Macro and Credit - Tangerine Dream

"I don't know where I'm going from here, but I promise it won't be boring." - David Bowie

Looking at the continuing pressure on the Chinese currency, with Hong Kong's yuan interbank rates rising to record highs (overnight rate at 66.82%), and the on-going heightened volatility in various asset classes, we thought this week we needed a dual reference for our title analogy. "Tangerine Dream" is a symbol of false perception of reality, when the situation in the eyes of a person is seen very differently than it is in reality. "Tangerine Dream" is also a German electronic music group founded in 1967 by Edgar Froese who died one year ago, on the 20th of January. For eighties buff like ourselves, you might remember their seminal title "Love on a real train" from 1983 classic "Risky Business", a prominent feature of today's markets, because the movie covered the following themes materialism, loss of innocence, coming of age and capitalism. We could have gone for another musical analogy such as "Under pressure" featuring the maverick David Bowie, that just departed, but, that will be for another time.

When it comes to our "Tangerine Dream" title analogy and markets, if in a dream you are eating a tangerine, it is a sign that in reality the situation is much more complicated and serious than you could have imagined which the case is today. In this case, you should only blame your excessive credulity in relation to central bankers. Therefore it is necessary to percept the events with your own point of view, and not with someone else's (or your usual sell-side analyst); you need to learn how to think and reason independently (like we do) and forget about the "herd mentality" that prevails often in overcrowded positions and markets. Given peak tangerine season lasts from autumn to spring, there is indeed plenty of opportunities for you to eat "tangerines" or dream you are eating "tangerines", but we ramble again...

In this week's conversation, we will look at some of the implications of the troubles in China from a creditor's perspective, given we think many pundits are having a "Tangerine Dream" when it comes to assessing the Asian corporate bankruptcy regimes. We will also look at why size matters in the credit markets and how to mitigate "liquidity" issues from an issuance perspective.

Synopsis:

• The "Tangerine Dream" in the Asian corporate bankruptcy regimes"
• Credit - Want to mitigate liquidity issues? Size matters
• Final chart - As in the US the distressed ratio in European High Yield is also rising

• The "Tangerine Dream" in the Asian corporate bankruptcy regimes"

Many pundits have been "speculating" whereas we have "Small Trouble in Big China" or "Big Trouble in Little China" (yet another 80s movie reference...) as we move from the Year of the Sheep towards the Year of the Fire Monkey. According to Chinese Five Elements Horoscopes, the "Monkey" Chinese sign contains Metal and Water and Metal is connected to gold (no surprise therefore to see a comeback of the precious metal as of late). "Water" is connected to wisdom and danger. Therefore, according to Chinese beliefs, we will deal with more financial events in the year of the Monkey. The Monkey is a smart, naughty, wily and vigilant animal. And, according again on the Chinese Zodiac forecast for 2016, if you want to have "good returns" for your money investment, then you need to "outsmart" the Monkey. Also, according to the same prediction, "Metal" is also connected to "Wind". That implies the status of events will be changing very quickly, hence the clear return, of "volatility" and plenty of "risk reversal" opportunities as we posited recently in our musings.

But, if indeed we are bound for "Big Trouble in Little China", then from a creditor's perspective it is highly relevant to assess the prospects for default and recovery value when the worst could be happening. 

It is, therefore paramount we think, that, "Tangerine Dreamers" focus on the bankruptcy regimes governing specific countries rather than rely on a false perception of reality. From a default and recovery value perspective, we read with interest Bank of America Merrill Lynch's Asian Strategy note from their 8th of January entitled "Default and recovery: What are the prospects when the worst happens?":

"What is the historical recovery experience for bond defaults?

We analyzed default and recovery data for 117 bond default cases by 105 issuers between 1997 and 2015 across ten countries. Of the 117 bond recovery cases assessed, 63 were straight bond defaults and 54 were convertible bond defaults. There is not a huge difference in terms of recoveries for the two bond types although country mixes differ. The results show an average recovery rate of 36%. Looking at unsecured recoveries from 2009, at a recovery rate of 43% Asia compares favorably versus recoveries from other regions including the US. This may come as a surprise considering 74% of our data comes from defaulted companies in China, India and Indonesia where legal systems are not considered particularly creditor friendly.

What factors impact recovery rates?

There are many factors which can influence the level of recovery that investors will get in a default scenario. Seniority and security are the two most important factors. On a macro level, low recoveries tend to be correlated with wide credit high yield spreads, higher default levels and when GDP growth and stock market returns are low.

The type of event precipitating default will also strongly impact recoveries. Other factors which we believe are relevant in Asia include complexity of group structure, management willingness to work with creditors and differences across legal jurisdictions. For more on the legal frameworks pertaining to insolvency, bankruptcy and restructuring please refer to our Primer: Asian corporate bankruptcy regimes.

What were some of our findings?

(1) There is a nice correlation between high yield spreads and recovery levels, (2) recoveries have been quite high despite slowing growth which is most likely due to the strong appetite for risk and yield. Recoveries could fall from the above 50% average levels over the last two years to around 30% based on growth today, (3) recoveries for distressed exchange/tenders are much higher than for missed payment and bankruptcy/liquidation situations. The Winsway bondholder who tendered in 2013 received 16% more than those who held to default, (4) secured bonds recovered less than unsecured bonds contrary to convention as bonds were actually unsecured in structure or secured on few hard assets so it pays to read the fine print, and (5) by industry, real estate provided the highest average recoveries and financials/basic industry the lowest.

We take a closer look at results in China, India and Indonesia
China: The average recovery rate is surprisingly high at 39% considering bonds are structurally subordinated to on-shore creditors putting them on par with equity. We believe this is because three quarters of the data comes from defaults in 2009 or later. In a broader downturn, recoveries are unlikely to be as high. India: We were very surprised to find that average recovery level was 40%. We surmise that the lack of trading liquidity for CBs (all data was based on CBs) led to imperfect pricing post default. Taking data based on latest/last prices (where available) the average recovery falls to 22% which is more in line with expectations. Indonesia: Has one of the lowest average recovery rates in the region at 28%. While there are a variety of factors we could point to, the key factor appears to be the weak legal system for dealing with bankruptcies, insolvency and restructuring." - source Bank of America Merrill Lynch

From a US credit perspective, as we have argued back in June 2015 in our conversation "Eternal Return", the "de-equitisation" process thanks to buybacks is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think. When corporate balance sheet leverage rises, default probability increases down the line. Shares buybacks drain liquidity away from balance sheets while share issuance replenishes coffers.

As we reported in our last conversation, half the HY universe by market value today trades at 310bps, while the other half is at 1050bps. The distressed list has a disproportionate representation of commodities (33%) while oil prices continue to fall. While this dispersion doesn’t bode well for US HY, default and distress ratios are increasing, even outside commodities. When it comes to assessing recovery levels, spreads do correlate as indicated by Bank of America Merrill Lynch's note:

"Spreads correlate well with recovery levels

While it intuitively makes sense that higher default rates would depress recoveries (too much distressed debt can overwhelm the capacity of distressed debt buyers to absorb the supply which negatively impacts prices), the relationship between recovery rates and default levels does not look particularly strong for Asia. This we believe is due (1) the size of the Asian high yield bond market was small in the late 1990s/early 2000s and; (2) we use convertible bond data for our recovery analysis which does not get included in the default rates (based on defaults in our bond index) impacting the results.

We find that high yield spreads provide a better relationship with recovery rates as spreads provide a good indication of risk appetite. We note the recovery level was low in 2006 which should not generally be the case given the tight spreads (and risk appetite strong). We chalk this up to the small sample size as two recovery points is hardly statistically significant. More telling is the lack of defaults during this period in general. Recovery rates have been quite strong over the last couple of years - not surprising given the overall market liquidity conditions.

Recoveries high despite slower growth and lower earnings

Recovery levels should correlate with economic growth and corporate earnings. We find that over the last few years recoveries have been quite high despite slowing growth. This is most likely due to the strong appetite for risk and yield.

However what this suggests is that recoveries could fall from the above 50% average levels over the last two years to around 30% based on growth today and lower if growth slows further."

 - source Bank of America Merrill Lynch

Where we disagree with Bank of America Merrill Lynch's take is that during last downturn the central banks "put" via QEs quickly came to the rescue which avoided a "distressed" glut and accelerated the recovery in prices, which led to a faster price recovery for many issuers in the process. The significant rise of "distressed" bonds in the US and the rising trend in Europe could weight in the next downturn on "recovery" values rest assured.

In similar fashion we played the "central bank put" game in European credit during 2011 in October when we bought BPCE 12.5% Tier 1 bonds at 94.5 cash price before the December LTROs from the ECB that "saved the day" for the increasing dollar liquidity crisis building up (liquidity crisis always lead to financial crisis...). The "ECB put" for financials enabled us to see our bond price surge by a cool 41% until we sold them this Monday at a cash price of 133, while enjoying some decent coupons in the process. 

On a side note, the implementation of the "Bail-in" process for financial bonds in Europe as of the 1st of January 2016 makes us much more wary of financials particularly in the light of the latest episode we commented recently on Novo Banco. While some care about the "carry", we decided to take profit as we do not want to get "carried away" given the weaker tone in credit as of late (yes, it is weaker in the US relative to Europe, cf Itraxx Main Europe 5 year vs CDX IG...).

But moving back to defaults and bankruptcy regimes in Asia in particular and "Tangerine Dreamers" alike, there are large differences in recovery values depending on countries as posited by Bank of America Merrill Lynch note:

"Country specific recoveries

In Chart 12 we look at the average recoveries by country and then compare them to data from the World Bank’s resolving insolvency report in Chart 13.

This is not an apples-to-apples comparison given the World Bank recoveries are based on secured loans but broadly we would expect higher recoveries from the more developed markets. This is not always the case based on the bond data. Recoveries in Singapore, HK and Malaysia are quite low relative to China, India and the Philippines where interestingly, the average recoveries from bonds are higher than the World Bank findings on secured loans. For the most part we can chalk this up to the small data set for a number of the countries on the bond side. Some of the data is based on defaults in the late 1990s/early 2000s which can also impact recoveries. We look more closely at the three biggest markets, China, India and Indonesia where we have the most data.


China
Shouldn’t recoveries be lower given structural subordination?
The average recovery rate for China is 39% which is surprisingly high considering that under China’s capital-account control regulations, funds from foreign creditors lent to an off-shore subsidiary are usually remitted to its on-shore parent in the form of an equity injection. Therefore, foreign creditors are structurally subordinated to on-shore creditors and are effectively on-par with equity.

We would attribute this to two things (1) 76% of the bond defaults in our China cohort have come from defaults in 2009 or later. The large amount of stimulus provided to the economy after the 2008 global financial crisis led to a strong rebound providing a better environment for restructuring and recovery and; (2) given the quick turnaround in economic growth we believe has led to a greater management willingness to work with creditors in order to ‘get on with business’.

What we do find is that there been quite a wide dispersion in recovery levels. In circumstances where there was some form of fraud involved, recovery for bonds has been negligible. There have also been a high number of distressed exchanges (which have all been since 2009) where recovery tends to be higher. On average though, if we exclude the fraud/distressed exchange situations, the average recovery is still quite high at 33%. However, as growth slows and defaults rise, particularly on-shore, we would expect recovery levels for off-shore investors to fall." - source Bank of America Merrill Lynch

So "Tangerine Dreamers", you have been warned, if you own Chinese off-shore bonds, as foreign creditors, you are structurally subordinated to on-shore creditors and are effectively on-par with equity hence your risk of false perception of reality when it comes to assuming the recovery value of your "off-shore" bond investment in China.

We also read with interest some interesting points made by Bank of America Merrill Lynch in their Asian Credit Strategy note from the 8th of January entitled "Asian corporate bankruptcy regimes":

"China is not a signatory to any significant international treaty relating to insolvency.

Apart from debt approval and registration requirements set by the State Administration of Foreign Exchange, there are currently no special procedures for foreign creditors. It is often more difficult for a foreign creditor to recover assets from a Chinese debtor due to the lack of recognition procedures. It is believed that treatment of creditors is based on whether they lent to onshore or offshore entities, not whether they were foreign or local lenders. To date, there are few bonds issued by Chinese companies offshore which have guarantees from the onshore operating subsidiary unless the company plans to utilize the funds off-shore due to the difficulty of obtaining approval from the Chinese authorities. Funds for use onshore can be injected as equity or in a shareholder loan format although the latter is less common. Funds injected as equity are effectively structurally subordinated to onshore borrowings and may not be party to any creditor agreements.

Hong Kong

Legal Infrastructure

Hong Kong’s insolvency framework is based on laws of England and Wales, contained within the Companies (Winding Up and Miscellaneous Provisions) Ordinance, Bankruptcy Ordinance, and the Companies (Winding-Up) Rules. Hong Kong does not have a dedicated bankruptcy court nor dedicated bankruptcy judges although it does have a companies judge who hears most corporate bankruptcy matters. The framework provides formal guidelines on bankruptcy processes other than rehabilitation, in which area Hong Kong has to date been unable to pass legislation.

Key risks

It is common to have large groups of banks (10-20) from different countries involved in a Hong Kong reorganization process and therefore reaching a consensus among creditors can be particularly difficult. Additionally, as Hong Kong does not have a statutory procedure for the rehabilitation of companies, there is little early recognition of financial difficulties on the part of companies. Further, despite the strong economic and trade relationship between China and Hong Kong, neither of them have devised a special procedure for effectively handling an onshore-offshore corporate insolvency situations. As there is no formal judicial recognition mechanism available to foreign creditors, foreign creditors who have received rulings in Hong Kong will have to initiate separate bankruptcy procedures according to China’s EBL." - source Bank of America Merrill Lynch

Should indeed we move towards a "Big Trouble in Little China" scenario, then, from a "restructuring" and "recovery" perspective, things could get interesting indeed, particularly for onshore-offshore insolvency situations when one takes into account that various Asian countries are not party to any international treaties for foreign insolvency procedures and they do not provide for the recognition of foreign insolvency proceedings. When it comes to "Asian recoveries" don't dream too much about "tangerines".

When it comes to "credit" and "liquidity", which has been a pet subject of ours and many others in the financial sphere, another way of "mitigating" liquidity issues, could be by selecting smaller issue size from a "contrarian" perspective as per our next bullet point.

• Credit - Want to mitigate liquidity issues? Size matters

As per our last conversation where we highlighted the rise of idiosyncratic risks thanks to central banks' "overmedication", the recent Novo Banco "bungee jump" drop in price to close an eventful 2015 was a reminder of the instability created by the rise of "positive correlations".

From a "contrarian" perspective, we read with interest Bank of America Merrill Lynch European Credit Strategist note from the 8th of January entitled "Go small, and go home":

"Welcome to the bear market

We believe so much monetary policy has become counterproductive for the IG credit market in Europe. “Yield fatigue” due to QE is the issue. And as a consequence, the functioning of the credit market is deteriorating.

The end of big inflows

The low yield environment has left the high-grade market more imbalanced between the “buyers” and “sellers” of credit risk. The “buyers” of credit risk – i.e. investors – are vacating the market. The “sellers” of credit risk – i.e. issuers – are coming in force. Nowhere is this first point more clear than in the flow data. Chart 4 shows that retail investors have withdrawn close to $30bn from European credit since June last year. 

The outflows have been relentless, and reflect far more than just a blip in preferences (previous outflows were much smaller around the Taper Tantrum and peripheral shocks). We believe we are seeing structural outflows from the asset class – driven by the realisation of a (very) low for longer yield backdrop.

At the same time, while the “sellers” of credit risk (i.e. issuers) continue to flock to Europe, the lack of inflows means that the new issue machine poses a greater strain on the market. Supply is being bought increasingly on switch, rather than with fresh cash. Thus high new issue premiums invariably reprice secondaries (as shown by the Daimler deal earlier this week).
This is a worry as January and February have historically each accounted for 10% of annual supply.

What if the credit market is not so deep?

With outflows and a tricky new issue machine, the consequence has been deteriorating credit market liquidity. Chart 5 shows that average bid-offer spreads in investment grade continue to rise. In fact the deterioration has been clear ever since the ECB first cut rates into negative territory. In all, we see a shallower credit market for 2016.

But what are the implications for other asset classes? For the equity market, a less healthy credit backdrop is likely to reduce some support for share price performance. However, our European equity strategist James Barty makes the key point that SX5E dividend yields of 3.7% still provide a strong tailwind for stocks.
What’s clear is that the “depth” of the credit market is past its best. Chart 6 shows that the average new issue size in European credit has been trending down for a number of years – but the decline was especially clear last year.

If debt funding capacity is lower in Europe, this could have a second order effect on equity sentiment. While this is unlikely to alter perceptions of debt-funded share buybacks in Europe (they are much less prevalent than in the US anyway), it may question the ability of European M&A to rise decisively this year. Chart 7 shows that US M&A (filtered by US companies acquiring), is past its previous peak. Yet, European M&A (filtered by European companies acquiring) is still way below the ‘07 highs.

When big isn’t so beautiful

To add fuel to the fire, ongoing idiosyncratic risk in credit is becoming troubling. Novo Banco bonds dropped 80pts in the final few days of 2015 (after senior debt was transferred to BES), Areva bonds have fallen 13 points this year on a rating downgrade (from BB- to B+) and Rallye spreads have also widened materially. This follows a 2015 when credit investors were greeted with the events of VW, Abengoa and the miners.

But we worry that idiosyncratic risk is starting to become a systemic risk for the credit market.

Why? Because “blow ups” are frequently happening to the larger credits in the market, and not to the small “overlooked” names (which has tended to be the perception of idiosyncratic risk in the past).

Nowhere is this more apparent than in the European HY market. In December, high-yield bonds widened close to 70bp, while investment-grade bonds widened by just 3bp – thus a massive relative underperformance of high-yield vs. investment-grade. Away from Novo, material widening in big credits – such as Portel – was detrimental to overall HY performance.

Chart 8 highlights the problem. The universe of European distressed bonds (issuers with bond prices below 85pts) is increasingly being made up of “large” names (i.e. credits with debt outstanding in excess of Eur 1bn). In fact, “large” names now account for 25% of the European distressed index.

Beating the event-risk blues: go small in ‘16

Avoiding the next idiosyncratic name in credit is, by definition, tricky. But a clear consequence of rising event risk in big issuers is that spreads of small issuers are starting to behave much more defensively. We see this trend continuing and expect spreads of “small” issuers to fare relatively better than spreads of “big” issuers this year.
As chart 9 shows, spreads of “small” names (defined as €1bn of debt outstanding and below) fared much better than spreads for “large” names in 2015. In fact, excess returns for “small” names in European HY were 6%, compared to just 0.3% for “large” names.

 - source Bank of America Merrill Lynch

This has, we think, profound implications for "Tangerine Dreamers" and we would like to make additional points that will alter somewhat your "perception of reality" (us breaking again the "fourth wall"). As per our conversation "The Cantillon Effects" from September 2013, if we take the art market as a proxy for the effect of QEs on asset prices and taking into account that art is removed from the capital structure, it is also worth pointing out that the higher returns of the art market also come with lower volatility. While the AMR Art 100 has an annual volatility rate of 12 percent from 1985 until 2012, the MSCI World Index had a volatility rate of 16 percent. Counterintuitively, this illiquid market is prone to less volatility. In the case of  European High Yield, counterintuitively, this "illiquidity" linked to the "size" of the issuer, as highlighted by Bank of America Merrill Lynch, is prone to less volatility and generates higher excess returns. To mitigate somewhat this "European High Yield" perception we would like to add that last few years in Europe, we have seen many "financials" particularly from peripheral countries migrating lower into the High Yield sector and indexes. Quod erat demonstrandum.

Interestingly enough, to add more thoughts to the concept of "liquidity" and "instability", we would like to point out the rising disconnect between European cash High Yield versus the Itraxx Crossover 5 year CDS index which is often used as a hedging tool. This disconnected is pointed out by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 13th of January entitled "The price of liquidity":

"Sell € iBoxx HY TRS, as a better hedge for HY portfolios
The Crossover CDS index has not been the perfect hedge for high-yield cash. December has been a month to forget for high-yield investors. The cash index (HE00) was almost 70bp wider, while Crossover was only 25bp wider. This was mainly on the back of name composition mismatch but also the differences of index weighting (equally for the CDS index, market value for the cash market).

This proves our point that high-yield cash investors need to stay close to home, and hedge with TRS. The € iBoxx HY TRS can insulate risks against wider spreads, with minimal tracking error (depending on benchmark)." - source Bank of America Merrill Lynch

This not a surprise to us.  Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:

"Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays"

Given callable high yield notes are generally "negatively convex", and are a "dominant" risk feature in the high yield space,  in periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space. 

We concluded at the time our "Alive and Kicking" conversation as follows:

"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..." - source Macronomics, August 2013.

The decoupling between High Yield cash and the CDS market is also a reflection of CDS being positively convex versus cash high yield being negatively convex (due to callable features).

When it comes to surging defaults and the low recovery risk link to a potential "distressed debt glut" is something that needs to be taken into account by "Tangerine Dreamers" as per our final point.

• Final chart - As in the US the distressed ratio in European High Yield is also rising

While we pointed out earlier the difficulty in clearing a "distressed debt" glut without central banks support à la QE1, the recovery levels in the next downturn will be depending on the evolution of distressed ratios on a global basis, taking into account as well the various bankruptcy and restructuring laws available. Our final chart comes from Bank of America Merrill Lynch European Credit Strategist note from the 8th of January entitled "Go small, and go home" and shows that the distressed ratio in European High Yield has risen from 8% to 12% since mid-November. For reference the distressed ratio in US High Yield is 25% currently due mostly to the "Energy" sector for now:

- source Bank of America Merrill Lynch

While spreads of small issuers are starting to behave much more defensively, should you want to hedge accordingly your High Yield exposure in Europe via the Itraxx Crossover 5 year CDS index, you might want to think of "overcompensating" your exposure, buying more protection in notional terms than your overall exposure...but, that's might be another "Tangerine Dream"...

"Who looks outside, dreams; who looks inside, awakes." - Carl Jung, Swiss psychologist

Stay tuned!

Macro and Credit - The fourth wall

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

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

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

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

- graph source Bloomberg

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

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

Further losses could lie ahead 

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

Cheap but we await clarity 

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

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

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

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

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

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

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

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

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

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

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

- source Bloomberg.

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

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

-source CLSA

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

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

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

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

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

Synopsis:

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

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

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

- graph source Bloomberg.

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

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

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

"High Yield Energy Bonds Drop 23.6% in 2015 

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

Leverage Sensitivities and Breakevens at $40/bbl WTI 

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

Hedging Protection is Limited in 2017 

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

- source Barclays

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

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

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

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

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

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

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

"2014 redux 

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

Winter is coming 

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

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

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

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

Even Ex Energy earnings are falling...

We know nothing, Jon Snow 

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

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

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

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

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

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

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

"Correlations getting higher in a macro-driven market 

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

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

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

- source Bank of America Merrill Lynch.

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

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

Stay tuned!

Macro and Credit - The Ghost of Christmas Past

"These are the shadows of things that have been. That they are what they are, do not blame me!" - The Ghost of Christmas Past, A Christmas Carol by English novelist Charles Dickens, 19th December 1843

While discovering with great pleasure that we had won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our recent "Cinderella's golden carriage", we reminded ourselves for this week's title analogy of the sayings of the Ghost of Christmas Past that came to haunt Ebenezer Scrooge in Dicken's 1843 masterpiece "A Christmas Carol". This angelic spirit showed Scrooge scenes from his past that occurred on or around Christmas, in order to demonstrate to him the necessity of "changing his ways", as well as to show the reader how Scrooge came to be a bitter, cold-hearted miser. Looking at where some High Yield Energy spreads are close to ending the year with the continuous downward pressure on oil prices and most of the commodity sector, is indeed, an illustration of the Ghost's philosophy. Credit spreads are what they are and do not blame us for having commented over the last few years over the deterioration of the credit cycle. If the Ebenezer Scrooges of the credit world have been hurt in the latest sell-off in the High Yield space, they had it coming. Low spreads of yesterday are indeed the shadows of things that have been to paraphrase Charles Dickens.

While typing this very note, we watched with great interest Central Bank of Azerbaijan (CBAz) decision to devalue the AZN by another 35% to AZN1.55/$ and deciding to shift to a fully floating exchange rate starting from December 21. We pointed out in our recent conversation "Cinderella's golden carriage" that in similar fashion to AAA ratings, currency pegs are as well a dying breed:

"In similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":

"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics

 - source of the table - Société Générale 

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been", hence our recent HKD peg break case that earned us some praise from Saxo Bank.

Before we move on towards our usual ramblings, it is that time of the year where we would like to take the time to wish you dear reader and your family a wonderful Christmas and a happy and prosperous New Year. On that special occasion, we would like to extend our thanks for the support we received on our blogging journey and to our growing number of our readers (thanks for your praise in 2015). We would also like to thanks our good friends from Rcube Global Macro Asset Management for their numerous qualitative and quantitative contributions throughout 2015. We also would like to extend our thanks to our good cross-asset friend "Sormiou" for providing us with his great insights on the subject of volatility and his regular comments, and interesting exchanges we had during the course of 2015. We are looking forward to hearing more of him in 2016 given the clear potential for more volatility to come in that respect. We also hope we will hear more from you dear reader in 2016. Don't hesitate to reach out and comment!

As we move towards the last few days of yet another eventful year full of "sucker punches" such as the CHF move thanks to yet another peg blowing out courtesy of the SNB and the Yuan "surprise" of the summer thanks to the PBOC, we would like this week in our closing conversation for 2015 to continue looking forward towards 2016, as we think, the rising instability will generate interesting proposals for the "contrarian" punters. Also we do think that our "outrageous" prediction prominently featured in Saxo Bank's recent publication is by no mean "outrageous", more on this later in the conversation. Similar  "convex" trades abound, as central banks' magic spells are losing their strength, and these "macro" trades will go hand in hand with "volatility" in 2016. To reiterate ourselves, there lies the crux of central banks interventions, there is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis.

Synopsis:

• 2016, will be all about "risk-reversal" trades
• The EM 2016 outlook - its weaker than you think
• Final chart - Short Hong-Kong? Go long Japan "tourism"

• 2016, will be all about "risk-reversal" trades

It seems to us that many investors today are "living in the shadows of things that have been", namely that they live under the "pretence" that the "central bank put" is still in play. This "pretence", we think is particularly entrenched within the "equities" crowd who suffers from "overoptimism", whereas us, in the "credit" crowd, we suffer from "overpessimism". Overall, investors, suffer from deep bipolar disorder but, that is another subject.

Furthermore, as we have shown in our last conversation "Charles' law", rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky, and they also have induced a reach for yield, pushing many "players" outside of their "comfort zone" leading to "yield compression" on a "grand scale" as displayed in the below chart from Bank of America Merrill Lynch's Global Equity Derivatives Outlook for 2016 published on the 9th of December:

"Reaching for yield in Europe given QEWith almost €3trn of negative yielding govt debt (~45% of the total outstanding), the hunt for yield in Europe is as strong as ever. With such low (negative) returns on safe haven assets, central banks have pushed income-seeking investors further out on the risk curve, resulting in a policy-induced contraction in yields across asset classes (Chart 26). 

With Mario Draghi unleashing QE in 2015 and leaving room to further expand it in 2016, the hunt for yield will likely gather steam, in our view. Indeed, the higher yields on offer in both EU equities and HY credit relative to safe haven assets are among the key investment reasons cited by our equity & credit strategists in their 2016 outlooks.

Yield is only half the story: need to weigh vs. asset riskYield vs risk framework: With a lack of assets offering reasonable yields, investors often focus excessively on (just) the yield on offer with less attention to the associated investment risk." - source Bank of America Merrill Lynch

Indeed, "yield hogs" are still on the "yield trail" and have been enticed by our generous gamblers to play on the "beta" game a little further up the risk scale.

What is once again "striking" to us, as me move towards 2016 is the "consensus" in many positions, which we think that from a "positioning" perspective and contrarian approach could be enticing. Could it be that when everyone is thinking the same, that no one is really thinking? We wonder.

In terms of "risk-reversal" punts, we read with interest Bank of America Merrill Lynch's Futures and HF positioning report from the 20th of December entitled "Leveraged Funds bought record S&P 500 –tugging a war with Asset Manager":

"Futures positioning across asset classes (CFTC data) 

Equities (disaggregated data)
S&P 500 (consolidated) – Leveraged Funds (LF) decrease short by $34.6bn over four week to -$16.6bn – a record buy since the consolidated TFF data started in June 2010. Asset Manager/Institutional (AI) decrease long by $6.1bn last week to $40.5bn. AI net position is near 3-year low (3.2%tile); LF near 3-year high (98%tile).
NASDAQ 100 (consolidated before June 2013) - Asset Manager/Institutional increase long by $0.2bn to $10.1bn. Leveraged Funds increase long by $1.5bn to $4.0bn.
Russell 2000 - Asset Manager/Institutional increase short by $0.7bn to -$6.4bn. Leveraged Funds decrease short by $0.6bn to -$0.9bn. One-year z-score is above two for LF (i.e. contrarian bearish). Total Open Interest is near a 3-year high (95.5%tile). 

Interest Rates (disaggregated data)
CBT US Treasury - Asset Manager/Institutional decrease long by $1.3bn to $19.3bn. Leveraged Funds decrease short by $3.0bn to -$1.4bn. Other reportables (sovereign) net
position is near a 3-year low (1.9%tile), with one year z-score below two.
10-yr T-notes - Asset Manager/Institutional decrease long by $2.6bn to $28.1bn. Leveraged Funds increase short by $0.7bn to -$28.8bn.
2-yr T-notes - Asset Manager/Institutional bought $4.1bn and flipped to a long for the first time since Nov. 3rd, with one-year z-score above two (abnormally bullish sentiments among AI). Leveraged Funds decrease long by $0.9bn to $11.2bn, with one year z-score below two (i.e. abnormally bearish sentiments among LF). 

FX (disaggregated data)
EURO - Asset Manager/Institutional increase short by -$1.4bn to -$2.2bn. Leveraged Funds decrease short by $1.7bn to -$17.3bn.
JPY - Asset Manager/Institutional (AI) decrease short by $0.9bn to -$3.7bn. Net position stays near 3-year low for AI (5.7%tile) and sentiment is on a buy signal (one-year z-score rallying from the Nov. 3rd low). Leveraged Funds decrease short by $2.7bn to -$5.7bn.
AUD – Asset Manager/Institutional decrease short by $0.2bn to -$1.9bn. Leveraged Funds bought $1.2bn and flipped to a net long for the first time since Oct. 2014; z-score is above two (contrarian bearish). Meanwhile, net positon for Other Reportables -(sovereign) remains near 3-year low (6.4%tile)." - source Bank of America Merrill Lynch

Whereas Asset Managers and Leveraged Funds agree on the Russell 2000 short position, which is of no surprise given its correlation with High Yield, what seems to us very interesting is the significant positioning of the Leverage community in being short 10 year T-Notes to the tune of -$28.8bn as per the chart below from Bank of America Merrill Lynch's report:

 - source Bank of America Merrill Lynch

Given the recent US Q3 GDP print at 2% (well below 3.9% growth in Q2) and given the current high level of inventories we highlighted recently in our conversation "Cinderella's golden carriage", it seems to us that US GDP is weaker than expected and is going to be "weaker for longer". On a side note, we have increased our US long duration exposure for this very reason. As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."

From a "risk-reversal" perspective, we think, the current sizable "short positioning" from the "Leveraged crowd", offers a good contrarian punt, given the "weaker" outlook as of late of the US economy. 

In similar fashion, the "consensus" trade of being "short" the Euro versus the USD, appears to us overly "crowded". In that sense, Steen Jakobsen's CIO of Saxo Bank's call of EURUSD flying towards 1.23 in the latest Outrageous Predictions for 2016  is not that "outrageous" we think, particularly if you factor in that for the 12 months to October, the cumulated current account surplus represented 2.9% of eurozone gross domestic product, compared with 2.4% for the 12 months to October 2014. The latest October figure for the current account surplus came at €19.8bn, which is €9bn more than at the same period in October 2014 (€10.8bn).

Here is below the significant positioning of the Leverage community in being short EUR/USD to the tune of -$17.3bn as per the chart below from Bank of America Merrill Lynch's report:

 - source Bank of America Merrill Lynch

It certainly looks crowded to us, and are the shadows of things that have been, given that as of late,  Le Chiffre aka Mario Draghi, hasn't been on his best "bluffing/betting" behavior.

When it comes to Emerging Markets woes which have been well commented by all the usual suspects, when it comes to our prognosis for 2016, we think that there is indeed more pain to come rather than to expect a "relief rally" from an "outrageous prediction" perspective. Our "reverse osmosis" macro theory we touched on again recently is still playing out. This brings us to our second point.

• The EM 2016 outlook - its weaker than you think

While the "commodity rout" is well documented, we think that in 2016, we will the materialization of defaults and restructuring in the EM world given the exposure of the banking sector in these countries to the sector. In relation to this exposure, we would like to point out to a Bank of America Merrill Lynch report published on the 16th of October and entitled "China spillovers and the leverage channel":

"The commodity channelCommodity exporters – Malaysia, Thailand and Indonesia (see Chart 2) – have been disproportionately impacted, largely as commodity prices slump on weaker demand, as China rebalances away from investment-driven growth. 

Casualties include coal, base metals (iron and copper) and palm oil. Coal prices, for instance, have fallen some 62% since January 2011. Falling commodity exports hurt the current account balance, fiscal revenue and also the wages of lower income, rural households.
Lower export revenues and the declining terms of trade have weighed on the growth of commodity exporters. Indonesia’s GDP growth is at its weakest since the Global Financial Crisis, at +4.7%. Infrastructure spending is failing to offset slumping commodity exports so far, given the slow progress. Malaysia's GDP growth will likely slow markedly in the second half of the year, as slowing exports spill over to weaker consumer and investment spending.
The IMF highlighted in its latest October WEO report that the weaker outlook for commodity prices implies that the annual growth in output for net commodity exporters will decline further, by almost 1% point, in 2015–17 compared with 2012–14. The reduction in growth for energy exporters is projected to be larger, at about 2.25ppt over the same period.

 

The leverage channelConcerns over financial system vulnerabilities have risen, given the commodity downcycle and the sharp depreciation of currencies in emerging economies, particularly commodity exporters. The latter has implications for foreign-denominated debt. Economies with high foreign currency borrowings and high exposure to commodities are particularly at risk of loan defaults and banking system losses.

We identify loan exposures to the commodity sector, defined as loans extended to the agriculture, forestry & fishing, and mining & quarrying segments. Singapore (9.2% of GDP), India (7.2%), Malaysia (3.7%) and Indonesia (3.4%) have the largest share of bank loans to the commodity sector, as a proportion of nominal GDP (see Chart 3).

As a share of total corporate debt, Thailand and Indonesia rank highest, with about 31% and 30% of corporate debt borrowed by commodity producers. China (26% of total), India (26%) and Malaysia (18%) also have relatively sizeable amounts of debt borrowed by energy and metals & mining companies (see Chart 4). This is worrying and may have profound implications on financial stability, as commodity demand and prices remain under pressure. Based on IMF data, ASEAN countries Indonesia (52% of total corporate debt), the Philippines (28%), Malaysia (18%) and Thailand (16.5%) have the largest share of foreign-currency non-financial corporate debt out of total company borrowings in Emerging Asia.

Our Asia Pacific financials team recently highlighted that Hong Kong banks would be the most directly impacted by a China hard-landing. Many Chinese firms borrow funds offshore in Hong Kong and firms in Hong Kong are also reliant on cross-border businesses (tourism, trade, shipping, etc.). Among banks in the rest of Asia, Singapore banks DBS and OCBC have the largest loan book exposure to HK/China, accounting for 36% and 26% of total loans, respectively. The exposure of UOB, Taiwanese financials, Public Bank in Malaysia, and Australian banks are generally much smaller, in the 4% to13% range. Banks in other markets have insignificant exposure, but could be indirectly impacted by any slowdown in their domestic economies. 

Defaults and restructuring of commodity-related firms may be early indicators of potential financial stress for banks. High gearing and foreign currency-denominated debt appear to be a characteristic of commodity producers and trading companies. Commodities are priced in US dollars and are, therefore, hedged, goes one argument. Exploration and mining often require heavy capital investment and, hence, large-financing requirements. Commodity trading companies are also highly geared by their very nature. The China contagion may be far from being over, as the financial stress on commodity and debt-laden firms starts testing banks." - source Bank of America Merrill Lynch.

The path of normalization of the Fed has continued to exert additional pressure on already strained EMs thanks to Global Tightening Financial Conditions triggered by the US Dollar "margin call" thanks to the tapering of the Fed and now with the latest small increase in rates.

When it comes to the Fed's hiking cycle, the Fed is not only hiking in an environment of slowing earnings in the US, it is also hiking in an environment where Asian growth is slowing as displayed by Deutsche Bank in the below chart from their report from the 17th of December entitled "Asia Macro in a non-zero world":

"Business cycles in the region are in much weaker shape, with growth slowing – not accelerating – into this Fed hike (Chart above). Export growth has been printing in negative territory across Asia, a far cry from the double-digit growth seen when the Fed last raised rates (2004). Asian central banks will not be able to keep up with even a gradual Fed this time, and front-end rate differentials will narrow. The only central bank we think could hike rates is the Philippines. Elsewhere, rates in China, Taiwan, Korea, and Thailand could be very close to, or even below, US rates by end-2016. The market appears underpriced for this divergence." - source Deutsche Bank

Furthermore, when it comes to EMs' growth, this time it's different as their growth have been much tepid as of late. On the subject of the outlook for EMs, we read with interest LCM's take from their Cross Asset Weekly Report from the 15th of December entitled "Themes for 2016":

"EM: How Will It End?This is a good transition for our second point: the EM situation. We wonder how it could end because we do not see any positive outcome for them. In the developed world, the most flexible economies that have enjoyed the highest accommodative financial conditions of history have needed several years to recover after the US centric financial crisis. How long will need an EM country under
financial repression to recover from an EM centric financial and economic crisis? We do not know precisely but we suspect much longer than the US.
The chart below gives an indication of the negative pressure on the whole EM universe. If we exclude the global crisis of 2009, never before so many EM countries have failed to generate an economic growth rate above 3-4%. 

High economic growth is becoming scarce for these countries so clearly, we can talk about a new paradigm for them. On the right, the chart shows that a consequence of that lower growth is a higher accumulation of the public debt, leading to a rise of the Debt/GDP ratio towards its 90’s level. The current crisis seems deeper than the 97/98 crisis which was initiated by a financial crisis. 

This time, it is not a financial crisis that triggers the economic crisis but an endogenous economic crisis that arises following excess investment in assets that turned unproductive (real estate and manufacturing for China and commodity-related sectors for LatAm, the Middle East and Russia). This is a big difference. This economic crisis is not the result of a fundamental financial vulnerability that would have been exploited by investors. There has been no US$ interest rates shock, no speculative attacks on countries. The weakness comes from the real economy and the depreciation of the currency is the consequence of that weakness, not the cause. 

We show with the following chart the Budget balance for 2015 of selected EM countries and their short term cost of funding (5-year sovereign bond yield). There is a clear discrimination: Brazil suffers unaffordable rates whilst Chile and Peru, its neighbours that are also affected by weaker growth, maintain access to global markets. 

On the right, we see that the Government bond yields of Brazil and Russia have reached very high levels. Contrary to Turkey, these countries are already in recession making the situation desperate. The financial system is under great pressure, NPLs are on the rise, the risk for them of running out of a US$ financing is a reality. Equity valuation is therefore intriguing as Brazilian banks trade at 0.7 times their book value and Russian banks at 1.0 times their book value. In other words, this does not look to be a capitulation phase. The situation is critical but investors have not thrown in the towel and this is why in our opinion the downside for the most fragile EM equities is intact.

The underweight position on EM assets is supposedly consensual but as we discussed in our weekly note #115 “Story Positioning”, we do not believe this lie. PMs are not underweight EM assets because they cannot short an oversold asset; it is inconceivable for them.
This negative trend is therefore intact because the investor participation rate is very low. The EM currencies are depreciating because of two events: 1) the US dollar rise with the expectations of higher real rates and 2) because of financial outflows resulting from a deterioration of the EM external position and a loss of investor confidence. 

 - source LCM, Bloomberg

The new story among EM countries is the weakness of the rich Middle East countries. Their economic disarray looks like 1998 as they return to deficit in terms of budget balance and current account position. It is clear that they can afford it after having benefited for several years from the oil rent but as is often the case, the deterioration is faster and stronger than the improvement. The currency peg of these countries may be tested. We should therefore keep an eye on this region because being anchored to the winner when you are a loser is of limited interest. 

The consequences of the reduced amount of petrodollars flooding to developed and emerging markets are unknown but in the EM case it helps to further reinforce the vicious circle they suffer. The later, slower and weaker recovery scenario that we mention is obvious and this is why on financial markets investors should not expect too much from EM assets.

The accumulation of debt adds another challenge to EM countries that could act as an accelerating factor for the economic crisis. Within the EM world we continue to distinguish three groups: 1) commodity exporting countries 2) China and 3) the rest (mainly EM Asia ex-China). This EM crisis started with the first group as the decline of commodity prices quickly revealed their intrinsic weaknesses. Now it is moving to Asia and because there remain many unanswered questions, it should be a recurring topic for 2016.
For markets, this change of focus from LatAM/Russia to China does not mean that the situation is fixed but that it is extending. This is the problem and this is why 2016 could be another bad year for EM assets. The corporate bond defaults remain limited, the help of the IMF has not been required, so we have not as yet seen the classic indicators of capitulation that increases the reward/risk ratio of being contrarian." - source LCM, Cross Asset Weekly Report, 15th of December 2015.

While these are the shadows of things that have been in 2015, we have to agree, with LCM. We do not think we have yet reach the "capitulation" point that would make the asset class an "enticing" investment proposal.

In terms of "enticing" proposal, we would like to end up on a more "positive" note in our final point of our conversation, with the "attractiveness of the Japanese tourism sector.

• Final chart - Short Hong-Kong? Go long Japan "tourism"

We think that the Hong-Kong woes which we have again highlighted in our conversation "Cinderella's golden carriage" have greatly benefited Japan and will continue to do so in 2016. This has been furthemore highlighted by the WSJ in their article from the 17th of December entitled "Hong Kong Retailers Lost in Currency Translation":

"Retail goods in Tokyo are on average 34% cheaper than in Hong-Kong. Hong Kong retailers lost in currency translation as Chinese shoppers turn to Japan amid cheaper prices and yen." - source The Wall Street Journal

Given Japan has been the big beneficiary as highlighted in our previous conversations when looking at air travel surge towards Japan from China mainland, it makes sense we think, to continue to play this theme in 2016. On that note we read with interest Société Générale's Best Trade Ideas for December and January and would like to point out to additional points made in their research note on the subject of Japanese tourism:

"Japanese tourism is a long-term theme and its development is a pillar of Abe’s growth strategy. The government objective of reaching 20m visitors by 2020 is within reach. 

Consumer demand, a tailwind for Asian equities. Tourism expansion in Japan results from a combination of factors, including a weaker yen and government policy encouraging foreign visitors flows (for instance through easing visa deliveries). Rising wages and robust Asian consumer demand is another key element. In the past three years, the bulk of Japan’s tourism growth is attributable to Asian visitors. 

Exposure to tourism through SG Japan Tourist Basket. The basket, launched in March 2015, has been constructed along liquidity and diversification constraints. Sectors represented in the basket include transportation, appliances (30%) and retail trade (25%). Given the liquidity constraints, the basket consists of a combination or “pure” and “less pure” players, with a significant overall flavour of outbound travel.

- source Société Générale

When it comes to Honk-Kong's retail woes thanks to its US dollar peg, Japan is indeed the prime beneficiary, particularly when one notices that luxury watches exports from Switzerland to Hong-Kong have fallen by 28% according to Bloomberg.

In relation to Hong-Kong's currency peg, we are left wondering if indeed the fall in "luxury watches" is not indicating that "time" is running out? Is our prediction for 2016 so "outrageous"? We will soon find out...

"Every adversity, every failure, every heartache carries with it the seed of an equal or greater benefit." - Napoleon Hill, American writer

Stay tuned!