Macro and Credit - Empire Days

"No one is free who has not obtained the empire of himself." - Pythagoras

Looking at the misery inflicted to battered German banking giant Deutsche Banks, emerging art getting trounced and the collectible car markets getting frothy (as we predicted back in July in our conversation "Who's Afraid of the Noise of Art?") , with luxury watches sales continuing to be under pressure in Asia, in conjunction with sabers rattling in the unresolved Syria situation and a tense election period in the United States with nationalist pressure on the rise globally, we reminded ourselves of this week title analogy of cold wave French-British group The Opposition's 1985 best album Empire Days. More and more we are convinced than the "statu quo" is failing and as we pointed out in our November 2014 "Chekhov's gun" the 30's model could be the outcome:

"Our take on QE in Europe can be summarized as follows: 

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014

It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "statu quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us.

On a side note, while discussing the US elections outcome with some friends and there "Optimism bias" we reminded them our take on the subject around the time of the Brexit results and our contrarian stance which was indeed prescient:

"While assisting in Paris to the "Brexit conference" set up by our friends at Saxo Bank, one of the members of the audience during the Q&A session pointed out the "accuracy" of the bookmakers for the remain to "prevail". We could not resist but intervene to rebuke that statement by using as an illustration how bookmakers got it so wrong when offering 5000/1 odds at the beginning of the season for FC Leicester to clinch the British football Premier League and still having the odds at 500/1 around October. The biggest liabilities for the bookmakers were accrued at around 100-1 to 500-1. To quote Mike Tyson: "Everyone has a plan 'till they get punched in the mouth". Since that "FC Leicester punch" the longest odds that can now be placed on any event will be 1,000-1 to ensure that the betting company Ladbrokes is less exposed in future to 'black swan' events. We reminded also the Saxo crowd the Nash equilibrium concept, us playing on this occasion the "Devil's advocate". In fact not a single time did the bookmakers anticipated a victory for "Brexit" yet another display of the "Optimism bias"" - source Macronomics, June 2016

To that effect we argued with our friends about how irrelevant the results of the first television confrontation between Hilary Clinton and Donald Trump were and how low were their predictive nature when it comes to finding out about the potential "outcome" of the upcoming US elections. Therefore, given we like to put our money where our mouth is and our  long standing contrarian stance, we decided this time around to place a "friendly" bet with our friends as we argued that Donald Trump has a much higher probability of getting elected (in similar fashion to the "Brexit" base case) as the Mainstream Media (MSM) would like to "spin it". To that effect we bet on a nice bottle of wine for the winner, two friends deciding to take us on so that it's a nice 2 versus 1 situation for the time being.

But, when it comes to our analogy and this week's conversation, whereas everyone and their dog are focusing on Deutsche Bank, we would like to steer our attention to what lies beneath, namely, a dollar squeeze of epic proportion as we mused in our conversation "Singin' in the Rain" back in 2013:

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

It might be that indeed "Deutsche Bank is one of these "big whales" turning belly up, there are indeed increasing signs in Asia and Europe that point to caution given Euro/dollar 3-month FX basis swap widest in 4 years on Deutsche Bank's troubles (-62 basis points). There is something nasty lurking we think. In similar fashion to 2011, regardless of the liquidity provided by the ECB, a widening of Euro/dollar basis swap should always be taken seriously.

Synopsis:

• Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity
• Macro and Credit  - Loan growth under NIRP - The case of Japan
• Final chart: Market’s growing dependence on central bank stimulus means more 
  prone to “corrections”

• Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity

Back in 2011, increasing bank stress during the summer led not only to a widening of credit spreads but as well to a significant widening of Euro/dollar FX basis swap. To that effect, dollar illiquidity was manifesting itself in the FX basis swap market as well as in the CDS space with the European financial sector credit spreads significantly widening until the launched at the end of 2011 of LTROs by the ECB which was followed by the establishment of swap lines between the Fed and the ECB. Many pundits are pointing towards the upcoming reform for Money Market funds in the US as the prime culprit for this impressive spike in the Euro/dollar FX basis swap market. We think there is more to it as per our 2013 worries. As shown by the BIS in its latest quarterly report released this month, "ultra-loose monetary policies" have increased global dollar shortage. The "crowding out" effect from lower yielding Euro denominated assets is pushing investors towards the US dollar in drove such as Japanese Life Insurers as we have shown in various musings. Also we argued in our July conversation "Eternal Sunshine of the Spotless Mind" that Bondzilla, the NIRP monster is more and more "made in Japan" as for Japanese Lifers, US assets remain preferred. Therefore there is a potential "crowding-out" effect we are seeing with rising yields in Europe with an acceleration of their allocation towards the US meaning effectively additional demand for US denominated assets and rising costs for hedging FX exposure. Remember you need to follow "Japanese flows" as they matter a lot.

So when it comes to Deutsche Banks woes and the attention it is garnering, to paraphrase our Rcube friends, when everyone is thinking alike, no one is really thinking. As a reminder, under the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity. When it comes to quantity, the surge of the significant Euro/dollar FX basis swap market is displaying in earnest, a dollar shortage. 

"When a wise man points at the moon the imbecile examines the finger." - Confucius

To that effect, rather to continue musing on European banking woes, deleveraging and "Japanification" this week given we have long been touching on these issues in numerous conversations, to paraphrase Confucius, we would rather steer you towards the moon, namely issues brewing in Asia in general and China in particular. As of late was as caught our interest is the acceleration of ebt-equity-swaps (DES) and defaults in China as reported by Nomura in their note from the 20th of September entitled "Both DES and defaults likely accelerated":

"According to local media today (Caixin, 20 September), the first debt-equity swap (DES) in this round (vs the c.RMB400bn DES in 99s) has been approved, in which half of Sino Steel’s RMB60bn debt could be converted into a six-year convertible bond (ie, c.RMB30bn), while the other half remains debt at a relatively low interest rate, likely at a discount vs the one-year benchmark loan rate of 4.35% pa. For the c.RMB30bn CB, according to the same news article, the first three years would see no conversion, and the conversion would come in the fourth year at the pace of 30/30/40% until the sixth year. 

Meanwhile, Guangxi Non-Ferrous Metals announced its bankruptcy per court release on 19 September, being the first on China’s interbank bond market. On the same day, Dongbei Special Steel also announced a potential default due 24 September, the latest warning after a series of bond defaults. 

The DES ratio reportedly is up to the cash flow coverage of relevant debt, thus it varies for different banks 

Sino Steel has faced default risks since 2014 and the regulators called a meeting to resolve the company’s debt issue, which was chaired by BOC as per the news article above. The debt restructuring plan was finalised early this year, and now reportedly the DES has been approved for implementation. 

Despite an overall c.50% DES ratio for the entire debt of RMB60bn for the Sino Steel group and its subsidiaries, this swap ratio varies according to individual banks, given that cash flow coverage over individual banks’ debt exposure differs, per the media coverage. It seems that loans well covered by collateral and/or cash flow of projects would remain as debt, and it is those loans primarily on credit or guarantee and not covered by cash flow that might be swapped into CB. Capital injections from SASAC were also expected in future, according to the media coverage. 

If the reports are accurate, DES through CB puts less pressure on banks’ capital and they could avoid material write-downs upfront; though debt burden remains in short-to-medium term 

DES triggers concerns over banks’ capital pressure, given that equity investments carry 400-1,250% risk weight vs 100% of loans (see DES: Trade-off between capital and provision, 6 April), and the swap through CB could likely alleviate banks’ capital pressure in the short to medium term, although in the long term capital pressure remains if such investments cannot be disposed of in a timely manner. 

Meanwhile, direct DES of potential bad debt requires either a bailout (like the DES in 1999-2003, Fig. 1) or material write-downs upfront.

Since a bailout for DES has been ruled out this time (Re-rating may start as defaults accelerate, 21 July), banks conducting DES may face material write-downs upfront if the loans convert into equity directly. DES through CB could have given banks more time vs direct swap into equity, and thus could facilitate progress.
For a company involved in DES, however, debt burden likely remains before equity conversion, and when conversion starts, it seems to be selective (eg, just the credit/guaranteed loans, with no underlying cash flow for Sino Steel). 

Reiterate our estimate of limited-scale DES this round 

With a full government bailout, the last round of DES digested c.RMB400bn in NPLs (non-performing loans) from banks, equivalent to c.30% of RMB1.4trn NPLs sold to AMCs (asset management companies) at par value. This time around, we see no government bailout, which makes DES a less attractive option both for banks and for companies, in our view. DES through CB may increase the feasibility of the swap, but long-term capital pressure remains for banks and debt burden remains for companies in the short to medium-term, as analysed above. We reiterate our view that DES is one of the options for NPL digestion in this credit cycle, but it is unlikely to be a primary tool for banks, compared with measures of cash collection, write-offs and sales to AMCs. 

Bond defaults expected to accelerate 

Compared to bank loans, the bond market is seeing a normalisation of risks, with this first bankruptcy case coming through on the interbank bond market today. We still see c.RMB50bn bonds on the watch list, all of which are bonds that have announced defaults but are still trying to work out repayment plans to avoid ultimate defaults, including Dongbei Special Steel as mentioned above. We believe that defaults are positive for the risk normalisation in the bond market, which we hope could lead to better risk pricing and higher liquidity efficiency. 

We see a change in the landscape, though we are cautious, with volatilities likely coming through as well 

As banks turn risk-off in 2Q16, DES were launched to start addressing the SOE debt issue (and may be a prelude to other more marketised deleveraging measures in future), as well as risk normalising on the bond market, we see the landscape change discussed in our 2016 outlook (see Changing the playbook in 2016, 2 November 2015) happening. However, fundamental volatilities may come together in this structural change, and we recommend booking profits on vulnerable banks, like mid-caps. In comparison, ICBC (1398 HK, Buy) remains our top pick, given its tighter risk control and stronger loss-absorbing capacity with decent capital ratios (12.5% CET1 by 1H16). CCB (939 HK, Buy) is the other fundamental pick, for similar reasons (13.0% CET1 by 1H16)." - source Nomura

Whereas prompt restructuring is a welcome feature when dealing with nonperforming loans (NPLs), as posited by Nomura, long term capital pressures will remain. Furthermore, the significant surge in Chinese property prices leading to many pundits talking about a large bubble, means that China needs no doubt to rein in credit growth at the time where credit continues to outpace nominal GDP growth!

Yet in another important report published as well by Nomura, it shows that all isn't that quiet on the Eastern front for some countries. in their September special report entitled "The party is getting crazier – stay close to the door":

"China is borrowing growth from the future 

1. China needs to adjust to the new normal of a persistent slowing in potential growth, as the working population shrinks and the low-hanging productivity gains diminish.
2. China has reached the point where the rubber hits the road: The problems of overcapacity, over-leverage and keeping zombie companies afloat have become so large that they are bearing down on growth via falling returns on capital and rising debt-servicing costs. Leaving it so late, rebalancing away from investment is being forced upon China, and is fraught with risks.

1. Rebalancing and restructuring is likely to hurt growth in the short run, including negative spillover effects on consumption and services. Unsurprisingly, the hardest supply-side reforms – restructuring SOEs, deleveraging and banks properly pricing credit risk – have been left to last. Monetary and fiscal stimulus can buy some time, but they are losing efficacy and can fuel bubbles.

1. For new engines of growth, the economy must be opened up to market forces, but as China is discovering, this is hard at the best of times, let alone when economic fundamentals are weak. History in EM shows that financial liberalisation often precedes credit crunches, banking crises and capital flight.

• We find it striking that the distribution of the latest 2017 growth forecasts display no fattening tail risk of hard landing (i.e., exactly 50% of forecasts are below the median).

• The downside risks to our growth forecasts of 6.5% in 2016 6.1% in 2017 and 5.5% in 2018 include a mass exodus of capital by Chinese residents and snowballing corporate defaults. Upside risks are mega policy stimulus (but this risks creating bigger bubbles) or window-dressing reported GDP (ultimately undermining policy credibility and the chance of policy mistakes).

Four reasons not to overburden monetary policy

1.  Easing monetary policy risks inciting even stronger capital outflows.
2. Aggressive monetary easing risks creating even bigger financial imbalances, since debt and asset prices are interest-rate sensitive. The inflation-adjusted bank deposit rate is near zero.
3. Monetary policy is a blunt instrument affecting the overall economy; it can be less useful when the economy’s performance is more uneven. In 2014, only one of China’s 31 provinces had sub-3% nominal GDP growth; in 2015, eight did, with a total population of 304mn. Also, China’s large manufacturers had a PMI reading of 51.8 in August 2016, compared with 47.4 for small manufacturers.
4. It may be wise to save some interest rate ammo to ease the pain of eventual deleveraging." - source Nomura

One might wonder if indeed it is a case of "Big Trouble in Little China" or "Small Trouble in Big China" but we ramble again. Of course while everyone is focusing on Deutsche Bank, we would like to point out to Nomura's very valid points regarding a potential credit crunch unfolding in Asia at some point from their very interesting special report:

"There is a high risk of a credit crunch in Asia

• The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can activate financial decelerator effects.

• Cheap credit has weakened productivity by misallocating capital (e.g., property speculation), reducing pressure for supply-side reforms and kept zombie companies alive. Potential growth is slowing across most of Asia. 

• Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.

• Potential triggers: faster than expected Fed rate hikes; sharp USD appreciation; large RMB devaluation; a major EM corporate default prompting global asset managers to pull out from the region en masse, causing market liquidity to evaporate; inflation shock in Asia; politics.

- source Nomura

Of course, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring. As a follow up on our HKD take from our  December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. While we 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 back in December last year,we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. maybe it will be for 2017 after all. As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far have not been able to gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals. For a short strategy to succeed, it is much better to hunt as a pack than to be a lone wolf or at least to cry wolf on a specific situation. When it comes to the fate of the HKD peg, Nomura has been solacing again our concerns in their note:

"HK stuck between a rock (Fed hikes) and a hard place (ebbing China)

• Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 109% (the recent correction is reversing), and the ratio of private non-financial credit to GDP has surged to 278%.

• The real effective exchange rate has risen 21% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015, and is no longer a larger buffer to net capital outflows.

• Foreign assets and liabilities have surged since 2008. This leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.

• Economic hardship could ignite further political and social unrest, or vice versa, ahead of the selection of a new chief executive in March 2017. We would not rule out rising pressures on the HKD peg regime.

HKD re-pegged to the RMB? The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed were to accelerate hiking and China’s growth keep slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura.

Back in September 2015 in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.

It remains to be seen, if the recent spike in Hibor rates will not once more put yet again some end of the year additional pressure on the currency peg. We might have been early but, after all, we might not be wrong eventually. We will of course continue to monitor this interesting trend rest assured. End of the day currency pegs like "empires" are not eternal as a reminder:

- source Société Générale

When it comes to Asia, while Japan has been at the forefront of Quantitative Easing for many years, they recently joined the NIRP club in early 2016 on the footsteps of the ECB, in our next point we will look at the impact the policy has had on loan growth and what it entails.

• Macro and Credit  - Loan growth under NIRP - The case of Japan

While we have long been indicating that QEs and NIRP in no way on their own were sufficient enough to trigger a material change in "credit impulse" which would therefore entail a significant change in real economic growth, we find that Japan's recent experiment with NIRP in the footsteps of the ECB is as well a confirmation of the broken credit transmission which has plagued Southern Europe in recent years thanks to bloated banks balanced sheets and the insufficient rapidity with which these NPLs were addressed in both instance but has as well impacted the Japanese economy.

On this particular subject of loan growth under NIRP, we have read with interest yet another note from Nomura from the 17th of September entitled "Loan growth has not changed materially in

real terms":

"The BOJ expects its negative rates policy to boost borrowing by companies and households as loan rates fall, spurring capital investment and housing investment. In this report, we examine changes in loan balances since the negative rates policy was introduced, trends in loan rates, changes in loan demand by companies and households, and changes in financial institutions’ lending stance.We found that growth in bank lending seems to be falling. However, this was largely due to changes in currency exchange rates (stronger JPY reduces the amount of foreign currency lending in nominal terms), while actual lending growth is almost unchanged. Financial institutions appear to have become more aggressive in lending, but corporate loan demand has not changed much, and the increase in loan demand from households was largely attributable to refinancing, with few signs of accelerated loan growth.

Implications and points to watch for in comprehensive assessment 

As noted above, loan rates have fallen since the BOJ adopted negative policy rates, but loan growth has not picked up, which suggests that BOJ policy has only a limited impact on the real economy.
The BOJ cites an increase in the issuance of super-long corporate bonds and subordinated loans as a result of its adoption of negative policy rates, but we believe this has had only a limited impact on the economy overall. The BOJ should also look at the impact that a stronger stock market and weaker JPY could have on the economy.
The BOJ’s main concern has been a deterioration of the financial intermediary function, which could occur if banks tighten their lending (i.e., extending fewer loans, raising loan rates) as loan margins narrow. This has not yet been the case.
The BOJ should quantitatively assess the negative impact of its policy on financial institution earnings and their net capital, and determine how much policy rates can fall before destabilizing the financial system." - source Nomura

As loan margins will continue to narrow, there is a heightened risk that banks could decide to extend fewer loan due to lack of demand or poor profitability, in effect triggering a credit crunch in a context where there is subdued demand for credit overall. This is as well highlighted in Nomura's report:

"According to a survey on major loan trends, loan demand was unchanged for companies (5 in June from 7 in December) and rose sharply for households (9 in June from 0 in December). However, lending to households may have included substantial refinancing demand.
In fact, the key factor cited by financial institutions in explaining the increase in individuals’ demand for capital is the drop in loan rates, not growing housing investment and higher personal spending. Moreover, we believe slow growth in corporate lending likely reflects weak loan demand in the corporate sector, and not so much financial institutions’ stance on lending. " - source Nomura

Weak loan demand means that at the Zero Lower Bound (ZLB) and now NIRP, there is very little monetary policies can do. Now that we have a case of broken monetary transmission to the real economy, there is very little in that context for additional unconventional policies from the Bank of Japan to work their magic on the real economy.

We have already touched on this subject in April in our long conversation "Shrugging Atlas" where we discussed Japan and the kite string theory:

"That is the very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016

We keep hammering this but it seems to us that central banks do not understand clearly the difference between stock and flows. Aggregate Demand (AD) as well as "credit growth" are flow variables, NPLs are stock issues. That simple. Despite aggressive monetary policy easing, the ability of central banks to boost bank lending and hence economic growth is been limited at the ZLB or NIRP level. The basic problem, both with monetary expansion and NIRP, is that the primary transmission channel is via the commercial banks, and that channel has, for a variety of reasons, is broken as we have pointed out in numerous conversations.

Maybe "The Cult of the Supreme Beings" aka central bankers should Bank of America Merrill Lynch's recent primer entitled "How European Banks work" from the 26th of September to fully grasp the stupidity of NIRP in a difficult deleveraging environment akin to adding fuel to the fire they have set up:

"Bank profits leveraged to economic cycle 

Bank profits are naturally leveraged to the economic cycle. Net interest income accounts for c.50% of bank revenues. Increasing this revenue generally involves growing the loan book, which relies on a combination of economic growth and product penetration. Fee revenue also depends on economic activity. On the other hand, economic downturns cause banks to increase provisions for credit losses.

Summary

• Credit risk has a pro-cyclical effect on profits. Credit losses are higher ineconomic downturns
• Credit provisions cumulate on the balance sheet as a negative asset and reduceboth shareholders’ equity and regulatory capital

Banks lend money on the expectation that the full amount is paid back. However, borrowers cannot always pay back all of the money they have borrowed, nor can they always meet their monthly loan costs.
Payment difficulties typically increase during times of economic stress: Individuals may lose their jobs, see a sharp fall in incomes and not be able to cover their repayments. Companies may find reduced demand for their products, affecting revenues and their debt obligations.
Banks are exposed to potential losses, as they may not get back the full amount they initially lent. Once a borrower misses a payment they are said to be “in arrears”. Once they are 90 days behind, the outstanding portion becomes a non-performing loan, (NPL).
Banks must set aside provisions for such losses. These provisions can be large and reduce profits, equity and regulatory capital. While critical to a bank’s health, such provisions are a non-cash item. This undermines the usefulness of cash flow statements for banks.
Loan growth and revenues are linked to the economic cycle. Credit losses are also linked to the cycle. Bank profits can therefore be highly cyclical. 

• Credit risk has a pro-cyclical effect on profits. Credit losses are higher in economic downturns
• Credit provisions cumulate on the balance sheet as a negative asset and reduce both shareholders’ equity and regulatory capital

- source Bank of America Merrill Lynch

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings. And, to say the least, one thing for sure, NIRP marks the end of Banking Empire Days rest assured. Also like we posited before, the problems facing Europe and Japan are more acute than in the United States because they are driven by a demographic not financial cycle. So, when it comes to low loan growth under NIRP, in the case of Japan, thanks to unfavorable demography, it marks we think the end of the "Empire Days" and the sun is setting, not rising.

Finally, as we have been commenting as well on various occasion, central banks meddling with asset prices is not only pushing cross-asset correlations higher but it is as well brewing instability and triggering more significant large standard deviation movements overall.

• Final chart: Market’s growing dependence on central bank stimulus means more prone to “corrections”

While we have shown in various conversations the instability created by "The Cult of the Supreme Beings" aka central bankers thanks to rising correlations, the impact can be seen in our final chart coming from Bank of America Merrill Lynch's The European Credit Strategist note from the 20th of September entitled "QE’s merry-go-round" from the 20th of September which displays the number of 4 plus SD (Standard Deviations) movements across markets over time:

“Corrections” par for the course 

"More broadly, because of the market’s growing dependence on central bank stimulus, we think assets are generally becoming more prone to “corrections”. Chart 1 highlights our Correction Counter: the number of 4 SD moves registered across markets over time. Brexit (June ’16) and China (August ’15) were clearly powerful events that drove market reversals. Yet, we think chart 1 also shows a general rise in the number of “corrections” since mid-2014 – interestingly, a time when the ECB first embraced negative rates." - source Bank of America Merrill Lynch

So there you go, what is indeed NIRP accelerating is the end of the statu quo and end of the low volatility regime which will of course end many "Empires" including banking Empires we think but, that's a story for another day...

"All enterprises that are entered into with indiscreet zeal may be pursued with great vigor at first, but are sure to collapse in the end." - Tacitus

Stay tuned!

Macro and Credit - Broken Arrow

"The seed of revolution is repression." - Woodrow Wilson, American president

While watching with interest unfolding our cross-asset correlation fears with equities, bonds, gold, oil and the lot getting the proverbial "sucker punches" thanks to VaR (Value at Risk) shocks and given Japan's on-going economic predicaments, we reminded ourselves the military code meaning of "Broken Arrow" when selecting this week's title analogy. "Broken Arrow" is a US military code phrase used at the last resort when a ground unit is facing imminent destruction from enemy attack and therefore needs all available air forces assets within range are to provide air support immediately. During the Battle of Ia Drang in Vietnam that took place on November 14–15 1965, as the battle along the southern line intensified, Lieutenant Charlie W. Hastings (USAF liaison forward air controller) was instructed by Lieutenant Colonel Hal Moore of the 7th Cavalry, (based on criteria established by the USAF) to transmit the code phrase "Broken Arrow", which relayed that an American combat unit was in danger of being overrun. When we look at the vicious rise in volatility, which is at the core of any allocation process, which we discussed in our previous conversation and what it entails for Risk Parity Strategies, Vol Control products and balanced funds getting "unbalanced", we do share the same concerns from various pundits such as Mark Spitznagel that, if indeed the Fed decides to "surprise" the market with a rate hike, things could indeed turn "south" very rapidly given that as our quote goes the seed of revolution is in our case "volatility" repression thanks for the actions of "The Cult of the Supreme Beings" aka central bankers. As we re-iterated in our previous rambling, "cash" is a "strategy" and given the potential risks that lies ahead (think Italy and more...), we think that rather than calling for a "Broken Arrow" to defend your positions from being "overrun" due to "herd mentality" and rapid deleveraging, you would be very wise to increase your cash levels accordingly in the current environment. While you might be at the mercy from yet another dovish Fed which would indeed be a catalyst for maybe yet another melt-up in assets, we do think that from our "credit perspective", we are indeed in the last innings of this credit cycle and we would stick with "Smart Alpha" (High Quality Investment Grade) rather than going for "Dumb Beta" (High Yield and High Dividends stocks) at this stage.

In this week's conversation we would like to look again at the dangerous paradigm of "repressed volatility" with "lower liquidity" and what it entails from a risk perspective for supposedly "diversified" strategies. We will also look again at "impaired" banking systems in Europe and why we continue to avoid like the plague "European banking stocks" such as Deutsche Bank due to their Investment Banking franchise being "broken" as well as it isn't only NIRP that is damaging their Net Interest Margins (NIM) on the "retail" side.

Synopsis:

• Macro and Credit - The seed of "repricing" is "volatility repression"
• Macro and Credit  - Broken Investment Banking franchises in Europe, time for some players to call it a day.
• Final charts: The business cycle is turning and storm season is coming

• Macro and Credit - The seed of "repricing" is "volatility repression"

While last week we touched on the rising costs in hedging strategies for insurers in conjunction with the "fast deleveraging" risks for some "leveraged" strategies that doesn't mix well with "herd mentality" when everyone is investing the same way in a poor liquidity environment, we think, that when it comes to the risk of being "overrun" and a case for calling for a "Broken Arrow", no matter how repressed volatility has been, it is bound to go higher which, in the current environment will have a significant impact on supposedly "diversification" strategies. When it comes to raising your cash levels, anything worth doing is worth "overdoing" in this central bank manipulated environment we think. When it comes to the new paradigm of low volatility and poor liquidity, we read with interest Bank of America Merrill Lynch's take in their Securitization Weekly Overview from the 9th of September entitled "The poor liquidity-low volatility paradigm":

"The poor liquidity-low volatility paradigm 

Arguably, the post-Brexit collapse in market volatility is the dominant story in financial markets these days. Many market participants, including the BofAML Quantitative Strategy team, think a pickup in volatility in the fall is likely. The Fed, US presidential election, seasonality, and the principal of mean reversion are some of the factors cited by various market participants as reasons for an increase. Stated somewhat simply, the view on historically low volatility seems to be: “this cannot last; it always goes higher.”
While the arguments for higher volatility are compelling, we explore the possibility that low volatility may simply be the central banker offset to the new, post-crisis regulatory regime that has substantially reduced market liquidity, which we measure using the BofAML Liquidity Stress Index. We note that while volatility has declined recently, liquidity stress remains stubbornly high, which should constrain central bank policy tightening.
This has been a consistent theme of ours for years. For example, published almost three years ago, our 2014 Securitized Products Outlook was titled “Regulatory tightening sustains monetary easing.” The argument has been a simple one: the highly restrictive post-crisis regulatory regime is a primary factor contributing to low global growth (we think ageing demographics is the other big factor), which has forced global monetary policy to remain exceptionally accommodative. In turn, this historic accommodation has reduced market volatility to historic lows.
One always has to be extra careful about positing new paradigms, since oftentimes the mere act of offering the characterization usually marks the end of the conditions that define the so-called new paradigm; but we posit it anyway. In our view, what could end the poor liquidity-low volatility paradigm is a sustained shift to less accommodative policies, such as the Fed tried with its December 2015 rate hike; but such a shift could well be catastrophic.
As we now know, the spike in liquidity and financial stress in early 2016 forced the Fed into a multi-month retreat from further tightening talk, while other central banks eased further. Recent statements make it clear the Fed wants to tighten again, even as the market remains dubious: current probabilities of hikes by September or December are 30% and 60%, respectively. We share the market doubts about September, which tells us volatility can remain low. But the Fed’s surprisingly hawkish Jackson Hole rhetoric makes us cautious about our view.
After strong post-Brexit performance across most securitized products, and the risk of a September Fed hike (the BofAML house view is December), we turn neutral on securitized products credit and agency MBS. Given liquidity considerations on the credit side, we don’t like to shift allocations too often. But, in the wake of Jackson Hole, the risk for the near term is too high for our liking, and remaining overweight seems imprudent." - source Bank of America Merrill Lynch

Indeed, being "overweight", for the time being is, we think fraught with danger in the near term and looking at the recent macro data as of late, if indeed, the markets does suffer again from "optimism bias" and the Fed decides to pull the proverbial rugh under investors' feet by hiking, then markets would indeed face a much more nasty reaction than during Brexit.

The "rate hike" risk remains elevated as posited by Bank of America Merrill Lynch's report while their Financial Stress index remain elevated:

"While the arguments in favor of higher volatility are compelling, and an increase over the near term seems likely, as we discuss below, we think the case for low volatility remains in place. We still believe that the combination of ageing demographics and a restrictive post-crisis regulatory regime (which has substantially reduced market liquidity) forces central banks to remain exceptionally accommodative and that it is this reality that keeps volatility at historically low levels. Periods of heightened volatility are indeed possible, as central banks attempt tightening or cease easing, but the past few years have shown them to be relatively short-lived.
If the Fed hikes in September, at least a modest replay of early 2016 market volatility is possible. This may sound like a change from our recent assertion that the probability of a market-disruptive Fed hike is low. It’s not. It would simply be that the low probability scenario is realized. In other words, the assumption of exceptionally accommodative monetary policy would no longer be valid. The shift to neutral on securitized products is an attempt to balance near term uncertainty on the Fed and the longer term constructiveness on securitized products that we have articulated in recent months. 

The poor liquidity – low volatility paradigm: liquidity stress remains elevated 

One possible reason for a September Fed hike is that financial stress has declined substantially in the post-Brexit period. Chart 2 shows the BofAML Global Financial Stress Index (GFSI) dropping over the past two months, through the 30, 40, and 50- week trend lines, to the lowest level in over a year.

The upward trend that started in mid-2014 appears to have reversed, and seemingly gives the Fed room to hike.

But if we consider a sub-index of the GFSI, the Liquidity Stress Index (Chart 3), the picture is less benign. Liquidity stress has declined in the post-Brexit period, but it is still elevated by historical standards.  

For context, the current level of 0.53 was observed in November 2007. As Chart 4 shows, by that time, the Fed had already begun to cut the Fed Funds rate, and was on its way to zero over the next year.

In other words, the current level of liquidity stress triggered massive easing in 2007, not tightening, as the Fed is now discussing.

The Chart 5 comparison of the Liquidity Stress Index (LSI) with the broader GFSI over the past year and a half shows two things:
• First, the current gap between the broad GFSI and the LSI is very high; in other words, although broad financial stress has declined substantially in the post-Brexit period, the decline in liquidity stress is far more modest.
• Second, the gap between liquidity stress and broader financial stress has tended to be closed by a sharp rise in financial stress (GFSI). Consider October 2015, when the GFSI of 0.06 was near the current level of 0.08. Over the next 3+ months, the GFSI rose to a peak of 0.85 and closed the gap to the Liquidity Stress Index. 

The takeaway is straightforward. A September Fed hike could quickly reverse the post-Brexit decline in financial stress and cause a surge to the upside, which in turn could create at least a modest repeat of the market sell-off of late 2015-early 2016. The BofAML Economics team, which is calling for a December hike, has repeatedly stressed that the Fed is risk averse and will be very cautious as it goes about raising rates (see “The Fed’s cacophony of sound”). Based on this characterization, it seems unlikely to us the Fed would risk a replay of another market meltdown. The more prudent path would seem to be to allow liquidity stress to decline further over the next few months and hike in December. Nonetheless, this is the chart that gives us greatest cause for concern, and pushed us to turn to neutral on securitized products. Post-Jackson Hole, a Fed-induced replay of October 2015-February 2016, where the GFSI rises sharply, seems quite possible.

The volatility-liquidity stress connection 

Chart 6 and Chart 7 provide long term views of liquidity stress relative to rate and equity volatility.

The differences between the pre-crisis and post-crisis data struck as noteworthy. Pre-crisis, liquidity stress was generally quite low, while volatility, especially rate volatility, was generally elevated. Post-crisis, liquidity stress is relatively elevated, while both rate and equity volatility have been relatively low. 

We believe elevated liquidity stress is a direct result of the highly restrictive regulatory regime implemented in the wake of the financial crisis (higher capital charges, liquidity ratio tests, proprietary trading restrictions, etc.). We also believe this elevated liquidity stress, or poor market liquidity, constrains the ability of central banks to tighten monetary policy (see our 2014 Securitized Products Outlook, “Regulatory tightening sustains monetary easing” for an earlier discussion).
The reaction to the Fed’s December 2015 rate hike, when liquidity stress was already high (about the exact same level as today) and the GFSI and volatility surged in the subsequent weeks, was a recent example of what happens when the constraint is not recognized by central banks – market meltdown. The Fed’s eventual reaction to that volatility surge – shelving additional tightening plans – highlighted the market feedback loop at work: the liquidity constraint will eventually be acknowledged and volatility will have to be forced lower before tightening talk starts again. The coincident surges in both liquidity stress and volatility in 2008 provides insight into what happens when they simultaneously move higher – crisis. We make the assumption that crisis is an unacceptable outcome.
This is our poor liquidity-low volatility paradigm succinctly explained. Due to the post-crisis regulatory regime, elevated liquidity stress is likely here to stay; the system cannot tolerate simultaneous elevation in liquidity stress and volatility; if tighter monetary policy leads to higher volatility, and high liquidity stress is permanent, then tighter monetary policy is not possible. The paradigm hypothesis may soon be tested. " - source Bank of America Merrill Lynch

Unfortunately, for the Fed and other central banks, the higher are cross-asset correlations, the larger will be standard deviation moves, the more unstable financial markets will become due to "Mechanical Resonance" thanks to poor liquidity and heightened volatility. As a reminder, "Mechanical Resonance" is the tendency of a mechanical system to respond at greater amplitude when the frequency of its oscillations matches the system's natural frequency of vibration (its resonance frequency or resonant frequency) than it does at other frequencies. It may cause violent swaying motions and even catastrophic failure in improperly constructed structures including bridges, buildings and airplanes—a phenomenon known as resonance disaster. In similar fashion, thanks to central banks meddling with "risk signals" such as interest rates and "volatility" (which is at the core of any allocation process again), playing with "cross-asset" correlations by messing with the signals will eventually lead to "Mechanical Resonance" at some point and trigger a "Broken Arrow" call from supposedly "diversified" players all having the same allocations and positions on. The trouble is that many pundits do not realize yet how depleted are central banks' ammunition depot. This will lead to more "unconventional" responses from "The Cult of the Supreme Beings" aka central bankers rest assured.

Of course as we posited last week, we are already seeing trouble brewing in "Risk Parity strategies" thanks to "Mechanical Resonance" triggered by a surge in "interest rates" volatility. This is as well clearly indicated in Bank of America Merrill Lynch Liquid Insight note from the 15th of September entitled "Getting unreal":

"Risk parity unwind 

One of the most talked about themes recently has been the impending unwind of levered risk parity portfolios (see here and here). Our equity analysts estimate that the recent moves (bond and equity sell-off) could trigger as much as $50bn in bond selling from risk-parity type investors. While data on holdings is minimal, the influence of risk parity deleveraging on real rates is clear from Chart 1 and Chart 2. 

As the correlation between equities and nominal bond yields turn negative, the risk parity community delevers, resulting in a sustained underperformance of real yields. While it is easy to think this is because risk parity performance mirrors nominal bond yields, our Chart of the day makes the compelling case that this is purely a real rate phenomenon.

If anything, risk parity underperformance has historically meant higher real rates and lower breakevens, with the breakeven beta being about half the real rate beta. This relationship is the primary reason why we would rather be short real rates as opposed to nominal rates for an unwind of the risk parity theme. Further, anecdotal evidence in both the taper tantrum and the China reserve sales episodes also support this view: real rates increased, breakevens declined as average risk parity performance fell more than 5%.

To us, the focus on risk parity unwinds is here to stay even beyond the next couple of weeks. As the polls for the US elections narrow further, higher volatility and increasing likelihood of fiscal stimulus will keep this theme alive." - source Bank of America Merrill Lynch

Now of course, if indeed "real rates" shoot up thanks to "Risk Parity Strategies" forced deleveraging, what is of interest to us has been in 2016 the return of Gibson's paradox. Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which could potentially be the case with a possible rally in the 10 year US government bond if we get a surprise rate hike that is, then of course, gold prices will go down as a consequence of the interest rate impact and gold miners will go down as well. This would lead to further "cross-asset correlations" playing out on the downside that is.

When it comes to additional banking woes in conjunction with the recent surge in volatility in the bond space, the recent large fine imposed on German Deutsche Bank continues to validate our long standing distate for European banks stocks and our much vaunted, yet more stable preference for credit when it comes to having some "banking" exposure. In our next point we will look at that not only NIRP has been a headwind for NIM (Net Interest Margins) as of late, but, European banks versus their American peers are as well facing a risk of "Broken Arrow" when it comes to their Investment Banking franchise.

• Macro and Credit  - Broken Investment Banking franchises in Europe, time for some players to call it a day.

Many European banks when on to a hiring spree in 2010 following the significant bounce in 2009 as they were saved by central banks and by the suspension of the "mark-to-market accounting rule" as they believed that the "good days" were coming back. On our side we always believed that the changes facing banks were more structural in nature and kept thinking in terms of analogy that the banking industry would be facing a wave of restructuring not to dissimilar to what the Steel Industry went through in Developed Markets (DM) at the beginning of the 80s. As per our conversation "Thermidor" in August, we continue to disregard the "value" argument put forward by some pundits about the "cheapness" of the sector given, for us, a bank is the second derivative play on the economy and as a pure "beta" play, it is tied to changes in "credit impulse" leading to an acceleration of economic growth. As far as we are concerned, the "japanification" process in Europe runs unabated and the restructuring of the banking sector in Europe has only just started:

"We will not re-iterate why we dislike banks stocks and in particular European banks stocks given the "japanification" process and the significant on-going deleveraging. If there is indeed some clear culprits when it comes to "capital destruction" thanks to Zero Interest Rate Policies (ZIRP) and now with Negative Interest Rate Policies (NIRP), the blame is entirely on the shoulders of our "generous gamblers" aka central bankers and their experiments." - source Macronomics, 5th of August 2016

Not only are European banks facing earnings headwinds thanks to NIRP, but, when it comes to their Investment Banking franchises, some players are clearly facing too many hurdles to continue to make a case to maintain highly regulatory capital intensive activities such as Investment Banking. On this particularly subject we read with interest Société Générale's take in their Global Investment Banking note from the 15th of September entitled "Making sense of broken business models":

• "I-bank sector’s ROE looks set to be only 6.2% in 2016, much lower than the COE (which we deem to be a simple 10%).
• Most I-bank products achieve lower than 10% COE.
• The bulk of capital continues to be allocated to the lowest return FICC products. Less capital-intensive equities products have higher profitability. Primary IBD products (especially DCM and M&A) are the most profitable of all.
• US I-Banks have greater market share and more leadership positions compared with European peers.
• European I-Banks are deleveraging in order to become smaller but more profitable niche players.
• JPM continues to strengthen its position as the dominant “flow monster”, pulling away from GS, C, BoA and DBK.

• Substantial capital can be released back to shareholders from winding down investment banking business, especially FICC.
• CS has a CHF2.8bn capital deficit, DBK has €12.5bn deficit. Significant deleveraging could more than solve these capital deficits and put the banks in an excess capital position. Realistically, we think CS management is the one most likely to consider further deleveraging at its forthcoming strategy day (which should be on 7 December).

- source Société Générale

It should not come as a surprise that with the on-going "deleveraging" exercise taking place for many players, ROE has come down in conjunction with leverage and rising cost of regulations and new capital rules set up.

But, given recent woes for Germany's banking champion Deutsche Bank, it is interesting to note that, when it comes to its Investment Banking franchise, it is at risk of having a case of "Broken Arrow" as displayed in Société Générale's very interesting report:

• Very weak capital strength has forced significant deleveraging. Cuts to the bonus pool have also caused significant revenue attrition. Core I-bank ROE is set to be only 2.6% for FY16e. Most products across the board have very weak ROEs.

• DBK commits the bulk of its capital to FICC. Rates trading should have put DBK in a good position for decent revenue growth in 1H16 (similar to JPM), but it ended up being the third-worst FICC performer over the period. Franchise weakness is a key issue we think.

• We believe DBK’s I-bank is a broken franchise and needs to be wound up almost entirely, leaving just a minimal platform to service its commercial clients. Doing so would release up to €35bn in equity, which would more than plug its €12.5bn equity deficit." - Source Société Générale

Not only is Deutsche Bank's struggling with legal issues, but, when it comes to the ROE of its FICC franchise at a very low 2.6%, one might wonder how long this will go on, until the music stops.

Furthermore, for pundits still believing in the "relative value" proposal of investing in bank stocks rather than having a less volatile credit exposure, we could add that as displayed by Société Générale, if the trend is your friend, when it comes to investment banking activities, revenues have gone down since 2009:

Total capital markets revenues have been declining since 2009 due to:

• Tougher regulation (higher CET1 and leverage ratio requirements, Basel 2.5 mRWA inflation) 
• Central bank QE measures – asset purchase schemes drain liquidity from trading 
• Deteriorating macro conditions, as over-leveraged countries reach the limit of supply-led GDP growth

We expect modest growth from 2016e due to slightly stronger GDP growth and inflation. There are downside risks, however, from i) further deleveraging of I-banks; and ii) global asset deleveraging causing a recession." - source Société Générale

We do share Société Générale's concerns when it comes to the downside risks and when it comes to our profound dislike for European banks stocks in general, it will continue, rest assured as we continue to prefer the stability of Senior Financial bonds which benefits from the current "implicit" backstop from the ECB.

Still, should you want to have "stocks" exposure to the banking sector, from a cost/income ratios approach, you would be better off with having American exposure than European exposure as posited by Société Générale:

The most efficient banks have:

• An intense focus on keeping structural costs low
• A keen eye on integrating technology
• Revenues with low volatility and steady growth
• Strong capital adequacy

US banks are more efficient than European banks for most of the above reasons. Looking more specifically to I-bank operations, the US banks also are better than their European peers. A big caveat is that that the CIB operations of the US banks tend to include much more significant corporate banking, transaction banking, securities services and similar (i.e. non-capital markets) activities compared with their European peers, which makes the overall CIB ratios appear lower. We still believe that US I-banks have lower cost/income ratios in pure capital markets activities than their European counterparts." - source Société Générale

But, if you believe, like ourselves, that the US economy is weaker than expected and is slowing down as per the latest raft of macro data points, given the performances of the US banking sector as a whole in 2016, it might make sense from a "risk" perspective, to start trimming your exposure, unless of course, you are a firm believer in the Fed's normalization process (we are not...). As far as Europe is concerned, we already made our case that Southern Europe's credit impulse process is a case of broken credit transmission mechanism thanks to weaker banking players in Europe being capital constrained due to "bloated" balance sheets by unresolved Nonperforming loans (NPLs) as in Italy and Portugal.

There you have it, "japanification" in Europe is still up and running and when it comes to "banking woes", we do have the case of "broken franchises" which could lead to some "Broken Arrow" calls. While we have long been vocal about the lateness of the credit cycle, we do think that regardless of the recent complacency coming from "repressed" volatility, there is indeed a large storm brewing as we will show in our final charts for this week's conversation.

• Final charts: The business cycle is turning and storm season is coming

 In January 2016 in our conversation the "Ninth Wave" we indicated:

"Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should "risk" decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy." - source Macronomics, January 2016

It is time, we think to remember that indeed, cash is part of a "defensive" strategy, given many signs are now clearly pointing, such as CCC issuance being shut down, that there is a storm brewing. On this subject we read with great interest another Société Générale report from the 15th of September from their Global Volatility Outlook series entitled "Make hay while the sun shines (and prepare for the storm)" for our final charts of our conversation:

"US focus 

Business cycle update (the storm is coming) 

The data-based Fed policy has the appearance of a self-correcting system. Poor economic data allows for delaying further rate hikes, which reassures investors in the short term, while positive economic data, theoretically makes it possible for the Fed to gradually normalise policy. But the US central bank has remained so cautious for so long that it is now running late. While the labour market is close to full employment, corporate profits have already embraced the downturn, even without the burden of strong wage pressure. When put into historical context and despite a decent bounce in the last quarter (with the Energy sector recovering on more stable Oil prices), US corporate profit margins still are not growing. They are only decreasing less rapidly. This is exactly what you would expect at this time of the cycle (assuming a recession in mid-2019), making this cycle the longest (10 years) in history, alongside the 1991-2001 cycle.
The joint analysis of profit margins and equity volatility, which we have used widely in the past, tell us that equity volatility should be on the rise at this point of the cycle and not close to lows. While end-2015 and early-2016 led us to believe that the trend was underway, Q2 and Q3 look abnormal with the VIX sub 12%. In our view, central bank policy and the low yield environment are the culprits once again.
By delaying the cyclical forces for so long and keeping rates artificially low, the Fed has created an environment which distorts classic analysis frameworks. US equities, despite trading at very high valuations, look more and more like bonds, posting limited but steady returns with low volatility, while bonds are taking on the role of the risky asset.

On a medium- to long-term perspective, the situation looks too imbalanced and the reversal could prove painful. Also worries are mounting over the fact that central banks in general could be vulnerable to external shocks, leaving them with very limited options. In this environment, the hedging theme cannot be ignored and should be handled with care by investors.
Still, the trigger for a full-blown bear market is difficult to pin down. From a tactical standpoint it is fair to say that this regime has proved robust so far and that staying outside US equities is difficult in this low-yield environment Our equity strategists highlight that a very soft Fed (we forecast an exceptionally slow pace of tightening with the next rate hike likely in December this year, two in 2017 and a peak Fed funds rate of 1.5% in this cycle), more fiscal easing, higher oil prices and accelerating M&A all will be catalysts to push the S&P 500 still higher." - Source Société Générale

While some might enjoy continue "playing" another "melt-up", it is time, we think to start thinking seriously about "hedging" as we risk moving into a new higher "volatility" regime following years of "volatility repression" if one wants to avoid having to make that fateful "Broken Arrow" call we think.

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." -  Henry Ford

Stay tuned!