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!

Macro and Credit - The Society of the Friends of Truth

"Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth." - Marcus Aurelius

Looking at the surging demand for insurance to protect cash aka "hoarding" taking place in Switzerland courtesy of NIRP, given this exactly what we discussed in our previous conversation "The Law of the Maximum", we decided again this week to pick yet another analogy in our chosen title towards the French Revolution given our "pre-revolutionary" mindset. The Society of the Friends of Truth (Amis de la Vérité) also known as the Social Club, was a French revolutionary organization founded in October 1790 and formulated political theories on democratic government, more equitable distribution of wealth and was the first revolutionary group to identify itself as cosmopolitan and made appeals to scholars worldwide. The Club's political orientation was liberal and promoted the ideal of a society composed of small and medium economic producers such as craftsmen, farmers, merchants and entrepreneurs. Given the rising critics relative to the "wealth effect", a strategy openly supported by the members of "The Cult of the Supreme Beings" aka central bankers, we wonder if we should not recreate through our musings "The Society of the Friends of Truth" hence our title. After all we have been hammering for a while the on-going "japanification" process of the European banking system and the unresolved issues of some banking system such as the Italian one in supporting economic growth through the "credit impulse" given their balance sheets "constraints". 

In this week's conversation we would like to revisit the threat of rising positive correlations thanks to the "The Cult of the Supreme Beings" and what it entails for diversification strategies, risk parity strategies as well as "hedging" for credit and more. After all, we do not think there is a better way to rekindle "The Society of the Friends of Truth" than discussing again the subject of "tail risks" and non-linearity events.

Synopsis:

• Macro and Credit - Watch out for rising positive correlations
• Macro and Credit  - Is inflation back into play?
• Final chart: The downward trend in bond yields has limited insurers' hedging budgets

• Macro and Credit - Watch out for rising positive correlations

While we mused on twitter at the end of August the following: 

"Piece of advice for Central Bankers, rising cross-asset positive correlations and risk parity strategies do not mix well..." - source Macronomics, twitter feed.

It is time we think for the members of the Society of the Friends of Truth to reacquaint themselves with our wise words from our February conversation "The disappearance of MS München" in which at the time we said we were writing for posterity and tackling in depth various aspects of risk including the inadequacy of VaR (Value at Risk) as a risk measurement tool. You might already be wondering where we are going from there but as a gentle reminder, in our book, rising correlations reduces the benefit from diversification, in the end hitting fund's equity directly. Whereas we have mostly disregarded "diversification" this year we opted to avoid the diversification risk in a NIRP world (putting in jeopardy "balanced funds" with reduced downside protection of the bond buffer component thanks to lower yields) for a much simpler "barbell strategy". Therefore we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that is there was a huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up and apart from the most recent "jittery" Fed induced hiking or not hiking moves, for us this strategy worked out fairly well in 2016.

This is what we wrote in our February long conversation:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing. The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016

In our Society of the Friends of Truth, rising positive correlations are a warning sign and also clearly indicative of central bankers meddling with asset prices. This can be clearly seen in the below CITI chart displaying rising cross-asset correlation and the VIX index:

- source CITI, H/T Steen Jakobsen

This also a subject we discussed in our May 2015 conversation "Cushing's syndrome". We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment.

Furthermore, there are some more indications of some other strategies being directly threatened by central banks intervention and rising positive correlations which could lead to some nasty non-linear price movements and VaR shocks we think.

This clearly the case for Volatility Control Products as indicated by Deutsche Bank in their Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions":

"One year later, vol control funds continue to draw focus in severe selloffs

One year ago today, on August 24, 2015, severe volatility drove S&P 500 futures to be halted in pre-market trading, listed SPX option markets to go black, and other equity market dislocations to arise. That moment was one of the most severe shifts in SPX volatility, switching from a relatively low volatility period to extremely high volatility (11% selloff in a week) almost instantaneously. Vol control funds, multi-asset investment portfolios with a dynamic asset allocation determined by market volatility, were important contributors to the severity of that selloff. In this piece, we provide background on vol control funds and guidance on how investors can monitor them going forward.

Vol up, sell stocks: a market feedback loop

Vol control products sell equities when volatility is rising and buy equities when volatility is falling, creating a market feedback loop. Product growth has slowed - but rebalancing impact has grown in illiquid, risk-averse markets. This has been, and continues to be a driver, of the repeated pattern of sharp selloffs followed by consistent rebounds seen in the last 2Y, and contributes to high skew and vol-of-vol in derivative markets. Several fund features - most importantly lags in trading following a volatility spike - keep the products from becoming a systemic risk. Vol control products are not the only large market feedback loop structure (risk parity, leveraged/inverse ETPs, and CPPI are other important ones) - but we believe they are the most important feedback loop given their size and responsiveness to market shifts.

 Sharp transitions from low vol to high vol are becoming increasingly common

The most important trading implication of a large vol control market is the funds' impact on sharp selloffs. We have had almost as many transitions from very low vol to much higher vol in the last 6Y as we have had in the prior two decades.

DB Vol Control Composite tracks current positioning

Through fund-by-fund research of $200bln of vol control funds, we have categorized the funds into four categories, and created a DB Vol Control Composite model based on systematic strategies that we believe captures the essence of these products' equity allocation patterns. We estimate that a sudden 4% global equity selloff today would drive $20bln of selling by vol control funds - less than earlier this year - as realized vol is now below many funds' thresholds.

Last August, around $50bln of equities were sold by vol control funds

We estimate that in the aftermath of the Aug-15 selloff, vol control funds sold around $50bln of global equities, and in the aftermath of the Brexit vote sold around $25bln. These numbers are large in absolute terms - and stand out when they're coming from an investment type that does minimal asset allocation rebalancing on a typical day-to-day basis.

Arguably rising positive correlations and repressed volatility are we think, recipe for large trouble ahead thanks to central banks meddling. A clear illustration of the impact of "Brexit" was discussed in our conversation "Optimism bias" back in June, which clearly caught "off-guard" many pundits. This "Brexit" sucker punch or Blue Monday" price action was clearly illustrated in Deutsche Bank 's very interesting report:

"Brexit: what matters is how big a surprise the vote was

In the aftermath of the UK's referendum to exit the EU, vol control funds likely sold around $25bln of global equities due to the sudden pickup in volatility. This would have been different had polls been more accurate: had market-implied Brexit likelihood drifted toward a Leave result over several days rather than shocking market participants in the middle of the night, markets may have ended at the same prices - but in a gradual path. Unlike what actually happened, this slow-motion drift toward Brexit would have left vol control products fully invested. It's not the outcome of the Brexit vote that drove selling by these investors - it's the path markets took to get there.

In the figure below, we compare the number of SPX shares held by a $10bln investment in a hypothetical fund linked to the S&P 500 Managed Risk Index - Moderate (a representative index of some vol control funds that we describe later in the note) under two scenarios: what actually happened, and a hypothetical slow-motion Brexit in which the market hypothetically realizes that Leave will win over the course of the vote week. The shock nature of the Brexit vote caused 900,000 shares of the SPX to be sold by this strategy than it would have had just four trading days' prices been replaced with a gradual descent toward the post- Brexit low.

Vol control products aim to achieve a fixed realized vol

Volatility control products are funds that promise their investors a specific realized volatility – either by aiming to achieve an exact number (e.g. 10% realized vol), a specific range (e.g 8-12% realized vol), or a limit (no more than 12% realized vol). The volatility objective is a constraint on the otherwise return-maximizing goal of the portfolio.

We define vol control funds as products having these characteristics:

■ Dynamic asset allocation. The percentage of assets invested in equites varies, at least partially systematically, over time based on market conditions.

■ Asset allocation is a function of volatility levels. The product's allocation to equities is primarily a function of how high either equity volatility or cross-asset volatility is, whether measured through implied, realized, or subjective metrics. We do not include products whose asset allocation is a function of asset classes' relative volatility to each other.

Typical vol control funds are global, multi-asset portfolios

Even though vol control funds are largely a US-based investment option, most vol control funds are managed as global asset allocation portfolios, including equities and fixed income, from both US and international markets. They typically hold almost-static allocations to either security-level or fund-level investments, and then manage the overall expected volatility of the portfolio by trading futures
contracts on global equity indices in response to changes in market volatility. The charts below show the asset allocation of the long and short sides of a typical vol control fund. The fund holds a diversified, multi-asset long portfolio, and then reduces its equity exposure by 17% of AUM via several short futures positions:

In similar fashion to CPPI strategies, these funds must decrease leverage to protect principal hence the dangerous feed-back loop for these strategies increasingly at risk from rising cross-asset correlations with reduced buffer from the bond allocations in some case such as the much vaunted stars of the last decade aka "balanced funds".

As we have pointed out, positive cross-asset correlations are on the rise and should be monitored and of great concern. As we pointed out in our short August conversation "Positive correlations and large Standard Deviation moves", indicates growing systemic risk we think. As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger...That simple.

The below chart made on Bloomberg by Adnan Chian (through our twitter feed), represents an illustration of the risk for "balanced funds" getting "unbalanced" as mentioned above:

- source Bloomberg / H/T Adnan Chian - Twitter - 30th of August 2016

In addition to this, we read with interest Bloomberg's take on rising correlations from their article from the 31st of August entitled "Stocks and Treasuries haven't moved together like this since China's Yuan devaluation":

"The last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan, with strategists heralding the onset of "quantitative tightening."

In stark contrast to the recent experience, modern portfolio construction has typically been predicated on a negative correlation between stocks and bonds, lowering the overall volatility of the portfolio and producing better risk-adjusted returns.
"The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield but that shift from negatively correlated to positively correlated will play havoc for portfolio level risk management (and risk parity)," writes Peter Tchir, head of macro strategy at Brean Capital LLC.
The risk parity strategy, which, in very basic terms consists of a levered long position in Treasuries and a long position in stocks, has been on fire in 2016. Bank of America Merrill Lynch Head of Global Rates and Currencies Research David Woo has warned that tough times could be in store for this strategy if investors heading into the U.S. presidential election begin to price in the possibility of fiscal easing in the U.S., anticipating a clean sweep at the polls by either party." - source Bloomberg

While we have touched on "Vol Control Products", "balanced funds" and CPPI, no doubt to us that very successful "Risk Parity Strategies" could as well be impacted by the rising trend as put simply by Bloomberg in their article:

"The diversification benefits of a traditional 60/40 (stocks/bonds) portfolio would disappear in such an environment, causing portfolio managers to scramble and search for a new hedge." - source Bloomberg

In our Society of the Friends of Truth, which you hereby are a member by now, in our "investing book", these strategies are indeed directly threatened by the rise of "positive correlations". On the subject of "Risk Parity Strategies" we would like to redirect you dear member to the guest post from our Rcube friends  which we published on the 14 August 2013 entitled "Is Risk Parity a Scam":

"Because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a big rotation that would bring 10-year yields back to a theoretical long-term equilibrium value.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…
From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself."

Conclusion

Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance based arguments that are often put forward by the proponents of risk parity.
From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:
1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategy's performance under different scenarios.
2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.
3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.
4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.
5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.
For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).
There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's numerous flaws.

However, we have little doubt that when the next "black swan" terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage one's life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.-"Is Risk Parity a Scam", August 2013

We could not agree more with our friends.  In addition to this, dear member of "The Society of the Friends of Truth", is that when it comes to Risk Parity and "Risk" we reminded ourselves Bank of America Merrill Lynch US Equity Derivatives Research note from the 30th of August 2015 entitled "Risk parity is not the risk, vol control is, but how big is it really?":

"Risk parity is not the risk, vol control is
Much has been made recently of the threat of forced selling by risk parity funds during market shocks as volatility spikes. However, the risk in our view lies not in the basic construct of a risk parity fund, but rather in the risk-management mechanism often overlaid onto risk parity funds (as well as other funds) which aims to manage an investment such that it has constant volatility. This “target volatility” risk overlay is a dynamic portfolio rebalancing mechanism that can induce rapid shifts in a portfolio’s allocation, particularly when volatility spikes from a low base level, which is when these funds apply maximum leverage.

The perverse side effects of vol of vol tail events

Our core thesis for volatility in 2015 was that we would witness a greater number of “local tail events” or contained but violent shocks in markets including volatility due to bank deleveraging, waning liquidity and the growth in high frequency trading. The recent market events appear to be yet another example of these risks playing out. A byproduct of these violent shocks, which erupt from a calm, low vol market, is true tail events in the volatility of volatility – the VIX recorded its largest 2-day percentage rise in history last week. This is also a toxic mix for strategies that aim for constant volatility exposure as the amount of leverage they employ is directly linked to their volatility.

Vol control applied to risk parity can further exacerbate risks

Because risk parity funds are inherently low volatility strategies (the recent volatility of an unlevered fund is less than 5%), they are often levered to achieve higher volatility (and higher returns), and in many cases a volatility control is also overlaid to maintain a more constant risk exposure through time. Risk parity derives its low volatility from the diversification benefits of holding both stocks and bonds in equal risk weighting. However, if a spike in volatility occurs at the same time that bond/equity correlation breaks down, this will lead to even larger spikes in risk parity volatility and therefore greater de-leveraging. In theory if these funds were large enough, their rapid liquidation of both bonds and stocks could lead to heightened correlation thus further exacerbating their rise in volatility and demanding further deleveraging.

From theory to reality, near term risks are much reduced

Volatility control is a dynamic risk-management strategy that has been applied widely in
recent years, not only to risk parity funds. If we assume $400bn in risk parity funds, half of which use vol control, we estimate recent events could have generated $30-$80bn in selling pressure on equities and $50-150bn on bonds. Estimated selling pressure from risk-control funds applied to non-risk parity portfolios could equate to an additional $25bn- $50bn in equity selling, which together is less than 10% of the $1.7tn of S&P 500 e-mini futures traded last week. Interestingly, we also see almost no evidence of impact on the Treasury futures market despite estimated liquidity demands from risk parity rebalancing being even greater. This selling pressure also assumes funds all operate mechanically. Many funds can exercise discretion to smooth out their rebalancing. Importantly, for those funds that operate mechanically, they likely have already de-levered, and with volatility now elevated, further shocks will be much less impactful." - source Bank of America Merrill Lynch.

By now you probably understand our "nervousness" in these strategies given that if correlations break down, and they are by the way, then no doubt that there is a heightened risk of "fast and furious" deleveraging at play.

All these strategies suffer from not only "optimism bias" but from a "herd mentality", meaning everyone is playing the same way, this for us reinforce somewhat this "doom-loop" or negative feedback loop which would entail much steeper drawdowns for these strategies than anticipated. All in all, these strategies we discussed are very sensitive to a spike in volatility, and what matters therefore as shown by the "Brexit" episode is not the news outcome but the "velocity" of the news to have an impact on the forced deleveraging prospects for these investment strategies mentioned. After all asset allocation strategies allocate capital on the basis of volatility. When "The Cult of the Supreme Beings" aka central bankers mess with the signal (VIX index), we wonder how "Vol control" is going to operate if indeed we get very large volatility moves going forward as put it bluntly by Bank of America Merrill Lynch in their 2015 report:

"It is really the combination of a sudden, violent drawdown following an extended period of calm that is most toxic for target volatility funds and generates the largest potential rebalancing needs" - source Bank of America Merrill Lynch

So what to do in this kind of "environment", we think that "diversification" is being threatened by rising positive correlations, therefore, increasing cash levels, cash being a strategy is therefore paramount in the case of violent intraday drawdowns and sudden spike in volatility.

When it comes to Fixed Income, what would really drive a sell-off in the asset class, would be a return of inflationary pressures. When it comes to our views, us being members of the Society of the Friends of Truth, we are in the "lower for longer" camp and until we see a clear manifestation of wages pressure in the US we will sit tightly in the deflationary camp. This brings us to our second point about "inflation" and "flows".

• Macro and Credit  - Is inflation back into play?

While back in March 2016 in our conversation "Unobtainium" we discussed the possibility of a rise in inflation hence the current perceived heightened risk of a rate hike in September by the Fed. Back in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:

"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

Obviously has indicated by Markit, our case for UK linkers in August clearly blew away our preference given the performance of UK linkers over US linkers with a very significant performance overall:

- source Markit, H/T Simon Colvin

But, given our "deflationary" incline and the embedded deflation floor of US linkers, from a diversification perspective we continue to like the asset class, particularly given as of late of the significant inflows through ETF as indicated by Société Générale in their ETF Market Signals note from the 5th of September entitled "Record creations on inflation-linked bonds":

"Inflation-linked bonds came back to net creations after net outflows in July and posted all-time-high $600m monthly inflows, mainly thanks to USD denominated benchmarks (see chart 6).

- source Société Générale

 
 Now, as per our October 2015 conversation, inflation-linkers, even in a rising cross-asset correlation world bring diversification benefits, although they have not been immune to the rising trend in cross-asset correlations. However their embedded deflationary floors at least for US linkers make them, we think particularly attractive. What is of interest is that unlike US TIPS, Gilt linkers do not benefit from this "deflation" floor. In a growing NIRP world with now some European Investment Grade companies (Henkel, Sanofi), US linkers have the advantage that both the principal face value and the coupon payment can never decline below the value at issuance. How that for a financially repressed world we dare to ask dear members of the Society of the Friends of Truth?

If we are indeed, in a prolonged period of deflation, such as the one we think we are currently experiencing, the embedded "deflation floor" both applied to the stated coupon as well as to the face value of the bonds. These are indeed very interesting features that should not be neglected when selecting an exposure to the index-linked sovereign bond markets. This is particularly true for believers like us that, the US economy is weaker than what every pundits think and that, going forward, US growth is likely to disappoint (see recent PMI for services for example...).

As we asked ourselves back in October 2015, could the  the Fed really hike when US breakevens are falling , which could be clearly indicative of deflationary forces at play? This also another reason why the embedded "deflation floor" in US TIPS is so enticing:

- graph source Thomson Reuters Datastream - H/T Warburg on Twitter

But, there is a caveat, with the on-going discussions surrounding "fiscal stimulus", especially in the US as both presidential candidates are pushing for it. As well at play, we think there is, in similar fashion to "Brexit", markets it seems are falling once more for an easy victory for Hillary Clinton it seems. 

We know how that played out for "risky assets" once the news hit the screens. On that subject we read with interest Bank of America Merrill Lynch's Cause and Effect note from the 26th of August entitled "Pricing a perfect gridlock":

"Gridlock = Goldilocks

Our analysis suggests the market is pricing an easy victory for Hillary Clinton but a split Congress in the November elections. In other words, the market is pricing a high probability of continued gridlock in Washington. We believe this is the reason why the market is long risk parity trades and short volatility right now.

Risk-off ahead of November 8

Risk parity portfolios have not done well when uncertainty and volatility go up. History tells us to expect Clinton’s lead to narrow and volatility to rise in the final stretch of the elections. We recommend buying a 3-month AUD/USD digital put to position for a possible unwinding of risk parity trades that can become self-fulfilling once it starts.

Clean sweep = higher USD and higher US rates

We cannot remember the last time the FX and the rates markets have so much at stake in a US election. While gridlock probably means lower rates and a weaker USD, a clean sweep would likely lead to both higher USD and higher rates over the medium-term, in our view. We believe the volatility market is underpricing the bi-modal nature of the outcome of the election for US fiscal policy outlook." source Bank of America Merrill Lynch

From our perspective, as members of The Society of the Friends of Truth and given our long lasting contrarian stance, we would tend to fade the "easy victory" for Hillary Clinton and as, we posited in our first bullet point, we would rather go short risk parity trades and long volatility right now, no offense to Bank of America Merrill Lynch. We do not want to suffer from "Optimism bias" but we are not yet falling for the "pessimism bias", we tend to sit nicely in the "realistic bias" camp. Overall, the big issue for risk parity trades comes when both volatility and correlation of the underlying components rise together. This we think is going forward a very important factor to keep in mind. Furthermore, we think that option markets are too complacent and pricing too little of a potential move. With risk parity still remaining levered at elevated levels, this we think could turn out to be a "bad recipe" for asset prices and significantly "boost" the "velocity" in the surge of "volatility".

When it comes to our inflation expectations, we continue to believe that wages acceleration hold the key to the "recovery story", so far, we are not buying it, and we will continue to fade it hence our attraction for the embedded deflation floor of US linkers.

For our final chart, we would like to point out to our fellow members of the Society of the Friends of Truth, that the unintended consequences of the "The Cult of the Supreme Beings" aka central bankers has had an impact on hedging budgets (particularly because both duration risk and credit risk have risen).

• Final chart: The downward trend in bond yields has limited insurers' hedging budgets

Our final chart comes from Deutsche Bank' s Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions". It shows that the unintended consequences of the trend in low bond yields has limited insurance companies' hedging budgets:

"Low interest rates, high vol-of-vol, and volatility aversion have driven growth

Three financial market trends have been catalysts for growth of vol control
products:

■ High vol-of-vol. Volatility itself has been volatile for the past few years, and as a result insurers' hedging costs have been changing quickly. In this environment, vol control funds' more stable volatility profile is particularly valuable to issuers.
■ Low interest rates. Interest on invested funds can be another source of hedging funds for insurers. With US interest rates repeatedly hitting new lows, insurance companies have little margin for error. Stabilizing hedging costs is one way to reduce the need for this cushion.
■ Post-financial crisis worries. Investors continue to be haunted by the ghost of 2008: recency bias has driven heightened worry about another 2008-like event. This volatility aversion has made volatility control attractive to investors (as a peace-of-mind feature) - even in products that do not have the technical hedging needs that drive much of the growth." - source Deutsche Bank

Furthermore, there is a well a clear warning in Deutsche Bank's note for the pundits such as pension funds that keeps picking up pennies in front of a steamroller namely selling volatility:

"Tail protection for short vol strategies increasingly timely at low vol levels

The growth of vol control products has, at least at the margins, the potential to re-frame how volatility sellers manage their positions. Conventional wisdom has typically been that selling vol is more dangerous at very high vol levels than it is at low levels despite the seemingly more attractive entry points. However, the potential for market feedback loops like vol control funds to intensify selloffs that start at low vol levels makes short vol strategies riskier at low starting vol levels - increasing the need for tail protection as an overlay." - source Deutsche Bank

 As a member of the Society of the Friends of Truth, we could not agree more. Any good trader will tell you that being short gamma is a very poor risk/return proposal....particularly pension funds with fiduciary duties we think...

"In a time of universal deceit - telling the truth is a revolutionary act." -  George Orwell

Stay tuned!

Macro and Credit - The fourth wall

"It is only with the heart that one can see rightly; what is essential is invisible to the eye." - Antoine de Saint-Exupery, French pilot and writer

While enjoying the festive season in Paris, we watched with interest a couple of interesting credit and market events that made us think about a theatrical reference which we decided to use as our title analogy. The fourth wall is the imaginary "wall" at the front of the stage in a traditional three-walled box set in a proscenium theatre, through which the audience sees the action in the world of the play (or markets). Speaking directly to, otherwise acknowledging or doing something to the audience through this imaginary wall – or, in film and television, through a camera – is known as "breaking the fourth wall" (think Ferris Bueller's day off...). The fourth wall being an established convention and given our disregard for conventions (us being contrarian), we will, therefore, in this first of the year conversation "break the fourth wall". The acceptance of the transparency of the fourth wall is part of the suspension of disbelief (or delusion) between the "fictional" recovery we have commented on numerous occasions and you, the audience.

Before we dive more into our first conversation of the year, which will relate once more to the state of affairs in the credit and macro space, we would like to make a quick parenthesis on two subjects of interest of ours, namely idiosyncratic risks in credit markets and the state of shipping (given for us it is not only a deflationary indicator, but a credit indicator as per our past conversations).

A good illustration of the idiosyncratic risk in the credit space was once more illustrated on the 29th of December by the price action relating to the "sucker punch" delivered to the senior bond holders of Novo Banco, the supposedly "good part" of former Portuguese bank Banco Espirito Santo - graph source Bloomberg:

- graph source Bloomberg

So what happened on the 29th of December that spooked the "innocent" senior financial bond holders you might rightly ask dear audience? Well, Bank of America Merrill Lynch in their note on Novo Banco from the 4th of January tells it all:

"The Bank of Portugal announced that, as part of the resolution of BES, it was transferring five bonds from Novo, back to the ‘bad bank’, BES. We believe that the resolution of BES could be viewed as a process and not a discrete series of events, since Novo is still a ‘bridge’ institution (the intention is that the resolution of Novo is complete when it is sold, although the deadline for the sale now appears to be indefinite). In our view, recovery on these securities should be viewed as uncertain as BES’s total assets were only €197m at end-2014 compared to a negative net asset position of €2.7bn, before the transfer of a further €2bn of senior bonds. It is our understanding that the senior bonds’ Governing Law is Portuguese. We note that in the original resolution of BES, the Bank of Portugal, as resolution authority, has reserved the right to move assets and liabilities between ‘bad’ bank and ‘bridge’ bank. In addition, the BoP appears to have chosen large denomination seniors, to avoid imposing losses on retail bondholders. In any case, with the transferred securities trading at ~€11, and BES now to be liquidated. 

Further losses could lie ahead 

Novo has in effect been given a further €2bn in capital post-transfer which, according to the company, means that its CET1 ratio has now increased to 13%. However, Negocios, at the end of 2015, reported that a further €2bn of ‘irregular’ loans linked to the ancien regime of the bank had been discovered (the newspaper adduces these irregular loans as the reason for the senior bail-in). The newspaper reports that the provisions relating to these exposures may be taken in 4Q15 (and beyond) leading to a significant deterioration in the accounts of the bank. Note Novo Bank did not comment on the press reports. The June report already detailed a loss of €252m. We would expect this to deepen through year end as provisioning likely catches up with the asset quality decline we saw at the bank in 2015. 

Cheap but we await clarity 

In our view the 5% bonds are quite cheap, with yields of nearly 10%. However, many erstwhile bondholders of Novo are now nursing substantial losses from their senior exposures – we assume this could lead to a degree of reluctance to take exposure on the name, at least for a while, which could mean poor technicals for the bonds. We understand that Novo is now better capitalised. However, this capital could come under pressure in the coming quarters if more losses are recognised. Events of the past few weeks have highlighted Novo’s problems and the fact that the deadline for its sale is no longer subject to public disclosure suggests a drawn-out sales process, especially as Santander has just bought Banif, so arguably does not necessarily need to add to its Portuguese assets." - source Bank of America Merrill Lynch

No, these bonds are not "cheap" and should be avoided. 

In addition to senior bond holders nurturing their losses, as of the 1st of January, depositors are now "pari passu" with senior creditors and are indeed next in the line of fire should additional "hidden losses" materialize (they will). When it comes to recovery assumption, we read with interest CMA (now part of Capital IQ)'s take on the estimated recovery value. They estimate it to be at 1%. You read that correctly. So much for an assumed recovery value of 40% for senior CDS. 

We might be sounding yet again in 2016 as a broken record but, we told you before dear readers, in the next downturn in credit, recovery values, rest assured, will be much lower. That's a given.

Moving on to the second part of our parenthesis namely "shipping", and "cheap credit", we read with interest the FT's recent article on the subject from the 3rd of January entitled "Cash burning up for shipowners as finance runs dry":

"The challenges facing DryShips are among the most acute of those facing nearly all dry bulk shipping companies after a slump in earnings drove most owners’ revenues well below their operating costs. Owners are haemorrhaging cash. Owners of Capesize ships — the largest kind — currently bring in around $3,000 a day less than the $8,000 they cost to operate. The losses for the many owners who have to service debts secured against vessels are far higher.
Basil Karatzas, a New York-based corporate finance adviser, points out that in an industry that has already been making steady losses for 18 months, such substantial losses quickly mount up.
“If you have 10 ships and you’re losing $3,000 to $4,000 per day per ship, that’s, let’s say, $40,000 per day, times 30 in a month, times 12 in a year,” he says. “You are losing some very serious money.”
The question is how long dry bulk owners — and the private equity firms which have invested heavily in the companies — can survive the miserable market conditions.
Michael Bodouroglou, chief executive of Paragon Shipping, another New York-listed dry bulk shipowner, says that owners are looking to negotiate partial repayments, standstills and payment moratoriums with their banks.
“They’re trying to batten down the hatches, reduce costs as much as they can,” he says.
Yet the brief arrest — seizure over unpaid debts — in November in Singapore of the Sparta, a Capesize dry bulk carrier controlled by private equity firms, illustrates why shipowners are especially pessimistic about this slump. The vessel’s arrest, at the request of Deutsche Bank, has been widely interpreted as a sign that banks’ readiness to keep amending loan terms to allow owners to ride out the slump might be coming to an end." - source Financial Times

We chuckled because although some pundits have the memory span of a goldfish, we don't and we clearly remembered the warnings we gave back in December 2013 on the billions poured by Private Equity players in the shipping industry in our conversation "All that glitters ain't gold":

"There is a wave of private equity money flowing into shipping, which for us is yet another manifestation of "mis-allocation" and "Cantillon Effects".We have long argued that "Shipping is a leading credit indicator", as well as a "leading deflationary indicator". We have also discussed at length the link between consumer spending, housing, credit and shipping back in August 2012.
The latest manifestation of the consequences of "cheap credit" and record cash is leading outside players such as private equity investors to dip into the structured finance shipping business

Whereas traditional shipowners tend to hold vessels for at least 20 years, private equity groups hope to turn a quick profit by listing companies or selling their vessels once charter rates and ship valuations recover.

The issue of course for our private equity friends that they will soon discover is that if quick profits depend on valuations, they also depend on "recovery". We think they are bound for some disappointment as overcapacity is still plaguing the industry. " - Macronomics, December 2013

Given the "evident signs" of the recovery as displayed in the latest dismal print for the Baltic Dry Index to 467, a new record low (since its creation in 1985), one might wonder if indeed the PE players will make their "quick buck" on their "shipping" ventures. We don't think so:

- source Bloomberg.

Why we don't think so? Because "cheap credit" has led to "malinvestments" with PE pundits placing bets on a business they hardly know, and they have added overcapacity to overcapacity. Simply put, there is a "shipping" glut.

One can ascertained QEs and ZIRP have been deflationary by looking at the fall in the US of M2 "velocity":

-source CLSA

In similar fashion in the shipping industry, the "velocity" of ships aka their speed has been as well falling as reported by Bloomberg in their article entitled "Slowing Boat From China Provides Clue to Health of World Trade" from the 17th of December:

"Even with fuel at its cheapest price in almost a decade, the ships that carry goods around the world have been reducing speed in line with the slowdown in China, the biggest exporter.
Shipping companies have been “slow steaming” since the global financial crisis in 2008, as a way to save costs and keep as many ships active as possible. Vessels are now operating at an average of 9.69 knots, compared with 13.06 knots seven years ago, according to data compiled by Bloomberg. 

That means Nike sneakers and Barbie dolls made in China can now take two weeks to arrive in Los Angeles and a month to reach Le Havre, France -- a week longer than if the ships were moving at full speed. And there’s scope for ships to go even slower, according to A.P. Moeller-Maersk A/S.
“This is the new norm,” said Rahul Kapoor, a Singapore-based director at Drewry Maritime Services Pvt. “The overall speed of the industry has gone down and there’s no going back.”
In the boom years before the 2008 financial crisis, shipping lines expanded fleets and ran ships as fast as they could to keep up with the surging demand for goods manufactured half a world away. As demand dropped, the lines were left with too many vessels, and customers eager to reduce inventory, who would rather pay a lower rate to receive goods than guarantee quick delivery." - source Bloomberg

The new norm has been slower M2 velocity, slower growth, slower shipping. For the PE punters who have played the "recovery" game, they will have to face the "music". End of our parenthesis.

In this week's conversation, given the on-going "bloodbath" in the oil space, we will look at some of the implications. We will also look at the debilitating state of the credit markets once more.

Synopsis:

• US Energy sector (ETF XLE) versus oil price - Much more downside to come
• Credit - The credit cycle has turned and global financial conditions are tightening
• Final chart - Correlations getting higher in a macro-driven market

• US Energy sector (ETF XLE) versus oil price - Much more downside to come

While watching the continuous downward spiral of oil prices, what really struck us is the resilience from the US energy sector in the equity space versus the price of oil. We are convinced that there is more downside to come on the equity side - graph source Bloomberg from the 6th of January:

- graph source Bloomberg.

Whereas at the end of 2008, oil and XLE where trading roughly at the same levels, today it appears to us that ETF XLE as a proxy for the oil equity sector is still at least 30% above the lows of 2009 with an oil barrel at a much lower level. More pain to come, we think...

On a side note, should a rebound of oil happen at some point in 2016, one sure way of playing it would be through Fx via the Canadian Dollar (CAD) and/or the Norwegian Krona (NOK). 

Whereas, equities present more downside risk, credit has already significantly underperformed in recent month in fact as indicated by Barclays in their Oil and Gas monthly note from the 5th of January indicates the following:

"High Yield Energy Bonds Drop 23.6% in 2015 

The Barclays high yield energy index decreased 12.2% in December, the second largest monthly decline since 1991 (worst was October 2008 at -19.2%). This month’s drop leaves high yield energy down 23.6% for the year, underperforming the overall high yield market by 19.1% in 2015. In December, high yield energy credits moved lower because of a 12% decline in front month WTI and a collapse in natural gas prices to a low of $1.75/mmBtu on warm winter weather. By rating category, BB bonds returned -11.6%, B bonds returned -13.6%, and CCCs returned -12.9%. The independent index declined 18.3% in December, reflecting sharp decreases in the unsecured bonds of California Resources, Legacy Reserves, Vanguard Natural Resources, and Memorial Production Partners. Oilfield services dropped 8.4% on decreases in Seadrill, Atwood Oceanics, and CGG. New issue activity dried up completely in December, leaving year-to-date high yield energy issuance at $33bn, down from $55bn issued in 2014. 

Leverage Sensitivities and Breakevens at $40/bbl WTI 

We recently published an E&P update on leverage sensitivities and breakevens at $40/bbl WTI (report). In the report, we show sensitivities to debt/EBITDA in 2016 assuming $40/bbl WTI and $2.25/mmbtu Henry Hub, close to where strip prices are today. Two-thirds of the peer group has leverage north of 5.0x and five companies have leverage north of 10x (SandRidge, California Resources, MEG Energy, Denbury, and EXCO). However, hedging gains account for almost half of the peer group EBITDA in 2016, leaving unhedged debt/EBITDA at an average of 20x. Under this screen, 16 of the 27 companies we model have leverage north of 10x. Lowest leveraged companies under a $40/2.25 deck include Concho Resources (2.2x), Hilcorp Energy (3.2x), Baytex Energy (3.7x), and EP Energy (3.8x). Although not our base case, we note that Moody’s recently lowered its 2016 price forecast to $40/2.25, potentially foreshadowing additional ratings downgrades. 

Hedging Protection is Limited in 2017 

In our latest hedge study (report), we found that high yield E&P companies have protected 36% of 2016 oil and gas production and only 12% of 2017 production. While some high yield producers used the rally in oil to $60/bbl in May 2015 to fortify hedges, few producers have added to hedges in 4Q15 given the decline in strip prices. Almost half the peer group remains unhedged in 2017. As of 3Q15, we estimate that the peer group had a hedge book value of $12.6bn, with Antero Resources leading the peer group at $2.8bn. Top hedgers in 2016 and 2017 include Memorial Production Partners and Antero Resources, with an average 78% and 76% of 2016/17 production hedged, respectively. Credits with no hedges in place for 2016/17 include Goodrich Petroleum, MEG Energy, Midstates Petroleum, and Swift Energy. Energy Spreads Wider in DecemberIn December, energy spreads widened 292bp, to 1,296bp, compared with 58bp of widening for the overall market. December’s move left energy spreads trading 636bp wider than the high yield market, cheap compared with the 10-year average of 38bp through. The sharpest outperformance came in the oilfield services subsector, which widened as little as 5bp versus the high yield market." 

- source Barclays

Given the lack of hedges for some as reported by Barclays, should the "oil conundrum" continues, meaning lower for longer, no doubt to us that some players are going to face the default/restructuring music in 2016. 

This brings us to the second point of our conversation relating to credit and the current state of affairs.

• Credit - The credit cycle has turned and global financial conditions are tightening

While looking at the evolution of Global Fx reserves and their evolution since 2003 and in comparison with the recent periods, one being 2008 and the start of the rise in the cost of capital since mid 2014, if we use the evolution of these Global Fx reserves as a proxy for "global liquidity", one can ascertain that an expansion of these reserves indicates expansion, whereas a fall, indicates a global contraction - graph source Macronomics / Bloomberg:

One can notice from the above chart that during the financial crisis of 2008, between the 31st of July and the 31st of March 2009, Global Fx reserves tightened by 4.86% ($339 bn in 8 months, roughly $42bn per month). Since the 31st of July 2014 until the 31st of December 2015, Global Fx reserves have fallen by 6.39% ($768 bn in 17 months = roughly $45 bn per month). The on-going "liquidity" crisis, which is indeed a very big US dollar "margin call", is not only much bigger than in 2008, but, is lasting much more longer!

So even if some "pundits" tell you that at these levels High Yield is a "bargain", dear reader you should think again, although no doubt there are some interesting credit story out there (much more likely in Europe where leverage is lower), credit in the High Yield space continues to deteriorate in the US, hence our recommendation of moving higher in the rating spectrum for the last few months and favor Europe from a relative value perspective (better credit metrics).

When it comes to US High Yield we have to agree with Bank of America Merrill Lynch's take from their latest High Yield strategy chartbook from the 6th of January, "Winter is coming":

"2014 redux 

Last year was a lot like 2014, only amplified. Bigger oil slump, worsening fundamentals and gappier price movements in HY, more geopolitical turmoil, and higher EM volatility. These factors were already eroding investor sentiment within HY when the US economy also buckled, showing signs of a slowdown at the heels of an already faltering global economy. The news of liquidation of several HY funds due to mounting losses from distressed credits turned out to be the last straw, driving US HY to a return of -4.6%, its first negative annual return in a non-recessionary period. The only bright spot: mutual fund redemptions were comparatively much lesser last year (-$10bn) vs 2014 (-$21bn), which arguably gave US HY a level of support. Across asset classes, US HY was the second worst performer. Only EM equities underperformed more, while less risky securities such as Treasuries, Munis, and Mortgages were the best performers. Leveraged Loans outperformed HY returning -0.69bps despite the heavy outflows (-$25bn). 

Winter is coming 

It’s a binary world we live in: 2015 returns were heavily dragged down by commodities, outside of which the index was roughly flat (tab 1.01). Half the HY universe by market value today trades at 310bps, while the other half is at 1050bps. The distressed list has a disproportionate representation of commodities (33%). However, this dispersion doesn’t bode well for US HY, as our fears of valuations eventually catching up to fundamentals have not abated. Default and distress ratios are increasing, even outside commodities:

and while rating migrations ex-commodities have not reached 2011 levels, they are heading in the wrong direction. CCC issuance has plummeted (chart below) and the US-domiciled USD HY market has seen a net annual contraction for the first time since 2008:

We expect all of this to continue well into 2016, putting more pressure on non-commodity paper. In terms of opportunities, we think Fallen Angels will provide a unique one to HY investors in 2016 as demand for higher quality paper increases, especially in light of reduced primary market activity. We also like Leveraged Loans for many of the aforementioned reasons, and believe they will outperform bonds once again this year." - source Bank of America Merrill Lynch

2016, no doubt will be an interesting year for US High Yield particularly given the contagion risk, should market turmoils continue to run unabated as it seems to be the case so far. As displayed in Bank of America Merrill Lynch's data, not only leverage is higher than in 2008, but earnings have been falling faster in terms of EBITDA YoY changes:

Even Ex Energy earnings are falling...

We know nothing, Jon Snow 

Is it possible that the world remains in its current bifurcated state? Yes, if oil prices don’t bounce back and ex-commodity fundamentals don’t degenerate further. We can sympathize with the commodity bears given the levels of global oversupply, but corporate earnings power has been eroding for one too many quarters (charts above), and top cycle behavior has surfaced one too many times this past year for us to think that the corporate credit cycle has not turned. This is the foundation of our opinion that spreads have more room to widen from here, and a broader default cycle is looming, especially if outflows pick up. The more nuanced questions for 2016 and beyond however, include: what will be the direction of the global economy and how will that impact the business cycle back home? Will events in the HY market be enough to create another impediment for the US economy? Enough to turn the business cycle? The answers to these, we don’t know yet." - source Bank of America Merrill Lynch

So, don't push your luck dear reader, we might be breaking the fourth wall, but "overplaying" the "beta" game when the US credit cycle has turned is, we think asking for more trouble than "carry".

What we have long argued during the course of 2015 is that the more correlations were getting "positive" the higher the number of "sucker punches" aka large standard deviation moves. It is no surprise to us, that the year ended, for some bond holders of Novo Banco, with a bang as described earlier in our conversation. When it comes to 2016, given cross asset correlations have risen, we do expect even more "sucker punches" being delivered hence our mention of "risk reversal" opportunities in our last conversation of the year 2015. When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.

• Final chart - Correlations getting higher in a macro-driven market

We already discussed the rise in +/-4 standard deviations moves or more in various asset classes back in August 2015 in our conversation "Charts of the Day - Positive correlations and large Standard Deviation moves":

"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations. Since the GFC (Great Financial Crisis), correlations have been getting more positive which, is a cause for concern" - Macronomics, August 2015

The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis. This is confirmed by our chosen chart from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 6th of January entitled "When credit met technical analysis":

"Correlations getting higher in a macro-driven market 

The credit CDS index market is a macro risk gauge. Post the global financial crisis and the subsequent central bank interventions, we find that pairwise correlations among different credits are now at a different (higher) regime (chart 4). 

Macro shocks (oil, Greece, China, EM risks, Fed, ECB) dominate credit markets. We see little prospect of the current market set-up changing in view of ECB QE.

Pairwise correlations across different asset classes have also been trending higher. Chart 5 shows the cross-asset pairwise correlations for equity, credit, implied vol and FX markets both in Europe and the US. Note that recently cross-asset correlations were at the highest level in a decade."

- source Bank of America Merrill Lynch.

Sorry to be breaking again the fourth wall dear readers, but, in our book, rising cross asset correlations is not a good sign for a smooth ride, but, at least indicates, there is convexity and risk reversal opportunities out there...and volatility is therefore a buy...

"A heart well prepared for adversity in bad times hopes, and in good times fears for a change in fortune." - Horace

Stay tuned!