Macro and Credit - Pregabalin

"Optimism is the opium of the people." - Milan Kundera

Watching with interest the largest outflow ever in US High Yield ($3.9bn last week) in conjunction with the unprecedented 9 days of weakness in US equities and the concomitant rise in the VIX index, given the indecisive outcome for the US elections thanks partly to the FBI's recent change of heart, when it came to selecting this week's title analogy, we decided to steer towards a pharmaceutical one. Pregabalin is a medication used to treat epilepsy but more commonly to treat generalized anxiety disorders. Given markets predicaments and violent gyrations, one might wonder if indeed one should take some pregabalin to ease these rising anxieties. While we have been musings around a pre-revolutionary mindset setting in on the global stage, no doubt to us that the rise in flare-ups in Hong-Kong, Florence in Italy, Greece and palpable rising tensions in France as a few examples, make us believe that the US elections anguishes are not the beginning of the end but more likely akin to the end of the beginning to paraphrase Winston Churchill. Although investors have received some respite as of late with the FBI changing again its tune, we do believe that no matter how some pundits would like to spin it, the lateness in the credit cycle appears to be as evident as the recent record numbers in M&A transactions typical of a late credit cycle rally.

In this week's conversation rather than focusing on the US elections outcome, we would like to look at the situation in Europe when it comes to disintermediation and deleveraging for the European banking system as well as shipping still being a deflationary indicator.

Synopsis:

• Macro and Credit - Disintermediation accelerating in Europe
• Macro and Credit: If you think about deflationary forces at play and global trade, think about shipping
• Final chart: Asia will become the largest driving force in world trade in the coming decades

• Macro and Credit - Disintermediation accelerating in Europe

While we have in many musings discussed the "japanification" process linked to the significant deleveraging process needed in the European banking system versus the US, we were reminded by KPMG as per Bloomberg's article on the 30th of October that European bank were still sitting on €1.2 trillion of nonperforming loans on their balance sheets:

"Eight years after Lehman Brothers’ collapse sparked the financial crisis, Europe’s banks still have 1.2 trillion euros ($1.3 trillion) of non-performing loans and will probably be stuck with them for decades to come, according to KPMG LLP.
Anemic economic growth across the region is making it harder for lenders to off-load toxic assets, hurting profitability while banks also come under pressure from tougher capital rules and fines for misconduct, London-based KPMG said in a report published Monday. Firms could take “decades rather than years” to reduce their exposures, hampering profitability.
European lenders are battling to cut soured loans as they face evaporating income from lending amid negative interest rates from the European Central Bank. Net interest margins, the difference between income from lending versus cost of funding, average about 1.2 percent in the region compared with about 3 percent in the U.S., according to KPMG.
“Reversing the profitability of European banks is not a lost cause but it will certainly be a lot of hard work,” Marcus Evans, a partner at KPMG’s ECB office, said in a statement. “It’s clear that across Europe banks are still grappling with the new world of low, or negative, interest rates and mounting capital and regulatory costs.”
The total value of toxic loans in Europe has surged since 2008 from about 1.5 percent of lending to more than 5 percent since 2013, according to the report. This has a negative impact on profitability from unpaid interest, raising provisions against impaired assets and realizing losses when disposing bad debts, according to KPMG." - source Bloomberg

When it comes to dealing with this burden, we have been pretty vocal in the past of what needed to be done back in July when we re-iterated our stance in relation to what the ECB should do in order to restore the credit transmission mechanism to Southern Europe in our conversation "Confusion":

"The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":

"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016

We also re-iterated our call on ailing Southern European banks back in August in our conversation "The Law of the Maximum":

"Either "Le Chiffre" aka Mario Draghi put up, meaning monetizing the lot, or he should shut up because in our book, no matter how charming the bluff he has pulled in the past with his July 2012 "whatever it takes" moment and his OMT, when it comes to ailing Southern Europe banks, it is decision time. The members of "The Cult of the Supreme Beings" might be numerous, but, saving Southern Europe banks requires more than an act of faith we think and haven't even mentioned German banks with some of their struggle with shipping loans such as HSH Nordbank, do not get us started...." - source Macronomics, August 2016

What is of course of interest when it comes to deleveraging, disintermediation and "japanification" is that corporate bond funding in Europe has been on the rise thanks to record issuance levels in the bond market. The financial repression from the ECB in conjunction with its latest corporate bonds asset purchases has moved hand in hand with the primary market for bonds. On the subject of disintermediation, we read with interest Société Générale quarterly note entitled "In the mood for loans" published on the 7th of November:

- source Société Générale

Whereas the above picture shows the overall picture, it is far more interesting to look at it on country to country basis given the significant differences between core countries and peripheral countries, where the impact of nonperforming loans has not been trivial when it comes to providing new loans regardless of the compression in interest rates for new loans as put forward as a success by the ECB:

- source Société Générale

What we find most interesting from Société Générale's report from a "credit impulse" perspective is the situation in Europe compared to the US, which we pointed out in the past has led to different growth outcome in recent years:

- source Société Générale

Obviously the pressure NIRP is putting on Europeans Banks Net Interest Margins (NIM) is accelerating the disintermediation process while in no way leading to some massive improvement for peripheral countries in credit impulse leading to better growth prospects, Italy being a good example of the failings of the ECB, not to mention the unresolved large pending issues of growing nonperforming loans which has yet to be addressed meaningfully. The impact of the European Banking Association core tier one capital rule which lead to a credit crunch in Southern Europe as some banks decided to drastically reduce their loan book to attain the core tier one ratio threshold can be seen in the below chart from Société Générale's extensive loan report:

"YTD figures show a big contrast between the two corporate lending markets. Bonds are obviously more resilient then loan funding, which could fall more than 30% short compared to 2015.
Part of this shift is attributable to the strong impact of the ECB’s CSPP buying programme. The impact of this programme (between €8-9bn of purchases per month) has strongly narrowed bond spreads and has very likely diverted supply towards bonds." - source Société Générale

As we pointed out in numerous conversations is that, liquidity doesn't resolve solvency but, more importantly, the longer time you take to deal with nonperforming loans, the weaker the credit impulse and your economic recovery and ultimately economic growth. But for now, the ECB and disintermediation, in similar fashion to what happened in Japan in the past, makes investment grade credit still an appealing proposal, particularly in the US thanks to the continuous appetite from the Japanese crowd in general and lifers in particular as pointed out by Nomura in their FX Insights note from the 28th of October entitled "JPY: Lifers still prefer foreign bonds":

"Japanese lifers’ investment plans show strong demand for foreign bonds, even after the introduction of yield curve control by the BOJ. Slight steepening in the JGB yield curve since early July is viewed as not enough for them to consider aggressive JGB investment. Their views on hedging suggest unhedged foreign bond investment is likely when JPY appreciates. The current USD/JPY spot is already slightly higher than their end-March forecast, but dip-buying demand from lifers is likely, especially if US political uncertainty disappears." - source Nomura

So while US High Yield as of late have seen significant outflows particularly in the feeble retail ETF space, we continue to favor quality (Investment Grade) over quantity (low rated US High Yield such as CCCs). Though some expect the convexity game to bite with additional rate hikes from the Fed starting in December which could impact dearly the long dated / low coupon investment grade crowd. At least for now, in terms of flows, the Japanese investor crowd still has your back.

Moving on to the never ending argument between inflation or deflation, while we chose the middle grown in our previous conversation discussing "biflation" over "stagflation", we continue to assess the deflationary forces at play thanks to the shipping industry as per our next bullet point.

• Macro and Credit: If you think about deflationary forces at play and global trade, think about shipping

As we pointed out in the past, when it comes to deflationary pressures, disintermediation and "japanification" process, we have long been looking at shipping loans as a good indication of deterioration in global trade and credit. We have regularly pointed out German banking woes when it comes to their outsized exposure to the sector which has been impacted in recent years by slumping freight rates illustrative of weaker global trade. This has been leaving shipping companies struggling to pay their creditors which meant that some German banks decided that they would even themselves run some ships to avoid recognizing their losses. For instance, back in 2013, German Commerzbank given their nonperforming shipping loans had resorted to running themselves the ships rather than recognizing the losses.

What some pundits fail to grasp when assessing world trade is that containerized traffic is dominated by the shipment of consumer products hence our stance regarding the weak recovery we are seeing. Any change in consumer spending trends depends on a more pronounced housing market revival and will directly impact container traffic. Weaker demand means weaker traffic, that simple.

When it comes to German banks exposure, there is much more deleveraging to come in relation to their shipping loan portfolios and woes as per Société Générale's report:

"Already evidenced in the 3Q15 data, German, Greek and UK banks shrunk their balance sheets in the sector in 2015 by -20% to -34%.
On the other hand, French, Benelux and Scandinavian banks all increased their balance sheets by 8% to 9%, while NL banks did so by+22%."

• "Within the container segment, mid-sized panamax vessels are being particularly hit by the situation. The Hanjin bankruptcy has been exacerbated by the re-opening of the widened Panama Canal, which means the Panama vessels are now undersized and outdated.
• In the offshore business, drilling business remains very weak. Many drilling rigs and jackups are struggling to find profitable redeployment at the end of existing contracts, and the idle fleet is therefore increasing, which will put pressure on cash flow in due course.
• New financing activity is low, and there has been a flight to quality among lenders, who are increasingly selective on new business while they closely manage existing portfolios. Liquidity remains strong for the top credits, and funding can be very aggressive despite the weak underlying markets. This is particularly true in Asia, where local banks (Malaysian, Taiwanese, Indian, etc) can price very aggressively to support their local clients, while Chinese lessors are being aggressive on a global scale to build market share.
• In addition to this difficult environment, the uncertainties regarding the Basel IV regulatory capital study are further constraining banks’ appetite for new lending. The new framework, as initially drafted, is based on more standardisation and higher capital requirements for shipping lending activities, the result of which would potentially further reduce bank liquidity for this business as well as increase the cost of borrowing for shipping clients. This might in time narrow the pricing gap between traditional bank lending and alternative sources of funding in the capital markets, particularly non investment grade. Banks will need to be more agile in managing portfolios, and without anticipating the final implementation of the Basel IV rules, banks will have to be more innovative in their distribution, extending their OTD model.
• During the summer, the industry acknowledged the bankruptcy filing of South Korea’s third largest shipping company, Hanjin Shipping. This is by far the largest bankruptcy in the sector and will have important consequences. The two other large Korean shipping companies, STX and HMM, have also been through significant restructuring in the past. HMM has announced that it is among a list of five potential bidders for some Hanjin ships.
• A number of significant strategic operations took place this year and could bring some discipline to the container sector in the future. Examples are Marseilles-based CGM-CGA’s acquisition of Singapore’s NOL; Hamburg-based Hapag-Lloyd’s merger with Qatar/Saudi Arabian-backed UASC; and, hot off the press, the likely merger of the container operations of the three largest Japanese shipping companies – NYK, MOL and K-Line.
• Overall, the outlook remains challenging, which is no doubt a source of stress to ship-owners and banks alike. This will require more innovation as banks evolve towards Basel IV, possibly accelerating their OTD business models to manage capital more smartly. Investor appetite for IG shipping debt is proven, with the likes of pension funds active in this market.
• The difficulty will stand with non-IG lending (i.e. the majority of the shipping sector) where alternative investors such as hedge funds and infrastructure funds have very different approaches to pricing. Whereas banks value the underlying collateral over which they have security and this currently drives the advantageous capital treatment and lower margin, typically hedge funds don’t value this component and price on an unsecured high yield basis." - source Société Générale

On top of the weakness in global trades, which has been plaguing the shipping industry and their banking creditors, the only solace they have seen as of late has been coming from weaker bunker fuel prices. As a reminder bunker fuel constitutes the bulk of voyage expenses for shipping companies. Higher bunker fuel prices would adversely affect already ailing earnings for the industry as a whole. Bunker fuel prices, the largest cost of running a ship, correlate with crude oil prices.  For the week ended October 28, 2016, the average bunker fuel price was $321–$325 per ton. Bunker fuel prices are 13% higher than they were in the same period in 2015, when they were $321–$324 per ton. A continuation in the rise of bunker fuel would of course put additional strain on already difficult earnings for the industry as a whole. On top of that new types of bunker fuel need to be developed to meet demand for low sulfur marine fuel following the decision of the International Maritime Organization to impose a global 0.5% sulfur cap on marine fuel in 2020, according to bunker industry organization IBIA. This will as well put additional pressure on the cost structure for existing shipping companies, meaning more pain to come thanks to increase regulation and more provisions to make for the likes of Commerzbank. This means probably more "pregabalin" intake for shipping companies and creditors alike we think but we ramble again...

When it comes to deflationary forces at play in global trade, we do not see a reversal in sight for the current weakening trend we have seen in recent years. This is as well clearly put forward by Deutsche Bank in their Logistics note from the 8th of November entitled "Weak environment - no trend reversal in sight":

"Over the next three to five years, global trade is likely to grow only at or around the same pace as global GDP.

This structurally weaker momentum should be reflected in slow growth in the global and regional flow of goods, as has already been the case in recent years. In its role as an open, export-oriented economy, Germany – and the German logistics sector in particular – should continue to feel the sting of this development. At a nominal average of 2% a year, turnover growth in the sector is likely to be below the long-term average in the years ahead.

Global openness – the share of trade in global GDP – increased from just over 10% in the mid-1990s to more than 30% in 2008.

In the wake of the 2008/09 global recession, global trade suffered a setback. Openness fell to around 27% in 2009. Due to the lingering weakness in global trade since 2012, global openness has yet to return to above 29% in 2015. We expect global trade to remain anemic in the years to come.

Low global trade growth goes hand in hand with weak momentum in the global flow of transportation.

The growth rate in international seaborne trade fell each year between 2012 and 2015. Growth came in at just 2% in 2015 – its slowest pace since 2009, a year plagued by recession. The situation is similar in global airfreight, where transport volume grew by an average of just 1.5% a year between 2010 and 2015. Between 1993 and 2010, airfreight transport volume expanded by more than 5% a year.

The slow expansion of trade in recent years is ultimately also reflected in domestic freight transport.

In 2015, the total volume of goods transported in Germany was only around 3% higher than it was in 2011, corresponding to an average annual growth rate of 0.7%. Between 1995 and 2011, transport volume increased by an average of 2.6% a year. The total volume of goods transported in Germany looks likely to grow by only slightly over 1% a year between 2017 and 2019.

In this climate, it is not surprising that the German logistics sector has also been mired in less than stellar growth for years now.

Nominal turnover in the sector increased by only slightly over 1% a year between 2012 and 2015. As a result, average growth was significantly lower than it was between 2003 and 2008 (4.6% a year). From 2016 to 2020, turnover growth in the German logistics sector will probably come in at just over 2% a year on average. Some segments, such as contract logistics and the provision of value-added services, fundamentally offer opportunities for higher growth." - source Deutsche Bank

So if you think that the rise of populism and discontent à la 30s is potentially coming back, then indeed, global trade could be further threatened down the line by additional pressure on "Global Openness as described above by Deutsche Bank. If global trade does remain anemic in the years to come, then indeed the deflationary floor we mentioned embedded in US TIPS we talked about recently as a low correlated asset allocation tool is still of good value we think.

If politicians start in earnest dealing with "globalization" thanks to rising discontent triggered by a rise in inequality, then again the inflationary burst we have seen will not lead we think to "stagflation" but no doubt to the "biflation" scenario we mentioned in our last conversation:

"What we are seeing we think is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand." - source Macronomics, 30th of October

The weaker trend in global trend has been running on since 2012 as illustrated by Deutsche Bank in their note:

"The lingering weakness in global trade since 2012 caused global openness to fall to 29% in 2015. Our analyses to date suggest that global trade is likely to continue posting anemic development in the years ahead, as the elasticity of international trade with regard to global GDP growth has probably decreased, partially due to structural factors. As a result, the link between cyclical and structural factors continues to exist.

In particular, the following aspects point to continued weak global trade going forward: slower economic growth in China and the realignment of the Chinese economy towards more domestic consumption, the probable plateau in the development of global value chains, the faltering status of multilateral trade liberalisation and the increase in the number of additional trade restrictions since 2008. Furthermore, there are no unique events on the horizon with the potential to boost trade globally or, at the very least, regionally. In the previous decade, such events included China’s admission to the WTO in late 2001 and the EU’s eastward expansion in 2004. This less positive outlook for global trade also means muted prospects for globally active logistics companies." - source Deutsche Bank

But, if you believe like ourselves in very long term trends, then indeed what we are seeing is the rebalancing towards Asia as mentioned by Angus Maddison in his outstanding book "Contours of the World Economy, 1-2030 AD, Essays in Macro-Economic History". The interesting part is relating to the share of World GDP for China, the peak was around 1820 at 32.9% according to Angus Maddison. It dropped to 17.9% in 1870 which is explained by the industrial revolution experienced by Western Europe at the same time. In 1950 and 1973, China's share of World GDP was 4.6 %. In 2003, China's share of World GDP came back close to 1870's level at around 15.1 % of World GDP.

This is where it is becoming interesting, according to Angus Maddison's projection for 2030(page 340 in his book), you can expect the following:

• Western Europe share of GDP will drop to 13% in 2030 from 19.2% in 2003.
• Asia (including Japan) shares of World GDP will power ahead from 40.5 % in 2003 to 53.3% in 2030.
• In 1820 Asia's share was 59.4 % with a low point of 18.6 % in 1950.

Before you reach for your pregabalin, we encourage you to read the stunning work of Angus Maddison given our final chart.

• Final chart: Asia will become the largest driving force in world trade in the coming decades

Asia will become the largest driving force in world trade in the coming decades and this is clearly illustrated as well in Deutsche Bank's note by our final chart taken from their note:

"Significant shift in the flow of trade away from Europe and towards AsiaBehind the aggregated global flow of trade lies a significant shift in the importance of regional trade within a continent or between continents. At 27%, the trade in goods within Europe continues to account for the lion’s share of global trade. But, from the early 1990s to today (2010-2015 average), it has grown slower than global trade overall, bringing Europe’s share down by five percentage points. Asia, by contrast, has grown significantly in importance. The share accounted for by trade within Asia increased by eight percentage points to 23% over the same period (chart 7).

China’s breathtaking rise to becoming the world’s largest trading power (WTO admission in 2001) was the main driving force behind Asia’s growing importance. China is a partner in each of the five largest bilateral trade relationships that have seen the strongest growth in their share of global trade since the early 1990s. Bilateral trade between China and the US has seen the strongest growth in importance and now places fourth with a share of almost 3% of global trade. In relative terms, trade between the US and Japan and between the US and Canada has lost the most significance. However, bilateral trade between the US and Canada remains in first place.
This shift towards Asia is likely to continue on account of the significantly higher growth rates in Asia than in Europe and progress on trade agreements, such as the Trans-Pacific Partnership (TPP), the Regional Comprehensive Economic Partnership (RCEP) and the Free Trade Area of the Asia-Pacific (FTAAP). Although the Transatlantic Trade and Investment Partnership (TTIP) negotiations between the US and Europe are still under way, critical voices have recently been gaining strength among the public and policymakers. Should the trend that has been around since the early 2000s continue, trade within Asia could outstrip trade within Europe by 2019.
A look at the flow of trade between the continents also illustrates Asia’s growing importance. The share of global trade accounted for by the flow of goods between Asia and Europe has grown by more than one percentage point since the early 1990s, reaching 13% in 2015. Although the significance of trade between America and Asia started to decline in the early 1990s, it has again risen to 12% since the mid-2000s. The importance of trade between America and Europe has fallen by almost three percentage points to 7%." - source Deutsche Bank

Sometimes the long term trend is indeed your friend...While the credit clock might be slowing thanks to central banks meddling, deflationary forces while temporarily at bay might come back thanks to the risk of renewed populism, rising discontent over inequalities and a return of protectionism, but that's another story. For the time being all eyes are on the US elections.

"Under the pressure of the cares and sorrows of our mortal condition, men have at all times, and in all countries, called in some physical aid to their moral consolations - wine, beer, opium, brandy, or tobacco.' - Edmund Burke

Stay tuned !

Macro and Credit - The Vasa ship

"In the ocean of baseness, the deeper we get, the easier the sinking." - James Russell Lowell, American poet.

When in Paris on the 5th of January to present our winning Saxo Bank community from their latest Outrageous Predictions for 2016 to their French clients, we had a very interesting meeting with Steen Jakobsen, their chief economist, who at the time, suggested we look into the Vasa ship as an interesting analogy for a post title. This time around curiosity did not kill the cat, and we waited, we must confess, for the right time to use this very interesting analogy in our musings. Given the on-going onslaught in risk asset classes (except for our comforting long US bonds, long gold miners and other positions) and also because, as always, credit leads equities (this means to lower levels that is), we decided it was the right time to use Steen's suggestion in this Macro and Credit related musing of ours.

So why the Vasa ship for our chosen title?

The Vasa ship was a Swedish warship built between 1626 and 1628 on the orders of the King of Sweden Gustavus Adolphus as part of the military expansion he initiated in a war with Poland-Lithuania (1621–1629). The ship is famous for having foundered and sank after sailing only about 1,300 m (1,400 yd) into her maiden voyage on 10 August 1628. Richly decorated as a symbol of the king's ambitions for Sweden and himself, upon completion the Vasa ship was one of the most powerfully armed vessels in the world (like the Bank of Japan). However, it had a massive design flaw. Vasa was dangerously unstable and top-heavy with too much weight in the upper structure of the hull (total amount of debt in the world). Despite this lack of stability she was ordered to sea and foundered only a few minutes after encountering a wind stronger than a breeze. In similar fashion, Bank of Japan's attempt in playing the Negative Interest Rate Policy game (NIRP) card sounds to us eerily familiar with the tragic fate of the Vasa ship. Kuroda's attempt foundered straight from inception with the Japanese Yen rising to 114 and the Nikkei rout continuing seeing the Nikkei lose another 2.31% on the 10th of February to 15,713.39.

The fatal order to sail was the result of a combination of factors. One being the king's impatience in seeing the Vasa ship becomes its flagship of the reserve squadron at Älvsnabben in the Stockholm Archipelago. The other was the king's subordinates lack of political courage to openly discuss the ship's structural problems or to have the maiden voyage postponed. Although an inquiry was organized by the Swedish Privy Council to find those responsible for the disaster, but in the end no one was punished for the fiasco. In similar fashion we think the central bankers at the Bank of Japan, the Fed, the SNB, the ECB responsible for the mess we are in will not be punished for the upcoming fiasco but we ramble again...

In this week's conversation we will look again at the dangerous evolution we are seeing from idiosyncratic "sucker punches" towards "systemic" risk. We will also look at why in similar fashion to the Vasa ship, new monetary policies such as NIRP will fail because of dangerously unstable markets and their top-heavy load (global world debt).

Synopsis:

• Central bankers' tricks are losing their "magic"
• Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"
• Final chart - Don't catch falling knives

• Central bankers' tricks are losing their "magic"

As we pointed out recently in our conversation "Under pressure", our Generous Gamblers aka our central bankers are losing their magic we think:

"Additional easing monetary policies, but as shown recently in the various iterations of QE in the US, the Fed is getting "less bang for the buck". Basically the "magic" of our "Generous gamblers" is losing its power on driving asset prices to new heights. "Overmedication" could in fact lead in the end to "overdoses", we think." - source Macronomics, January 2016

 We also added:

"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

It was bound to happen as per the Vasa ship (positive correlations leading to instability). From the inception of "unorthodox" monetary policies, the biggest issue which has yet to be addressed as brilliantly pointed out by William R. White, the chairman of the Economic and Development Review Committee (EDRC) at the OECD in Paris in a Bloomberg interview in similar fashion to the Vasa ship which was dangerously unstable because of too much weight in the upper structure of the hull, is the total amount of debt in the world.

In the light of Mr. William White's great interview we would like to rehash the quotes we have used in our March 2012 conversation "Shipping is a leading deflationary indicator"particularly in the lights of the very concerning comments made by AP Moller-Maersk's CEO on the current state of affairs of his company, seeing a situation worse than 2008:

"He who rejects change is the architect of decay. The only human institution which rejects progress is the cemetery."
Harold Wilson
"He who rejects restructuring is the architect of default." - Macronomics.

This is why Mr White's comments are so to the point. The longer you delay the restructuring, the lower will be the recovery value.

But, when it comes to central bankers losing their magic, the latest "results" in the markets from the Bank of Japan's implementation of NIRP speak for themselves. This is does not come as a surprise whatsoever. It was bound to happen and it is clearly pointed out by Bank of America Merrill Lynch in their FX Vol Trader note from the 10th of February entitled "Central Banks puts expire":

"Key takeaways

• As confidence in central bank puts erode, market participants are adjusting by paying for their own protection.
• Hedge demand has pushed vols indiscriminately higher. We view this as excessive and prefer to fade the move.

Markets adjusting to less stimulus

The painful adjustments taking place across global financial markets can partially be attributed to the re-pricing of central bank expectations. With Fed QE quickly becoming a distant memory and both the ECB and BOJ failing to deliver expansion packages, the market has been forced to learn to stand on its own two feet. As implicit central bank puts expire, the market must now pay for protection out of pocket, reflected in the structural shift in long-dated EURUSD and USDJPY risk reversals, which have both turned for USD puts (Chart 1). 

Like most forms of insurance, by the time the accident is being assessed, further coverage will be expensive. The demand for options has pushed FX vols towards the highs of the past couple of years. In our view, the indiscriminate demand for vol across all currencies and tenors is excessive and we prefer to fade the move." - 

Markets anxious, buying vol indiscriminately

Concerns about the health of the US economy and the European banking sector wreaked havoc on global markets this week. The broad anxiety is reflected in the indiscriminate vol purchases across currencies and tenors (Page 5, Table 3).

Gamma in general is performing, but our core view has been that barring some sort of crisis, it will be difficult to sustain volatility without a core divergence story." - source Bank of America Merrill Lynch

Also, as we posited in back in November 2014 in our conversation "Chekhov's gun", the changes in the communication of monetary policy have indeed taken a turn for the worse. This was clearly demonstrated by the SNB in 2015 and the surprise NIRP implementation by the Bank of Japan:

"What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:

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

Kuroda abandons forward guidance

It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time.Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants.But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ’s toolkit.When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making “steady progress” towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed

The BOJ governor’s decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market—including forward guidance—is essential when winding down such a policy, as the IMF has repeatedly warned.There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharplyhigher.The Fed’s intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation.In summary, the BOJ’s shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed." - source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured." - source Macronomics, November 2014

Exactly! The Bank of Japan has painted itself in a corner (and soon the Fed will as well). The shock announcement of NIRP has led to an unexpected outcome and more "sucker punches" delivered in the form of falling Japanese equities and a sudden "risk reversal" on the Japanese yen. Remember, we told you in December in our conversation "Charles law" significant "risk reversal" opportunities would happen in 2016:

"We don't see conditions improving either in 2016 and last Monday was once again an illustration of "Blue Monday" in the works we think. With liquidity deteriorating and hydrogen having been used by our "generous gamblers" as a lifting agent in  "asset balloons", there is indeed no surprises in seeing a significant rise in idiosyncratic risk leading to significant price movements. 2015 saw an increase in the number of "sucker punches" inflicted to the "cross-asset" crowd. By no means 2016 is going to be different." - source Macronomics, 15th of December 2015

When it comes to the latest "sucker punch" delivered to the Japanese yen courtesy of Kuroda's NIRP, we read with interest Richard Koo, chief economist at the Nomura Research Institute in his latest note from the 2nd of February:

"Negative interest rates an act of desperation driven by failure of past accommodation

In my view, however, the adoption of negative interest rates is an act of desperation born out of despair over the inability of quantitative easing and inflation targeting to produce the desired results. That monetary policy has come this far is a clear indication that both ECB President Mario Draghi and BOJ Governor Haruhiko Kuroda have fundamentally misunderstood the ongoing recession.
To begin with, despite the all-out efforts of central banks in Japan, the US, the UK and Europe, neither quantitative easing nor inflation targeting were able to achieve their initial objectives.
The BOJ has now pushed back the date when it expects to achieve its inflation target from “around the second half of fiscal 2016” to “around the first half of fiscal 2017,” which would be fully four years into the Kuroda/Iwata era.

Failure of monetary easing symbolizes crisis in macroeconomics

This failure clearly demonstrates that the Japanese economy envisioned by Mr. Kuroda and Mr. Iwata at the time of their appointments when they pledged to step down if they failed to achieve 2% inflation in two years was very different from the reality. In short, their models were wrong.
The same mistake has been made repeatedly in the US, the UK and Europe. In each case the monetary authorities undertook extreme quantitative easing measures in an attempt to achieve inflation targets, yet price growth continues to run far below the target levels.

In view of the fact that some of the most talented, well-educated economists in these countries are working for these central banks, it is hard not to conclude that this global policy failure is less a reflection on the abilities of Mr. Kuroda and Mr. Draghi than a signal of a crisis in the discipline of macroeconomics itself.

Conditions in today’s real economy do not conform to macroeconomic assumptions

The definitive difference between the economics that they (and we) studied as university students and the actual economic experience of the US and Europe since 2008 and Japan since 1990 is that traditional economics assumes the private sector is everywhere and always trying to maximize profit. But today the private sector is trying to clean up its balance sheet by minimizing debt.
In terms of financial markets, traditional economics means there will always be borrowers as long as interest rates are lowered far enough. In today’s world, there are no borrowers no matter how low interest rates are taken.
Traditional economic theory and econometric models assume the private sector is always forward-looking and is always seeking to maximize profit. As such, there will always be someone willing to borrow money to invest as long as real interest rates are low enough. Given that assumption, the focus of economic policy is naturally going to be on the central bank’s monetary policy.
And if we assume that the private sector is always trying to maximize profit, fiscal policy (under which the government borrows money to spend) wastes precious private-sector savings and raises the risk that the private sector—which can use funds more effectively than the government—will not receive all the money it needs. That is the primary reason why fiscal deficits are so unpopular.

Traditional economics never envisioned a debt-minimizing private sector

The private sector will always seek to minimize debt after the collapse of a debt-financed bubble. Yet traditional economics not only did not foresee this kind of situation, but does not even have a term to describe it.
Traditional economics did not envision the sort of world we have been living in since 2008 because such conditions were never observed in western economies between the 1940s, when the discipline of macroeconomics as born, and 2008.
Until 2008, in other words, there were always willing private-sector borrowers in the US and Europe who responded to changes in interest rates. In such a world, monetary policy is effective and fiscal stimulus generally frowned upon since it has the potential to crowd out private investment.

Interest rates no longer relevant once people start minimizing debt

But after a debt-financed bubble collapses, the debt remains while asset prices fall, leaving many borrowers technically insolvent or at least struggling.
This is a frightening situation for a company to be in, inasmuch as its banks can shut it down at any moment. After all, banks are not allowed to roll-over loans to bankrupt borrowers, and all financing, including trade credits could disappear once the creditors and suppliers realize the true state of the borrower’s balance sheet. For a household, too, it is a dangerous state of affairs in which assets that had been set aside for emergencies or retirement suddenly disappear. The overriding priority for these businesses and households, therefore, is getting out of this situation as quickly as possible.
Emerging from this debt overhang requires businesses and households alike to focus on saving more and paying down debt. Whether interest rates are zero or even negative, people will continue minimizing debt until they have dug themselves out of the hole. The probability of their behavior changing because of a shift in interest rates is negligible.
When this state happens throughout the private sector, not only do private-sector borrowers disappear, but the private sector in aggregate may begin saving instead of borrowing.

Central bank cannot control inflation during a balance sheet recession

Once the private sector begins saving (and paying down debt) in aggregate, the money multiplier turns negative at the margin. The money supply—the money available for the private sector to use—not only does not increase but can actually decrease, regardless of how much base money the central bank supplies.
When the balance-sheet-constrained private sector chooses to minimize debt in spite of zero interest rates, the liquidity supplied by the central bank cannot come out of financial institutions and enter into the real economy due to lack of borrowers. I have dubbed this state of affairs a balance sheet recession, a term that is now heard quite frequently. Unfortunately, the vast majority of people—including Mr. Kuroda and Mr. Iwata—remain unaware of this economic malaise.
Those who do not recognize that balance sheet problems are keeping potential borrowers from borrowing believe the recession is attributable to insufficient monetary easing by the central bank. That leads them to espouse policies such as quantitative easing and negative interest rates. But no matter how far these policies are pursued, there is no reason why the economy should recover until the private sector overcomes its balance sheet problems and turns forward-looking again.
Professor Paul Krugman, who was the first to recommend that this state of affairs be addressed with inflation targeting and quantitative easing, has proposed that a 4% target should be adopted if a 2% target does not work. But the current situation is not one that can be addressed with such trivial adjustments. Interestingly, even Professor Krugman has come to admit that non-conventional monetary easing adopted up to now were “not a game changing tool.” (“Krugman: ‘Meh’ is grade Fed gets on QE,” published on Nov 9, 2015 on Market Watch.)

The theory that inflation is a monetary phenomenon that can be controlled by the central bank, since the central bank controls the supply of money, is valid in a world in which there is an ample supply of private-sector borrowers. But it is mere nonsense in the post-bubble-collapse world of a balance sheet recession, where this condition is not satisfied.
Gulf between real world and economy as envisioned by economists continues to widen
In that sense, the economies of Japan, the US, the UK and Europe now fall completely outside the realm of traditional economics, yet the vast majority of policymakers and economic agents continue to operate as though this were not the case, and the textbook world envisioned by economists still existed. This misunderstanding has complicated the situation greatly.
In other words, the equity and forex markets have responded directly to central banks’ negative interest rates and quantitative easing, but businesses and households in these countries refused until quite recently to borrow any money at all. The implication is that the exchange rates and share prices set by these markets are on very shaky ground.
As noted in the last issue of this report, forex traders over the past seven years have orchestrated heavy sell-offs of the currencies of countries announcing quantitative easing programs based on the assumption that the money supply in those countries would increase far more than the money supply of non-QE nations. But in reality, the money supply in all countries has been essentially stagnant as businesses and households continue to pay down debt.
In the same way, stock prices have appreciated each time further monetary easing measures have been announced, based on the assumption that those measures would increase the money supply and lift the economy. But the money supply has not grown meaningfully in any of these countries.
Although the forex and equity markets responded sharply to the BOJ’s negative interest rate announcement, the changes in the real economy that would justify such moves and nowhere to be seen. At some point, therefore, I would not be surprised to see a reaction in the forex and equity markets that helped to fill the gap between expectations and the real economy" - source Richard Koo, Nomura Research Institute

In similar fashion to the ill-fated design of the Vasa ship, the Bank of Japan has induced much more volatility in an already fragile situation. The best illustration of an economy "rebooting" after a total collapse of its financial sector remains Iceland we think. The pill was hard to swallow but in the end both inflation (2.10% as of January) and unemployment have been tamed (from 9.20% in May of 2010 to a low of 2.30% in December 2015):
.

- source TradingEconomics.com

The major issue that seems to lack the attention of our "Generous Gamblers", is that you have to choose your battle wisely. They cannot ignite inflation and reduce unemployment at the same time without an increase in wages and this would mean that corporate earnings would have to revert to the mean. Unfortunately CEOs seems to care these days more about their own bottom line rather through buybacks in order to trigger their alluring stock options. As we posited in the "Pigou effect" last year real wage growth is the Fed's greatest headache. We quoted Sir Jimmy Goldsmith at the time from the lengthy but great thoughtful reply called "The Response" (link provided) to the critics of his great his book "The Trap" which was eerily prescient:

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " - Sir Jimmy Goldsmith

And lowering the standard of living of one's own nation has indeed been the results of the repeated foolhardiness of the Fed and its zealous "put".

Real wage growth is the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

Of course, as underlined by William White in his stunning interview, another solution to make the marginal-utility-of-debt going positive would be to restructure private debts (Iceland) so that the ailing US households (14.24% of the population receiving Food Stamps) could indeed save more, invest and consume again, which is in essence the purpose of good allocation of debt to the real economy. Not into inane speculative endeavors which have been extensively encouraged by the various iterations of QEs and their inefficient "Wealth Effect" to the "real economy".


When it comes to understanding credit and the buildup in a liquidity crisis (which we reminded you a couple of days back that it always leads to a financial crisis) we would like to use again a previous extract from our conversation "Pigou effect"from Sir Jimmy Goldsmith in his work "The Response":

"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.

But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.
Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent." - Sir Jimmy Goldsmith - "The Response"

Since 2008, the losses have not gone away, as we reminded you as well, European banks even with LTROs and QEs Nonperforming Loans (NPLs) have not gone away and there is still around €1 trillion of NPLs sitting on their balance sheets....

If you think NPLs are going to go away when we have mounting signs of headwinds for European growth with December Industrial Production coming at -1.6%  (+0.2% expected) for France, Italy -0.7% (+0.3% expected) and even the UK -1.1% (-0.1% expected), then think again.

In the current environment where we are seeing financial conditions tightening rapidly across the world as pointed out recently by the BIS for Emerging Markets and by the latest Fed US Senior Loan Officer Quarterly Survey, it means lack of credit will slow growth and therefore will not help out whatsoever the reduction of these NPLs. Furthermore, the stupidity is compounded by NIRP because banks cannot be profitable with a massive reduction in Net Interest Margins (NIM). That simple. So please, spare us the "value beta play" mantra because so many are trading under book value (most of the time banks balance sheets are such a black box, that you have a hard time detecting you what's being hidden). We are not buying it.

This brings us to our second point related to credit given our "2007" feeling. Credit is always leading equities and what we have been commenting  throughout our musings as we watched the credit cycle unfold, is in effect happening and it's we think it is still a cause for concern as the contagion is in effect spreading.

• Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"

What we have been indicating during last summer were the many signs of the credit cycle maturing. The record wave of M&A in 2015 coincides clearly with the late stage of the cycle. This has been clearly illustrated by our friend Cyril Castelli from Rcube (he finally joined the twitter family and you can reach him there: @CyrilRcube):

"The M&A cycle leads the credit cycle. M&A mania =>weaker balance sheets =>tighter bank lending => wider credit spreads"

- source Rcube - @CyrilRcube

When it comes to the potential "overshoot" in US High Yield, our friend Cyril Castelli from Rcube illustrated as well this potential:

"Excess leverage explains the US high yield crash. High Yield always overshoot. It won't be different this time"

- source Rcube - @CyrilRcube 

We agree with our friend and given that initial spreads explain nearly half of 5yr forward returns, and that spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors, given credit investors like suffer from bipolar disorder and are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates, we will still tight until we see much more of an overshoot. Although, it doesn't mean that they are not "opportunistic" short term High Yield / distressed name out there but this necessitate some solid credit analysis in the first place. Relative value arbitrageurs did enjoy outsize returns ever since 2008 precisely because of the “uneconomic” distortions created in markets by central bank liquidity operations. The Barnegat fund, a New Jersey-based hedge which launched after the collapse of LTCM – the world’s most notorious relative value arbitrageur – returned 132.68 per cent in 2009, thanks to “the largest arbitrage ever” – in the US bond market, caused by the Fed’s quantitative easing. But this time around, it looks like the Fed is running low in terms of "ammunitions" particularly at the time where "idiosyncratic" risk is moving towards "systemic" risk.

This brings us to the continuous drift in credit. Not only are seeing a continuation of the flattening of the US yield curve, but credit is also affected given that according to CMA part of S&P Capital IQ, the 1 year CDX HY index is wider month to date by 81 bps and the basis (difference between the index and the single name constituents) is still very high at 79 bps apart:

- source CMA part of S&P Capital IQ

More interestingly, the continuous drift in credit is starting to point towards a more systemic risk environment as pointed out recently by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 8th of February entitled "The tide has turned":

"Connecting the dots

Does the recent weakness resemble the 2008 global financial crisis sell-off or the 2011/12 European crisis one? Are we still in an idiosyncratic risk world, or are recent developments pointing to a more systemic risk environment?
Our analysis shows that: (i) the recent sell-off in bank stocks and senior financials CDS, (ii) the continued weakness in EM/oil names and (iii) the fact that the recent sell-off is not driven by the tail anymore and it is more widespread, points to one conclusion: that the tide is turning. Risks are not idiosyncratic anymore; systemic risk is rising.

Currently the level of our selloff depth indicator - that has been steadily increasing over the past weeks - is the highest since the taper tantrum and is quickly approaching levels seen in 2008/9 and 2011/12.

In chart 1 we present the % of the iTraxx Main portfolio (125 constituents in total) that has moved more than 10bp wider over a 4-week period, while the broader market (average spread of the pool) credit spreads are also heading north.
o The higher the % of the index that contributes to a sell off the more systemic is the nature of the move wider.
o The lower the % of the index that contributes to the market weakness the more the idiosyncratic is the nature of the sell-off.

• Bank stocks are back to levels seen in 2012. The recent sell-off of bank stocks has added more pressure to financials credit spreads. Risks remain to the downside for the sector. Bail-in fears (see underperformance of Italian names over the past couple weeks), the ECB looking at NPLs (an area of focus this year), EM exposed fins still under pressure, Brexit risks looming for the UK names and weak Q4 earnings season (in particular for DB and CS), keep fins CDS better bid. With bank stocks at these levels, iTraxx Senior Fins will remain the key hedging instrument against increasing pressure in high-beta banks paper.

• US non-manufacturing econ data - even though still on expansionary levels -are deteriorating at the fast pace since 2008/9 period (chart 4).

Additionally, our rates strategy team points that their model shows that the OIS curve (adjusted for the zero-bound effect) is already inverted and therefore may already be pricing a recession

 • Oil prices are back at the $30 area; same as in 2008 (chart 5).

• Equity markets are punishing high risk (vs. low risk) stocks. The underperformance is the highest in years; only slightly away from the 2009 lows (chart 6).

 • The iTraxx Main constituents (5y CDS spreads) distribution exhibits extreme levels of skewness and kurtosis. Both these metrics measure the asymmetry of the portfolio's distribution. High level of skewness and kurtosis are typical characteristics of a fat-tailed distribution that prices high level of idiosyncratic risk.

o The higher (more positive) the skewness the thicker the tail on the wide end.

  o The higher the kurtosis, the thicker the tail and the higher the concentration around the index level, leaving not many names in between.

However, both these metrics have started to move lower over the past couple of weeks.

This clearly indicates a shift in market risks: from predominantly idiosyncratic as in 2008/9 (few wide names underperform, on balance), to more systemic risks as in 2011/12 (a broader widening). Note that financials did not feature even on the 50 widest names back in 2008. However, they dominated the widest names list in 2012.

• Weakness is now a broader issue - it is not the widest names that underperform.

We analyse the performance of single names CDS since the recent tights (early December'15). We find that the names that have underperformed (in %-move terms) are not necessarily coming from the tail. In fact we see a widespread weakness in names across the credit spectrum (chart 9). 

 - source Bank of America Merrill Lynch

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

As we posited in our conversation "Le Chiffre" aka Mario Draghi and given the market's anticipation for the ECB's next moves:

"QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.

Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations". - source Macronomics, October 2015

It seems that at least the European credit Vasa ship's structural flaws come from deeply impaired banks balance sheet bloated by significant NPLs which have yet to be addressed. Italy in particular is a base case as illustrated by Richard Koo earlier in the failings of QE when one looks at the Aggregate retail loan books as displayed in Société Générale November 2015 European Banks note entitled "A wake-up call":

- source Société Générale.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs:

"Italian banks have already started setting up bad debt securitization platforms. Italy’s third biggest bank, Monte dei Paschi di Siena (MPS), sold a €1 billion portfolio of NPLs into a securitization vehicle financed by affiliates of Deutsche Bank in December. The state will now guarantee the senior debt of such operations. It is unlikely ever to have to honour the guarantee, as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans.
The guarantee should attract a much broader array of investors to bonds issued by such vehicles, even if the banks still have to hold onto most of the riskiest tranches. However, the price could put off all but those banks with the highest funding costs.  The state’s fee for the guarantee will be based on CDS of issuers with similar ratings to the SPV tranche. To make sure the banks are not tempted to sit back and forget about the underlying loans, the price will rise over time – initially being based on three-year CDS, then five-year, then seven. As research from Milan-based Banca Akros points out, that’s hardly encouraging, given the time it takes to realise collateral in Italy." - source Euromoney

It looks to us like a nice new Vasa ship in the making...

Before we move on to our traditional final chart, here is another one courtesy of our friend Cyril Castelli from Rcube (from his twitter page: @CyrilRcube) showing that not only is AP Moller-Maersk a leading deflationary indicator but as we discussed in our post "The Cantillon Effects", the use of fine art might is an effective means to measure "bubbles" as art is removed from the capital structure of the economy. The performance of Sotheby’s, the world’s biggest publicly traded auction house has always been a good leading indicator and has led many global market crises by three-to-six months:
"Art & Shipping stocks lead the economic cycle. Recent price action of Sotheby's & Maersk is similar to 2000 & 2008."

- source Rcube - @CyrilRcube

If you think that we are bound for a "strong economic rebound" then you might want to hold off buying AP Moller-Maersk and Sotheby's because as per our final chart shows, it is never great to catch falling knives.

• Final chart - Don't catch falling knives

Whereas we keep hearing about some tremendous values offered by some levels reached by some equities, given the points we have made on credit leading equities and credit moving from "idiosyncratic" risk to more "systemic" risk, we thought we would point out to Société Générale's take on "falling knives" in the below chart from their Global Style Counselling" note from the 9th of February entitled "We love a bargain but should you buy falling knives?":

"Performance of falling knivesWe start our analysis with a simple exercise, where we look at the relative performance of a strategy that buys companies that have seen 1) 20%, 2) 30%, 3) 40% and 4) 50% declines from their 12-month peak. As our portfolios might only include a handful of companies in some periods, we only take into account periods where we have at least 20 companies, and otherwise we assume a zero return. All portfolios are then rebalanced on a monthly basis, and our universe is based on FTSE World stocks since 1990.

As the chart below shows, despite some periods of strong outperformance (these periods are often referred to as the “dash to trash”), all portfolios eventually underperformed the market.

- source Société Générale 

Then again, you might want to check if indeed your "falling knife" doesn't boast the same structural flaws of the Vasa ship....

"Beware of little lending. A small leak will sink a great European ship." - Martin T. - Macronomics

Us thinking of Italy again...

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!