Macro and Credit - Who's Afraid of the Noise of Art?

"Nations have their ego, just like individuals." -  James Joyce, Irish novelist

Back in September 2013 in our conversation "The Cantillon Effects" we described increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply. We pointed out a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":

"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.
In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.
Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.

-Endogenous money, PQ => MV (Hume, Wicksell, Marx)

-Exogenous money, MV => PQ (Keynes, Monetarist)

In our on-going "Cantillon Effects", we get: Δ M  => Δ Asset Prices or the famous "wealth effect" dear to our "Generous gamblers" aka central bankers.

The most interesting part of using the art market as a "proxy" for asset bubbles is indeed that money changes (namely the monetary base) leads to the creation of "asset bubbles".

So you might be wondering why our chosen title on this specific topic? Well, (Who's Afraid Of?) The Art of Noise! was Art of Noise's debut full-length album, released in 1984, a called it a "techno-pop classic" and had a clear influence from German band "Kraftwerk". Given our fondness for electronic music from the 80s, we thought it be interesting to use this reference as in this particular conversation we would like to focus on the potential changing trends in the art market we are seeing. This additional indicators such as prices for classic cars as well, could be additional pointers to the lateness of this credit cycle we think.

In this conversation we will look at the trends in the art markets as well as classic cars which could portend a reversal in financial markets hence the importance, we think to regularly monitor this different yet important alternative "asset class" from a "macro" perspective and ask ourselves if indeed we should be afraid of the "Noise of Art" and its consequences.

Synopsis:

• Macro and Credit - Sotheby's woes are only beginning as the art market and the economy are entering a soft patch
• Macro and Credit  - Classic cars? Downshifting...
• Final chart: Classic cars have been "turbocharged" 

• Macro and Credit - Sotheby's woes are only beginning as the art market and the economy are entering a soft patch

Looking at the fall in Sotheby's stock and volumes in sales, is always of interest as in the past, the art market has always been an interesting indicator. The only major listed auction house Sotheby's (ticker BID) has on numerous occasions proved a timely indicator of potential global stock markets reversal by three to six months. While one year return for the stock has been dismal at -38.98%, Year to date so far the stock is up 5.82%. yet we believe that given that the art market, as well as the US economy is about to enter a soft patch and we think this is already confirmed by lower US government bond yields and a flatter yield curve and also we expect weaker Nonfarm payrolls going forward to that respect. If indeed we are correct in our assumption, then we think you are better off sticking with Sotheby's bonds rather than its stock, us of course having somewhat a credit bias. To that effect, we were in agreement with interest Bank of America Merrill Lynch's note on Sotheby's 5.25% bonds which date from the 6th of April 2016 entitled "5.25s are a masterpiece; Initiate at Overweight":

"Cyclical industry entering soft spot

The art market is entering a soft spot as a result of unfavorable changes in global exchange rates, a slowing economy and decelerated asset appreciation. Based upon lower art industry volumes, we believe that Sotheby’s Adjusted EBITDA will decline in FY16. However, the company has substantial liquidity to weather a more difficult environment.

Much to like

We believe that there are many attractive attributes of Sotheby’s business, including: (1) a strong brand name and positioning within the art auction industry; (2) the predominantly duopolistic nature of the art auction industry; (3) limited risk of substantially-levering acquisitions; (4) significant liquidity; (5) minimal maintenance capex; and (6) no near-term maturities. Sotheby’s has been engaged in the art auction industry since 1744 and over this tenure, has built a brand that would be challenging to replicate. Additionally, the duopolistic nature of the industry provides the company with the ability to increase price, as evidenced by a February 2015 increase. Despite small acquisitions over recent history, we believe that the company will not be a major participant in M&A activity in the future, limiting the risk of leveraging transactions. Financially, we estimate that maintenance capex is ~$10 million, which contributes to strong free cash flow and the company has no near-term maturities with which to contend.
FY16 EBITDA to decline, but free cash flow positive We estimate that Sotheby’s Adjusted EBITDA will decline 24% to $236 million in FY16.
However, we estimate that free cash flow will total $88 million, leaving net leverage only 0.4x higher at the end of FY16 (vs FY15).

Initiate at OverweightWe recognize that financial results could be soft in the immediate future. However, we believe that the rough period will be brief and that the company has adequate liquidity to operate through an extended downturn. Trading at a yield-to-worst of 7.3%, we believe that current trading levels are attractive, and initiate coverage on the BID 5.25% Sr Notes with an Overweight rating." - source Bank of America Merryll Lynch.

Whereas tactically this recommendation paid handsomely given the bonds are trading back close to par, when it comes to assessing the viability of Sotheby's business in the long run as well as most recent fall in art trading volumes, we must confide that we do not share Bank of America Merrill Lynch's views on Sotheby's ability to survive in the long run.

First of all as per Bank of America Merrill Lynch's note, inventories are up, leverage is up but, thanks to "cheap credit", the loan portfolio balance is still increasing, meaning that from our perspective, Sotheby's is resorting increasingly to "vendor financing" thanks to "Cantillon effects" and the "generosity" of our central banking deities:

"Inventory sales increased 23% to $36 million with $3 million of losses on inventory sales. Finance revenues totaled $17 million, a $2 million increase from 4Q14. The loan portfolio balance was $682 million at the end of 4Q15 (an increase from $644 million at 4Q14).
From an operating cost perspective, marketing expenses increased $1 million to $7 million. Salaries and related costs decreased $14 million to $75 million. G&A expenses decreased $4 million to $42 million. 4Q15 Adjusted EBITDA totaled $145 million vs $152 million in 4Q14. Based upon outstanding debt of $1.2 billion, total leverage was 3.8x at quarter end." - source Bank of America Merrill Lynch

Secondly, we do not believe no matter how "dominant" Sotheby's position is, that its business as well as its financial position are secure. On that note, we read with interest Artemundi's note from the 10th of June entitled "Sotheby's with one step closer to the grave":

"It has been a disastrous year for Sotheby’s, but the writing has been on the wall for a while. A series of unfortunate events has driven Sotheby’s to walk a tightrope, beginning with Bill Ruprecht stepping downin November 2014 -amid criticism- as CEO after being with the company for 34 years. His rookie successor, Tad Smith, and the new amateur directing board committee have exhibited their lack of experience within the art market, refocusing company ideals to make Sotheby’s a marketing brand that favors advertising and technology for online retail. The new management, forgetting that art remains a business where knowledge really matter, has adopted a new strategy limiting PR expenses. This has led to an unprecedented exodus of the company’s best asset: knowledgeable staffers with strong client relationships and more than 300 years of experience. Vicepresidents, Specialists, Worldwide Heads, Chairmen, and even CFOs have abandoned the sinking ship. The resulting feeling of an uncertainty and instability now pervades the glittering glass-and-granite-fronted building on Manhattan’s Upper East Side. Personally visiting the venue on Sunday, left us with the distressing feeling of a rundown business, just like a ghost with spiritual emptiness, or a phantasmagoric carcass of what once was one of the world’s largest brokers of fine art.

In a desperate effort to compensate for the auction house’s emptiness, the board of directors decided to overpay the private firm, Art Agency Partners, around $85 million on January 11th, 2016 to boost private sales. Thus, this auction season, all art market analysts’ eyes were on Sotheby’s expecting a miracle with Amy Cappellazzo as Sotheby’s triumphant savior. As expected, Post-War and Contemporary auctions developed smoothly with an astonishing 95% sell-through rate. It was a solid $242 million sale made extraordinary if we consider the context within which it was developed but a small sale nonetheless. Clearly the resulting revenue from this sector is not enough to cover the entire auction house’s expenses and debts. The failing 66% BI-rate for the Modern and Impressionist catalogue was a big downturn for Sotheby’s confidence. Excluding Post-War and Contemporary, the lack of talent on the other business sectors has deeply affected the quality and quantity of artistic offer.

 - source Artnet

To summarize, Sotheby’s total sales volume dropped almost by half: last year the house generated $748 million in sales, compared to this year’s $386 million. Furthermore, it seems that Sotheby’s own team tries to boycott its own selling process. The Latin American auction held on May 24th, suffered from serious technical problems for the morning online bidding, when the firm was unable to stream the live auction or place the selling results. The Latin American department surely worked very hard for six months, only to find themselves victims of the IT department’s inefficiencies.

As a result, the insufficient cashflow forces the company heavily depends on its credit facility. In fact, Sotheby’s has just announced that total sales revenue dropped 8%, suffering a $73M loss in 2015, which incremented $11M from last year’s forfeiture of $66M. In 2015, Sotheby’s gross margins narrowed from 47.25% to 43.72% compared to the same period last year, operating (EBITDA) margins now 27.19% from 30.75%.2 Narrowing of operating margins contributed to decline in earnings. As of today, Sotheby’s EBITDA margin keep falling, since on Friday 10th, the company’s EBITDA was of 14.58. This position had seriously affected Sotheby’s BID stock, which has crashed 54% over the past twelve months. Consequently, Sotheby’s current credit rating is at risk. That is to say, if Sotheby’s corporate credit rating from Standard & Poor Rating Services is downgraded to “BB-”, “B” or “B+”, the revolving credit line might be recalled and the auction house may be facing insolvency problems too frightening to even mention.

In addition to the current long-term debt of $603 million, Sotheby’s 25-year-mortgage originally had an initial annual rate of 5.6% has now increased to 10.6%. In fact, the possibility of relocating the business’ headquarters was presented at the New York Times in June of 2013. According to the New York Post, Sotheby's has retained Peter Riguardi of commercial real estate company JLL to help it search for a new location, possibly in the Hudson Yards development on Manhattan's far west side.

In what may be a "coup d’grace", a private, Singapore-based investment group called Shanda has just announced its ownership stake in Sotheby’s. Shanda originated as an online gaming company and is run by co-founders Tianqiao Chen and Chrissy Qian Qian Luo. They currently own two percent of Sotheby’s shares and could increase their stake to as much as 10 percent, raising the possibility that Sotheby’s could be acquired or taken private. According to Forbes, Chen, a self-made millionaire was a pioneer in China’s online game industry a decade ago and holds a Bachelor of Arts from Fudan University. As a collector himself, Tianqiao Chen might be acquiring prestige through the auction house’s purchase. In case you have not recalled this situation, the name Alfred Taubman might sound as a déjà vu. That is to say, Alfred Taubman took over the auction house in 1983, after he was object of ill treatment at Sotheby’s before he bought the business.8Would Chen’s money be just a tantrum or a fuel of fresh energy that Sotheby’s urgently needs? Let us hope that China’s 10th richest man truly understands the situation he is getting into." - source Artemundi - "Sotheby's with one step closer to the grave"

Maybe Bank of America Merrill Lynch analysts and their loan officers aren't afraid of the "Noise of Art" but, when it comes to our assesment of the situation, increasing leverage and "vendor financing" is not a long term "good recipe". The credit facility due in 2020 is $541.5 million. If indeed the credit facility get recalled, it might be "game over" for this business founded in 1744.

Furthermore, there is an ongoing assymmetry in the art market particularly in contemporary art where only a few names are dominating sales as well as the auctions. This assummetry is well described in ArtAscent article from the 1st of February 2016 entitled "Market trends and reality: two examples":

"At a sale on March 7, 2014, Koons’ ceramic Balloon Dog (Red), number 131 of an edition of 2,300, sold for $22,500. This appears to be a good return on an investment held by the collector for 18 years. If one considers the transaction in a little more detail, the return on investment is not all that it might seem at first glance. The process of calculating a return on investment is a little complicated, but it is well worth understanding how it is done.
First the sale price must be discounted by the 25 percent buyer’s premium retained by the auction house. In this case of Koons’ Balloon Dog (Red), it was 25 percent of $22,500. So from the transaction, the seller’s account was credited with $18,000. From this was deducted the auction house seller’s premium or commission of 20 percent. Thus, the seller pocketed $14,400 from the sale. In calculating the return on investment we need to know the cost base or book value of the work. This is particularly difficult as commercial galleries are notoriously tight-lipped on sale prices. It is possible that the owner of the single piece from the large edition of Koons’ Balloon Dog (Red) acquired it for something in the range of $2,000. The return on the 18-year investment ($14,400 – $2,000) may have been around 34 percent per annum. But, there is another way of looking at this. If we put $14,400 actual return from the sale into a calculator at usinflationcalculator.com, we find that this sum equals $9,499 in 1996 dollars. Over 18 years, the real/uninflated annual rate of return for this investment, was about 26 percent. Koons’ Balloon Dog (Red) was a very good investment no matter how it is calculated, but not as stunning as it may first appear.
Only a few lucky investors had the foresight – or available cash – a couple of decades ago to invest in a work by Jeff Koons or one of his colleagues who now happen to top the art index. It is a question of predicting future demand for the works or a particular artist.

Currently, 68 percent of contemporary works sell at auction for under $7,000. They are not the works of so-called “market leaders.” Consider a single work, chosen more or less at random, as an example – a 10-inch X 96-inch oil on canvas, Lamay Bridge, (1987) by the American artist Woody Gwyn (b. 1944). In February 2010, it sold at auction in San Francisco from the collection of a law firm, fetching $4,575. Subtracting the 25 percent buyer’s premium, the return to the seller was $3,432. Because this work was part of a large consignment by the law firm, the auction house seller’s commission was probably discounted to around 10 percent. The law firm likely received in the vicinity of $3,089 from the sale of this work that was originally acquired in 1987 from a Santa Fe gallery. The price at the time might have been about $500. The difference between the book value of the artwork and the return from its sale ($3,089 – $500) shows a $2,589 capital gain. The annual rate of return on investment was in the range of 23 percent. But, when we put the $3,089 return from the sale of the work into an inflation calculator, this sum is equivalent to $1,609 in 1987 dollars. Subtract the cost of acquiring the work originally and the uninflated gains from the purchase are $1,109, or ($1,109/22 years) $50 per annum or 10 percent.

These two examples show the differences in return on investment. If a collector with a small budget is lucky – or clever enough – to acquire a work by an emerging artist who eventually rises to the top of the market, the rewards can be substantial. This applies equally to investment in works by skilled artists who do not achieve a mega-star status. In both cases, the risk must be considered in relation to a best guess at future demand and the potential rate of return.

The good news must be tempered with an important warning. All the statistics on which art market trends are calculated are based on actual public sales. No one reports on the huge number of works that are put up for auction and fail to find a buyer. Depending on the prevailing economic conditions it is not unknown, for as many as half the works in a sale to be bought in or remain unsold.

In the art market, statistical trends are an imperfect guide at best. They are not of much use in helping an art investor determine risk. In the case of the acquisition of art for investment purposes, the eye is invariably mightier than the math. Even if capital gains are not forthcoming, a well-chosen work will delight the owner. There is no way to put a monetary value on this, so it’s not subject to the vagaries of statistical analysis." - source ArtAscent, 1st of February 2016

Furthermore there is even more distortion in the auction process particularly with Sotheby's not only engaging in "vendor financing" but, as well paying some buyers to bid on its artwork as reported by Bloomberg by Katya Kazakina on the 10th of June in her article entitled "Sotheby’s Is Paying Buyers to Bid on Its Artwork":

"Sotheby’s was in a bind. The auction house had won several top consignments for its bellwether spring auction, including a Jean-Michel Basquiat that sold for $7.4 million four years ago, by guaranteeing the sellers minimum prices.
But as volatile financial markets sent jitters through the art world, Sotheby’s faced the prospect of owning the work if it failed to sell. In the weeks leading up to its May 11 auction, the company began pitching a new perk to potential buyers: a fixed fee to those who agree, before the auction even starts, to make at least a minimum bid. The new incentive helped Sotheby’s find buyers for guaranteed pieces.
Sotheby’s is joining Christie’s in offering the fees to buyers, whose private deals sometimes undercut the notion of a public auction market. Sotheby’s previously resisted the incentive on concerns it would reduce profit and price transparency. The auction house’s change of heart comes after new Chief Executive Officer Tad Smith reshuffled the ranks of managers and specialists and brought in a former top Christie’s executive. The company’s shares have lost about a third of their value in the past year.
Sotheby’s change “makes them more competitive on the financial side with Christie’s,” said Thomas C. Danziger, a partner in Danziger, Danziger & Muro LLP. “In the current climate, every advantage that you can have helps the bottom line. Stupid money is not flowing in the ways it might have 12 to 18 months ago.” Sotheby’s declined to comment for this story.

The new perk in Sotheby’s arsenal of incentives, disclosed in catalogs in April, sweetens the deal for investors who agree to step in as buyers of last resort. In the past, so-called irrevocable bidders were compensated with a part of the auction house’s sales commission only if another buyer purchased the artwork that they had backed. Now, by opting for a fixed fee, they are guaranteed a payout and can get the artwork effectively at discount.

‘Onion Gum’

The new approach reduces the risk that Sotheby’s ends up with too much artwork in its inventory -- a concern particularly in a slowing market. But as the May 11 auction showed, the company can still lose money.
“Onion Gum” was one of four works in that sale consigned by hedge fund manager Daniel Sundheim. Sotheby’s gave him undisclosed guaranteed prices for the paintings, and in the weeks before the auction, it lined up irrevocable bidders for the four pieces.

The Basquiat sold for $6.6 million, net of the fee paid to the mystery buyer, who was the only bidder. That was less than the guarantee to Sundheim, according to a person familiar with the matter, leaving Sotheby’s with a loss on the painting.

Transparency Concerns

Sotheby’s lists the price net of fees paid to such buyers, making it possible to estimate the fee that the company doesn’t disclose. The buyer of the Basquiat work received $258,000, based on Sotheby’s standard sales commission.
The company argues this form of disclosure is more transparent, because the fee paid to the irrevocable bidder works like a discount. Christie’s does not adjust for such fees in its reporting of final prices.

Christie’s declined to comment. The fees are “a separate transaction to the sale, reflecting the risk the third party has taken in relation to the minimum price guarantee,” the company says on its website.

Sotheby’s is offering the new incentive to investors after it took a loss on a $509 million guarantee on the collection of its former chairman A. Alfred Taubman and had to take possession of $33 million of unsold artworks last year.

Like ‘Steroids’

Auction guarantees have proliferated since the financial crisis, covering half of the $2.1 billion of art in November’s semi-annual auctions in New York. Since then, the number of guarantees at Sotheby’s and Christie’s has fallen as the market slowed. Art adviser Todd Levin says guarantees act like "steroids" in the market by presetting bids often at artificially high levels.
David Nash, a co-owner of Mitchell-Innes & Nash gallery in New York, says irrevocable bids are part of financial machinations that distort the art market. When highly valued works with prearranged bids come up for auction, in many cases there is no genuine bidding and they are bought by the guarantors, he said.
That’s what happened with Roy Lichtenstein’s "Nurse," which was purchased in November at Christie’s for $95.4 million -- an auction record for the artist that was 70 percent higher than the previous high two years earlier.
“It’s a sale agreed in private to take place in public and pretend it’s an auction,” said Nash." - source Bloomberg.

So if you think that only central banks are "manipulating" markets, think again. Having "auctions" rigged through this "new process" makes us indeed afraid of the "Noise of Art". We disagree with Bloomberg in the sense is that this new approach in no way reduces the risk that Sotheby’s ends up with too much artwork in its inventory - a concern particularly in a slowing market. On the contrary "rising leverage", "rising inventory levels", "rising vendor financing" in conjunction with this new process makes us even more worry of the consequences in a market where volumes have been falling significantly. Whereas it is difficult to "time" the consequences of "easy money" and "market manipulations" (even in the art market), we do not think it is different this time and the weaker credit rating of Sotheby's make us wonder if now the time is not right to start thinking again about shorting both the bond and the stock in the near future...

This brings us to the second point of our conversation, namely that not only the art market risk facing a "soft patch" but "classic cars" who have enjoyed "stellar returns" for the savy and wealthy investors are beginning to show sign of slow down and price revisions.

• Macro and Credit  - Classic cars? Downshifting...

While active use of engine braking (shifting into a lower gear) is advantageous when it is necessary to control speed while driving down very steep and long slopes, the latest slope of the US economy in particular and the global economy in general makes us wonder if indeed the "down trend" is not your friend. 

For the last couple of months we have made an interesting, yet entertaining exercise of building up a "virtual garage" made up of "classic cars" of interest and monitored on an ongoing basis their valuation by using the website "mobile.de". What we have noticed since we added a few cars since April in our "virtual garage" is some interesting price revisions taking place. For instance, one of the most recent car added to our garage was a Ferrari 250 GT Lusso which we parked on June 7th, to the price of: 1,712,000 EUR seeing the car's price today coming down to 1,689,000 EUR. Another interesting price revision on a downtrend was for an Aston Martin DB6 which we parked on April 17, 2016 at the price of 415,000 EUR and which is now being offered at 365,000 EUR. Some of the most striking price revisions were for some more recent Ferraris we must admit such as a restored Ferrari 330 GT 2+2 we parked on April 5 at the price of 339,000 EUR which is now being offered at 239,000 EUR. There was as well a 1971 Ferrari Dino GT4 246 GT SERIE M parked also on April 5, 2016 at a price of 490,000 EUR, now offered at a revised price of 399,000 EUR. Rarities such as 1955 Mercedes-Benz 300 SL Coupé Gullwing are still commanding an impressive 1,600,000 EUR price tag and are yet to show any price revisions at the moment.

While it is difficult to come to any clear conclusion from such a small sample, the website "Hagerty" enables us to have a broader and clearer picture of the downward trend for classic cars in the US. The Hagerty Market Rating uses a weighted algorithm to calculate the strength of the North American collector car market. The Hagerty Market Rating is expressed as a closed 0-100 number with a corresponding open ended index (like the DJIA or NASDAQ Composite). The Hagerty Market Rating measures the current status of the collector car market in terms of activity or “heat”; directional momentum; and the underlying strength of the market:

"How it Works:

Each individual component of the Hagerty Market Rating is comprised of a number of individual measures, with each measure being scored on a scale of 0-100. Each component’s individual measures are combined into a “weighted average” based on how indicative the measure is of market status, which results in the overall score for each component of the Hagerty Market Rating. Like the rating for the individual components, the overall Hagerty Market Rating is a weighted average of the eight components’ individual scores, with those measures that are a more correlative of the market’s status treated with more preference in the algorithm.
Therefore, in order to calculate the overall Hagerty Market Rating, each component’s score must be calculated, which in turn requires that each individual measure’s 0-100 score must first be determined. To do this, we calculate each measure’s current performance against its historic performance. Scores for any measures that are based on dollar amounts are calculated using inflation-adjusted values relative to 2014 dollars. The resulting scores are then combined according to their predetermined relative weights for a final number.
For all measures, components, and the overall Hagerty Market Rating, a “bell curve” type distribution is expected, with 0 falling on the far left, 100 falling on the far right, and 50 landing at the curve’s peak. Because of this, the rating is more fluid in 40-60 range, and much more difficult to move at the rating’s extremes." - source Hagerty

Right now the reading for June 2016 according to Hagerty is down to 69.01:

• Following a very slight increase last month, the Hagerty Market Rating is down to 69.01 for June.

• While last month marked the largest increase of 2016 in the auction channel, auction activity instead saw its largest decrease so far this year for June and is currently at a 33-month low.

• Private sales activity fell for the third consecutive month. Over the last 12 months, the average private sale price has fallen 10 percent and the percent of vehicles selling for above their insured values has fallen 1.4 percent.

• Requests for insured value increases for braod market vehicles declined for the ninth consecutive month.

• Requests for insured value increases for high-end vehicles fell for the second consecutive month and are at a 15-month low.

• Correlated instruments saw an increase for the second time this year, as the price of gold per ounce fell and the S&P 500 passed 2,100 forthe first time since November 2015.

• May's reported rating was revised from 69.35 to 69.17 due to newly released inflation numbers." - source Hagerty

What we find of great interest is the "Cantillon effect" and the significant rise in price appreciation for classic cars which can be directly link we think to our central bankers generosity and their "dear wealth" effect and balance sheet expansion. In similar fashion it had an impact in art prices and equities indices we think:

"The Hagerty Market Index is an inflation adjusted open ended index (similar to the DJIA or NASDAQ Composite) based on change in dollars and volume of the market. 

- source Hagerty

The all-time high was reached in September 2015 whereas the Dow Jones Industrial Average reached an all time high of 18312.39 in May of 2015.

On a continuation to our "little" personal entertaining exercise we did notice on Hagerty that the hottest part of the market in the US namely classic Ferraris is experiencing a slowdown:

"The Hagerty Price Guide Index of Ferraris is a stock market style index that averages the values of 13 of the most sought after street Ferraris of the 1950s-70s. The graph below shows this index’s average value over the past five years. Values are for #2 condition, or “excellent” cars.

As the top of the market moves, so moves the Hagerty Ferrari Index. This group of cars performed similarly to the Blue Chip Index in that it recorded its first drop since September 2009 and in that the drop was also a nominal 1% slip. None of the index’s 13 component cars increased in value—the first time since May 2009 that this has happened—which is remarkable considering Ferrari has hands down been the hottest part of the market for half a decade.
In particular, softness was exhibited for some of the biggest movers of the past two years, as these models find new footing following a rapid run up. The Lusso dropped by 9%, the 275 GTB/4 fell by 8%, and the Daytona Spyder lost 9%. Over the past 12 months the 330 GTC is the loss leader with a 10% decline in value.
This may be bad news for anyone who bought a car in the last 6 months expecting to sell for a quick return, but will likely be of little concern to an end user. Looking through a longer lens, the most sluggish of the bunch over the past three years—the Dino—has still gained more than 50% in value and it is unlikely to retreat back to pre-2013 numbers. -Brian Rabold, May 2016" - source Hagerty

Could the Dino retreat back to pre-2013? Us not suffering from "Optimism bias" and being as you know by now "contrarians" would beg to differ. So overall, not only are we afraid of the "Noise of Art" but we are also very wary of what the "Ferrari index" has been doing as of late.

• Final chart: Classic cars have been "turbocharged" 

Our wariness of the latest trend in "classic cars" and the recent slowdown warrants close monitoring we think from an "alternative" macro perspective. The chart below comes from the latest Knight Frank Classic car special Luxury Investment Index review for Q1 2016 and clearly index the significant performance reached overall by classic cars:

Classic Car performances relative to other "tangible asset classes":

"Classic cars were once again the top performing luxury asset on an annual basis, according to the latest figures from the Knight Frank Luxury Investment Index (KFLII).
While the overall value of KFLII increased by just 5% in the 12 months to the end of March 2016 – the lowest annual increase since the first quarter of 2010 – cars outperformed with a 17% surge.
Wine saw the second strongest growth, up 9%, with coins in third position, rising 6%. Art and furniture were the biggest losers, dropping by 5% and 6%, respectively." - source Knight Frank

To quote one of the recurrent themes of our friends at Gavekal research, it has “never been so expensive to be rich” particularly if you want to snap up a classic Ferrari it seems. Kudos to our central bankers and their obsession with the "wealth effect":

"As most of our readers will know, modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn of the economic cycle. And interestingly, over the past couple of months, these assets have really been shooting up, breaking several records on the way" - source Gavekal, July 20th 2006.

History does indeed rhyme and we must confide that at this stage of the "credit cycle", we are afraid of the Noise of Art given back in 2006 our Gavekal friends indicated the following:

 "Usually, the last thing to go up in prices are rare automobiles" - source Gavekal Five corners, July 20th 2006.

This time it's different? We don't think so.

"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Arthur Fisher

Stay tuned!

Macro and Credit - Optimism bias

"The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails." -  William Arthur Ward, American writer

While looking at the numerous "sucker punches" delivered on Friday due to the "Brexit" results, we reminded ourselves for our title analogy for a subject we already touched back in January 2012, namely the "Optimism bias" which we touched in our conversation "Bayesian thoughts". Following the dismay of so many of our friends relating to the outcome and as well to both markets and bookmakers being all wrong at the same time, we reminded our friends and ourselves the following on this occasion:

"Brexit analysis simply explained: « Optimism bias »: One of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. Many tend to overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, many underrate our chances of getting divorced, being in a car accident, or suffering from disease and overestimate probability on extreme long-shots such as winning the lottery." - source Macronomics

Last week, when it came to assessing the potential outcome for the much dreaded referendum we also indicated the following:

"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016

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" as displayed in the below chart from the following The Telegraph article "Why the 'experts' failed yet again to call which way Britons would vote" from the 25th of June:

- source The Telegraph

Parsing through the markets various "reactions" on Friday akin to a "deer caught in the headlights" kind of moment, us being contrarians, we were ready for the "sucker punch" on our "gold miners" exposure (which we have been advocating for a while for those who follow us...). It looks like indeed our "pessimism bias" was this time around the "lucky approach". But at this juncture dear readers before we go into the "nitty gritty" of this week's conversations, we think it is is important for us to "illustrate" our core philosophy which we have nurtured in recent years by asking a simple question: Why people get lured into making inaccurate conclusions?

What affect one’s judgment in today’s world markets one might rightly ask?

We think the below four points resume our core contrarian "philosophy":

1. « Herd mentality »: People are influenced by their peers to adopt certain behaviors, follow trends, and/or purchase items. Examples of the herd mentality include stock market trends and fashion.
2. « Information cascade »: One of the topics of behavioral economics often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...) or a specific asset, like a stock that becomes overly popular among investors.
3. « Dunning-Kruger effect »: a cognitive bias in which unskilled and inexperienced individuals suffer from illusory superiority, mistakenly rating their ability much higher than average. 
4. « Optimism bias »: One of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. Many tend to overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, many underrate our chances of getting divorced, being in a car accident, or suffering from disease and overestimate probability on extreme long-shots such as winning the lottery.

Of course Friday's shock result was clearly illustrated by the last point, hence our title analogy given we have already used as title analogies most of the above points in previous musings. Therefore, challenging  the “consensus” is like betting in a race horse on the outsider – the returns, if achieved, will be significantly higher.

For instance we have told you before that Government bonds were always correlated to nominal GDP growth, regardless if one looks at it using "old GDP data" or "new GDP data". So, if indeed GDP growth continues to be weak, then one should not expect yields to rise anytime soon. As a matter of fact in January 2014 we recommended and bought very long duration exposure on US Government bonds using PIMCO ETF ZROZ when nearly all « experts » were calling for higher US yields by the end of 2014. Very few such as us, Dr Lacy Hunt and Jeff Gundlach called it differently. The ETF ZROZ finished the year 2014 as the best performing ETF in the Fixed Income space, gaining more than 44% in US dollar terms but that's another story...

While everyone is still reeling on the "Black Swan" outcome from the Brexit vote, we watched with interested US Durable-Goods Orders cratering further by 2.2% in May (vs. -0.5% expected). Not only U.S. firms are already cutting back on their capital expenditures but we would also expect going forward weaker Nonfarm payrolls, neutering in effect the "recovery" story and stopping in its tracks the hiking process of the Fed which is reinforcing even more our appetite for US long duration exposure and of course validating our gold miners exposure.

In this week's conversation we will look focus on the productivity puzzle and its impact on economic growth leading to the on-going "secular stagnation", we will as well look at additional pointers on deterioration of credit metrics and why the trend in medium term is not your friend.

Synopsis:

• Macro and Credit - Secular stagnation? It's the productivity stupid!
• Macro and Credit  - Our "pessimism bias" make us continue to prefer the safety of US High Grade
• Final chart: Global Non-Financial Corporate Debt to GDP is "off the charts"

• Macro and Credit - Secular stagnation? It's the productivity stupid!

On numerous occasions on this very blog we have pointed out our lack of "optimism  bias" towards the much vaunted "recovery story" being sold mostly by pundits due to the lack of "wage growth" as indicated in our conversation  "Perpetual Motion" from July 2014. We argued that real wage growth was indeed the "most important" piece of the puzzle the Fed has so far been struggling to "generate":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014

But, there is more to it when it comes to the theory of "secular stagnation" and this has all to do with the lack of "productivity" it seems. On that very subject we read with interest Bank of America Merrill Lynch's take from their Global Economic Weekly note from the 3rd of June entitled "The global productivity puzzle":

"The global productivity puzzle 

• Labor productivity growth has slowed significantly across developed markets over the past half-century; it currently is at record-low levels.
• Weak total factor productivity (TFP) growth is the main reason; low capital investment or declining labor quality only account for a small portion of the slowdown on average.
• There are many potential explanations for weak productivity but much of the decline remains a puzzle, with no clear policy offset.

Pronounced, and potentially persistent 

Growth in most developed markets (DM) has been disappointingly slow, while emerging markets have seen their growth rates decelerate each of the past five years. Many observers have gradually come to the conclusion that the supply side of the global economy appears to have been damaged — perhaps permanently. The clearest evidence of this phenomenon is the sharp reduction in labor productivity — total output divided by total hours of labor input — in most developed markets (and many emerging markets) over the past several years. In fact, DM labor productivity has converged to historically low, sub-1% growth rates (see Chart 1 and Chart 2 for G10 country data). More significantly, the decline appears to have begun  before the global financial crisis hit.

These two observations have important implications. First, it strongly suggests that common global factors may be responsible for the worldwide decline in productivity growth. Second, the global financial crisis is unlikely to be the main, let alone the only, explanation — although persistent spill-overs or hysteresis (cyclical shortfalls that become structural) from the crisis may be playing some role in holding back the supply side globally. Indeed, one of the troubling aspects of this analysis is that the causes of the productivity slowdown remain elusive, despite a myriad of potential interpretations.
Notably, some of these are much more persistent than others, and some are more amenable to policy fixes. Together, these imply the global economy isn’t doomed to low productivity forever, but it could drag on for quite some time.

Lower everywhere you look 

The simplest and most direct measure of productivity is output divided by hours worked. The more output that can be produced with a given amount of labor input, the more productive each hour of labor is. Conversely, if hours are growing faster than output, labor productivity must be slowing down. Such slowing has been a common occurrence over the past few decades among developed economies (and more recently among emerging markets). Chart 1 plots a smoothed measure of labor productivity growth (estimated by locally weighted regressions) for each of the G4 economies since 1951. All are appreciably lower during the last 5 to 10 years than at any time in the prior 55 to 60 years. Chart 2 is a similar plot for several other European economies. 
In the US, productivity growth slowed notably in the 1973-1995 period, then accelerated for about a decade before slowing down more significantly from around 2004 until today. Japan and Germany had notably higher labor productivity growth in the aftermath of the Second World War but recently have converged toward US levels. Britain started slower but its labor productivity surpassed the US pace from the late 1960s until around 2000, before diving below zero recently. Chart 2 shows a similar pattern for other DM economies, with labor productivity growth generally peaking at some point in the 1960s and declining ever since; Sweden and Switzerland experienced some stability in the 1990s and early 2000s before declining further. Like the UK, Italy’s measured labor productivity has turned negative on average recently.

Accounting for the growth slowdown 

A capital concern 

To understand the factors that have slowed productivity growth, economists often engage in “growth accounting.” One way to increase labor productivity is to give workers more or better capital (tools, equipment, computers, etc.) to work with — so called “capital deepening.” As investment spending has been weak in the post-crisis period, that seems like an obvious place to look for an explanation for the slowdown in labor productivity. Chart 3 illustrates how much a decline in capital deepening has impacted labor productivity growth across the eleven G10 DM economies. Note that due to data limitations, we analyze annual data from 1994 to 2014.

All eleven economies experienced a decline in productivity growth in the 2005-2014 period relative to the prior decade, by nearly 1.1pp on average. And, in most of them, the contribution from capital deepening (the sum of the orange and green bars) declined as well — but only by less than 0.3pp on average. Japan experienced the largest decline (60% of the fall in labor productivity growth can be attributed to less capital deepening), followed by the UK and the US (although only about 40% of the productivity slowdown); in Canada capital deepening actually grew slightly. All told, only a relatively small proportion — about 25% — of the slowdown across DM in labor productivity growth over the past two decades is due to slower growth in the amount of capital per worker.

A related hypothesis is that investment in information and communication technology (ICT) capital boosted labor productivity in the late 1990s and early 2000s, but that impact has since faded. Chart 3 also separates capital deepening into ICT (green) and non-ICT (orange) components. Some countries experienced measurable slowdowns in ICT capital deepening — most notably France, the Netherlands and the UK — while several others — Germany, Canada, Sweden and Belgium — actually saw a rise. Thus there is no systematic relationship between ICT investment and the decline in labor productivity among the G10 economies since the mid-1990s.

We don’t need no education? 

A second underlying factor that could change labor productivity would be changes in the quality of the labor force. A more skilled or educated labor force is likely to be more productive, all else equal. Chart 3 additionally contains estimates of “labor quality” from the Conference Board. Some analysts have speculated that more skilled workers are hired early in a recovery, and as it progresses the average skill level of newly hired workers goes down. That dynamic might help account for lower labor productivity recently versus a few years ago, but cannot readily explain the decadal differences in Chart 3. That said, with the exception of the UK, the decline over time has only shaved 0.1 to 0.2pp from labor productivity growth. Hence, changes in the composition of the labor force are not a significant factor for lower trend productivity." - source Bank of America Merrill Lynch.

What we find of interest on the above statement relating to "education" is clearly that the "student debt growing bubble" has not translated we think in an increase in the quality of the labor force. This can be seen on a monthly basis through the BLS data relating to employment components and education as per our below updated chart:

- source Macronomics / BLS - June 2016 update

So, you will excuse our "pessimism bias" because when it comes to "student loans debt", it's "much ado about nothing" in our book hence our lack of belief in education translating in "productivity labor growth". It hasn't happen and will not happen.

When it comes to explaining the "productivity" conundrum, in their note Bank of America Merrill Lynch try to put forward several possible explanations on the subject:

"Residual issues 

The part of labor productivity growth that cannot be explained by factor inputs (as above) is called “total factor productivity” (TFP). Conceptually, TFP can take a variety of forms, including technical innovations, gains in efficiency of operations, management style changes, etc. Practically, TFP is also known as the “Solow residual,” named after the prominent macroeconomist Robert Solow, the father of growth accounting. As the name implies, TFP is what is “left over” after other observable supply-side factors are accounted for. Significantly, the decline in measured TFP accounts for most of the decline in labor productivity for the DM countries in Chart 3. More generally, variation in TFP tends to account for most of the variation in labor productivity both over time and across countries. What has led to a decline in TFP is the key question.
There are a few big theories about why TFP growth has slowed over time across DM, listed in order from the most persistent — ie, the most likely to result in long-run low
TFP growth — to the least: 

• No more “low-hanging fruit.” The big economic innovations have happened already according to this argument, and inventions today are simply not as significant as (say) electrification or penicillin or the internal combustion engine.
This is a structural story that has an “end of history” flavor to it: the internet is just a fancy telegraph; nothing transformative here. Growth will stay low in this view; better get used to it. 

• Consumption over production. In this argument, innovation has shifted from supporting more efficient production to more intense consumption. Mobile phones, ubiquitous cellular service — these are used for casual gaming and sharing cat videos, rather than pushing out the production possibilities frontier. That doesn’t necessarily preclude a more productive use down the road. But to the extent this too is a structural shift, it likely means TFP growth remains lower for longer.

• Diffusion dynamics. Important technological development is still happening; it just takes time for its effects to show up on the shop floor and in the data. Firms are still learning how to most effectively utilize mobile, cloud, sharing, etc, to raise TFP. Robotics, genetic engineering, the “internet of things” — these innovations will raise productivity (and with it trend growth) at some point in the future.  

• Mismeasurement. Productivity growth  already is high, for all the reasons mentioned above — it just isn’t measured correctly. Output excludes many free services because they aren’t priced; significant quality improvements aren’t fully captured. In this view, the statistics will eventually catch up to reality. Meanwhile, in this view real output is higher and inflation lower than commonly reported. The future’s so bright, you’ve got to wear shades.

The first two more persistent slow growth stories may have some ring of truth, but history is littered with prior assertions that productivity growth had ended — only to be proven unduly pessimistic. However, if TFP is embedded in the capital stock and investment remains low, a self-reinforcing adverse feedback loop could arise: weak productivity creates few incentives to invest which perpetuates weak productivity. Indeed, there is a risk that such a feedback loop is already in place. The third explanation does have recent history on its side: the US (as well as some other DM economies) experienced a significant slowdown in TFP growth in the 1980s as the personal computer age began, but then saw more rapid growth from the mid-1990s until the mid-2000s as the returns to ICT investment were realized. Economic historians have found related evidence that the introduction of the steam engine into manufacturing did not materially improve productivity until the production processes were altered to better take advantage of this new invention. This diffusion process took several decades in that case. Something similar may be occurring with today’s latest technological innovations, such as mobile and cloud computing.
The mismeasurement story, on the other hand, has some optimistic appeal but is hard to reconcile with the data. A recent in-depth study finds evidence of mismeasurement of technological innovation, but this has not changed over the past few decades while,the share of such products in domestic production has declined thanks to offshoring. As a result, mismeasurement actually exacerbates the productivity slowdown rather than explains it. Meanwhile, the combination of low wage and price inflation suggests that weak demand is as much at play as weak supply. Strong productivity growth historically has produced strong real wage growth, yet real wages are generally depressed in DM." - source Bank of America Merrill Lynch

What we have seen with "the rise of the robots" and the very aggressive "cost cutting exercise since the Great Financial Crisis undertaken by many large corporations is that the productivity slowdown has indeed been exacerbated leading to non existing wage growth and depressed "real wages" à la Japan as discussed in our previous Macro and Credit conversation.

So what are the implications for policymakers around the world given the continued rising of populism? Bank of America Merrill Lynch in their note give us some sobering indications:

Implications for policy 

Weak productivity growth translates into weaker long-run economic growth, which means it is harder to grow out of budgetary shortfalls or debt burdens. Coupled with slowing population growth and declining worker-to-retiree ratios, it means more stress on social safety nets. For monetary policy, slower productivity growth will tend to mean output gaps close more quickly for any given pace of recovery, which will force central banks to normalize policy sooner or risk overshooting on consumer and/or asset prices. It also means a slow, drawn out recovery cannot be remedied merely with low rates and large-scale asset purchases.
Fiscal policy may be able to help jumpstart faster productivity growth by encouraging innovation through product and/or labor market reforms, but these take time and tend to be politically divisive. Investment in public infrastructure also may be supportive. Evidence strongly supports the idea that global competition via open trade boosts productivity. Unfortunately, around the world both the volume of trade, and the political support for promoting it, appears to be waning. This, too, could be an avoidable factor that is helping to push down productivity growth across countries. But without a clear diagnosis of the reasons for the decline in productivity, it is difficult to suggest a set of feasible policies to counteract it." - source Bank of America Merrill Lynch

Furthermore, for the "Optimists" crowd, we think that the weak productivity situation should not be taken lightly. This is clearly re-iterated in the most recent BIS annual report published in June:

"Less comforting is the longer-term context – a “risky trinity” of conditions: productivity growth that is unusually low, global debt levels that are historically high, and room for policy manoeuvre that is remarkably narrow. A key sign of these discomforting conditions is the persistence of exceptionally low interest rates, which have actually fallen further since last year." - source BIS, 86th Annual Report

In our book, "secular stagnation" is not only due to the burden of high global debt levels but, as well by the evident slowdown in productivity labor growth, which is clearly impacted by the "rise of the robots". This does not bode well for the stability of the "social fabric" and with rising populism in many parts of the world.

Back in November 2014 in our conversation "Chekhov's gun" we argued the following:

"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?
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend." - source Macronomics, November 2014

Obviously our "Hopeful equation" suffered from "Optimism bias" and as we argued at the time:

"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

Increasingly it looks to us that we are moving towards the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). That's our take and our "pessimism bias" for now.

When it comes to "asset allocation" in the current "risk-off" environment, we continue to like long duration high quality credit such as US High Grade. It benefits from the rally in the "Greenback" (US dollar) as well as higher yields than its European peers. More on this in our next bullet point.

• Macro and Credit  - Our "pessimism bias" make us continue to prefer the safety of US High Grade

While we have long advocated going for "quality" and indicated that US Investment Grade credit was the only "game in town" particularly for Japanese investors, the current "risk-off" environment is favoring the safety of the US Dollar Index given today as we write our latest musing, we have seen the largest 2-day increase since 1992, a "cool" 5-sigma event. This is what you get with central banks meddling with asset prices for too long: rising positive correlations leading to significantly large standard deviation moves. This was highlighted in our "lenghty" but nonetheless must read February post on risk and VaR (Value at Risk) conversation "The disappearance of MS München".

What is currently being priced in the US government bond market contrary to the Fed's recent stance is more "easing" rather than "hiking" we think hence the relative safety and comfort in US Investment Grade credit from an allocation perspective. On this subject we agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 24th of June entitled "European divorce":

"More monetary policy easing 

Behind today's plunge in global yields lies - in addition to lower global growth – the expectation that Brexit will prompt more monetary policy easing from global central banks. Included in this is that we now expect the Bank of England (BOE) to lower rates and start engaging in QE this summer. Brexit is also expected to dampen the Fed’s rate hiking cycle – case in point right now the Fed funds futures market is pricing in equal probabilities of a rate hike and a rate cut at the next FOMC meeting in July (12%).

However, clearly since foreign countries lead the decline in economic growth the net result is incrementally more dovishness abroad than in the US.
That explain why US yields remain high relative to European yields, even though the absolute level of US yields is coming down (Figure 9), which should continue to attract European buying of US corporate bonds.

Moreover, on the Japanese side US corporate bonds are now more than ever the only game in town. Specifically Japanese corporate yields are now 0.13% and the situation is not much better in 30-year JGBs yielding 0.15%. However, the yield on a fully currency hedged basis for a Japanese investor buying a 10-year US senior bank bond is 0.80%, or 5-6 times as high (Figure 10)

Corporate yields can decline 

A defining aspect of the big sell-off in the beginning of the year was the stability of corporate yields – hence as Treasury yields plummeted spreads blew out almost in the relation of one-to-one. That happened as both domestic and foreign investors stepped to the sidelines with the simultaneous decline in US yields and yields relative to foreign fixed income (Figure 9). However, because the weakness this time around is driven more by expected European weakness, as explained above, our market is not becoming less attractive to foreign investors. This means that, even though yield sensitive domestic investors may now become very defensive we should continue to attract significant foreign demand. We think that the Brexit surprise means that US corporate yields can now decline further – which is what we saw in today’s post-Brexit reaction – both in the USD and EUR markets. 

Credit outperforming on Brexit 

Given the low Brexit probability priced by the market by the end of Thursday the reaction on Friday was severe across most markets. In high grade credit, on the other hand, the move wider in spreads was rather underwhelming. In particular banks and some industrial spreads are actually tighter today following the actual vote for the “leave” camp than the wides reached last week in response to just the risk of Brexit.
Moreover, highlighting the strength in credit and unlike February, Friday’s widening in high grade credit spreads was less than the decline in rates, pushing corporate yields lower in both in the US and in Europe.
On Friday, following the results of the UK EU referendum, the Sterling was down 8.2% (a 15 standard deviation move for the period Jan 2010 to the present), European stocks sold off 8.6% and iTraxx Main closed 18bps wider. Naturally the shock spilled into US markets as well, pushing the yield on the 10-year Treasury down 19bps to 1.57% and stocks down 3.6% on the S&P 500, including 5.4% for the financial sector (Figure 1).

- source Bank of America Merrill Lynch

Having exposure to US High Grade Credit in this on-going "Japanification" process can indeed dampen the volatility experienced in various asset classes, while US credit still boast more favorable carry thanks to higher yield and roll-down compared to European credit which has tightened even more dramatically thanks to ECB meddling with Corporate credit as of late. Furthermore US Investment Grade credit still benefit from favorable flows unlike equities and High Yield.

While we have been in recent months describing the slow deterioration in the credit cycle, "Brexit" or not being the catalyst for the recent bout of "sell-off", it was our belief in the US economy being weaker than expected that has enticed us again this year to play à la 2014 the long US duration play (partly once more via ETF ZROZ). We keep telling you that we are indeed in the last inning of the credit game and as per our last conversation we'd rather focus on the big picture being tighter financial conditions and deterioration in macro data rather than on the "political fallout" stemming from "Brexit". Once again like any behavioral psychologist, we tend to focus on the process rather than on the content. When it comes to advising you to reach for quality in 2016 credit wise, we also agree with Bank of America Merrill Lynch's High Yield team when it comes to assessing the credit picture. For instance, we read with interest their High Yield Wire note from the 20th of June entitled "Bifurcate or break: the investment conundrum of a rolling blackout":

"Laelaps and the Teumessian fox 

In Greek mythology the Teumessian fox’s great power was to always be able to escape its hunter. Laelaps the dog, on the other hand, charged with catching the fox, had an equally great power: to always catch its prey. And with such simplicity a great paradox was created: how can one who catches everything catch something that can never be caught? The answer? It can’t. In the case of Laelaps and the Teumessian fox, Zeus turned both into stone. We find great meaning in the story … what happens to an economy that can’t grow or generate inflation when it is met with a central bank that, although has made mistakes in the past, seems to always right the economy eventually? Like Zeus, who turned our main characters to stone, do the modern day fox and dog effectively become paralyzed in their current states of low growth and accommodation? And if so, what does this mean for markets?
We believe the credit cycle is currently in its latter innings as the growth process has arguably stalled if not begun to slip backwards. Although Draghi, Kuroda and Yellen are doing their best, monetary policy can only be as useful as fiscal policy allows. And although our belief is that eventually deteriorating corporate earnings will lead to layoffs, a collapse in consumer confidence and spending and ultimately a recession, we also believe that an increasingly compelling case can be made that in between bouts of volatility our rolling blackout scenario may become the norm for much longer than any of us can anticipate. Under such circumstances the most levered companies with the poorest earning potential, those disrupted by technological innovation, and issuers relying on constantly open capital markets would trade at distressed-type levels. Meanwhile, those companies with consistent capital market access, strong management structures and who are financially nimble effectively would trade at some liquidity premium and very little credit risk premium, likely becoming targets for IG M&A. Effectively, valuations in high yield could become even more binary than they are today: trading at distressed levels or like an investment grade credit with a bit of extra liquidity premium.
Under such a universe, we think the case can be made that bigger is not better. In fact, we would argue that smaller high yield, high quality corporates that are attractive M&A candidates for IG companies would be compelling vs. a large BB and high quality single B credit that has a massive balance sheet and is susceptible to shocks. For those who must play high yield, believe in our barbell strategy, and are looking for index-level yields and returns, own small-cap BBs (along with a cash position in treasuries) with smaller CCC risk in issuers that have “already realized” their event.

The bigger the tree the harder the fall 

With our view that bigger companies are susceptible to risks and shocks, and that default risk has the potential to be a constant presence — even if a subdued one — for a long period of time, we are often told that the market is safer today because it’s more a “real” market relative to pre-crisis. “Real”, often defined as a bigger universe of names, larger issuers, more recognizable brands and higher EBITDA is a term we would hesitate to use. And although there is no doubt that the high yield market today is not only larger than it has ever been (it has grown in size by 90% since 2008), we would challenge the assertion that the high yield market is any safer because of growth. We prefer to judge markets more on their “maturity” and would focus more on the increase in the base of investors, breadth of industries, as well as the degree of price transparency and liquidity than on size. Clearly the ability for capital markets to structure deals in difficult times is also crucial to defining credit market maturity and having investors up and down the capital structure is also important. When considering this definition, we find that today’s market is not significantly more “real” than it has been in the past. Although we do benefit from increased price transparency because of the documentation of TRACE activity, the high yield market today still shows a relatively small investor base and high concentration among the top 3 industries (table 2):

Mutual fund ownership peaked in 1998 and — absent a brief increase in 2012 — has been on a consistent decline ever since, allowing institutional funds to gain greater market share and concentrate ownership into the hands of a few large investors (Chart 2).

The same story holds true as it relates to sectors, where in today’s market Energy, Healthcare, and Telecom make up 37% of US HY by face value. This is not all that different from Telecom, Media, and Materials’ 42% representation in 2000 and suggests the lack of industry breadth present in today’s market. We do not deny that the development of TRACE in 2005 has led to significantly greater price transparency and was the harbinger of future technological developments, including our own Instinct® Loans e-platform that was recently launched. However, these financial innovations have been coupled with increased regulatory burdens and more balance sheet restrictions, and we have actually seen lower trading volumes (Chart 3) and little change in bid/ask spreads since 2008. In fact, some would argue TRACE has hurt liquidity, as the transparency into small transactions makes it difficult to execute larger transactions discreetly.

Additionally, we believe the ghosts of markets past coupled with indebtedness never before seen will likely cause financial burdens that are not fully appreciated. Our view is that central banks have effectively obfuscated the true health of the global corporate markets and absent a significant increase in growth — something we question accommodative policy’s ability to spark – this cycle is unlikely to look meaningfully different than past cycles when the business cycle ultimately turns. In fact, when coupled with the growth in commodity issuance in the post-crisis years, the lingering impact of 2006 and 2007’s LBOs and the lack of earnings power outside of just a few sectors, we argue that in real terms, the US high yield market today looks remarkably similar to how it looked like during the Clinton and Bush years.
This is in contrast to the view that more mature capital markets and larger companies will cushion the next cycle. In fact, we think we could make just the opposite case — that large serial issuers, fueled by cheap debt and poor organic earnings prospects will likely prove a problem when the cycle turns, as history suggests size is not a good determinant for defining credit or default risk. Additionally, the biggest high yield issuers are unlikely to spur any targeted M&A, sponsor or strategic deals just given their size and bloated balance sheets. To this end, high yield is no more a “real” market than it has ever been. Have some aspects matured? Yes. Do traditional size-based measures indicate a healthier investing landscape? No." - source Bank of America Merrill Lynch

While some might infer with their "Optimism bias" that eventually things will turn out alright, we beg to disagree, in this long credit cycle fueled boy over-zealous central bankers, we believe that when the cycle will turn in earnest with US slowly grinding towards recession, the default rate will be much larger and recoveries will of course be much lower. That's a given.

What makes us having this "Pessimism bias" you might rightly ask? How about our final chart below?

• Final chart: Global Non-Financial Corporate Debt to GDP is "off the charts"

Our "Pessimism bias" stems from the very high leverage of the non-financial sector on a global scale and as pointed out before, a lot of Emerging Markets corporate debt has been issued is US dollar denominated, we believe this is a recipe for disaster as previously highlighted by the BIS as well as by our friends from Rcube. Our final chart comes from Deutsche Bank's Credit Bites note from the 8th of June entitled "A no excess cycle? Not true in corporates":

"Figure 1 looks at global non-financial corporate debt/GDP based on the BIS dataset and definitions. Whilst it’s not always easy to categorise debt into various buckets and whilst we have some issues with slightly different results across different data providers it’s fair to say that the BIS data is the best way of looking at the global debt picture. 

So non-financial debt has increased significantly in this cycle. On this measure the increase is of the magnitude of around $15 trillion since the lows after the financial crisis." - source Deutsche Bank

So in a world plagued by low productivity labor growth and high level of debt we wonder how some pundits can continue with their "Optimism bias". We'd rather stick to our "Pessimism bias and play the "minimax principle":

"A principle for decision-making by which, when presented with two various and conflicting strategies, one should, by the use of logic, determine and use the strategy that will minimize the maximum losses that could occur. This financial and business strategy strives to attain results that will cause the least amount of regret, should the strategy fail." - source businessdictionary.com

It is isn't a game of capital appreciation but it certainly becoming one of capital preservation we think...

"A pessimist is a man who tells the truth prematurely." -  Cyrano de Bergerac

Stay tuned!