14th May - Credit guest: "Cushing's syndrome"

A crosspost from and courtesy of Macronomics - the deep end of the pool for market swimmers.

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Credit - Cushing's syndrome

"Ninety-nine percent of the people in the world are fools and the rest of us are in great danger of contagion." - Thornton Wilder, American novelist

Looking at the dizzying volatility in the government bond space and in continuation of our recent theme dealing with "alkaloids", we remembered Cushing's syndrome when choosing our title analogy, also known as "hypercortisolism" which is a collection of signs and symptoms due to prolonged exposure to cortisol (or QEs). Cushing's syndrome is generally associated with rapid weight gain (bond prices), moodiness, irritability or depression to name a few. The most common cause of Cushing's syndrome is "exogenous" administration of glucortocoides prescribed by a health practitioner to treat other diseases such as asthma and rheumatoid arthritis. In our "market case", one could argue that the most common cause of the sudden rise in government bond yields could be linked to the exogenous administration of "QEs" prescribed by central bankers in order to treat weak aggregate demand (AD). Strictly, Cushing's syndrome refers to excess cortisol of any etiology (as syndrome means a group of symptoms). 

When it comes to QE and its impact on asset prices, we have largely discussed its effect in our September 2013 conversation "The Cantillon Effects":

"Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

We also commented at the time about the increase of money supply on the art market as posited by our friend 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.

It is was therefore not a surprise for us  to hear that yet another record in the art market has been broken with a Picasso painting "Les femmes d'Alger" selling for $179.4 million, smashing the previous record of Francis Bacon's triptych "Three Studies of Lucian Freud," which sold for $142.4 million at Christie's in November 2013.

The only "rational" explanation coming from the impressive surge in asset prices (stocks, art, classic cars, etc.) has been "Cushing's syndrome aka monetary base expansion and the belief that indeed, our central bankers are "Gods" which by the way is a clear application of "Pascal's Wager".

In the classical equation of exchange, MV = PQ, also known as the quantity theory of money. we have: 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)

Of course, "Cushing's syndrome" is "exogenous" thanks to our Keynesian/Monetarist central bankers practitioners but we ramble again. 

In this week's conversation we will look at the gyrations in the government bond markets and the worrying trend of rising "positive correlations" courtesy of central banks meddling, or put it bluntly "excess" medication. 

Synopsis:

• "Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations"
• The interest of balanced fund management in a ZIRP world.
• Credit CDS market is under-pricing volatility in the rates space
• "Overmedication" has created an abnormally long credit cycle
• Final note: True health of the US economy - Where is the CAPEX recovery?

• "Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations"

There is a growing systemic risk posed by rising "positive correlations". 

Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:

- source IMF, April 2015

This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoils, bond prices and equities are all moving in concert.

"Positive Correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:

"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 
Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

We could not agree more with the above. Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). When it comes to rising risk and the threat of "positive correlations" and Cushing's syndrome we read with interest Nomura European Strategy note from the 6th of May 2015 entitled "At the mercy of macro":

• "The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. This is the first time this has happened since 2006 and the difference between the two correlations is the largest than at any point in the post 2000 era.

• The average pairwise correlation between stocks in Europe is close to its post Lehman low. However, we do not think that this heralds the return to some kind of stock-picking nirvana (if such a thing exists).

• The rapid move up in bund yields and EUR-USD reversals of recent weeks has been felt in some sharp factor reversals, most notably an underperformance of Momentum both across the market and within sectors.

• We have moved away from a world where changes in macro variables cause short-term rallies and corrections in the overall index level, to a situation where the same macro variables are the driving force for groups of stocks within the market. So understanding the macro risks is no less important. This perhaps represents a market where the main focus is on the nature of the recovery and the timing and type of earnings growth rather than macro developments prompting a continuous existential crisis as we have seen in recent years. We take this as a positive development." - source Nomura

No offense to Nomura but, we do not take it at all as a "positive development". On the contrary, we think it is representative of the excess of "alkaloids" use leading to Cushing's syndrome and rising instability as posited by the great Hyman Minsky. From the same Nomura note:

"In Fig 1 we show the absolute correlation of the European (ex UK) market with a range of macro variables (bund yields, EUR-USD exchange rate and oil); we also show the absolute average pairwise correlation of long-short factors with the same macro variables (using Momentum, Value, Growth and Risk as our factor set). It is unsurprising that the market-macro correlation is usually the stronger of the two. However, now the factor-macro correlation is stronger than the market-macro correlation for the first time since 3Q06.

Moreover, the degree to which the factor-macro correlation exceeds market factor correlation is greater than at any point in the post 2000 era. We show the spread between the factor-macro and market-macro correlation in Figure 2.

Although it is not shown here we also note that the correlation between factors and these macro variables is greater than the correlation between sectors and macro variables at present." - source Nomura

In August 2013 in our conversation "Alive and Kicking" we argued the following:

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 
However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 
Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

What we are currently seeing is a repricing of bond volatility which had been "anesthetized" by central bankers leading to Cushing's syndrome. Central bankers meddling with interest rates levels have led investors to get out of their comfort zone and extend both their risk exposure and duration, taking the repressed volatility regime as an empirical factor in their VaR related allocation risk process. Now they are rediscovering in the ongoing turmoil that, yes indeed long duration exposure is more volatile than shorter ones. They are also rediscovering "convexity" with artificially repressed yields. They are being significantly punished the more exposed to "credit" duration they are. When looking at the average maturity of new issues in the Euro Investment Grade Credit market one can see it has jumped to 10.4 years in March as displayed by Bank of America Merrill Lynch in their European Credit Strategist note of the 22nd of April entitled "The Time for Duration":

- source Bank of America Merrill Lynch

Obviously, flow wise, Investment Grade Credit long term exposure has seen less significant inflows since January 2012 than short term fund as displayed in Bank of America Merrill Lynch Follow the Flow graph from their 8th of May note entitled "the wrath of the Bund" but, nevertheless, overall many pundits have been playing the "beta" game of increasing duration exposure courtesy of new issues and the hunt for yield:

- source Bank of America Merrill Lynch

This brings us to our second point, the interest of balanced fund management in a ZIRP world.

• The interest of balanced fund management in a ZIRP world.

We remind ourselves when it comes to our musings from our previous conversation entitled "Misstra Know-it-all" that, when it comes to undoing the great "destabilizing" work from Ben Bernanke (aka "The Departed"), rising volatility would lead to re-calibration of risk exposure:

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.

The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking".

To that effect and in continuation to Martin Hutchinson's LTCM reference, we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":

“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

Today investors face the same "optimism bias" namely that they overstate their ability to exit. We share our concerns with Matt King from CITI which was quoted in a recent post on FT Alphaville entitled "Der Bundshock, revisited" on the 11th of May:

"To date, the air pockets and flash crashes represent little more than a curiosity, having mostly been resolved very quickly, and having had little or no obvious feed- through to longer-term market dynamics, never mind to the real economy. But we think ignoring them would be a mistake. Each has occurred against a largely benign economic backdrop, with little by way of a fundamental driver. And yet with each one, investors’ nervousness about the risk of illiquidity is likely to have been reinforced. When the time comes that investors do see a fundamental reason all to sell – most obviously because they start to doubt the extent of central banks’ support – their desire to be first through the exit is liable to be even greater."- source CITI Matt King via FT Alphaville.

On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured.

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out. On this subject we read with interest Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net":

"Balanced fund managers are the “stars” of this market cycle as they exhibit excellent performances. We would not say that they are smarter than other fund managers, but would like to remind rather how lucky they have been to have lived in an investable universe of two asset classes that have never stopped rising since 2009. Below, we show the equity and government bonds asset classes for France since 1992.

In theory in period of economic recovery/expansion, the ratio of equities to bonds tends to rise as equities are bought for their leverage on this economic growth and bonds are sold due to increasing expectations of higher interest rates. From this perspective, this cycle is – as we all know – unusual.
Balanced portfolio management, also named diversified portfolio management, comes from the mantra “do not put all your eggs in one basket”. Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle.

The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle. Meanwhile, on the equity market, the high economic uncertainty has maintained a high level of preference for investors in terms of quality-defensive stocks. We summarize these two regimes on the chart below:

The correlation between bonds and equities, which was rather negative in “normal times”, has become neutral or slightly positive in this market cycle. So diversified portfolio managers have dealt with two asset classes whose market’s behaviour has been quite similar. The diversification argument has lost some of its power, but up to now no asset manager has sought reason for complaint as they have made a lot of money. In fact, they have enjoyed the biggest “benchmark bull market” of their life, explaining why they are quite happy these days. 

There is a limit to the appreciation of any financial assets. We do not know the level for equities, but for bonds, when the coupon they will detach for the next 10 years is around 0, we can say without taking too much risk that their potential to increase further is not very high. This is not a crazy statement that we are making. As we can see it has become a consensus on financial markets. We show below the implicit probability of a 3%+ rise of 10y government bonds in Germany within 6 months extracted from the derivatives markets and it is historically low.

 At the same time, the probability of seeing the equity market declining by 10% in the next 6 months has remained more or less the same around 25%.

For all these reasons, it becomes obvious that a diversified PM should expect a far less effective bond buffer in case of an equity correction. The “raison d’être” of the balanced fund management is fading and should therefore reinvent itself, trying to find what kind of assets could truly reduce the volatility of a 50/50 equity/bond portfolio in case of an accident on the equity market.

Many investors are ready to return to gold these days following its significant underperformance and its theoretical capacity to safely navigate through periods of uncertainty. We have previously discussed gold investment and remain convinced that gold is a good hedge against a US$-centric crisis, but not against a non-US economy related crisis.

Furthermore, investors have to understand that gold is above all else a commodity. Its underperformance over the past months is not only due to factors affecting the price of gold, but is also due to factors affecting the whole commodity asset class. Thus, we have to look at the relative performance of gold against other commodities. This is what we show on the following chart and the message appears very different. The ratio of gold prices over commodity prices is trading at an all-time high.

We do not think that gold can be a genuine hedge against a rising risk aversion on the equity market. Until the Fed implements QE4, gold prices will remain capped." - source Louis Capital Markets.

For us gold is not an inflation hedge, it is an inflation signal; 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.

• Credit CDS market is under-pricing volatility in the rates space

On numerous occasions we looked at the CDS market as proxy of the built up in instability in the financial markets, the widening in credit spreads in 2007 and 2011 were good early warning signals of the rising tension in the markets. In similar fashion credit spreads widened in sympathy with the 2013 taper tantrum. What we find of interest is while Cushing's syndrome has indeed been as of late reflected in the acute volatility in government bond yields, so far the reaction in the CDS credit space has been so far fairly muted in Europe in the Itraxx Main 5 year CDS index, a proxy for investment grade credit.

On this muted volatility we read with interest Bank of America Merrill Lynch's Credit Derivatives Wrap note from the 13th of May entitled "Hedging rates volatility":

"Credit CDS market under-pricing rising rates volatility
We think the CDS market is currently under-pricing the high levels of volatility currently being seen in the rates space. iTraxx Main has widened 6% since rate volatility started moving higher (April-16th). But looking back at the 2013 taper tantrum in the US, we can see that CDX.IG had already widened by almost 40% at this point (chart 1). 

Admittedly the drivers were different (end of QE in US, a host of fundamental and technical reasons in Europe), but nonetheless iTraxx Main appears tight relative to rates volatility.
What’s the downside? We think iTraxx Main could potentially reach 80bp should CDS better reflect the current level of rates volatility. Risks to spread widening are also clear should Greece volatility linger. Yet, moderate widening remain our base case amid the powerful backdrop of ECB QE." - source Bank of America Merrill Lynch.

The Cushing's syndrome effect on credit spreads thanks to major central banks meddling has indeed "neutered" the CDS market in its role as an early indicator of systemic risks during the sovereign crisis as described by Bank of America Merrill Lynch:

"Is the CDS market too complacent over the underlying risks or is the ECB backstop simply too strong? It seems both…

Once upon a time, the CDS market mirrored the rise of systemic risks. iTraxx Main used to be well correlated to moves in Greek stocks (ASE index). This was the case up until mid-2014.

However since then, even though Greek stocks continued to trade lower, iTraxx Main kept moving tighter, on anticipation of an ECB QE moment.

Actually, when the ECB announced the QE program, spreads broke the long-standing resistance point of 55bp. Despite risks around Greece, spreads have not repriced wider.

Clearly the CDS market is pricing little of the potential risks around Greece, simply on the back of the backstop provided by the ECB QE.

Historically, index and single-name CDS has been the liquid way to protect cash portfolios. In periods of significant stress, the CDS/cash basis would have widened, with the CDS market pricing-in more risk than the cash market. That would simply reflect CDS market insurance premium.

However, with the ECB in the driving seat, CDS did not decouple to cash spreads, keeping the CDS/cash basis close to historical lows, and below long term averages.

The CDS market is also underpricing the rising volatility in the rates market. 10y yields move higher; rates volatility rise; credit spreads on an upward trend. This is a familiar pattern for credit investors who saw CDX.IG selling off during rising treasuries volatility in May’13.

This time around European bond markets are in the driving seat. While European CDS indices (iTraxx Main) had initially embarked on an identical market reaction to that of CDX.IG back in May’13, they recently have outperformed.

At these levels credit spreads are underpricing the rising volatility in the bond market. We expect European CDS indices to track closer the move higher in rates volatility. iTraxx Main could potentially reach 80bp should we have a repetition of the previous patterns seen back in May’13. (see chart 1 above)

Nowadays, credit spreads seem to be short-term volatile and long-term range-bound. Spreads are volatile within relatively tight ranges, simply because of the absence of a strong catalyst. We think this is more apparent recently, when looking at the intra-day volatility in the CDS market. This has been mainly driven by headlines around Greece, on the 14th to 17th of April, (same in December last year), but also the strong bund moves recently.

However, we increasingly think that these ranges will break in the near-term and most likely on the downside. 

Risks around Greece still remain to the downside, till an agreement is reached, and thus spreads could back out further. Additionally, the recent spike in rates volatility will put an upward pressure on the CDS market, we think.

Undoubtedly, the credit index vol market has been the sole pocket in the credit space that has been tracking risks around Greece. Over the last 4 years credit implied vols have been tracking moves in the Greek equity market surprisingly closely, in contrast to the underlying credit spread levels.

- source Bank of America Merrill Lynch

Rising positive correlations and dwindling liquidity in the credit market making space in both cash and CDS, with the major withdrawal of Deutsche Bank in single name CDS trading will no doubt weight in the future in the ability for fund managers to protect their cash positions and mitigate rapid redemptions in their funds rest assured. This is the result of the"exogenous" administration of liquidity as posited by our Cushing's syndrome analogy.

• "Overmedication" has created an abnormally long credit cycle

What credit investors forget is that in a deflationary environment, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield. But, due to the "overmedication" thanks to our central bankers "market health" practitioners, the long credit cycle has indeed been extended into "overtime".

Investment Grade credit is a more interest rate volatility sensitive asset, High Yield is a more default sensitive asset. What warrant caution for both we think are, the risk of rising interest rates for the former as per our previous bullet point and the risk of rising default rates for the latter. For more on credit returns we suggest reading our March 2013guest post from our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns" as they indicated the following in their very interesting previous note:

"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube

On the subject of "Overmedication", for us it means that the fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets meaning that in the next downturn, we expect the recovery rates to be much lower than in previous cycles!

On the subject of the "extended credit cycle", we read with interest Bank of America Merrill Lynch's  recent HY Wire note from the 6th of May entitled "Collateral Damage Part I : A recovery recession":

"Recovery drudgeryRejoice! Low default ratesWith the low-rate environment causing the extension of cheap credit to hundreds of high yield companies, we are currently bearing witness to what we believe will be an abnormally long credit cycle. As we noted last week, with default rates below historical levels, investor cash balances high, and little yield globally, Q1 saw the third most issuance in US high yield history. And with central banks continuing to provide unprecedented stimulus, with little end in sight, we don’t expect a meaningful increase in defaults for several years to come. In fact, we wrote last fall that we believe this cycle will be much like that of the late 1990s, with defaults increasing to mid-single digits for a period of time before spiking significantly. Over the past 43 years, the average length of time it takes to go from the height of defaults to the lows has been about 5.5 years- the exact amount of time since the peak of bankruptcies in late 2009- but we believe there is runway for this cycle to extend several years more before we see double digit default rates.

In fact, given the availability of cheap credit, the lack of an imminent maturity wall and the increase in interest coverage, high yield corporates could currently appear as a safe haven. After all, where else in the world can an investor receive a yield of nearly 6% for a 2% default rate? Consequently coupons have decreased from 8.5% to under 7% and the maturity wall has been pushed out to 2019. Note, we caution our readers to not read too much into the wall itself, as debt tends to default 12-18 months prior to maturity. The wall, therefore, always appears in the distant future. However, even if defaults meaningfully increase a year to a year and a half earlier, in 2017-2018, this cycle will be in line with the longest in history.

But it’s not necessarily all about defaultsOn the surface, investors should welcome such news. However, default rates are in and of themselves not the only measure financiers should be concerned with. In fact, if our estimate is correct about an elongated cycle, we think bond holders should be just as concerned, if not more so, about recovery rates. Last year we coined the phrase “zombie companies” to characterize those issuers able to survive longer than they would otherwise be able to- either as a consequence of looser covenants or simply due to the willingness for investors to search for yield and fund nearly any high yield corporate at any cost (see above decline in coupon). In an environment where earnings and revenue are growing at a healthy clip, such reach for yield behavior could perhaps be tolerated. However, fundamentals have not improved significantly, and up until recently, clients adopted a kick the can down the road mentality. Additionally, we are in the midst of witnessing CEO decisions (buybacks/dividends) that erode value rather than create it, in our opinion, further fostering an environment where the formation of long-lasting asset wealth has been supplanted by the formation of short-term financial wealth. This transformation will have a long lasting impact on recoveries, we think, likely causing investors to recoup fewer pennies on the dollar than any time in the last 30 years.
So far recent history has corroborated this view, as recovery rates have been very low during the last several years. In this two part series we examine the many factors that determine recoveries, focusing in this publication on some of the macro variables that have traditionally been good indicators. As we will see below, however, this cycle is unlike any other; with losses given default much higher so far despite what the “literature” and conventional wisdom may otherwise imply." - source Bank of America Merrill Lynch

For us and our good friends at Rcube Global Asset Management, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey).

One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. 

• Final note: True health of the US economy - Where is the CAPEX recovery?

Many pundits argue that the US consumer should finally start to realize the benefits of lower oil prices, a healthier job market, and with an increase in financial asset valuations, it should lead to a healthier economy. Given Retail sales barely budged in April, why on earth would corporate CEOs invest in CAPEX if demand in the US will continue to remain anemic thanks to Cushing's syndrome?

On the subject of seeing the true health of the US economy, we agree with Bank of America Merrill Lynch's recent HY Wire note from the 6th of May entitled "Collateral Damage Part I", that indeed CAPEX matters and will continue to be absent in this "recovery recession":

"Perhaps a better place to see the true health of the US economy, and further see the psychological impact of the Great Recession, is by looking at the behavior of corporate CEOs. We wrote last March our expectation for CAPEX to remain deflated for the foreseeable future. Why spend on the potential for growth when you can acquire proven growth? Why increase costs when you can realize cost efficiencies through a merger? In our view the thought process behind this behavior is one of the reasons we have not had a pickup in wages and investment in the future. It also could be one of the key reasons that recovery rates are lower this cycle than during any other period in history- there is little investment in tangible assets. Furthermore, not only are CEOs not investing in growth, but by returning capital to shareholders in order to boost stock returns, they’re inherently diminishing their own recovery values should the business experience trouble. As Chart 9 below shows, as a percentage of operating cash flow, S&P 500 companies today are spending at historically low levels on CAPEX while are near historical highs for dividends and buy backs."

- source Bank of America Merrill Lynch

No matter how you want to spin it but given the lack of investment in tangible assets, in the next downturn, recovery rates will be much lower. It is a given.

"Criticism may not be agreeable, but it is necessary. It fulfils the same function as pain in the human body. It calls attention to an unhealthy state of things." - Winston Churchill

Stay tuned!