The Macronomics is here with another weekly, looking at the increased leverage, credit market micro issues and of course the ECB - with the usual market overview first, of course.
Previously on MoreLiver’s:
Current Specials:
Special:
Reinhart & Rogoff Debacle (updated)
Credit - Pain & Gain
"The aim of the wise is not to secure pleasure, but to avoid pain." - Aristotle
Looking at the continued rally in the credit space, with the Iboxx Euro
Corporate benchmark tightening to the tune of 5 to 6 bps every week in
the last three week in the cash market, in conjunction with the massive
compression of spreads in the Itraxx Credit indices space, we thought
this week, we would use a reference to 1999, New Times three-part series
of articles called "Pain & Gain" by writer Pete Collins
which inspired 2013 American film directed by Michael Bay. The story
revolved around a gang of local bodybuilders with a penchant for
steroids (liquidity from central bankers?), strippers, and quick cash.
They later became known as Miami's Sun Gym gang and quickly developed a
taste for blood and money.
Gain:
We closed the week on almost 15 bps on Itraxx Main Europe to 92, the
lowest since May 2010, which is the risk gauge for Investment Grade
credit, and 50 bps in Itraxx Crossover to a low of 378 bps.
Pain:
As one credit index trader put it in his closing comments (which are reminiscent of the early days of 2007):
"With street put short yesterday by the massive short cutting, dealers are finding it hard to recycle positions and were having more and more pain as client kept selling index today as well. With shallow volumes, every enquiry drove the market lower.
The incredibly strong payrolls drove us through 90 and this was the
point when people were starting to have discussions of whether these
tights are the new fair trading range or whether they should put those
shorts."
There you go, the penchant for steroids induced rallies in the credit
space is starting to inflict some serious pain to market makers as they
are having to bid for credit indices and getting hit in a severe
tightening market, not only inflicting P&L pain, given they are
having trouble recycling their positions with less players in the market
place than in 2007 (gone are the prop traders, fewer credit hedge funds
and fewer market making banks) but, they are also facing negative carry
on the trades they have had to absorb and did not recycle. Oh well...
So this week, we will focus our attention to the credit space, the
releveraging taking place in the US and Mario Draghi's ambition of
reviving the Euro Zone Corporate lending . But first, a quick market
overview.
The absolute level of core European government yields has continued to
fall even after the 25 bps rate cut this week - source Bloomberg:
2 year Italian yields dropped to 1.068% the lowest since Bloomberg
started tracking the data in 1993 and Italian 10 year yields fell 7 bps
to 3.84% the lowest since October 2010. Spanish yields also receded with
the 10 year falling to 3.97% below 4%, the least since October 2010 and
2 year below 1.60%, the lowest since April 2010.
Credit wise Europe is indeed turning Japanese. It's D, D for deflation.
German 2 year notes versus Japan 2 year notes going negative again and
indicative of the deflationary forces at play we have been discussing
over and over again - source Bloomberg:
Credit wise the rally in 2012 has been epic courtesy of "whatever it
takes 1" (Mario Draghi) and "whatever it takes 2" (Abenomics). Itraxx
Main Europe 5 year CDS index (Investment Grade credit risk gauge based
on 125 entities) and Itraxx Crossover 5 year index (European High Yield
risk gauge based on 50 European entities) - source Bloomberg:
The absolute spread between both credit indices is closing to the level
of March 2011 (255 bps apart) before the liquidity crisis of summer 2011
which was tempered by a good dose of "steroids" (LTRO 1 and 2).
The relationship between the Eurostoxx volatility and the Itraxx
Crossover 5 year index (European High Yield gauge) - source Bloomberg:
We are back to early 2008 levels for both the Itraxx Crossover index and Eurostoxx volatility.
While the Eurostoxx seems struggling to break the 2800 level, the German
10 year Government yields have touching record low levels this week
towards the 1.16% yield level and the Itraxx Financial Senior 5 year
CDS index (indicative of credit risk for financials in Europe) have been
dramatically falling towards 140 in the last couple of weeks while
volatility remains muted at 18 for the V2X index - Top Graph Eurostoxx
50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10
year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied
volatility. - source Bloomberg:
We already indicated that divergence between the US PMI and European PMI divergence which we explained in our conversation "Growth divergence between the USA and Europe",
was here to stay in 2013. This divergence can be seen as well in the
difference in credit spreads risk gauges such as the Itraxx Main Europe
CDS index and its US CDX counterpart - source Bloomberg:
What has been interesting has been the strong correlation between the
US, High Yield and equities (S&P 500) since the beginning of the
year. We have also noticed the strong rebound in Investment Grade as
indicated by the price action in the most liquid US investment grade ETF
LQD - source Bloomberg:
Talking about Pain and Gain, whereas March was brutal for investment
grade, the rebound in April has indeed been very significant. As one can
see the correlation between High Yield and equities seems to be
stronger than ever as both the S&P 500 and the ETF HYG seems to be
perfectly moving in synch.
But, if we focus our attention this week on credit, we would have to say
that the unintended consequences of "steroids" induced policies from
Central Banks is pushing investors more and more up the risk spectrum as
everyone is seeking higher returns as indicated by Fitch recent
European High Yield Chart book:
Deteriorating credit quality poses a risk to the market, but this is largely expected to translate into a migration of ratings to lower levels rather than any substantial increase in the default rate. The legacy loan market is at greater risk of rising defaults due to the concentration of riskier borrowers from 2006 and 2007 who were able to access tighter spreads and higher levels of leverage than the high-yield market could accommodate at the time.
However, further spread compression may entice riskier lower B‟ or CCC rated issuers from the leveraged loan market to issue high-yield bonds. Such developments tend to signal the end of cycle in European high yield and a period of yield and spread widening together with subdued new issuance. To date in 2013, the market is accepting lower quality instruments from higher quality borrowers, such as Sunrise Communications Holdings SA (BB−/Stable) recent PIK note (B− instrument rating). When the market tests low-quality instruments from low-quality borrowers the cycle will be set to return." - source Fitch
The European and US High Yield Market, new issuance and yields - source Fitch:
Using again our "Pain & Gain" title analogy, we would like to
further delve into our analysis of the "Japonification" of credit in
Europe and the difference with the US where we are seeing re-leveraging
at play in the credit space.
For instance, many pundits are wondering how come peripheral EMU bond yields and peripheral bonds have been performing so strongly when indices such as the FTSE Italian bank index is still flat at 10,000.
For us, it is very simple, deleveraging is generally bad for equities and in particular financial stocks, but good for credit assets. We discussed this very subject back in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out."
Why would we have had a rally in Italian banks? It doesn't make sense.
For us a bank is a leverage play on the economy, it is the second
derivative of a sovereign. No credit, no loan growth, no loan growth, no
economic growth and no reduction of aforementioned budget deficits and
no earnings for banks. Banks in peripheral countries had no choice but
to shrink their loan books, reducing therefore their profitability and
ROE.
European Banks ROE by countries from 2005 to 2011 - source Bloomberg - Macronomics:
Nota Bene: 2011 data for Germany not available. McKinsey & Co. said
in its bank sector annual report. European bank average returns on
equity were 15% to 17% in 2005-07, vs. 7% to 9% currently. With the
revenue outlook poor, further cost cuts remain a key profitability
lever. Median ROE in 2011 in the European Union was 2.2%.
As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
Credit dynamic is based on Growth. No growth or weak growth can lead to
defaults and asset deflation which is what we are seeing in Europe and
what a 1.2% inflation rate is telling you hence the ECB rate cut this
week. But, once again ECB is behind the curve courtesy of the stupid
European Banking Association decision of imposing a 9% Core Tier 1
threshold to European banks to be reached by June 2012, which
precipitated a credit crunch in peripheral countries, leading to a surge
in unemployment, bankruptcies and rapid rise in nonperforming loans.
A liquidity crisis happens when banks cannot access funding (LTRO helped
a lot in preventing a collapse in 2011). A solvency crisis can still
happen when the loans banks have made turn sour, which implies more
capital injections to avoid default (hence the flurry of subordinated
bond tenders we have seen in the European banking space and other
accounting tricks...). Rising non-performing loans is a cause for
concern as well as rising loan-to-deposit ratios in peripheral
countries.
Therefore in Europe, you have been much better off buying senior
financial corporate bonds as part of the reflation "whatever it takes"
trade in this deflationary environment than peripheral financial stocks.
As seen in Japan in the past, credit outperforms equities in a
deflationary environment.
Peripheral banks equities = Pain
Peripheral banks senior financial bonds = Gain
At this juncture, we think it is very important to look back on how the
"Global Credit Channel Clock" operates, as designed by our good friend
Cyril Castelli from Rcube Global Macro Research which we introduced in our conversation "The Night of the Yield Hunter":
Whereas credit wise, European peripheral financials are deleveraging,
hence the performance of their bonds ("Gain" - Love) rather than their
equities ("Pain"- Hate), what we are starting to see in the US is
leverage rising as indicated by Fitch, in their recent US High Yield
Default insight from March 2013:
In the March 2013 edition of the “Fitch Ratings/Fixed Income Forum Senior Investor Survey,” a majority of investors saw U.S. corporate leverage moving higher over the coming year and expected some credit deterioration across both high grade and high yield. Fitch’s recurring analysis of the aggregate financial performance of a large sample group of speculative grade companies shows that leverage began to turn up in 2012 — a product of higher debt balances and sluggish EBITDA growth (see Debt / EBITDA chart below).
In terms of flattening yield curve, indicative of the credit cycle, we think as credit investors you should start monitoring the flattening of CDS curves. As a market maker commented recently:
"1 year and 2 year CDS curves are flattening, only a matter of time before 3 year versus 5 year curves does the same and flatten."
We have of course seen this movie before in the credit space in the heyday of the credit bubble build up in 2006 and 2007.
So as credit investors, yes we are indeed still dancing as the music is
playing, but, given the liquidity levels closer to 2002 than 2007, we'd
rather be dancing close to the exit door. As Aristotle put it, our aim,
being wise we think, is not to secure pleasure, but to avoid pain, which
will no doubt materialise at some point.
On a finale note, Mario Draghi ambitions to revive the real economy and
corporate lending that is. The LTROs after all amounted to "Money for Nothing":
"Although LTRO provides cheap funding to European banks, rising
unemployment levels and deteriorating credit conditions should
consequently lead to a significant rise in Non Performing Loans (NPLs)
on banks balance sheet."
Meaning plenty of liquidity impact (steroids) for banks (our European
Sun Gym gang which have a taste for blood and money) but confirming our
2011 fears of credit contraction for corporates and households (Italy
and Spain) - source Bloomberg:
As far as we are concerned, the deflationary forces at play and the unemployment levels in Europe cannot be addressed by ZIRP for the following "creative destruction reasons" as indicated by CreditSights in their recent Sovereign Analysis from the 1st of May entitled -If the ECB doesn't mind Spain deficit, nor do we":
"Spanish
non-financial corporates alone saved the equivalent of 3.3% of GDP last year.
That difference between corporates' revenues and expenses was used to pay down
debt. Spanish, non-financial corporates have net debts equivalent to 129% of
GDP. But it comes at the expense of Spanish households'. In the process of
using revenues to pay down debt, corporates are ensuring that they aren't
spending it and in the vast majority of cases won't not generate incomes for
households. Those cut backs in investment spending are contributing to the
decline in wages and rise in unemployment.
Unemployment has now reached 27.2% as of the first
quarter. And wages have fallen by 1% over the past year. The decline in incomes
mean that household savings have fallen from 6% of GDP in 2009 to 1% of GDP in
2012 as they have been forced to fall back on savings to be able to maintain
spending. While households added €22 bn in financial assets in 2011 they
reduced their holding of financial assets by €15 bn in 2012. That swing from
saving €22 bn to dis-saving €15 bn contributed €37 bn to household spending and
meant that year on year it rose by 0.2% in nominal terms rather than falling by
more than 5.5%." - source CreditSights
Since 2008, you have seen creative destruction at play, meaning
companies have preserved their margins by doing more with less people.
Some job will just not return. What is the benefit of QE and ZIRP on
structural unemployment? Zero so far:
ZIRP isn't only a European problem in this credit "japonifiaction" process at play. It is also the case in the US.
In fact productivity in the US has been rising as companies have been
indeed preserving their margins by managing very tightly their labor
costs and adapting to the low growth environment they face as reported
by Shobhana Chandra in her Bloomberg article from the 2nd of May - Productivity in U.S. Rises as Companies Try to Cut Labor Costs:
The measure of employee output per hour increased at a 0.7 percent annual rate, after dropping 1.7 percent in the prior three months, a Labor Department report showed today in Washington. The median forecast in a Bloomberg survey of economists called for a 1 percent advance. Expenses per worker increased at a 0.5 percent rate after jumping 4.4 percent.
Employers tried to control expenses by making do with their existing staff as demand grew in the January to March period. The emphasis on wringing efficiency gains may mean hiring will take time to accelerate, particularly as across-the board federal budget cutbacks and higher payroll taxes restrain the world’s largest economy." - source Bloomberg.
By keeping interest low to promote investment, like the Fed is also
currently doing, full employment would therefore be "attainable" in the
pure Keynesian tradition. For Keynes, the velocity of money should move
together with the level of economic activity (and the interest rate).
Well guess what. It isn't.
Why?
Credit growth is a stock variable and domestic demand is a flow variable.
Does the end (lowering unemployment levels) justify the means
(increasing M) or do the means justify the end (deflationary bust)?
The only country in Europe we can think of which tackles efficiently
structural unemployment by retraining the labor force is Sweden.
Why would the US labor participation rate in the US increase?
If the cost of capital is not priced but set by central banks, how can
capital be efficiently deployed to innovation and not "mis-allocated"?
Monetary policy at the moment is a desperate race. They are increasing money supply but velocity keeps falling. So the Fed’s problem is best understood as one of trying to bend this velocity curve.
Alan Greenspan made mistakes after mistakes, bubbles after bubbles,
central bankers do not understand that negative real rates always lead
to a collapse in velocity and a structural decline in Q, namely economic
growth rate.
Pain in employment levels - Gain in financial markets.
Stay tuned!