peripheral banks in the form of nonperforming loans, therefore in no way repairing the broken credit mechanism that stills explain the on-going "japanification" process and much weaker growth prospects. To that effect, if indeed the US reflation story is playing out, then again it makes sense to "over allocate" to US credit as once again decoupling could be on the menu between both regions. This is clearly illustrated by Bank of America Merrill Lynch in their European Credit Strategist note from the 2nd of December entitled "The Italian job":

"The last month has presented something rather rare: a truly decoupled global credit market. For instance, US high-grade spreads went 2bp tighter in November, while Euro high-grade spreads went 16bp wider. And the phenomenon seeped into high-yield credit too: US spreads tightened by 24bp in November, while European spreads widened by 47bp. After the moves of the last month, headline IG spreads in Europe are now wider than US high-grade spreads out to almost 10yrs in maturity.

“Politics” has been the undoing of European credit lately. Italy heads to the polls on Sunday amid a climate of rising global populism. And ECB tapering noises have driven a pattern of rising rates and wider spreads in Europe over the last month (note, though, BofAML base case is for an €80bn QE extension until Sep-17).
Yet, even with all the political hiccups that Europe has encountered over the last 5yrs, genuine decoupling of credit markets has not been common. Chart 2 shows that there have only been 3 periods over the last 10yrs when European and US credit spreads went in different directions.

Decoupling – the new norm for ‘17

We think decoupling between US and European credit will be a lot more common in 2017 though. In fact, our US credit strategy colleagues forecast US high-grade spreads to tighten by 20bp next year. In Europe, we expect high-grade spreads to widen by 20bp.

Much of the divergence in views is simply down to technicals – which shouldn’t come as a surprise given how technicals have been the be-all and end-all of credit markets for the last few years. In the US, we expect Republican tax proposals to lead to a big drop in US high-grade net supply next year. But in Europe, we expect shareholder-friendly activity (M&A, in particular) to broaden out in 2017, and contribute to a further jump in supply. This should leave the Euro market with too many bonds and not enough buyers.

Get in quick…

In fact, lingering QE tapering noises may just coax European companies to speed up their spending and issuance plans, for fear of missing the (low-yield) boat. This means the risk of supply being front-loaded in the first half of next year, leading to some heavy indigestion for the Euro credit market.
Recall that this is not too dissimilar to what US companies did in 2014 as the Fed drew closer to their first interest rate hike. As chart 3 shows, US M&A volumes were brisk in the middle of 2014. Then, as better US data pushed yields higher, issuers moved quickly to fund the M&A backlog, leading to some big months of US high-grade supply in September and November 2014.
This also caused a big decoupling in credit markets: US high-grade spreads widened by almost 40bp in the second half of 2014, while European high-grade spreads went slightly tighter. We fear the same bad technicals could be at work in Europe next year if companies rush to issue ahead of any potential QE tapering." - Bank of America Merrill Lynch

If indeed we get this "reflationary" case playing out, then again we might have a situation where US credit continues to outperform European credit in 2017.

Going forward, when it comes to following a potential deterioration in US High Yield we encourage you to keep an eye on a possible flattening of the CDX HY curve, being the derivatives proxy for the US High Yield market. As per Credit Market Analysis (CMA) latest chart, it is worth following the trend to see if indeed the CDX HY series 27 will be getting flatter as we move towards 2017. We noticed that one year protection has started to move upwards albeit very slowly, while it is yet a meaningful move for the moment contrary to what we had back in November last year where 1 year was only 50 bps apart from 3 year, you should keep an eye on the shape of the curve:

- source Credit Market Analysis

Right now, it is hard to be as sanguine as we were in November regarding US High Yield given at the time of the fast flattening movement we were seeing at the end of 2015. We continue to see a risk-on environment for the time being, although as we pointed out last week when discussing credit conditions in the US for Commercial Real Estate, it does appears to us that some segments including our CCC credit canary are already experiencing tightening financial conditions. The most important indicator to track, risk wise is "Mack the Knife" aka King Dollar + positive real US interest rates. 

Finally for our final chart and if the "spun-glass theory of the mind" is correct, then indeed we think if the US dollar continues to shine, then it makes sense to "over allocate" to Japan given earnings are higher there.

• Final chart - Could Japanese equities be antifragile in 2017?

While the risk-on mode is still prevailing thanks to the strong beliefs in the reflation story playing out, from an equity perspective, corporate earnings and payouts remain the principal drivers of equity returns. To that extent, our final chart comes from Barclays Global equity and cross-asset strategy note from the 28th of November entitled "Reassessing the rotations" and displays earnings in Japan relative to the US and Europe:

- source Barclays

While it remains to be seen how long the "reflationary story" continues to play out, for now it is indeed "risk-on", but no doubt there are many political events lining up in 2017 that could put a spanner in the works. One thing is clear to us though, is that when it comes to markets commentators and some members of the sell-side, 2016 has proven with both Brexit and the US election that the spun-glass theory of the mind is alive and well...

"Success breeds complacency. Complacency breeds failure. Only the paranoid survive." -  Andy Grove, former CEO of Intel.

Stay tuned!

Credit - River of "No Returns"

Matt Calder: "There are lots of ways to die. Starving to death isn't my favorite." - from the 1954 movie River of No Return by Otto Preminger starring Robert Mitchum and Marylin Monroe.

Looking at the velocity in falling government bonds yields as well as the ever growing scarcity of highly rated bonds at the disposal of real money managers (courtesy of central banks buying: FED, ECB, BOE, BOJ) and decline in new issuance for fixed income spread products, we thought our analogy to Otto Preminger's great movie would indeed be appropriate this time around.

Therefore we thought it would be interesting to focus our attention on the consequences of "travelling", like Matt Calder heading downriver, on our flimsy log raft, and encountering trouble in the rapids (or markets), on this river of "No Returns". But first our credit overview!

The Itraxx CDS indices picture, a tale of ongoing volatility - source Bloomberg:

Itraxx SOVx Western Europe Index (credit risk gauge on 15 governments with Cyprus replacing Greece) climbed three basis points to 334 bps, adding to the gauge’s 50 basis-point jump in May. The Sovereign CDS on Italy climbed 14 basis points to 575 bps , approaching the record of 602 basis points of the 15th of November according to Bloomberg data. Meanwhile Spain Sovereign CDS reached 620 bps while Spanish Telecom company Telefonica rose 13 bps to an all-time high of 481 bps.

In conjunction with sovereign risk, as always, financial risk rose in synch, with the cost of insuring bank debt also increasing, with Itraxx Financial Senior 5 year CDS index (linked to senior debt of 25 banks and insurers) rising 5 basis points to 303, after surging 23% in May. Itraxx Financial Subordinated 5 year  index increased 5 basis points to 501 bps. Itraxx SOVx 5 year index is trading closely to the Itraxx Financial Senior 5 year index which is an indication the ongoing issue of circularity and the impossibility so far in decoupling both. We have been discussing on numerous occasions this very subject of circularity (most recently in our conversation "The Daughters of Danaus") - source Bloomberg:

The Itraxx Crossover 5 year index (linked to 50 European High Yield companies) increased 10 bps to 730 bps, after a 70 bps rise in May. Itraxx Main Europe 5 year index representing the risk gauge for Investment Grade credit (125 companies with investment-grade ratings) advanced 2 basis points to 183 bps. The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

"Mind the gap", we have been warning for a while, given the disconnect between the Eurostoxx and the flight to quality mode experienced with the rapid drop in the German Bund 10 year yield with rising volatility as indicated in the bottom graph. The gap is in fact closing. - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.20% yield) touching a new record low around 1.12%, with 5 years Germany Sovereign CDS rising slightly above 100 bps - source Bloomberg:

A story of volatility as far as "safe haven" government bonds are concerned (German Bund, 10 year US Treasuries), looking at the intraday picture for the German Bund yield movement - source Bloomberg:

Touching a low of 1.1238% before bouncing back at the close towards 1.18%

In fact, another indicator we have been monitoring, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:

While touching again on our recent subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level.  The correlation between both the German Bund and US 10 year note is rising very fast, now above 70%. The above graph was our reasoning behind our 30th of March call:
"One has to ask oneself if the time has not come to start taking a few chips off the table." - Macronomics  - "Spanish Denial".
 Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).

As far as asset correlation are concerns, the weakness in Oil prices warrants caution when looking at the relationship with the SPX 500 since QE 2, so, "Mind the gap":

Oil fell on Friday to an eight month low, falling as much as 4.6% after the disappointing employment data in the US (Non-farm payrolls coming at 69K with jobless rate at 8.2% from 8.1%. Crude futures declined to 83.59 dollars a barrel after touching 82.56 dollars, the lowest intraday level since the 7th of October according to Bloomberg. Brent for July delivery fell 3% to 98.78 dollars a barrel. The European benchmark has fallen about 8% this year. The SPX 500 Index declined 1.8 percent and touched 1,286.63, the lowest intraday level since the 13th of January validating our recent comments on the relationship.

"Mind the gap" because the Euro Swap Curve is the flattest it has been  since the Lehman collapse according to Bloomberg:

"The gap between short- and long-term euro-denominated interest-rate swaps is the narrowest since the months following the collapse of Lehman Brothers Holdings Inc. as Europe’s debt and banking system crisis worsens. The top panel of the CHART OF THE DAY shows the difference between rates on two- and 10-year euro-denominated interest-rate swaps fell last month to the least since December 2008. The bottom panel is the so-called euro FRA/OIS spread, or the forward market projections for the gap between three-month Euribor and expectations for the euro overnight index average, known as Eonia." - source Bloomberg

Eonia index:
"The Eonia index is a gauge of the cost for banks in Europe to borrow from each other overnight in euros, similar to the U.S. effective federal funds rate. Euribor is the rate at which European banks say they see each other lending in euros, according to the European Banking Federation." - source Bloomberg.

As a reminder and from the same Bloomberg article:
"In November, the FRA/OIS spread surged to a 33-month high as concern over contagion from the sovereign crisis drove Italian debt yields to levels that forced Greece, Portugal and Ireland to seek bailouts. The 10-year German bund yields fell yesterday to a record low on concern European leaders won’t agree on measures to contain the debt crisis. If funding conditions in the European banking sector worsen to levels reached in the fourth quarter the two-year swap rate could increase and cause the swap curve to “flatten significantly” according to Societe Generale strategist Sandrine Ungari."

German 2 year notes falling in negative territory versus 10 year Bund - source Bloomberg:

The current European bond, from convergence to divergence with Spain experiencing a serious bout of volatility in conjunction with Italy and core countries experiencing an important drop in yields with France and Belgium even touching record low yield levels (France at 2.21%) - source Bloomberg:

While Italian bond yields dropped 21 bps to 5.69%, Spanish yields only receded 9 bps to 6.47% at mid-day as many pundits are speculating on an activation of the SMP (Securities Market Programme) by the ECB.

As far as credit is concerned as one market maker puts it:
"We keep waiting for capitulation in the credit space. It hasn't happened yet for several reasons:
-Hedge Funds are short and reducing.
-Real Money (Asset Managers) have not capitulated yet on cash bonds given they hedge using index and futures but the German Bund is saving them given the bund is up 11 points and if credit spread are wider by 2.5 points, they are still doing well (German Bund moving up a point a day versus Itraxx Crossover - HY risk gauge- moving 20 bps or Itraxx Main Europe - Investment Grade risk gauge-  by 5bps).
-Credit was the first to react and now all other markets have followed suit. But Credit has stopped widening as we are expecting intervention and credit is mostly correct."

Following up on our assertion: "In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar" ("Risk-Off Correlations - When Opposites attract"),  dollar is indeed the big winner in this "Risk-Off" environment.
The dollar posted its biggest monthly gain since May 2011, beating everything in its path, bonds, stocks, commodities as investors sought refuge in the U.S. It climbed 5.5%. And as Douglas Borthwick, head of foreign-exchange trading at Faros Trading LLC in Stamford, Connecticut, said  in a May 29 interview with Trish Regan and Adam Johnson on Bloomberg Television’s “Street Smart.” in relation to investors seeking the safety of the dollar:
“They’re forced into owning the dollar,” he said. “Not because they like it or they think the dollar is going to rally, but because there’s nothing out there for them to buy.”

Which brings us to the main theme of our "River of No Returns" conversation namely the consequences of asset scarcity.

Torsten Slok, (Deutsche Bank Chief International Economist)in his latest presentation entitled "The Pension Challenge" puts forward some very important points we think:

"- The number of highly rated bonds has declined, implying fewer risk-free assets to buy for real money managers.

- In addition, central banks (Fed, ECB, BoE, BoJ) buying government bonds has lowered supply of risk-free bonds real money managers can buy (for example, the Fed currently holds 30% of all 5-10 year US Treasuries outstanding).

- New issuance of fixed income spread products (i.e. credit and mortgages) has declined. One reason is that the housing recovery has continued to be weak and as a result fewer new mortgages are originated. Another reason is that corporates have strong balance sheets and as a result they don’t need to issue new debt.

- There are three long-term risks to global growth including: a) long-term growth consequences of European debt challenges, b) long-term growth consequences of US fiscal challenges, and c) long-term growth consequences of China’s housing bubble and demographic problems.

- Bottom line: More demand for risk-free assets and less supply of risk-free assets combined with three significant long-term risks to global growth imply that interest rates are likely to stay low for many more years."

Hence our river of "No Returns" title and analogy in these treacherous river/markets.

One as to ask oneself if stock markets have not been driven by baby-boomers first saving for retirement, and then retiring as indicated by Deutsche Bank Chief International Economist Torsten Slok:

When it comes to outstanding "risk-free" assets globally, the pool is dwindling according to Deutsche Bank:

In fact there are fewer risk-free assets outstanding, as we posited in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!", welcome to a credit world!

As far as we can see we are still in the D world of Deflation and Deleveraging meaning that we think credit assets will undoubtedly outperform their equities peers. This is exactly what we have argued in "Deleveraging - Bad for equities but good for credit assets".

In fact Bank of America Merrill Lynch seems to be validating our assertions given that they have written recently the following:
"In Europe, a lot indicates that equities have "died":
- The market cap of the Italian Financial sector is now the same as the market cap of Colgate-Palmolive ($47bn).
-The market cap of all euro-zone Financials ($361bn) is less than that of Canadian Financials ($377bn)
-The market cap of Spain and Italy equities combined ($396bn) barely exceeds that of Taiwan ($368bn).
-The market cap of Portugal equities ($16.4bn) is the same as that of Whole Foods, the 191st largest stock in the S and P 500.
-The market cap of Greece equities ($5.8bn) is the same as that of TripAdvisor, the 400th largest company in the S and P 500.
The CDS of Portugal exceeds Venezuela's, the CDS of Italy exceeds Lebanon's and the CDS of Spain substantially exceeds Iraq's."

In consolation for our equities friends, we can only point out that hopefully "there's life (and value) after default!"

On a final note we would like our equities friends to meditate on the following two graphs, one is from Morgan Stanley relating to the high Beta in Consumer Discretionary equities from their highlights of their May 23rd Consumer conference, the second is from Societe Generale in relation to the Global IT sector and Nasdaq following the "interesting" IPO from Facebook from their Multi Asset Snapshot - "Nasdaq still running, but low on batteries":

Morgan Stanley:

"While 56.5% of Discretionary Stocks have a Beta greater than 1.1."
"Consensus EPS growth estimates for 2013 are highest in discretionary. Analysts are embedding 16.7% 2013 EPS growth for the sector, with revenue growth of 5.7%."
- source Morgan Stanley.

Morgan Stanley also indicates:
"Can we count on more dis-savings driving the consumer spend? Can the high end continue to spend at the rate it has? Several investors have been positing to us that consumer deleveraging is “basically” over, and that wealth creation through the equity market will have a self-reinforcing positive effect on the market. We find it difficult to forecast that the saving rate will go lower."
And low growth is bad for "Forward Earnings in Different EPS Growth Environments.":
"There is a popular thesis that when interest rates are low the multiple is usually high. We don’t subscribe to this thesis. In fact, we believe it is quite the opposite. As we have written about extensively, extreme 10-year real yields have historically been coincident with lower price-to-forward earnings multiples for the S and P 500." - source Morgan Stanley.

"Earnings, like trees, don’t grow to the sky:
The IBES consensus indicates analysts expect strong and resilient earnings growth (+46% for
the next three years) from US Technology stocks, sustaining their recent track record. We believe that this is too optimistic and highly at risk given 1) the weak global macro-economic framework and 2) sector return on equity is already at all-time highs." - source Societe Generale

"With 46% earnings growth forecast for the next 3 years, the consensus looks very optimistic at a time when the macro framework is an increasing concern (see Samsung CEO interview) and IT stocks’ return on equity (RoE) is at an all-time high of 25%. Given these inflated expectations, we expect to see profit warnings." - source Societe Generale.

We agree with Societe Generale and Morgan Stanley, namely that high expectations + strong consensus = danger. So while you are navigating these treacherous river/markets of "No Returns", starving for earnings should not be your favorite choice (in true Matt Calder fashion).

"A consensus means that everyone agrees to say collectively what no one believes individually."
Abba Eban - Diplomat.

Stay tuned!