Credit - Big in Japan

"The real reform Japan needs is decisive politics when we face issues that need to be decided." - Yoshihiko Noda, Japanese statesman.

While we already touched on the meteoric rise of the Japanese Yen in conjunction with the Nikkei and with a significant tightening of credit spreads as displayed by the Itraxx Japan index in our March conversation "The rise of the Kagemusha", the latest announcements from the Bank of Japan to buy up JGBs, especially longer-dated JGBS, has led us to refer to top hit from 1984 German band Alphaville namely "Big in Japan" in this week's title for our conversation.

And, in terms of "Alpha", no doubt, we have seen "lift-off in risky assets" or "Risk-On" that is, in Japan; as indicated in the below graph where we have been monitoring the USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

A typical central bank's intervention, the "reflation trade" lifting risky assets, reducing perceived credit risk and suppressing volatility as displayed in the bottom graph with Japanese equity volatility close to the lows of 2011.

When it comes to credit and spread tightening, the above significant correlation between rising equities and tighter credit spreads is clearly explained by the wealth effect induced by the Japanese QE as indicated by a note from the 4th of April from Bank of America Merrill Lynch entitled Japan SB and CDS Markets evade a harmful flattening:

"Rising stock market prices also act to tighten credit spreads BoJ purchases of ETFs and J-REITs can easily put upward pressure on Japanese equities and real estate markets. Under these conditions, the larger buffer for companies’ potential credit risk will likely act to tighten credit spreads. Also, as a result of aggressive quantitative easing, we think credit risk itself could lower due to the wealth effect on company assets and greater ease procuring large amounts of funds via debt financing." - source Bank of America Merrill Lynch

Truth is back in January in our conversation "If at first you don't succeed", we indicated that the BOJ had some catch up to do with the Fed and the ECB and even hinted what we had been doing investment wise precisely, a practice which we not necessarily do:

"We have to confide, that since our October post, we have continued "practicing" the effect of our magicians "secret illusions" by having been short JPY against USD (via proshare ETF YCS) and we have been as well long Nikkei but in Euros via a quanto ETF from Lyxor (more on the reason below) but until you all become magicians, we have to stop revealing tricks unless, of course, dear readers, you all swear to uphold the Magician's Oath in turn*, but we ramble again..."

We have become in essence the sorcerers' apprentice, the new magical spell being these days "whatever it takes", a powerful one that it...

The rationale behind our call was that our macro world is more and more "centrally driven" or led by Central banks (or sorcerers/magicians that is):

"In similar fashion to the 1866 artist depiction of 1866 by the magician Sangoku Taro, the rationale behind our "long Nikkei in Euros" stance was fairly simple given that until recently, arguably the Bank of Japan has been behind the curve when it came to "magic tricks" as indicated in the below Chart of the Day from Bloomberg which we used in the concluding remarks of our "Zemblanity" conversation in September last year:" - source Macronomics - "If at first you don't succeed"

As far as global deflation is concerned, and in relation to Japan, another indicator we have been closely following has been the 30 year Swiss bond yields which had been nearly 100 bps lower than Japan 30 year bond yields throughout 2012 until the recent "Big in Japan" bang moment following the Bank of Japan "all in" move - source Bloomberg:

Back in March this year we even discussed this trade with some of our cross-asset and macro friends concluding that this relationship would converge due to the aggressive stance of the BOJ after all:

"The greatest trick Macronomics ever pulled on its readers was to convince them there is no "market tricks" displayed in their posts." - Macronomics

But, we have to confide, we did not expect the convergence to be that fast, because we did not expected the Bank of Japan to be that bold!

As indicated by Nomura's note from the 4th of April entitled - How does the BoJ's QE stack up against the Fed and the BOE, the BoJ's response in terms of QE as a percentage of GDP is impressive:

So in this week's conversation, we will look at the impact of the BoJ had on the euro area sovereign bond market as well as the importance of looking at global credit channels as well as why we still think France should be seen as the new barometer for Euro risk. We will also look at some of our January calls for the first quarter 2013 and our some of our thoughts for the second quarter in the process.

The European bond picture, with Spanish 10 year yields below 5% at 4.87, whereas Italian 10 year yields well  below 5% hovering around 4.50% and German government yields racing down towards 1.25% levels, but the most impressive move was on French OAT10 year bonds closing around 1.80% (13 bps down at some point) courtesy of "Big in Japan" - source Bloomberg:

Japanese have been net buyers of OATs in 2012 to the tune of 4.07 trillion JPY (44.2 billion US), the most since 2005. The gain in yen was 26% versus 15% for US Treasuries and they only bought for 3.35 trillion JPY worth of US debt in 2012.

As indicated by Nomura's 4th of April 2013 note entitled Post-BoJ / ECB thoughts on euro sovereigns, European sovereign bonds have been benefiting from the support of massive purchases from Japan regardless of the deteriorating macro picture. The BoJ impact is significant:

"Today's news from the BOJ was highly significant and has broad implications for global asset markets. Much like QE1 and QE2 in the US, we expect that the impact of it could filter out through global assets. To put it crudely, the price of assets, in toto, is a function of the amount of money in the system, divided by the number of assets. Increase the numerator without comparably increasing the denominator and the price must rise. The skill, of course is estimating which assets, and by how much.

This effect will, we believe, be felt in European government bonds, our area of focus. We note with interest that the onset of QE1 and QE2 from the US Fed led to France tightening to bunds, for example, albeit that the effect took two to three weeks to really take effect, consistent with this being a portfolio effect, not a signaling effect. The link between natural buyers of JGBs and natural buyers of EGBs is strong, which should make BOJ QE more impactful on EGBs.

We can already see some evidence of this in today's trading: France has outperformed Germany by 5bp, Netherlands has outperformed by 2bp, Austria by 3bp and so on. We do not believe that this is the move over and done with, and particularly think that there is room for performance at the long-end of the curves in the core and semi-core." - source Nomura

"The data up to January (February data are released on Monday) show very big buying of France throughout 2012, big buying of Germany coming through late in the year, decent buying of Netherlands relative to its market size and what we will generously call apathy towards Gilts.

What today's announcement by the BOJ has told the market is that there is now room for plenty more buying:

1). There will be relatively less JGBs and long-end JGBs for Japanese real money to buy.

2) The spread of non-JGBs to JGBs just pushed higher by 5-10bp in the 10yr and close to 30bp in the long-end.

3) Asset allocators may have more confidence in the higher risk segments of their portfolios (i.e. equities) and thus be happy to take spread in the less risky segments. Also there may be greater confidence in the stability of the yen at these weaker levels.

For us, the key point to note here is the duration requirements of the Japanese real money account base, as with their Dutch and British counterparts. This duration requirement can be met perfectly adequately with the purchase of cheap long-end euro area bonds." - source Nomura

The effect of the very aggressive policies of the Bank of Japan have indeed leading Japanese equities to catch up with Emerging Markets equities, they have not only closed the gap but are also racing ahead - graph source Bloomberg:

Since 2009, Emerging Markets had been outperforming Japanese equities, and as we posited in our conversation "Have Emerging Equities been the victim of currency wars?":
"The decline of the JPY is negative for emerging markets, obviously more for those in Asia, putting pressure on emerging company market shares for exported goods and leading to cuts in investments in Asian countries by Japanese companies." - source BNP Paribas

EM equities to continue to underperform in the second quarter of 2013:

So our call for the second quarter of 2013 is that Emerging Market equities will continue to underperform. There is a new sheriff in town, the BoJ and they really do mean business...

EUR/USD and Gold view for the 2nd quarter 2013:

In our first conversation of the year "The Fabian Strategy" on the 8th of January we made the following call in relation to Gold:

"Gold could recede towards 1550-1600 levels during this quarter before bouncing back when "Risk-Off" will materialise again." - source Macronomics

Dollar index versus Gold - source Bloomberg:

 In the second quarter and given the enlargement of the "whatever it takes club" to Japan, we expect gold to rally back towards 1700 level.

In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%). 

The story for 2013 in Europe is still France:

This is what we argued in January and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress. 

France should be seen as the new barometer for Euro Risk. With Industrial Production expecting to hit -3.7% next week, French minister Moscovici is seriously deluded on his growth assumptions: 0.1% in 2013, 1.2% in 2014 and 2% in 2015! 

French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - source Bloomberg:

An industrial production at -3.3% equals zero growth.

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 41.3 for Services PMI is close to the lowest level reached in February 2009 which was at 40.2.

If the Services PMI contracts at such a rapid pace, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can’t do that well as long when they are no entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will tank.

A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy.

One would have thought you could have played it via a simple Bund vs OAT widener but given Japanese have thrown the money printing gauntlet to the world, and that we are close to the lowest point since April 2011 at 50 bps apart (lowest was around 28 bps apart) and with Friday's epic move in core government bond spreads shows that they are more "pain" than "gain" in the aforementioned strategy (French OAT were down 13 bps at one point!).

The divergence between the US PMI and European PMI divergence which we explained in our conversation "Growth divergence between the USA and Europe", is here to stay in 2013 - source Bloomberg:

Why is so? Europe is in deflation and much of a story of broken credit transmission channel to the real economy.

At this juncture, we think it is very important to understand how the "Global Credit Channel Clock" operates, to that effect we would like to thank our good friend Cyril Castelli from Rcube Global Macro Research for providing us with his great chart:

Europe is still struggling due to the necessary deleveraging that has to be undertaken by European banks, plaguing in essence the real economy due to the lack of loans provided. 

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits.  In the US new borrowing surged and credit conditions continue to improve as reported by Deutsche Bank in their 2nd of April Quarterly credit impulse update:

"The main area of strength globally is the US, where new borrowing surged in Q4. The Senior Loan Officers Survey suggests credit conditions continue to improve, and we expect the credit impulse to remain positive and private demand growth to remain strong in the coming quarters. The main hurdle for the US is that consensus expectations are being revised up." - source Deutsche Bank

"The rise in the global credit impulse in Q4 was due largely to the US (Figure 3). We expect the US credit impulse to moderate in Q1 but remain positive, consistent with above-trend demand growth." - source Deutsche Bank

For instance Jeff Black, Jana Randow and Stefan Riecher in their Bloomberg article entitled - Draghi Considers Plan B as Sentiment Dims after Cyprus Fumble from the 4th of April, indicated the following in terms of the broken credit transmission channel:

"More than four times as many small businesses in Spain were rejected for loans in the second half of last year than in Germany, or walked away from an offer because it was too expensive, research published by Barclays Plc shows." - source Bloomberg.

Euro Area Credit Growth - source Deutsche Bank:

The recent Cyprus story has led to a significant weakness in the European banking sector which is still heavily relying on the ECB support as indicated by the recent rise in ELA (Emergency Liquidity Assistance)

Bloomberg indicated a 26 percent jump in a line item on the European Central Bank’s balance sheet  pointing to a rise in emergency borrowing by banks in Cyprus and Greece:
“Other claims on euro-area credit institutions” rose to almost 89 billion euros ($114 billion) for the week ended March 29, up from a 12-month low of 70 billion euros two weeks earlier. The balance-sheet item, published yesterday on the ECB’s website, includes Emergency Liquidity Assistance, or ELA, provided by national central banks when a country’s lenders don’t have enough collateral to borrow directly from the ECB." - source Bloomberg


When one looks at the below chart from Deutsche Bank's note, in Europe, credit demand is rising but European bank are failing to provide the necessary supply:

The Cyprus story has weighted heavily on the banking sector and given for us banks are a leverage play on the economy, the lack of economic growth means no doubt additional pressure on the banking sector as a whole. The impact on the banking sector in March was as follows as reported by Bloomberg:

"The Stoxx Europe 600 Banks Index dropped 6.8 percent between March 15 and 27, the day before banks reopened in Cyprus. The cost of insuring against default on European bank bonds surged 41 percent in that period, with the Markit iTraxx Europe Senior Financial Index of credit-default swaps on 25 lenders jumping 58 points to 201." - source Bloomberg

As indicated by Exane BNP Paribas's above chart on Senior Financial credit Risk:
"Eurozone unlikely to enjoy a sustained recovery; Italian politics/weak banking system pose downside risks".
We do not think current Itraxx Financial Senior Risk reflects correctly the rising impairment risks coming from the acceleration of the bail-in procedures which would impact senior unsecured bondholders which Mario Draghi, Germany, the Netherlands, Finland and Denmark would like to see put in place in 2015 rather than 2018.

There is no doubt risk of a stronger than expected deleveraging in Europe will mean yet another credit crunch in the process.
Post ECB conference we agree with Nomura's take from their 4th of April 2013 not entitled  - ECB states readiness to act:
"Mr Draghi acknowledged that the weakness in activity continuing from the end of last year is spreading to countries where “there is no fragmentation”, that is to the core of the region and most importantly Germany. The most recent PMI releases show for example the German composite PMI declined for two consecutive months in February and March and at an accelerating pace (by 1.1 points and 2.7 points, respectively) and is currently at 50.6, consistent with expansion but well off the level of 54.4 reached for January. More broadly, the PMI data for February, as we have highlighted in our post flash PMI note, is consistent with a rate cut this quarter and any further corroborating evidence of economic weakness will prompt the ECB into action, in our view." - source Nomura

Given that now Draghi is falling behind the Fed and behind Japan, we can expect that our "whatever it takes" European "magician" will react sooner rather than later given the increasing credit growth differences in Europe as displayed in the below graph from Deutsche Bank:

As we argued in "The Omnipotence Paradox", the Zero Rate policies induced by our "omnipotent" Central Banks are damaging capitalism in the sense that capital because of lack of return cannot be deployed efficiently and is once again "mis-allocated as reported by Sarika Gangar in Bloomberg in his article - High Grade’s Bottom Eclipses AAAs Over Rate Risk: Credit Markets:

"Offerings of bonds rated Baa3 made up 11.7 percent of the $310 billion in high-grade offerings in the first quarter, Bloomberg data show. Issuance of the lower-rated debt compares with $94.3 billion in all of last year and $60.4 billion in 2011. “When you look at single A rated and above industrials, it’s really very unattractive,” Hans Mikkelsen, a credit strategist at Bank of America in New York, said in a telephone interview. “You have insufficient spread cushion to offset the increase in interest rates. You have a lot of re-leveraging risk because these companies have access to very cheap financing.” - source Bloomberg


It is as well, to some extent, neutering volatility - evolution of VIX versus its European counterpart V2X - source Bloomberg:

Volatility, a story of a spring which has been coiled by Central banks actions.

On a final note, we agree with Bill Gross, namely that Kuroda's Big easing in Japan is going to drive treasuries as indicated by Bloomberg Chart of the Day:

"The CHART OF THE DAY shows yields on sovereign bonds around the world due in 10 years and longer were at the highest level relative to their Japanese peers since November 2011, based on Bank of America Merrill Lynch data. The spread widened to 2.07 percentage points yesterday from 2012’s low of 1.45. The chart also shows the yen plunging to touch 97.19 per dollar today, the weakest since August 2009.

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said the BOJ’s unprecedented easing may lead investors to favor securities outside the nation. Kuroda increased the BOJ’s monthly bond purchases to 7.5 trillion yen ($77 billion) and set an inflation goal of 2 percent in 2 years.

“The BOJ has gone all in, in terms of the amount that they’re going to be buying,” Gross said yesterday on Bloomberg Television’s “Street Smart” with Adam Johnson and Sara Eisen. “That money now is expected to move out of Japan into Treasuries, into other high-quality markets at higher yields. Much more depreciation of the yen has to take place in order to get even close to 2 percent” inflation, said Gross, who is based in Newport Beach, California.

Japan’s 10-year yield tumbled to an all-time low of 0.315 percent today. Thirty-year rates slid to 0.925 percent, also a record. Comparable rates on U.S. Treasuries were 1.77 percent and 2.99 percent as of 1:13 p.m. in Tokyo.

Investors from Japan, the world’s third-largest economy, held $1.1 trillion of Treasuries as of January, second to China’s $1.3 trillion, according to U.S. government data." - source Bloomberg

So if you look back at the Global Credit Channel Clock, for the second quarter you should think about:
-Going long volatility
-Going long government bonds
-Going long gold
-Playing flattening yield curves

"Logic is the technique by which we add conviction to truth." - Jean de la Bruyere, French philosopher

Stay tuned!

Equities, playing defense - Consumer staples, an embedded free "partial crash" put option

"Defense is a definite part of the game, and a great part of defense is learning to play it without fouling." - John Wooden, American coach

In continuation to previous conversations discussing the relationship between equity versus credit we would like to point out the downward protection offered by Consumer Staples and its recent relationship with High Yield since the financial crisis of 2008/2009. We will also look at the "greatest anomaly" namely that you get superior long term returns from low volatility equities.

As indicated by a very interesting note from Societe Generale from the 26th of March from their Global Quantitative Research team entitled - Consumer Staples outperformance solely attributable to market crash protection where they indicated the following relationship with the high yield bond market:

"Over recent years, the Global Consumer Staple sector has performed more in line with the high yield bond market than the broader equity market – or indeed, the MSCI high dividend yield index. This market-beating performance has been attributed to the clamor for quality yield but we’re not convinced. Here we show that the outperformance was wholly driven, not by yield, but the ability to limit losses during periods of acute market weakness. Essentially, fund managers are not seeking yield but buying downside protection, and in a world where market shocks are more common, the resulting premium is perfectly understandable." - source Societe Generale

Consumer Staples, or how to play defense when capital preservation dominates performance:

"The chart below plots the performance of the Global Consumer Staples sector versus high yield bonds, high yield equity and the overall global equity market. As the chart shows, in recent years, whilst ‘high dividend yield’ has largely tracked the equity market, the Consumer Staples sector has more closely mirrored the high yield bond market. Not only are total returns similar, but drawdown (peak to trough losses) have also been around 35%." - source Societe Generale

"From the chart above it seems that the outperformance of high yield bonds and the Consumer Staples sector has been fairly consistent, but the relative performance versus MSCI World reveals that the bulk of outperformance came during the financial crisis of 2008/09 and the Eurozone crisis in the summer of 2011." -  source Societe Generale

"Capital preservation is a concept that many investors understand but perhaps underestimate. No doubt this is because major market declines tend to happen suddenly and on a relatively infrequent basis. This is also why market bears – as we know from experience – tend to look completely stupid most of the time. To demonstrate the importance of loss avoidance, we have taken the often quoted Consumer Staples sector as our example and we aim to demonstrate that the premium afforded to this sector and its outperformance in recent years is courtesy of downside protection." - source Societe Generale

On another note, Gary Shilling in a Bloomberg column on the 30th of January entitled - Where to Invest While Markets Remain "Risk On" also seems to favor Consumer Staples as part of an overall investment strategy:

"Consumer Staples and Food:

Items such as laundry detergent, bread and toothpaste are essentials that are purchased in good times and bad. Their producers’ equities will remain attractive. The Standard &Poor’s Consumer Staples Sector Index was up 10.8 percent last year, after a 14 percent gain in 2011. Among retailers of consumer staples, the winners may continue to be discounters, such as Family Dollar Stores Inc. U.S. used-merchandise stores have been thriving. Producers of national brands will need to continue to adapt to weak consumer incomes and high unemployment by emphasizing cheaper “value” products."

But moving back to the downside protection offered by Consumer Staples, Societe General offers some an interesting analysis on the downside premium offered by this sector:

"Firstly, we devise a strategy that invests mainly in Consumer Staples but we switch into the equity market rather than the staying in the sector during periods of major market declines. By doing this we effectively remove the drawdown protection from the sector by being totally invested in equities instead of lower-beta Consumer Staples during market pullbacks. 

So, with perfect foresight, we identify the months when the MSCI World index lost more than 3%. Then, rather than stay invested in Consumer Staples (as you should), we invested (mistakenly) in the equity market instead. The purpose here is to understand just how important capital preservation is in driving overall returns from the Consumer Staples sector versus the market by replacing the best months of relative performance with the market return. By investing in the market, and not the sector, during those periods when the market was down 3% or more effectively kills the outperformance of the sector, to the extent that the sector goes from outperforming by nearly 50% to underperforming by 20%. This in part starts to demonstrate just how important the downside protection is in driving the performance of this sector.

If we repeat the exercise but this time for a threshold of -5% or more (which happened 12% of the time), we find that the sector performs in-line with the market. This suggests to us that the value of the put option offered by the Consumer Staples sector protects investors from monthly declines of 5% or more i.e. you can generate market performance and be insulated to a degree from major market shocks." - source Societe Generale

"Let’s explain things a little differently. Imagine a strategy where one invested in the market most of the time but (with perfect foresight) switched into the Consumer Staples sector during months when the market fell by 3% or more. By comparing this strategy to the performance of Consumer Staples sector we can measure the protection being offered and, as we show below, see that this strategy outperforms the Consumer Staples sector, implying that the better performance of the sector is not sufficient to compensate the investor when markets decline by 3% or more. But what happens if we switch to investing in the sector during months when the market fell by 5% or more?

While our strategy invests in the market 88% of the time and in the sector just 12% of the time, its performance almost perfectly matches the overall performance of the Consumer Staples sector. Hence our assertion that the sector is primarily a market index with a put option attached, much in the same way we describe another quality measures such as Merton’s balance sheet model and Piotroski’s F-score." 

Societe Generale concluded their note with the following important point relating to the limitation of the protection offered by Consumer Staples:

"Of course the Consumer Staples sector does not fully protect the investor as it too can fall, but historically by only 60% of the market fall. Valuing our put option is difficult. But with the incidence of months when the market fell by 5% or more being twice as common in the last 15 years than in the previous 25 (see below), this put option has become more important to investors. As we have stated on numerous occasions, understanding drawdown risk and capital preservation qualities is paramount to understanding what an asset is worth. With the events in Cyprus still ringing in our ears, that has never been more relevant than today." - source Societe Generale

The downward protection from Consumer Staples can be illustrated from the following Bloomberg graph highlighting the performance of Consumer Staples versus Consumer Discretionary and Financials since October 2007 until October 2012:

Another way in protecting a portfolio is investing on ETFs such as the PowerShares S&P Low Volatility Portfolio for protection from stock-market swings as indicated by Charles Stein in his Bloomberg article from the 20th of March - ETF Beating Markets With Gains Less Price Swings:

"Investors who bought PowerShares S&P 500 Low Volatility Portfolio for protection from stock-
market swings when it debuted almost two years ago got an unexpected bonus: They also made more money.
The $4.1 billion exchange-traded fund, which owns the 100 stocks in the Standard & Poor’s 500 Index with the lowest volatility, gained 30 percent since its inception on May 5, 2011, compared with 21 percent for the benchmark U.S. index. The ETF, the largest of its kind, achieved that performance with about 70 percent of the volatility in the index, giving it a risk-adjusted return double that of the market, according to the BLOOMBERG RISKLESS RETURN RANKING." - source Bloomberg

Of course, no real surprise looking at the composition of the index detailed in the article and the "defensive theme" of its components:

"In the low-volatility index, utilities represented 31 percent of the portfolio, compared with 3.4 percent in the regular U.S. benchmark, and consumer staples accounted for 24 percent, versus the index’s 11 percent at the end of February, according data from Standard & Poor’s. Information technology, which represents 18 percent of the S&P 500, made up 3.6 percent of the low-volatility portfolio.
Among the biggest individual holdings in the PowerShares ETF are Johnson & Johnson and PepsiCo Inc., the two stocks in the S&P 500 with the lowest volatility over the past year --10.1 and 10.4, respectively. Johnson & Johnson, based in New Brunswick, New Jersey, advanced 21 percent in the 12 months ended March 15, and Purchase, New York-based PepsiCo climbed 18 percent." - source Bloomberg.

In terms of top contributors to the performance, in continuation to our "defensive them" the article indicated Consumer Staples as the top performers:

"The biggest contributor to the ETF’s performance over the past year include H.J. Heinz Co., the Pittsburgh-based ketchup maker being acquired by Warren Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc., portfolio data compiled by Bloomberg show. Hershey Co., the Hershey, Pennsylvania-based candy company, was the second-biggest." - source Bloomberg

We indicated early in our conversation we would look at the "greatest anomaly" namely that low volatility stocks have provided the best long-term returns. In addition to Societe Generale's point on the defensive features of low-volatility stocks such as Consumer Staples, they also provide the best returns as indicated in the same Bloomberg article from Charles Stein:

“The long-term outperformance of low-risk portfolios is perhaps the greatest anomaly in finance,” Harvard Business School Professor Malcolm Baker wrote in a 2011 paper in Financial Analysts Journal.

When S&P designed the low-volatility product, it traced the history of the index back to 1990 in a process known as backtesting. The numbers showed that over three, five years and 10 years, the low-volatility index had a higher total return than the S&P 500.

Harvard’s Baker said market data going back to the 1930s show that low-volatility stocks have delivered about the same returns as market indexes, a result that contradicts the notion that higher risks translate to higher rewards. “In this case you are taking less risk, but not giving up any return,” he said in a telephone interview.

Investor Behavior

Other studies have come to similar conclusions, according to Joel Dickson, a senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group Inc., who said finance scholars have a hard time explaining the mismatch. Most theories attempting to explain it revolve around investor behavior.

Because people are overly smitten with fast-growing, glamorous companies, they bid up the prices of those stocks to the point where future returns suffer, said Dickson.

Dickson offers a caveat. When stocks soar as they did in the 1990s, low-volatility holdings can underperform for long stretches, said Dickson, a senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group Inc. “As an investor you have to be willing to stomach periods

when this strategy gets killed,” Dickson said in a telephone interview.

In the nine years ended Dec 31, 1999, a period in which stocks gained 21 percent a year, the S&P 500 Index returned more than twice as much as its low-volatility counterpart, according to data compiled by Bloomberg. It also outperformed after accounting for price swings, with a risk-adjusted return of 32 percent, compared with 20 percent for the low-volatility index." - source Bloomberg

We therefore disagree with Gary Shilling, Consumer Staples are not purely a "Risk-On" strategy given that as indicated by Bloomberg:

"In the nine years ended Dec 31, 1999, a period in which stocks gained 21 percent a year, the S&P 500 Index returned more than twice as much as its low-volatility counterpart, according to data compiled by Bloomberg. It also outperformed after accounting for price swings, with a risk-adjusted return of 32 percent, compared with 20 percent for the low-volatility index." - source Bloomberg

But, Consumer Staples are mostly a defensive play that can outperform during phases of "Risk-Off" which we have been experiencing on numerous occasions since the financial crisis of 2008:

"The low-volatility index did best in times when stocks fell, such as 2000 to 2002, and in 2008, according to S&P data. In 2008 the low-volatility index fell 21 percent compared with 37 percent for the S&P 500." - source Bloomberg.

On a final note, in relation to the differences between equity and as posited by our good friend Paul Buigues, Head of Research at Rcube Global Macro Research in his post "Long-Term Corporate Credit Returns":

"Equity is an infinite claim on the free cash flows generated by a company. Due to the inherent uncertainty of future cash flows, relying on a pure valuation framework to predict equity returns is often a disappointing experience, for both specific companies and equity as an asset class.

Corporate debt, on the other hand, is generally a finite claim on a predetermined stream of cash flows (coupons + principal repayment)."

Corporate credit is a much simpler bet than equity, especially for investors that hold credit instruments until maturity. For instance in High Yield as indicated by our friend Paul "initial spreads explain nearly half of 5yr forward returns" (even for a rolling investor (whose returns are also driven by mark-to-market spread moves). 

When it comes to yield the PowerShares ETF has a dividend yield of 2.78 percent compared to 2.13 for the S&P 500 Index, according to data compiled by Bloomberg, so could it be that after all Consumer Staples in  the equity space are a much more simpler bet, in similar fashion to corporate credit? One has to wonder...

"Right is its own defense." - Bertolt Brecht

Stay tuned!

Credit - Gunfight at the O.K. Corralito

"Peace cannot be kept by force; it can only be achieved by understanding." - Albert Einstein 

Looking at the evolution in Cyprus, reminiscent of Argentina's 2001 "Corralito", which eventually led to its default, we thought this week it would be entertaining to use in our title, yet other multi-dimensional references as per last week conversation "The Doubt in the Shadow". 

Our first reference is of course the "Gunfight at the O.K. Corral" which took place on the 26th of October 1881 in Tombstone Arizona, and is generally regarded as the most famous gunfight in the history of the American Old West. Arguably our European Gunfight at the O.K. Corralito, will no doubt be regarded as the most infamous "deposit-levy" fight in "Old Europe's history". The O.K. Corral gunfight represented a time in American history where the frontier was open range for outlaws (tax havens) opposed by law enforcement that was spread thin over vast territories (Europe), leaving some areas unprotected (Cyprus). In similar fashion, the lack of a true European Banking Union from inception of the European project, means, that given the European banking sector's  leverage and thin equity buffers, the depositors can rightly feel unprotected. Yes, we know, on the 29th of June 2012, European leaders expressed their determination to "break the vicious circle between banks and sovereigns". The initial statement focused on the establishment of a "Single Supervisory Mechanism" (SSM) which would pave the way to direct recapitalization of banks by the ESM (European Stability Mechanism). This banking union would not just cover the Eurozone initially but would also be open to the soon to be 28 members of the EU (with Croatia being the next joiner), if they choose to join.

Our second reference is of course, Argentina's 2001 Corralito, which has been recently reenacted in October 2012, limiting ATM withdrawals for Argentinians. The Corralito was the informal name taken by Minister of Economy Domingo Cavallo's economic measures in order to stop bank runs in Argentina. It was not very successful...

Our third reference, is less so evident, but nonetheless, entertaining we think, given the famous Gunfight at O.K. Corral, also gave its name to a mathematical model - The Ok Corral and the Power of the Law (A Curious Poisson-Kernel Formula for a Parabolic Equation) by David Williams and Paul Mcilroy submitted in 1998:

"Two lines of gunmen face each other, there being initially m on one side,n on the other. Each person involved is a hopeless shot, but keeps firing at the enemy until either he himself is killed or there is no one left on the other side. Let μ(m, n) be the expected number of survivors. Clearly, we have boundary conditions:

We also have the equationThis is because the probability that the first successful shot is made by the side with m gunmen is m/(m + n). On using the recurrence relation (1.2) together with the boundary condition (1.1), the computer produces Table 1 below, in which1991 Mathematics Subject Classification 60F05."

In similar fashion each European politician involved in our European Gunfight at the O.K. Corralito is as well a "hopeless shot" but keeps firing (or making blunders that is) until either he himself is killed (or his country's economy) or there is no one left on the other side (we have yet to see an Italian government...). Of course there is an elegant solution to this mathematical model - Solution to the OK Corral model via decoupling of Friedman's urn by J.F.C. Kingman and S.E. Volkov. Just for an illustration, the authors presented the probability that exactly 5 gunmen would survive provided there were initially 20 on both sides. 

We will let you mathematically work out in your own time how many  "hopeless shot European gunmen" will survive this "European O.K. Corralito gunfight" given than they will soon be 28 countries in the European Union, 14 on each side, but, as usual, we ramble again...

While in the last two credit posts we focused our attention on the lack of equity buffers (Dumb Buffers and The Doubt in the Shadow), in this week's conversation we would like to direct our attention to the "unintended consequences" of the Gunfight at the O.K. Corralito given that, in true "Zemblanity" fashion. (Zemblanity being defined as "The inexorable discovery of what we don't want to know"), there will indeed be casualties, and most likely in the peripheral banking space that is, with rising nonperforming loans due to lack of economic growth, thin equity buffers and high loan-to-deposit ratios and soon to happen deposit flights.

Although the intentions of the European Union has been to severe the link between financials and sovereigns with a move towards a European Banking Union, the ban on naked Sovereign CDS imposed on the 1st of November has effectively killed the Itraxx SOVx 5 year index market for good. This market had been trading closely to Itraxx Financial Senior 5 year index in the past (25 European banks and insurance single names CDS). Financial spreads have been as of late on the receiving end of the widening move in cash and CDS markets courtesy of discussions surroundings "bail-in" procedures  from one of the European gunmen (Jeroen Dijsselbloem). 

The EU Recovery and Resolution Directive proposes an orderly introduction of bondholder write-downs, with the bail-in tool set for implementation in 2018 but it looks like our lone gunman is trigger happy and ready to shoot early in the gunfight . Graph below SOVx versus Itraxx Financial Senior 5 year index since March 2011 -  source Bloomberg:

"27 February 2013 - The Markit iTraxx SovX Western Europe index will not roll into Series 9 in March 2013 due to low trading activity as recorded by the DTCC Section IV: Market Risk Transaction Activity data. Series 8 will remain on-the-run." - source Itraxx Markit

While Cyprus replaced Greece has a member of the SOVx index back in 2012, the only remaining series, will remain at 14 for the foreseeable future for lack of liquidity, or lack of market thereof:

Goodbye SOVx CDS market...

Financials have no doubt been the early casualties of the European Gunfight at O.K. Corralito, when one looks at the increasing divergence between the Itraxx Main Europe 5 year CDS (risk gauge for non-financial Investment Grade European Credit)  versus the Itraxx Financials 5 year CDS index - source Bloomberg:

In fact, CDS insuring against default on European financials have risen for 10 days in a row, the longest streak since August 2011, closing on the 28th of March towards the 205 bps, heading for its worst month since November 2011.

Of course in the financials space CDS wise, the Itraxx Financial Subordinated index (indicative of the risk gauge for subordinated debt, in the direct line of fire for bank recapitalization as per the SNS case...) took a pounding as well in this European Gunfight and widening towards 325 bps versus 205 bps for the Itraxx Financial Senior 5 year CDS index. - source Bloomberg:

Back in February in our conversation "House of pain and House of cards" we argued  the following in relation to the SNS case which saw subordinated debt totally wiped-out by the Dutch government:

"If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS."

We were glad to see Matt King from CITI joining our concerns in his note on the 15th of March entitled "Behold the new form of bail-in":

"The CDS trade has the additional advantage that not only are losses at senior level becoming more likely, but sub CDS protection is likely to be rendered worthless in cases where bonds are completely converted to equity or wiped out, because of a lack of deliverables. With sub/senior relationships still trading pretty much in line with their long-term averages, this does not seem yet to be priced in (chart below).

Perhaps the SNS auction next week (which is likely to confirm sub recoveries of zero) will be sufficient to give trading a jolt, a result which seems quite likely if there are eventually auctions on Laiki Bank or Bank of Cyprus CDS.5 Conceivably it may take longer: as with many factors in the current outlook, we fear the potential for discontinuities even as the market fails to react today — a sort of “ball in a bowl” phenomenon.6 But even if it takes a while, we think the bailin of bank bondholders on one small island today is ultimately likely to have significance far greater than its size suggests." - source CITI

The recent  "Dutch" case of SNS Reaal has indeed illustrated the shortcomings of the restructuring credit events in financial CDS.  Given the Dutch government expropriated all of the lender's subordinated debt in February before a CDS auction could be held, we wonder if the Subordinated market will indeed suffer a similar fate to the Sovereign CDS market and SOVx in particular. CDS notionals have remained on a downward trend since the market's peak of USD 58trn notional outstanding at the end of 2007, touching a new low of USD 27 trillion at the end on June 2012, according to the Bank for International Settlements. A dying market or simply yet another victim of our European Gunfight at the O.K. Corralito. We wonder...

Another "unintended consequence of the European Gunfight, has no doubt been the growing divergence between European volatility gauge V2X and its US equivalent VIX - source Bloomberg:

 The spread between both volatility risk gauges has been rising steadily since December, closing towards 8.60 but has yet reached its 2011 record of nearly 15.

Of course the obvious "unintended consequences" of the Gunfight at the O.K. Corralito, should be that depositors will think about spreading their wealth across banks to ensure they are below the 100,000 euros "implicit guaranteed" threshold - Euro deposits table, source Bloomberg:

"A key positive of the restructured solution for Cyprus is the underpinning of the 100,000 euro deposit insurance scheme, explicitly noted in the release. A consequence of the decision to use uninsured deposits along with equity and bond instruments to part-fund the recapitalization of Bank of Cyprus may be depositors spreading money across banks to ensure they don't exceed the threshold at any one lender." - source Bloomberg.

And, as we posited in "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary.

In this European Gunfight at the O.K. Corralito, we wonder if Germany is really a "straight-shooter" when looking at the level of capitalization of some of its banks which have been deeply impacted by their venture into structured finance and shipping in particular fuelled by cheap credit.

We discussed in depth the issues plaguing Germany's second largest bank Commerzbank in our conversation Dumb Buffers: "Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Another high profile German institution which had been on the receiving end of state aid has been HSH Nordbank:
"In December 2008 HSH was granted to issue up to EUR 30bn guaranteed notes under the German SoFFin program. One requirement that was imposed on HSH was to raise the capital ratio to at least 8%. On January 20, 2009 EUR 3bn 3 year guaranteed notes were issued. On February 24, 2009 HSH received new capital of EUR 3bn and credit guarantees of EUR 10bn by the two main shareholders, the states of Hamburg and Schleswig-Holstein. The other shareholders, JC Flowers and the savings bank association, did not participate in the capital infusion. Together with this increase of its core-capital, HSH announced further restructuring. It plans to spin off non-strategic activities and the Toxic asset portfolio into a—yet to be created—Bad Bank." - source Wikipedia

Could HSH subordinated bondholders suffer the same fate as Dutch bank SNS? Of course!
We agree with a recent note from Bank of America Merrill Lynch on this subject entitled "At the mercy of shipping":
"The most recent legislative proposals in the German banking sector do not appear to allow for direct bondholder expropriation by the German government / states, as happened with SNS REAAL. But if HSHN’s key sector exposure (ie, shipping) does not show signs of stabilization in the near term, negative outcomes for bondholders (ie, (very) low recoveries) could be achieved through transfer orders and/or recovery / resolution plans, we think. Also, when considering the relentless drive by the EU towards bailing in sub bondholders, we would not necessarily take the existing regulatory framework and – proposals in Germany as the last word on burden sharing by sub bondholders." - source Bank of America Merrill Lynch.

For, us, you probably know by now, why shipping is a leading credit indicator. For Dutch SNS it was commercial real estate, for HSH (and Commerzbank as well) it is shipping issues first:
"Shipping – plagued by overcapacity
At end-1H12, HSHN’s exposure to shipping was EUR32bn, of which about EUR12bn was housed in the restructuring unit. The bank finances ship owners, not ship yards. Due to the overcapacity in shipping and the low level of fleet utilisation (exacerbated by weaker economic growth and reduced global trade flows), the sector has been struggling for some time now, which has led to higher problem loans for most lenders in this field. Collateral values (ie, ship prices) have also come down.
Overcapacity in the shipping industry is unlikely to be resolved until 2014 at the earliest, due to the high number of new ships ordered over the past few years. A number of competitors are retrenching from shipping finance. On the one hand, this could result in financing problems for some shipping companies. On the other hand, it could improve the competitive position of the remaining players. As for HSHN, it has agreed with the EC to reduce its shipping exposure to about EUR15bn by end-2014 and to limit its share of new business in worldwide ship financing to 5% until end-2014." - source Bank of America Merrill Lynch

As far as HSH credit metrics are concerned, they are indeed very weak as indicated by Bank of America Merrill Lynch in their note:

"HSHN’s asset quality is weak. At end-1H12, its reported NPL ratio was 12.6% and this is expected to have increased significantly in 2H12. The bank’s reliance on wholesale funding remains high, with a loan/deposit ratio of 195% at end-3Q12. Its profitability has been very poor in recent years - it was loss-making in 2008, 2009 and 2011. It expects to be loss-making again in FY12 and in FY13. The bank will report FY12 results on 11 April." - source Bank of America Merrill Lynch.

And given structured finance and shipping loan books are very dependent on the evolution of the US Dollar, we expect trouble ahead in accordance with Bank of America Merrill Lynch's note:
"However, in 1H12, the bank’s RWAs jumped by 32%. This was due to ‘the renewed appreciation of the USD […] as well as the crisis in the shipping markets, which caused the risk parameters to deteriorate significantly.’ The negative impact of this RWA increase on the bank’s capital ratios was mitigated by:
- the EUR500mn capital injection by the federal states of Hamburg and Schleswig-Holstein in January 2012 (see below); and 
- the est. EUR260mn gain on the cash tender offer for LT2 bonds in February
2012.

But this was insufficient to offset the decrease in the bank’s capital ratios caused by the negative rating migration and USD appreciation in the shipping portfolio. This has meant that HSHN now needs the additional capital relief of lower RWAs. Therefore, in February 2013 the bank asked the two states to return the asset guarantee to its original size of EUR10bn." - source Bank of America Merrill Lynch.

So yes, we think, that looking at the shipping industry HSH subordinated bondholders could indeed face the SNS treatment at some point...and we also think that German banks will most likely welcome deposits from stricken peripheral countries. Michelle Wiese Bockmann in her Bloomberg on the 1st of March entitled - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:

"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship owners are forgoing seizing vessels even after soured loans to the industry rose to a record.
Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an Athens-based consultant" - source Bloomberg

It looks to us that the German gunslinger, is no doubt, a "fast-draw" artist in this European Gunfight at the O.K. Corralito.
Oh well...

The other "unintended consequences" for large depositors could as well benefit the buy-side, with large depositors seeking potentially the havens of managed funds rather than concentrating their deposits in banks as indicated in another note from Bank of America Merrill Lynch:

"Yet large depositors have clearly been put on notice that they should be careful where they invest. In our view, this could push larger sums out of the banking system into managed funds, e.g. money market funds or fixed income funds, and will likely spread deposits across a country’s banking sector at the insured level (which may be positive for risk assets)." - source Bank of America Merrill Lynch - A backward step - 26th of March 2013.

One thing for sure, in similar fashion to the O.K. Corral gunfight, this European O.K. Corralito, will not end up nicely for some in particular and for the euro in general.

On a final note, we were entertained by Bank of England's announcement that UK banks had a capital shortfall of 25 billion pounds (38 billion USD), to cover higher estimates for loan losses due to their exposure to commercial real estate as reported by Ben Moshinsky in Bloomberg in his article - BOE Says U.K. Banks Have Capital Shortfall of $38 Billion:

"The BOE said expected losses on loans could exceed provisions by 30 billion pounds, while future conduct costs could be 10 billion more than banks expect. It said lenders underestimated assets weighted for risk by 170 billion pounds, leading to a 12 billion-pound capital shortfall in that category. While the full impact of the three areas could deplete lenders’ capital by 52 billion pounds, some banks already have enough resources to cover them, leading to a total 25 billion-pound shortfall." - source Bloomberg.

"The Bank of England warned expected losses from high-risk loan portfolios, including U.K. commercial real estate and euro zone exposure, could exceed existing provisions at major banks by about 30 billion pounds ($45 billion) in the next three years. Lloyds noted at FY12 earnings that U.K. commercial real estate values fell in 2012, and were down 4.2% yoy, with non-London asset values struggling and only 5% higher than their 2009 trough." - source Bloomberg.

What was our previous comment in our last conversation "The Doubt in the Shadow" on Chancellor of the Exchequer George Osborne's latest 130 billion pound worth of mortgages guarantees?
"This is pure madness and will end up in tears"

"Insanity - a perfectly rational adjustment to an insane world."- R. D. Laing, Scottish psychologist.

Stay tuned!