Previously on MoreLiver’s:
Current Specials
Credit - The Night of The Yield Hunter
"Ah, little lad, you're staring at my fingers. Would you like me to
tell you the little story of right-hand/left-hand? The story of good and
evil? H-A-T-E! It was with this left hand that old brother Cain struck
the blow that laid his brother low. L-O-V-E! You see these fingers, dear
hearts? These fingers has veins that run straight to the soul of man.
The right hand, friends, the hand of love. Now watch, and I'll show you
the story of life. Those fingers, dear hearts, is always a-warring and
a-tugging, one agin t'other. Now watch 'em! Old brother left hand, left
hand he's a fighting, and it looks like love's a goner. But wait a
minute! Hot dog, love's a winning! Yessirree! It's love that's won, and
old left hand hate is down for the count!" - Reverend Harry Powell - The Night of the Hunter - 1955 American Thriller by Charles Laughton
While watching with interest gold hitting an intraday low of $1,493.35
per ounce, putting it 22.3% below September 2011's intraday peak of
$1,921.41, with Cyprus selling its bullion in the process, we thought
this week we had to use as a title analogy one of our favorite movies of all time being "The Night of the Hunter".
In the movie Reverend Harry Powell, a serial killer and self-appointed preacher has tattooed across the knuckles of his right and left hands two words "LOVE" and "HATE" so that he can use them in a sermon about the eternal struggle between good and evil. As
investors, we think you should have two words tattooed across your
hands: "INFLATION" and "DEFLATION" so that you can use them in assessing
the eternal struggle between inflation and deflation in this current
environment.
The sell-off in gold, a clear "sucker punch" moment - chart source Bloomberg:
But as indicated by David Goldman, the former global head of fixed
income research for Bank of America, in a previous article about Gold and Treasuries and bonds in general he wrote in August 2011:
"Why should gold and Treasury bonds go up together? Gold is an
inflation signal and bonds are a deflation hedge. At first glance it
seems very strange for both of them to rise together. Why should this be
happening?
The answer is simple: bonds are an option on the short-term interest
rate, and gold is a perpetual put option on the dollar. Both rise with
volatility.
It’s like the old joke about the thermos bottle: “How does it know
if it’s hot or cold?” If the policy compass is spinning and there’s no
way to predict how governments will react, you don’t know whether to
hedge for inflation or deflation, so you hedge for both. By put-call
parity, if there is huge volatility in the policy responses of
governments, the option-value of both gold and bonds goes up."
We also agree with David Goldman's previous comment on gold, namely that
it is not an inflation hedge; it is a hedge against the end of the
dollar’s status as a reserve currency, a deep out-of-the-money put
against the US currency as a whole.
So after all, our call last week for higher gold prices in the second
quarter might be premature and some people might see the right hand
"LOVE" (inflation) as "a goner" in similar fashion to Reverend Harry
Powell's sermon.
It appears to us that old left hand "HATE", namely deflation, to the
great sorrow of our self-appointed "preachers" aka central bankers, is
currently having the "upper hand". Therefore in this week conversation,
we would like to review some of the key indicators we are seeing as
evident signs of the deflationary forces at play in this eternal
struggle between "LOVE" (inflation) and "HATE" (deflation).
As we posited in "Zemblanity", being "The inexorable discovery of what we don't want to know", we
have always found most interesting the "relationship" between US
Velocity M2 index and US labor participation rate over the years. Back
in July 1997, velocity peaked at 2.13 and so did the US labor
participation rate at 67.3%. Now at 63.5% the US is back to 1981 and
velocity is still falling (1.58), even lower than 1960's levels- source
Bloomberg:
The great Irving Fisher told us in his
book "The money illusion" and in his equation MV=PQ that what matters is
the velocity of money which is the real sign that your real economy is
alive and well. We do not see any sign of rebound in velocity.
We do agree with James G. Rickard's view
of the situation, a partner at JAC Capital Advisors, which he made in a
presentation at the recent Global Investment Risk Symposium which was
summarized in an article entitled "The Fed is playing with a Nuclear Reactor" at the CFA Institute:
"To really understand what is going
on, you have to start with the quantity theory of money, or MV = PQ.
(Quick refresher: PQ = nominal GDP, Q = real GDP, P =
inflation/deflation, M = money supply, and V = velocity of money.) The
issue here is that the theory doesn’t hold up in the real world because
velocity — the number of times money changes hands, or turns over — is
not constant. ”Velocity is collapsing,” Rickards said. “You can think of
monetary policy as a desperate race between increasing money supply and
decreasing velocity, and the Fed is printing money to offset the
decline in velocity. . . . So the Fed’s problem is best understood as
one of trying to bend this velocity curve."
A similar disconcerting image is the growing disconnect between Oil
prices, US Treasuries, which have seen their yield falling and the
S&P500 - source Bloomberg:
We think there is currently an accumulation of worrying signs that the
global economy is decelerating and that old left hand deflation has
indeed a solid grip when one looks at China's shrinking electricity use,
a bearish sign for a price index of industrial metals that, according
to Bloomberg, has posted a first-quarter decline for the first time in
12 years - source Bloomberg:
"The CHART OF THE DAY shows that a gauge of six prices from the
London Metal Exchange fell 5.6 percent in the three months ended March,
the first drop for the period since 2001. China’s electricity demand in
January and February gained 5.5 percent from a year earlier, compared
with an increase of 6.7 percent in those months in 2012 and more than 12
percent in 2011.
China, the world’s biggest consumer of metals from aluminum to zinc,
targets economic expansion of 7.5 percent in 2013. Factory production,
which accounts for two-thirds of power use, increased 9.9 percent in the
first two months of the year, the weakest start since 2009. Profit at
industrial companies still rose for the fourth straight month,
indicating higher corporate investment to fuel growth." - source Bloomberg
While our friend Cullen Roche from Pragmatic Capitalism tracks Rail Traffic as an economic activity indicator, we, at Macronomics, tend to track shipping and Air Cargo Traffic,
because they are not only economic activity indicators but as well as
credit/deflationary indicators as we pointed out in our conversation "Shipping is a leading credit indicator":
"For us the Baltic Dry Index is another indicator in the
deterioration of credit as well as an indicator in deteriorating credit
conditions leading to a surge in Non-performing loans on Banks' Balance
Sheets."
For instance, Shanghai's containerized freight is 6% lower year on year
as of the 22nd of March, 23% below its peak in May 2012 as indicated by
Bloomberg:
In similar fashion the burst of the credit bubble had a dramatic impact on housing, shipping was as well not spared as cheap credit did indeed fuel a bubble of epic proportion - source Bloomberg:
"The Baltic Dry Index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina. During 1Q, the index typically increases from its seasonally weak period. In 2013, it has been no exception, as the index declined 30.2% sequentially in 1Q. The gain was driven by the tightening panamax market." - source Bloomberg
The Baltic Dry has yet to recover.
China's slowdown is the reason behind the difficulties encountered by shipbuilders such as STX Group as indicated by Kuynghee Park on the 4th of April in his Bloomberg article - China Turns Graveyard From Goldmine Hurting Ship Makers:
"For shipbuilders such as STX Group, China was once a goldmine. Now it’s a graveyard. China’s
lower appetite for commodities undermined the group’s plan to sell its
shipping line, wiping out a combined $435 million of investor wealth at
the South Korea-based conglomerate’s three main companies this week.
That also threatens the group’s ability to repay $1.2 billion of debt by
the end of the year. STX’s crisis comes after last decade’s boom
prompted the group to set up a shipbuilding and offshore complex in
Dalian, northeastern China. With Asia’s biggest economy slowing down and
the European crisis adding to a plunge in cargo rates, China Cosco
Holdings Co., the nation’s biggest mover of bulk commodities and
containers, last week reported a loss for 2012, a third straight annual
loss." - source Bloomberg
From the same Bloomberg article:
"Since the credit crisis, orders to build new ships have plunged. Contracts for new vessels halved to $84.7 billion last year, compared with $174.7 billion in 2008, according to Clarkson Plc, the world’s biggest shipbroker." - source Bloomberg
For financial institutions such as Germany's second largest bank Commerzbank and impaired German bank HSH Nordbank, a large part of their recovery is linked to the fate of new ship deliveries given their shipping loan books have been seriously damaged by over-supply in the container ship markets as reported by Michelle Wiese Bockmann in Bloomberg on the 1st of March in her article - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:
"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship
owners are forgoing seizing vessels even after soured loans to the
industry rose to a record. Europe’s biggest bank by assets, as well as
HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale,
which finances 1,500 ships, are restructuring loans and setting money
aside instead of repossessing vessels, officials from the companies
said. They have about $69 billion in loans to the industry out of $500
billion in total, according to data compiled by the banks and Petrofin
Research SA, an
Athens-based consultant. Owners from Denmark to Indonesia defaulted
in the past year, while U.S. tanker company Overseas Shipholding Group
Inc. sought bankruptcy protection and ship earnings fell to a record last
month. An unprecedented $80 billion out of $125 billion of German loans
to the industry aren’t performing as they should, estimates Paul
Slater, chairman of Naples, Florida-based ship-finance consultant First
International Corp." - source Bloomberg.
HSH Nordbank has shipping loans of 29 billion euros covering about 2,800 vessels, but looking at weak trading conditions, as indicated in a recent note by JP Morgan on HSH Nordbank published on the 4th of April, some ship owners are pushing for new ship deliveries originally scheduled in 2013 to be delivered later in 2014, with additional deferrals expected:
But looking at the deflationary depressed level of Dry-Bulk Shipping rates which are down 9% YoY, but up 78% from 2012 lows - source Bloomberg:
In that context of depressed rates, it is currently driving ship owners to scrap vessels at a strong pace as indicated by Bloomberg:
"This year is expected to be the third straight year of strong
scrapping of dry-bulk vessels, according to Eagle Bulk, with scrap rates
at about $450 per lightweight ton. Eagle Bulk management forecast in
its 4Q call that scrapping rates could equal 4% of the world fleet, or
30 million deadweight tons in 2013. Scrapping should be strongest for
sub-panamax vessels, given that about 16% of this type are 20 years old
or older." - source Bloomberg
Bulk vessels and Container ships have seen a steady number of ships
being broken up due to weak rates and tied up to the weakness in global
economic activity - source Bloomberg:
"Excess capacity and depressed charter rates have increased the
number of container ships sent to be scrapped by 503% since June 2005.
This is creating a more efficient fleet as older ships are replaced by
newer models. Triple-E ships consume about 35% less fuel per container
and are able to carry 16% more containers, according to Maersk." - source Bloomberg
This deflationary environment, and "Schumpeter" like creative
destruction is enabling innovation, in the container shipping space
benefiting, the fittest to survive such as Danish Maersk currently busy
upgrading massively its container fleet.
Whereas German HSH Nordbank's survival is depending on renewed global
economic activity and its fate is tied up to shipping and so is the
fate of its subordinated bondholders who, at some point could indeed
face the same "restructuring" music as Dutch SNS bondholders as
indicated in JP Morgan's note:
"We remain negative on the T1 instruments, as we believe that the
next catalyst for these bonds would provide negative pricing pressure
due to our expectation that there will need to be a retroactive charge
for the increased risk shield at HSH which will impact the cash flow
expectations of the T1 instruments. We acknowledge the bonds are pricing
in a significant number of deferrals already, however, we do not see a
positive catalyst in the near term. For both the LT2 and T1 instruments
we will be keeping a keen eye on the deliveries of ships and any delays
into future years as this could potentially prolong the turn in the
shipping cycle out into 2015. If this were to happen we would become
much more concerned for the outlook of HSH and its debt securities." - source JP MorganAnother economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:
"Over the past 13 years’ monthly data, there has been an 84% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months. In turn,
this has translated into a clear relationship between air cargo and chemical industry volume growth" - source Nomura:
"Our air cargo indicator of industrial activity came in at -3.8%
(y-o-y) in March, following -7.8% in February and -8.3% in January. As a
readily available barometer of global chemicals activity, air cargo
volume growth is a useful indicator for chemicals volume growth." - source Nomura.
Of course another sign of that old left hand "HATE", namely deflation,
has been the absolute level of core European government yields, which
have no doubt been supported by "Abenomics" like we indicated last week -
source Bloomberg:
Government bond market yields across the euro zone dropped near 2-year
low as the aggressive Japanese monetary action ripples through. Italy
sold 7.2 billion euros of debt and French and Belgian government bond
yields declined as well to record lows. The European bond picture, with
Spanish 10 year yields well below 5% at 4.71%, whereas Italian 10 year
yields well below 5% now around 4.35% and German government yields
stable around 1.25% levels, but the most impressive move was on French
OAT10 year bonds closing around 1.80%.
No doubt Kuroda's "whatever it take" moment has delivered a powerful
right hand "LOVE" moment, inflating its Nikkei index in the process and
surging past emerging markets equities surging now well above the MSCI
EM index - source Bloomberg:
In relation to our title being "The Night of The Yield Hunter", it
appears to us that Japan, is having a very strong effect on global
yields, in similar fashion to a gigantic black hole or a powerful vacuum
cleaner. So on that premise although last week we indicated that
France's economy was in trouble, selling OATs is "NO GO" at the moment
for that specific "Japanese" reason. We would therefore be incline to go
for duration and look for visible, stable sources of income.
This Night of The Yield Hunter is as well marking the return of the famous retail Uridashi funds also known as Double-Deckers which we discussed in February in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds."
The Brazilian Real is one of the top "Double-Deckers" preferred currency play for its interesting carry:
"As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again."
And as indicated by Boris Korby and Julia Leite on the 11th of April in their Bloomberg article - "Kuroda’s $75 Billion Lets Gerdau Win Lowest Yield", Brazilian corporate credit is benefiting from this Yield Hunt from yet another self-appointed preacher namely Kuroda:
In that global hunt for yield which has been further stigmatised by Kuroda's monetary policies, even the lowest rated Brazilian issuers are taking advantage of the on-going hunt as indicated in the same article:
"Brazil’s lowest-rated investment-grade issuers are taking advantage of the absence of Brazil’s largest and most creditworthy borrowers from the market to raise funding and reduce borrowing costs, according to Henrique Catarino, the head of international sales at Banco Votorantim SA in Sao Paulo.
Lenders Itau Unibanco Holding SA and Banco Bradesco SA as well as state-run oil company Petroleo Brasileiro SA and iron-ore producer Vale SA, which sold a combined $13 billion abroad in the first quarter of 2012, have refrained from issuing bonds this year, flush with cash and willing to delay issuance until borrowing costs retreat further, according to Catarino. All four companies are rated at least Baa2 by Moody’s and BBB by S&P, on par with Brazil’s government." - source Bloomberg
We made the following point in "Structural Instability":
"The great Hyman Minsky thesis was "stability leads to instability", we would argue that dwindling liquidity and excessive spread tightening in core quality credit spreads courtesy of zero interest rates policy in both the US and Europe is extremely concerning and are already indicative of a great build up in structural instability."
We also added our previous "Hooke's law" ending remarks:
"Given the "Yield Famine"
we are witnessing, we believe our credit "spring-loaded bar mousetrap"
has indeed been set and defaults will spike at some point, courtesy of
zero interest rates."
When reading the following article from Lisa Abramowicz entitled "Hardest-to-Sell Junk Lures Buyers Hooked on Fed", no doubt the self-appointed preachers of this world, namely central bankers have set this credit mousetrap:
"Investors are favoring the riskiest, hardest-to-trade junk bonds by the most in 17 months as confidence mounts that central banks from Japan to the U.S. will prop up debt markets through year-end.
The extra yield investors demand to buy the least-traded bonds with the lowest speculative-grade ratings instead of more liquid securities narrowed to 1.2 percentage points on April 9, the smallest gap since November 2011, according to Barclays Plc data. Yields on the smallest and oldest CCC rated notes contracted by 1.9 percentage points this year, three times the drop on yields for more active notes with comparable grades. Bond buyers seeking to escape the financial repression brought on by near zero interest rates are venturing deeper into the market in search of returns. They are bidding up the debt of companies that would otherwise be the most vulnerable to bankruptcy had the Federal Reserve not injected more than $2.3 trillion into the financial system since 2008." - source Bloomberg
Moving back to our "The Night of the Hunter" analogy, we think that
Japan is a well a great illustration for assessing this LOVE / HATE
relationship between inflation and deflation in this current
environment. One just have to look at gold priced in yen and the
weakening of the yen versus the dollar to get the point - source
Bloomberg:
We would like to make the following points in relation to the deflationary forces at play in Europe:
-Without private credit growth, how exactly do you get inflation in
Europe? It would be the only big reason to sell core European
governments bonds and French OATs, or another reason would be 'The Big
One" (to use another analogy, this time an earthquake analogy), meaning
the unwind of the European project.
-Unless European banks start lending to the private sector again – and
this seems unlikely – how is this scenario not deflationary?
Consumer credit, which represents 12% of lending to households, decreased on average by 2.8% over 2011.
-Lower banking profits are a symptom of deflation as well, you are
getting smaller ROE in the European banking space, well below double
digits
The place to buy banks is where there is economic growth. Banks are the
second derivative of an economy. For us, it is a leverage play.
(Brazilian banks have double digits ROE in the region of 15% - 17% but
that's another subject...).
LOVE - HATE / DEFLATION - INFLATION:
-Falling home prices in Europe are a symptom of deflation
-Governments restructuring debt is a symptom of deflation.
-A contraction in Europe of banks balance sheets is deflationary.
We believe Europe face the risk of a disinflationary aka deflation bust.
A great definition of a disinflationary bust was made by the Gavekal team:
"Disinflationary Bust: If credit conditions tighten too much then
capitalism is strangled: companies pull back on investment, their
customers put away their wallets, and economic growth slows. These
conditions encourage the marginal equity investor (some of whom have
bought with leverage) to exit the market. Investors then typically head
for the safety of long-term bonds, as there is little sign of inflation
and short rates are likely to fall in response to slowing growth and/or
deflation fears."
In similar fashion UBS in their March 2012 note entitled "The Ides of
March" made an interesting point which could validate the on-going
weakness in both commodities and Emerging Markets:
They published last year on that subject an interesting investment clock:
UBS indicated at the time they were following the HY ETF HYG as a stress indicator:
"We follow the HYG US high yield bond ETF to signal the state of US credit conditions."
In the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit and we indicated the relationship between High Yield and Consumer Staples in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option" how defensive the rally in the S&P500 has been so far - source Bloomberg:
The risk of a deflationary bust, validates our negative stance towards commodities and emerging markets as indicated last week for the second quarter. Here comes that "HATE", that old left hand.
On a final note, the 30 year-year interest-rate swap spread is approaching zero again linked to the fact that Dodd-Frank is forcing swaps to become cleared which will be supportive for US Treasuries as indicated by Bloomberg:
As far as Europe is concerned one could argue in similar vein to Reverend Harry Powell that:
"Salvation is a last-minute business, boy."
Stay tuned!