Europe just got a little bit more Japanese

"Harmony makes small things grow, lack of it makes great things decay." - Sallust, Roman historian

One should obviously never read too much from volatile monthly macro data points. Still, isn’t this morning simultaneous release of December German retail sales (-2.5% (!) vs +0.2% expected) and Eurozone January headline CPI data (+0.7% vs +0.9% expected) a scary symbol of the deflationary Japanese-like picture developing in Europe?

The consensual bullish European pitch involves, among other things, a German consumption pick-up to rebalance intra-zone current account imbalances. The trouble is, judging by recent consumption data, the German consumer doesn't seem extremely confident about its upcoming prospects. With no real demand improvement from Northern Europe, the deflation threat may quickly clearly come back with a vengeance to haunt an extremely bullish yield-seeking investors community, who kept the last year bidding up Southern Europe assets.

No doubt that another few rounds of weak inflation data will put the lights back on those Debt/GDP ratios that fell out of fashion recently. The heat should rapidly be mounting again on the ECB to act.

On a side note, these developments could prompt some investors to revisit the short EUR/USD trade. 

Many people have been burned last year by this almost european version of the JGB "widowmaker". Retrospectively, massive eurozone current account surpluses were probably too strong of a force vs the FED/ECB divergence bet. If deflation scares gather steam in Europe, then the latter could have its day.

Eurozone - Harmonised Index of Consumer Prices (source Bloomberg)

"All things are subject to decay and when fate summons, monarchs must obey." - John Dryden, English poet

Stay tuned!

Credit - The Departed

"Faithless is he that says farewell when the road darkens." -  J. R. R. Tolkien 

We have long posited that by suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns. This week's chosen title is not only a reference to departing Fed chairman Ben Bernanke, but as well a reference to Martin Scorsese movie masterpiece "The Departed". In the final scene, a rat is seen on the window ledge, symbolizing according to Scorsese "the quest for the rat", which we can ascertain today in the strong sense of distrust towards the actions of the US central bank and in relation to our chosen analogy. We could ramble further and quote Don Delillo's 2003 Cosmopolis: "A rat became the unit of currency".

Under Ben Bernanke's guidance, there has been a growing disconnect between Wall Street and Main Street as displayed by Bank of America Merrill Lynch graph displaying the evolution of Wall Street versus Main Street:

From its 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion.

No doubt to us that the 2013 performance of the US stock market has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks thanks to increase leverage given many corporates have issued bonds to finance their buybacks program as displayed by the graph below displaying the growing divergence between the S&P 500 and trailing PE since January 2012  - graph source Bloomberg:

 The S&P 500 trades at 25x cyclically adjusted PE ratio (CAPE), exceeding the highs reached in 1901 and 1966. In 1929 CAPE reached 33x and in 2000 44x. 

Our "Departed" strategy has relied heavily on the "Cantillon Effects". The rise of the Fed's Balance sheet coincided with the rise of the S&P 500, and boosted as well by the rise of buybacks. The greatest failure of "the Departed" can be clearly seen in the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

What the "Departed" aka Ben Bernanke as achieved is as follows:

More liquidity = greater economic instability once QE ends

No surprise therefore that the $4 trillion of flows which have been going towards Emerging Markets have been impacted by the return of US rates into positive real yields territory as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

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

Of course, what we are seeing right now in Emerging Markets is the continuation of "reverse osmosis".

So in this week's conversation, we will look at the growing downside risk posed by some Emerging Markets, the implication for European stocks, and our growing uneasiness with the credit risks being taken and the deflation build-up we are seeing.

We already discussed EM troubles brewing in our conversation "Misstra Know-it-all" relating to the great work from Ben Bernanke aka "The Departed":

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

And as posited by Nomura at the time of our September 2013, the risk of the situation turning nasty for lack of liquidity is significant:

"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

We also added at the time:

"Misstra Know-it'all has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets"

In the same conversation we also indicated an interesting trade we particularly like and enjoy today:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up." - David Goldman's article about Gold and Treasuries and bonds in general written in August 2011 (the former global head of fixed income research for Bank of America)

This is exactly what is happening at the moment from a tactical point of view we think and at least the gold leg of the put-call parity, has indeed been performing in this fashion year to date while Emerging Markets currencies have been on the receiving end of the sell-off - graph source Bloomberg:

Interestingly, when it comes to Japan and the crowded trade in JPY (which we have been playing since late 2012) appears to us overly crowded and the risk of a strong reversal cannot be ignored anymore, making as well the Nikkei vulnerable in the short-term (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro). The USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

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.

But, the recent rise in the Nikkei 3 month 100% Moneyness Implied Volatility could indicate a potential near term rise in the Itraxx Japan, representative of the credit risk perception for corporate Japan. It has stayed at record low levels for many months and could easily climb back towards the 100 bps level we think - graph source Bloomberg:

Given the recent bout of volatility, which has been caused from the "Great Rotation" from Emerging Markets aka the "Tourist Trap" (a tourist trap being an establishment, that has been created or re-purposed with the aim of "attracting tourists" and their money), when it comes to playing "defense", Consumer staples offer partial crash protection. On that subject see our April 2013 post - "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option".  From a contrarian stand-point, Consumer Staples, as displayed by Bank of America Merrill Lynch January 2014 Long & Shorts summary, appears extremely underweight:

When it comes to equities and credit sensitivity to Emerging Markets turmoil, Europe is more sensitive to China/EM weakness as indicated by the below chart from Bank of America Merrill Lynch from their note from the 25th of January entitled "Love EM or Hate EM" displaying the massive underperformance in Europe main investment grade risk perception indicator namely Itraxx Main (125 European investment grade entities):

We already touched on the sensitivity of equity index earnings versus FX sensitivity on the 21st of March 2013 in our conversation "Have Emerging Equities been the victim of currency wars?":
"For some countries, the major equity indices can be much more heavily affected by foreign earnings than by domestic earnings." - source BNP Paribas

No wonder the IBEX is on clearly on the receiving end of the latest sell-off. In similar fashion peripheral issuers such as Santander, Mapfre and BBVA in the credit space have not been spared either. The underperformance of the IBEX - graph source - stockcharts.com:

Credit wise, "The Departed" has indeed pushed "mis-allocation" to deep instability level, you would have thought the prime role of a central bank was financial stability, but then again, looking at the recent developments, one might wonder about the "unintended consequences" which increased the instability of the system were worth the efforts put on in over-reflating financial markets.

Recent examples abound to show the increasing risks taken by brazen investors moving clearly outside there comfort zone.

For instance investors are dipping their toes back into illiquid investments as reported by Lisa Abramowicz in Bloomberg on the 23rd of January 2013 in her article "Hard-To-Sell Junk Debt Lure Oaktree to JP Morgan":
"Bond investors are losing their aversion to difficult-to-trade corporate debt that handed them some of the biggest losses in the credit crisis.
The extra yield note buyers demand to own older, smaller junk bonds that trade infrequently has shrunk to an average 0.25 percentage point this month from more than 1 percentage point a year ago, according to Barclays Plc data. JPMorgan Chase & Co. money manager Jim Shanahan said he’s preferring “good credit quality and less liquidity” when picking bonds, while Howard Marks, the head of distressed debt investor Oaktree Capital Group LLC, said he’s finding bigger potential gains in private, less-traded debt.
The evaporating premium for illiquid assets is showing the depths to which money managers are reaching to boost returns after a five-year rally that pushed relative yields on junk bonds to the least since August 2007. With Federal Reserve monetary policies suppressing interest-rate benchmarks for a sixth year, credit buyers are showing more concern that they’ll miss out on a continued rally than get stuck with debt that lost 26 percent during the market seizure in 2008.
“For the past several years, people have been concerned about liquidity,” said Eric Gross, a credit strategist at Barclays in New York. “Now we’re hearing more about people seeking out illiquid bonds.”

Fragile Market

Such debt tends to be more vulnerable to price swings when market sentiment deteriorates, because there are fewer buyers to bid on it when investor withdrawals force money managers to sell. Those risks intensified after stricter banking rules accelerated a pullback by Wall Street dealers that used their own money to facilitate trading.
Primary dealers that trade directly with the Fed cut their holdings of corporate bonds by 76 percent to $56 billion after peaking at $235 billion in 2007, Fed data through March show. After the central bank changed the way it reported the holdings in April, net speculative-grade bond holdings fell as much as 24 percent to a low of $5.63 billion in May before rising to $7.7 billion on Jan. 8.
Investors are demanding an average yield of 5.94 percent to own bonds sold at least 18 months ago in batches of less than $250 million, Barclays data show. That compares with an average 5.7 percent for newer debt offerings of at least $500 million.
The gap, which averaged 0.5 percentage point last year and 0.92 percentage point in 2012, reached as much as 1.95 percentage points at the peak of the financial crisis in March 2009."  - source Bloomberg.

Just a thought for our confident credit investors:
"Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth - - they trust, instead, on their supposed ability to exit."
Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” - "Corzine Forgot Lessons of Long-Term Capital"

Another example as well to the extreme the "Departed" has pushed investors is the return of the old credit binge instruments such as "PIKs" bonds (Payment in Kind) as discussed by Sarika Gangar in Bloomberg on the 24th of January in her article "No-interest Junk Bonds Make Comeback With Twist":
"The riskiest types of corporate bonds are getting a makeover, providing more protection for investors while showing the limits of a rally in junk-rated debt that pushed yields to a record low.
Issuers from Neiman Marcus Group Ltd., which sold $600 million of notes in October that allow it to make interest payments in more debt instead of cash, to Jacksonville, Florida-based Bi-Lo Holdings LLC led $14.8 billion of payment-in-kind offerings in the U.S. last year, the most since 2008, according to data compiled by Bloomberg and Fitch Ratings. The 36 issues were a record.
While the bonds became popular during the last credit boom before the downturn, the new generation of securities are smaller in size, come from companies with less leverage and some compel borrowers to pay interest in cash unless they violate certain financial targets. These protections show that investors are treading carefully even as they search for additional yield amid unprecedented central bank stimulus measures that pushed interest rates to all-time lows.
“The issuance of PIK tends to move the same way as the credit cycle and credit has been loosening,” Sharon Bonelli, a managing director at Fitch in New York, said in a telephone interview. Still, “the market is not as aggressive as it was.” Sales of PIK-bonds were the third most on record last year, behind the $16.2 billion in 2007 and $14.9 billion in 2008." - source Bloomberg.

Kuddos to the "Departed", the Fed's ZIRP since 2008 has forced investors into riskier securities to get extra payouts. But, there is a catch we have repeatedly pointed out:
Definition of Credit Market insanity - "Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

When it comes to credit risk and luck, recently some investors in hybrid securities learned the hard way when ArcelorMittal called early some subordinated bonds at 101 when they had been trading recently around 108.96 cents, a good sucker punch for some unwary investors as indicated by Alastair March in Bloomberg on the 21st of January in his article entitled "Arcelor Mittal's Hybrid Bonds Slump on Early Redemption Call":
"ArcelorMittal’s $650 million of hybrid bonds slumped 6.8 percent after the steelmaker said it would redeem the notes early because of changes to the way the securities are treated by Moody’s Investors Service.
ArcelorMittal will buy back the subordinated securities on Feb. 20 and pay investors 101 percent of their principal, the Luxembourg-based company said in a statement. The notes, which combine elements of debt and equity, were trading at 101.55 cents on the dollar at 11:05 a.m. in London after closing on Friday at 108.96 cents. Moody’s said on July 31 that it would consider hybrids of speculative-grade companies to be entirely debt, rather than half equity as is now the case for all issuers. ArcelorMittal’s move to call the securities early “shocked the market” and highlights the vulnerability of hybrid bonds to ratings changes, ING Groep NV analysts led by Mark Harmer wrote in a note to investors." - source Bloomberg

When the facts change, which they did in July last year, as a credit investor, change your facts or face the consequences.

We are nearing a top in the gentle credit cycle and no doubt there will be a second distressed wave in the not so distant future, rest assured.

This is what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, wrote back in 2011 - Corporate Subprime - The default crisis that never happened:
"Armageddon never arrived. The Federal Reserve slashed interest rates, helping to spark a huge rebound in the price of risky debt. According to S&P, during the past five years cov-lite debt returned a total of 33 percent, versus 31 percent for standard loans with covenants. Companies that were running into trouble were able to raise more money in the markets. Corporate default rates stayed very low. And it all happened so quickly that the protection afforded by the covenants, or the lack thereof, never seriously got tested." - Bethany McLean - The default crisis that never happened.

She also added in her 2011article:
"The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with."

Another interesting development in the desperate search for yields at any risk by credit investors, has been in the the speculative loan space as indicated by Sridhar Natarajan in Bloomberg on the 22nd of January in his article "Loan Surge Above Par Putting Investors at Risk":
"More speculative-grade U.S. loans are trading above par than at any time since May, exposing investors who are funneling record amounts of cash into the debt to greater risks as rising prices encourage borrowers to refinance at lower interest rates. 
Spanish-language broadcaster Univision Communications Inc. and KKR & Co.-controlled First Data Corp. are among at least 30 companies seeking to reduce rates on $31 billion of bank debt as more than 80 percent of leveraged-loan prices exceed 100 cents on the dollar, according to JPMorgan Chase & Co. That’s up from 40 percent at the beginning of October, according to a report from the New York-based lender last week. “Loans are trading well above their call prices because the investor community is reaching out for existing loans, "Jonathan Kitei, head of U.S. loan distribution at Barclays Plc in New York, said in a telephone interview. “You will see more loans getting repriced.”
Investors last year deposited about $63 billion into loan funds that invest in debt with rates that rise with benchmarks and have limited restrictions on early repayment. Banks from Barclays Plc to JPMorgan and Citigroup Inc. expect loans to underperform compared with 2013 as the Federal Reserve begins to taper its bond purchases, paving the way for an increase in rates that have been kept near zero for the last five years.

Limited ‘Protection’

“Whenever loans are trading above par, you introduce an additional risk element as there is limited call protection,” David Breazzano, president of DDJ Capital Management LLC, which manages more than $7 billion in high yield assets, said in a telephone interview. “Value in loans has dissipated a bit in the last couple of months.” Companies reduced borrowing costs on $281 billion of speculative-grade loans last year, or almost 4 times more than 2012, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data." - source Bloomberg.

The divergence of growth between the US economy and the European economy has been indeed reflected in credit prices such as the US leveraged loan cash price index versus its European peer. - source Bloomberg:

While both the PMIs and Leveraged loan prices cratered in 2008, you can see the impressive rebound in 2009, leading in the rapid surge in cash prices for leveraged loans and the increasing divergence in cash prices as indicated by the growing spread between US leveraged loan prices and European leveraged loan prices now at only 3 points apart.

The divergence of loan growth has indeed explained the divergence of economic expansion between Europe and the US. The divergence between US and European PMI indexes - source Bloomberg:

The growth differential between both economies is due to credit conditions. You can clearly notice the uncanning similarity with leveraged loans prices in both regions.

Moving on to the growing deflationary risk we have been warning about for some time, Europe seems indeed to be sleepwalking into a deflationary trap as pointed at recently by Christopher Woods from CLSA in his recent Greed & Fear note:
"At some point the equity market must surely focus on the reality that this market action reflects an increasingly deflationary environment in the Eurozone which is fundamentally equity negative. In this respect it is worth noting that 20% of the items in the Eurozone’s CPI inflation basket are now in deflation, with an average 2.2%YoY decline in December, contributing a negative 45bps to the Eurozone CPI inflation." - CLSA, Christopher Woods

Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going down again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg

Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully.

Another sign of the many failures of the "Departed": Inflation is nowhere to be seen but in rising asset prices, which are more and more grossly disconnected from reality. QE was supposed to create inflation. It hasn't been the kind of inflation the "Departed" was hoping for.

On a final note, of course one of the main culprits in 2013 which we have discussed at length has been Japan which has been exporting deflation on a large scale and the US has not been immune. It is still the "D" world (Deflation - Deleveraging). On that point we agree with Albert Edwards from Société Générale on the deflation risk, as displayed in a recent Chart of the Day graph from Bloomberg:

"The CHART OF THE DAY shows annual rates of inflation excluding food and energy, based on indicators that Edwards cited in a similar chart two days ago. It tracks the monthly changes in a consumer-spending deflator compiled by the U.S. Commerce Department and a price index from Eurostat.
The U.S. deflator rose 1.1 percent for the 12 months ended in November. The increase was smaller than the 1.7 percent gain for the core consumer price index that month, which was matched in December. Last month’s reading for the euro-region gauge was 0.7 percent, the lowest on record.
“Investors have yet to react to the deflationary threat,” wrote Edwards, a London-based strategist who says stocks are in a multiyear bear market that he calls the Ice Age. “They simply do not believe a recession that would trigger outright deflation is on the horizon.”
International Monetary Fund Managing Director Christine Lagarde highlighted the risk of falling prices two days ago during a speech in Washington. She urged policy makers in the U.S. and other advanced economies to avert deflation, which would hamper a “feeble” economic recovery.
“If U.S. growth in 2014 proves as disappointing as in previous years, then there should be a large market reaction as inflation expectations get pegged back closer to euro-zone levels,” Edwards wrote.
Economists expect gross domestic product to rise this year by 2.8 percent, exceeding last year’s 1.9 percent, according to the average estimate in a Bloomberg survey. They also expect a bigger increase in the deflator for core consumer spending, to 1.6 percent from 1.3 percent." - source Bloomberg.

To conclude on Ben Bernanke's legacy, we quite enjoyed Doug Noland recent take on the subject in his column entitled "The Departing Bernanke on Macro-Prudential":
Q&A from the National Association of Business Economics conference, Philadelphia, January 3, 2014: William Nordhaus, Yale University economics professor and chairman of the Federal Reserve Bank of Boston: “I asked my students if they had a question for [Bernanke]. And there were a number of them, one which I won’t ask is ‘what about bitcoin?’ – which I know he knows about. But I thought a really interesting one was this: ‘If you knew in 2006 what you know now, what step or steps would you have taken then to prevent or ameliorate the financial crisis and subsequent severe downturn?’” 

Bernanke: “Well that’s a really unfair question. I mean, the reality is that everybody – every policymaker has to make – this is the nature of policy – it has to be made in very, very foggy conditions with very imperfect information – a lot of uncertainty. So, in order to do anything, I think I would not only have to know everything in advance, everyone else would have to know I knew everything in advance. In other words, if I went out and started saying – all of the sudden I’m arbitrarily raising capital requirements by five percentage points, the banks would say ‘What!’ and it would be very difficult to get Congress and the other regulators and so on and so on to agree. I mean I think the crisis was very complex, involved many many issues. One of the concerns, I want to respond indirectly to a point…, the usefulness of macro-prudential-type measures. I think one of the practical questions is, even if you think you’ve got macro-prudential measures that work, can you put them in place quickly enough and responsibly enough, preemptively enough.

"To know and not to act is not to know." - Cosmopolis - Don Delillo

So long "Departed".

Stay tuned!

Credit - The Sleepwalkers

"Those who have compared our life to a dream were right... we were sleeping wake, and waking sleep."- Michel de Montaigne 

As 2014, marks the anniversary of probably one of the greatest human tragedy, namely the start of the First World War, we thought our title would reflect one of the greatest book written on the subject on how Europe went to war, "The Sleepwalkers: How Europe Went to War in 1914" by Christopher Clark. In his masterpiece, Christopher Clark analyses what caused the spark that led to the Great War. In similar fashion, we think that there is a possibility some future historian will write an opus on how in 2014 Europe went into deflation but, we ramble again. 

In his book, Clark asserted that the Great War was an entirely avoidable and unnecessary tragedy. "Unintended consequences" of the most colossal sort led to the outbreak of the Great War. In similar fashion the "credit crunch" that plunged Europe into a very deep recession and soaring unemployment levels, we have long argued, was as well an entirely avoidable and unnecessary tragedy. 

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

"If banks cannot access term funding, given the deleveraging they ambition to do, it could put additional pressure on bank lending, in effect reducing access to credit for the economy, namely triggering another credit crunch in the process." - Macronomics, November 2011

We have been sitting in the deflationary camp for a while and while last week, we argued that we could not see a significant drop in the Euro versus the dollar unless the ECB resorted to more "unconventional policies" such as QE. One of the main reasons we cannot fathom a rapid depreciation of the euro comes from the current account balance of the Euro Zone in % of GDP which continues to rise as displayed in recent study done by French bank Natixis in a report published on the 14th of January:

As described in Natixis note, the appreciation of the euro drives a fall in import prices which therefore lowers inflation levels in the Euro Zone. This does increase the deflationary pressure on the Euro zone. Given 73% of the turnover from companies pertaining to the Eurostoxx is coming from outside Europe, this can in turn explains the relative underperformance of European stocks versus the S&P 500 or Nikkei index. European stocks, in similar fashion to Emerging Markets, have as well been the victims of the on-going "currency war".

Looking at the recent discussions surrounding the capital requirement favored by the ECB in the upcoming stress tests, it seems it favors 6% of retained capital, slightly above the 5% used in 2011 during the EBA (European Banking Association) stress tests. Of course, this 6% benchmark must been agreed by the EBA which will coordinate the exams. The slight increase in capital requirement is still below the Comprehensive Assessment (balance sheet review), where the ECB will be using a minimum capital requirement of 8% to evaluate the 130 euro-area lenders under review. The ECB will only become a full member of the EBA when its starts its supervision role later in 2014. 

Still on the regulatory front, the Basel Regulators recent ease of the leverage-ratio rules for banks have not improved financial stability for the near future as reported by Jim Brundsen in Bloomberg on the 13th of January in his article "Basel Regulators Ease Leverage-Ratio Rule for Banks":

"Banks such as BNP Paribas SA, Bank of America Corp. and Citigroup Inc. called for amendments to the draft leverage rule published last year, saying it would adversely affect economic growth and job creation, make it more expensive for governments to sell their debt and give banks incentives to invest in riskier assets." - source Bloomberg.

We touched at length the subject of banks equity buffers in March 2013 in our conversation "Dumb buffers":

"Back in September 2011, we quoted Dr Jochen Felsenheimer from asset management company "assénagon" now called "XAIA", we would like to quote him again looking at the current context:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. 

Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? Because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity." - Anat R. Admati."

And if leverage is the issue, when it comes to providing loans to the real economy, although there has been some improvement in the euro-zone fragmentation in lending rates between core Europe and the periphery, resolving this divide has yet to be achieved as displayed by Spanish loan rates which have been jumping up as of late:

"ECB President Mario Draghi noted, in comments following November's rate cut, that while euro-zone fragmentation had been improving since mid-2012, progress had foundered since late summer. The latest data on Spanish loan pricing, often cited as a measure of the North-South divide, paint a dark picture. The two-month jump is the biggest increase in more than a decade and will likely stoke fears about this divide, potentially prompting talk of a rate cut." - source Bloomberg.

This fragmentation can as well be ascertained from this graph displaying the interest rate on MFI loans to non financial corporations (1-5 year maturity,

As far as we can see the European "Sleepwalkers" can either provide sufficient ammunitions via the carry trade for banks to rebuild their capital and deleverage, increasing in the process and not severing their fate with their sovereigns, but cannot provide at the same time the necessary credit support to boost economic growth sufficiently in the periphery, therefore not reducing the solvency issue.

For the time being, the situation is one of stability as indicated by the improving sentiment indicator in the Eurozone and Eurozone Real GDP which should improve at least in the short term - graph source Bloomberg:

Due to the fragility of this "recovery", for a change, the less restrictive approach regulatory attitude in relation to banks is supportive of the macro picture. 

We do agree with Bank of America Merrill Lynch Alberto Cordara when it comes to Italian banks from his recent note from the 15th of January entitled "Rules & Recovery":

"Sovereign spreads on a normalisation trail

Italy was hit hard by the crisis, suffering from the malaise spread by the Greek debacle, the collapse of the Spanish real estate market and in our view, the political quagmire of mid-2011. Italy, the third-largest Eurozone economy, has a strong and diversified industrial backbone, individual wealth is high and households are underleveraged. So far, the Italian government has seemed reluctant to implement structural reforms, which have come under fire from the traditional lobbies. In our view, the recent change of guard in the Democratic Party bodes well for reforms, in particular for the labour market, which is in need of modernisation. We think this may lead to further tightening of Italy’s spreads (still higher than in mid-2011).

A punitive regulatory attitude would be plainly ineffective 

As we highlighted in Breaking with tradition 18 October 2013 Italian banks’ lending businesses are currently loss-making and are thus subsidised by profits from elsewhere (AM, product placings, sovereign carry trades). Banks have been damaged by i) high sovereign spreads affecting their ability to issue term funding, and ii) low ECB rates which destroyed their ability to extract margins from depositors. Both variables are exogenous to banks (i.e. not related to their credit worthiness). We do not believe an increase in capital requirements would help address these issues.

Domestic authorities set out a favourable backdrop

We believe that the best way to reactivate the lending cycle is to allow banks to extract more profits, loosen capital requirements and (to a degree) front-load future losses. Recent steps by Italy’s authorities are supportive allowing full tax deductibility of credit losses, a shortening of the DTA amortisation cycle (from 18 to five years), and turning existing IRAP goodwill DTAs into tax receivables, while AFS sovereign losses will continue to be sterilised. Further, banks may ultimately be allowed to benefit from the revaluation of BOI stakes. On the other hand, it stands to reason that banks will be pushed to a credit clean up in 4Q13 as part of the AQR." - source Bank of America Merrill Lynch

When it comes to Italy Bank of America Merrill Lynch makes the following important points:

"In contrast with the rest of the Eurozone, Italy remained in recession in Q3 with unemployment at 12.5% and GDP growth contracting by 0.1% (-1.9% yoy) albeit at a softer pace (Q2: -0.3%; Q1: -0.6%). The overall framework for recovery remains fragile but signs are emerging. Business confidence is improving steadily and industrial production turned positive in November (+1.4% after 26 consecutive months of decline). On latest available data (June 2013), household gross wealth declined by 1% mainly as a result of a fall in house prices, but this was also counterbalanced by a fall in financial debt that currently stands at around 65% of disposable income compared with about 80% in France and Germany and 120% in Spain. Only 25% of Italian households have financial debt and the share of financially vulnerable households is low (3%). Italy’s historically high saving rates have contributed to the formation of a relatively high stock of wealth and a high degree of wealth dispersion among the population." - source Bank of America Merrill Lynch

In relation to Italian banks, the situation is much more different than the poor lending standards and risky loans and real estate exposure which decimated the Irish and Spanish banking sector as pointed out by Bank of America Merrill Lynch's note:

"Capital not the answer although politically appealing

In theory, more capital may help reduce funding costs for those banks that are issuing at a premium to sovereign spreads and potentially reactivate lending to the economy. However, experience suggests that the end result may be exactly the opposite. Higher capital requirements mean that banks are pushed to enforce stricter lending criteria and will adopt suboptimal practices to satisfy the regulator and avoid shareholder dilution. This goes beyond the check dates outlined by the regulator as there is always the risk that the regulator may come back asking for more (this has happened every time…).

The Italian case is very telling: in early/mid-2011, most Italian banks (BP, UBI, ISP and MPS) carried out massive recapitalisations, which proved completely ineffective as funding costs skyrocketed when the price of Italy’s sovereign bonds hit the skids in July 2011. In other words, banks are price-takers and are impacted by Italy’s sovereign – probably a different situation to in Spain and Ireland where poor lending standards and the collapse of the real estate markets were the very epicentre of the crisis. This is also very different from the US situation where TARP was introduced and is often cited as an example of regulatory foresightedness, a panacea for all ills. Italy’s problem resides with the country’s high level of public debt and disappointing ruling class, not with bad banks’ underwriting nor obscure asset values (subprime, etc.)." - source Bank of America Merrill Lynch

While the "stabilisation" is a welcome respite in the Euro-zone, our European "Sleepwalkers" should not take this recovery for granted and continue to push forward for some additional much needed structural reforms, in particular for France which as of late has been significantly lagging its European peers. Nevertheless the increase in European Consumer Confidence has been reflected as well in the EU27 new passenger car registration increases - graph source Bloomberg:

Credit wise, the correlation between the US, High Yield and equities (S&P 500) since the beginning of the year is back on track. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

What caught our attention is Credit Indices, when one look at the positioning of credit investors, as displayed in a recent note from Morgan Stanley entitled "The Future of the CDS Market", US investors are net long credit risk in the US, particularly in Investment Grade via the CDX IG index:

"In terms of positioning, investors are net long credit risk in the US, particularly in IG (via a net short position of $40 billion in CDX IG). As such, there is some demand from index users to be simply long the market in an unstructured form via the indices." - source Morgan Stanley.

2014, is indeed a continuation of 2013, namely that the liquidity backstop continues to provide ample support for a continuation of carry trades, releveraging and an increase in the search for yield in the riskier part of the credit space as indicated by Lisa Abramowicz in Bloomberg on the 15th of January in her article entitled "Firms Tripling Junk Returns Lure Most Since '07":

"Firms that use borrowed money to lend to the smallest and riskiest companies are attracting cash at the fastest pace since before the crisis, wooing buyers with returns that are triple those of the broader junk-debt market.

Investors from retirees to wealthy individuals plowed $4.1 billion into publicly traded business development corporations last year, the most since 2007, as the firms known as BDCs gained an average 16.4 percent. The entities are juicing returns by borrowing about 50 cents for every dollar raised from equity investors, up from 36 cents in 2011, as Keefe, Bruyette & Woods predicts average gains of as much as 13 percent this year.

BDC shareholders are wagering that an accelerating economy will bolster earnings for companies that are the most vulnerable to default, even as the Federal Reserve starts scaling back the unprecedented stimulus that suppressed borrowing costs. After shunning funds that used derivatives and leverage in the years after the 2008 credit crisis, buyers are returning to pad yields that reached record lows last year while seeking shelter from bonds that face losses as rates now rise." - source Bloomberg.

So we wonder if investors are not indeed indulging themselves into "sleepwalking", although generally sleepwalking cases consist of simple, repeated behaviours, there are occasionally reports of people performing complex behaviours while asleep. 

On  a final note, and in relation to our European Sleepwalkers, the recent surge of the EONIA and Euribor, seems to point to some additional concerns when it comes to credit supply in the Euro area as shown in this Bloomberg graph highlighting the rise of the EONIA index and Euribor:

"The decline in excess liquidity in the euro region, driven by a decision by southern European banks to repay LTRO cash early, is raising key short-term interest rates, threatening the supply and cost of credit to Europe's struggling small- and medium-sized companies. A near doubling of one-month Euribor and EONIA since late November poses a growing threat, even though the ECB has pledged to do whatever necessary, including further rate cuts, to defend the euro zone's recovery." - source Bloomberg.

Let's hope Mario Draghi is not sleepwalking towards the deflationary slippery slope.

"Each man should frame life so that at some future hour fact and his dreaming meet." - Victor Hugo 

Stay tuned!