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Monday, February 25

25th Feb - Credit Guest: Winner-take-all

This week's highly anticipated, long overdue and terrific credit guest post from Macronomics - your man in the land of strange acronyms like DV01, CDS and PMI. Enjoy and prosper!

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Credit - Winner-take-all

"One should always play fairly when one has the winning cards." -  Oscar Wilde

"Winner-take-all is a computational principle applied in computational models of neural networks by which neurons in a layer compete with each other for activation. In the classical form, only the neuron with the highest activation stays active while all other neurons shut down, however other variations that allow more than one neuron to be active do exist, for example the soft winner take-all, by which a power function is applied to the neurons." - source Wikipedia

Looking at the recent raft of European data in general and PMIs in particular, we thought we would venture again towards computational analogies in our chosen title, in similar fashion to our previous post "Banker's algorithm" in 2012.
In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down - source Bloomberg:
In our first credit post of the year, namely the "Fabian Strategy", we sounded the alarm in relation to France being clearly in the crosshair in 2013:
The story for 2013 in Europe we think, will be France:
In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").
Back in November in our credit conversation "Froth on the Daydream" we argued:
"Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far")."

In this week's conversation, we would like to reiterate our views on France in particular and Europe in general and why France will be in the spotlight in 2013.

While the French government has decided to revise its growth outlook for the year, the overly ambitious fiscal deficit in France of 3% will not be met and even the revised growth outlook of 0.2% to 0.3% will not be reached.
Why so? Well, having a look at one definitely scary graph displaying, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tells the story on its own, we think - source Bloomberg:
A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 42.7 for Services PMI is the lowest since February 2009. Overall French composite PMI is at 42.3, the lowest level since April 2009. 
If the Services PMI contracts at such a rapid pace, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).
Germany versus France, a story of growth divergence and unemployment divergence - source Bloomberg:

In that context, we would have to agree with Nomura's take on French Q1 GDP forecast of -0.3% q-o-q and as well with their annual GDP forecast of -0.5% in 2013, meaning France will have to find additional resources to fill the gap in its public finances.
"At the sector level, the euro area manufacturing PMI dipped slightly to 47.8 from 47.9 in January (Consensus: 48.5; Nomura: 48.4), mainly owing to the fall in the output sub-index (from 48.7 to 47.5). However, the forward-looking indicators seem to be more positive than the headline index, with the new orders component rising to 47.7 from 46.8 previously, thus taking the new order-to-inventories ratio to 1.02, the highest level since June 2011. In particular, thanks to the strong demand in Asia and the US, new export orders, mainly led by Germany, returned to expansion (at 51.7 from 49.5) for the first time since May 2011. In the services sector, the headline index (at 47.3 from 48.6) and almost all the sub-indices declined. Against a weak backdrop for domestic demand, new business and business expectations remained at low levels, suggesting a bleak near-term outlook. Country details again revealed significant divergences across the region, with the situation in France increasingly worrying." - Source Nomura - Euro area composite PMI to increase pressure on ECB - 21st of February 2013.

 The divergence between the US PMI and European PMI, is here to stay in 2013 - source Bloomberg:

But, before we look into more details about France in particular, first a quick credit overview.

The European bond picture, with Spanish 10 year yields staying around 5.15%, whereas Italian 10 year yields below 5% hovering around 4.45% and German government yields stable around 1.60% levels - source Bloomberg:
While this picture has been relatively stable for the last couple of weeks, the uncertainties surrounding the Italian elections could through a spammer and derail this overall picture of yields stability for peripheral countries.

Sovereign CDS wise, Credit Default Swaps in Portugal, Spain, Italy and Ireland have tightened over the last 3 Months, with Portugal showing the biggest improvement, tightening 32% to 381.1 bps. Italy improved the least, but still tightened 12.5bps (5%) to 247.5 since 23rd November according to CDS data provider CMA part of S&P Capital IQ:
Looking at the week ahead, arguably the Italian elections taking place on Sunday and Monday will be key in determining the willingness of the Italian population to push forward reforms: Italian elections (Sunday and Monday) as indicated by Nomura's take in their latest "The Economy Next Week" from the 22nd of February:
"The Italian national elections will be held on Sunday 24 and Monday 25 February, with polls closing at 2pm London time on Monday and the first exit polls likely available a few minutes after that. Our baseline view is for a centre-left majority in both houses of parliament, with Pier Luigi Bersani as prime minister. In the likely case Bersani fails to win the Upper House, we then believe he will negotiate and build a coalition with Mario Monti for the remainder of next week. We view this as more likely than new elections and we expect such a coalition to face difficulties in implementing reforms. The fragmented political landscape and the possibility that the shape of the government will be decided as a consequence of post-election alliances rather than from a decisive vote are recipes for instability and slow reform momentum, our main concerns after the elections." - source Nomura

One thing for sure, the Italian election is going to be a close call and could add potential uncertainty to the European project. As displayed by Bloomberg's Chart of the Day, the Berlusconi effect, while present, might
not be enough to counter Italian premiership candidate Pier Luigi Bersani - source Bloomberg:
"The CHART OF THE DAY shows that Bersani’s average lead in opinion polls of 6 percentage points for elections to the lower house of Parliament is similar to Romano Prodi’s advantage of 5.8 percentage points over Berlusconi in 2006. While Prodi went on to win by just 0.1 percentage point, the victory margin for Bersani will drop to only about 2.4 percentage points assuming the same survey bias this year, as more parties contest the election now than seven years ago. The bias may reflect a so-called Berlusconi effect, whereby voters tell polling companies they won’t support the three-time premier, perhaps out of embarrassment, only to cast ballots for him on election day, D’Alimonte said. The case resembles the “Bradley effect,” named after Tom Bradley, the black former Los Angeles mayor who unexpectedly lost the 1982 California election for governor after most surveys indicated he would win. “There’s certainly a number of people who are reluctant to say they’re going to vote for Berlusconi, but they actually will,” D’Alimonte said by phone. Still, “it’s unlikely they will be enough” to give Berlusconi the edge over Bersani in the election for the Chamber of Deputies, he said." - source Bloomberg

Interestingly we have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:
The lag in European stocks given the very recent negative tone in European economic data has made them much more volatile. Should the "Risk-Off" scenario come back in the coming weeks it should lead to additional weakness for the Eurostoxx and rising Italian yields in the process.

In similar fashion, the recent weakness in European stock has led to a growing divergence between the evolution of VIX versus its European counterpart V2X - source Bloomberg:
While V2X has reached 20.40 from a low of 14.85, VIX has surged from its low of 12.31 towards 15.22.
As we pointed out last year in our conversation "The two main drivers of equity volatility" with the help of our friends from Rcube Global Macro Research:
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
As we posited in "Yield-Famine": "Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability."

On the subject of credit becoming a crowded trade, it seems some high-yield investors are also starting to take notice of credit entering bubble territory. As reported by Cecile Gutscher and Doug Alexander in Bloomberg on the 22nd of February - Top Junk Bond Manager Marshall Sees Rally Ending:
"CI Investments Inc.’s Geof Marshall, the second-biggest Canadian manager of high-yield debt, said the four-year rally in below-investment-grade bonds is coming to an end as companies begin to take on too much risk. “The high-yield rally is long in the tooth,” Marshall, who manages $6.8 billion as head of high-yield investments, said in a Feb. 20 interview at his Toronto office. Investors can expect “coupon-like returns” this year, he said. The Bank of America Merrill Lynch High-Yield Index gained 18.8 percent in 2012, beating the returns of investment-grade corporate debt for the third time in four years. After using junk bonds to propel his Signature Diversified Yield mutual fund to the top 10 among Canadian balanced funds last year, Marshall is cutting holdings of the securities to 35 percent, from 40 percent in the middle of 2012. Following four years of balance-sheet repair and cost-cutting, many issuers are shifting their preference back to boosting return on equity, while the re-emergence of debt-laden takeovers such as Dell Inc. and HJ Heinz Co. will undermine confidence, he said. “Companies can borrow cheaply, shareholders are clamoring for returns, so to the extent that high-yield companies can borrow for growth or to increase dividends, I think you’ll see more of that,” Marshall said. “The quality of high-yield issuance probably begins to deteriorate in general.”' - source Bloomberg.

In terms of sector allocation and as far as the story of the "Great Rotation" goes, namely allocating from credit to equities, it seems some players are already taking a few chips from the High Yield table and rotate some of their High Yield allocation into equities as reported in the same Bloomberg article:
“What we’re doing is very gradually letting the high-yield weight fall” in funds including the High Income fund, where junk is mixed with other assets, Marshall said. “As we get inflows, the marginal dollars are being invested in equities as opposed to credit.” Apart from equities, Marshall is boosting bets on U.S. dollar leveraged loans, which pay similar coupons of about 6 percent to U.S. junk bonds and get paid first in bankruptcies. “The value gap between loans and high-yield bonds is greatly diminished,” he said." - source Bloomberg.

Geof Marshall concluded is  Bloomberg interview with the following important points:
"“We’re at the cusp of transitioning from a market that’s driven by systemic, macro challenges, risk-on, risk-off, to a market that’s going to be more idiosyncratic,” Marshall said. “I don’t think the high-yield trade is over per se, I just think that returns are going to be lower going forward.” - source Bloomberg.

Moving back to our French subject, and in continuation to last week conversation around goodwill impairments on corporate earnings, French giant France Telecom, in similar fashion to its French relative Credit Agricole wasn't spared either by goodwill writedowns and took a 1.84 billion euros impairment charge on its units in Poland, Romania and Egypt which dragged down its 2012 profits. As we indicated last week in our conversation "Bold Banking", the Telecommunications sector has seen some large goodwill impairments in recent years, such as Deutsche Telekom 7.4 billion euros goodwill writedown in November 2012 on its T-Mobile USA unit and Vodafone as well with a 5.9 billion pound writedown on assets in Italy and Spain.
Whereas France has been one of the worst performer of core European countries, its flagship France Telecom has been arguably the worst performer in French CAC40's index falling 32.4% during the past 12 months.

But, what have the factors plaguing French GDP?

In a recent note entitled French GDP - Drivers of Corp Revenues and Investment, CreditSights indicated the following:
"The shrinkage is primarily a result of weak corporate investment spending, which is in turn the result of weak household expenditure and, since the fourth quarter, falling export demand." - source CreditSights.

What are the swing factors according to CreditSights:

"It is household consumption and investment spending that tend to be the swing factors. Government's purchases of goods and services from the private sector have tended to be reasonably stable.

But investment spending (to the extent that it is corporate investment spending) is not only a driver of corporate revenues, it is also responsive to revenues. If companies are experiencing weaker sales they will run down inventories and then look to cut back on capex.

That relationship between investment spending (including building of inventories) and company revenues is illustrated by the scatter plot on the right hand chart above. It shows annual changes in investment spending versus annual changes in revenues. Even ignoring the outliers in investment and revenues during the 2008 recession, the R square (the extent to which changes in revenues are associated with changes investment spending) is still 33%. That suggests that French companies' investment plans are, unsurprisingly, heavily reliant on their revenues. And therefore French companies are unlikely to start investing unless it is in response to a pick up in demand somewhere else. In short, corporates require an external stimulus either from greater household spending or greater export demand." - source CreditSights.
Truth is when it comes to greater export demand which could offset the current headwinds plaguing the French economy, France is indeed the outlier, has displayed in the following graph from Deutsche Bank's note "Why Italy and France lack competitiveness from the 20th of February 2013:
As far as our title and computational analogies goes "Winner-take-all". While Germany has been the clear winner in the period going from Q1 2008 to Q3 2012, both Spain (+12.2%) and Ireland have seen their performance improve as far as peripheral countries are concerned.

As a follow up on our introduction relating to the significance and importance of the recent poor display in France's Services PMI, France export underperformance is not due to unfortunate sectorial diversification as indicated by Deutsche Bank note:

"French machinery exports in cumulative terms increased 68% in the 12 years to 2011. But they would have risen by twice as much if they had kept pace with the trading partners’ demand levels in the machinery sector. Indeed, France’s performance gap in the machinery sector is 0.5.

An advantage of developed economies is a more advanced service sector. Unfortunately, France’s poor performance was not limited to exports of goods, as shown in Figure 9. Even in services, the country did not manage to keep up with the expansion of trading partner demand." - source Deutsche Bank.

Regarding the growing divergence between Germany and France, both countries have taken different paths leading to different outcomes as indicated by Deutsche Bank's note:
"France and Germany have followed different strategies to take advantage of globalisation. German companies have outsourced only part of their production process to low-cost countries, mainly located in Central and Eastern Europe. Germany’s geographical position facilitated this process. Using the intermediate low-cost inputs allowed German firms to reduce overall production costs and increase the productivity of their own production plants as well as their profitability. Conversely, French companies often outsourced the entire manufacturing process to lowcost countries. So although the product is sold by a French company, it does not enter French exports." - source Deutsche Bank

A stark reminder of the "Regret Theory":
"The Regret theory (also called opportunity loss) being defined as the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen by our European politicians. The Regret theory is also a model of choice under uncertainty defined as the difference between the outcome yielded by a given choice (credit crunch, economic recession) and the best outcome (muddle through) that could have been achieved in that state of nature (deflationary forces at play).

As far as Europe is concerned, one can wonder what would have been the "economic outcome" if a different course of action would have been undertaken. On that matter we wonder why our "European elites" did not use the minimax regret approach being a decision rule used in decision theory, game theory, statistics and philosophy for minimizing the possible loss for a worst case (maximum loss) scenario." - source Macronomics 

Not only France has lost ground in industrial exports but more critically in high-tech sectors as displayed by Deutsche Bank:

"France’s export market share in high-tech products decreased sharply from 7.1% in 1999 to 4.4% in 2006, rebounding modestly to 4.8% in 2008. Over the 1999-2008 period, Germany’s export market share in high-tech products increased slightly from 7% to about 8%.

The EC sees France’s decreasing market share of high-tech exports as a consequence of insufficient innovation. While – contrary to Italy – R&D in France is not too far from that of Germany (Figure 19) and public investment is high, private investment in R&D lost ground compared to Germany. According to the EC, over the past decade R&D spending by companies in France remained broadly constant at 1.4% of GDP per year, while in Germany it rose to 1.9% of GDP." - source Deutsche Bank.

Finally, loan growth in France to households and corporates points to additional weakness in economic growth, as indicated in the below graph from Nomura's economic research:
We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits.

After all the "Japonification" of Europe is a story of a broken monetary policy transmission channel, leading to liquidity constraints to the private sector with and therefore no impact whatsoever to the real economy, so no potential for economic growth to resume in France in particular and Europe in general.

"Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom." - Viktor E. Frankl, Austrian psychologist.

Stay tuned!