Saturday, 2 June 2012

Credit - River of "No Returns"

Matt Calder: "There are lots of ways to die. Starving to death isn't my favorite." - from the 1954 movie River of No Return by Otto Preminger starring Robert Mitchum and Marylin Monroe.

Looking at the velocity in falling government bonds yields as well as the ever growing scarcity of highly rated bonds at the disposal of real money managers (courtesy of central banks buying: FED, ECB, BOE, BOJ) and decline in new issuance for fixed income spread products, we thought our analogy to Otto Preminger's great movie would indeed be appropriate this time around.
Therefore we thought it would be interesting to focus our attention on the consequences of "travelling", like Matt Calder heading downriver, on our flimsy log raft, and encountering trouble in the rapids (or markets), on this river of "No Returns". But first our credit overview!

The Itraxx CDS indices picture, a tale of ongoing volatility - source Bloomberg:
Itraxx SOVx Western Europe Index (credit risk gauge on 15 governments with Cyprus replacing Greece) climbed three basis points to 334 bps, adding to the gauge’s 50 basis-point jump in May. The Sovereign CDS on Italy climbed 14 basis points to 575 bps , approaching the record of 602 basis points of the 15th of November according to Bloomberg data. Meanwhile Spain Sovereign CDS reached 620 bps while Spanish Telecom company Telefonica rose 13 bps to an all-time high of 481 bps.
In conjunction with sovereign risk, as always, financial risk rose in synch, with the cost of insuring bank debt also increasing, with Itraxx Financial Senior 5 year CDS index (linked to senior debt of 25 banks and insurers) rising 5 basis points to 303, after surging 23% in May. Itraxx Financial Subordinated 5 year  index increased 5 basis points to 501 bps. Itraxx SOVx 5 year index is trading closely to the Itraxx Financial Senior 5 year index which is an indication the ongoing issue of circularity and the impossibility so far in decoupling both. We have been discussing on numerous occasions this very subject of circularity (most recently in our conversation "The Daughters of Danaus") - source Bloomberg:

The Itraxx Crossover 5 year index (linked to 50 European High Yield companies) increased 10 bps to 730 bps, after a 70 bps rise in May. Itraxx Main Europe 5 year index representing the risk gauge for Investment Grade credit (125 companies with investment-grade ratings) advanced 2 basis points to 183 bps. The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

"Mind the gap", we have been warning for a while, given the disconnect between the Eurostoxx and the flight to quality mode experienced with the rapid drop in the German Bund 10 year yield with rising volatility as indicated in the bottom graph. The gap is in fact closing. - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.20% yield) touching a new record low around 1.12%, with 5 years Germany Sovereign CDS rising slightly above 100 bps - source Bloomberg:

A story of volatility as far as "safe haven" government bonds are concerned (German Bund, 10 year US Treasuries), looking at the intraday picture for the German Bund yield movement - source Bloomberg:

Touching a low of 1.1238% before bouncing back at the close towards 1.18%

In fact, another indicator we have been monitoring, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:
While touching again on our recent subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level.  The correlation between both the German Bund and US 10 year note is rising very fast, now above 70%. The above graph was our reasoning behind our 30th of March call:
"One has to ask oneself if the time has not come to start taking a few chips off the table." - Macronomics  - "Spanish Denial".
 Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).

As far as asset correlation are concerns, the weakness in Oil prices warrants caution when looking at the relationship with the SPX 500 since QE 2, so, "Mind the gap":
Oil fell on Friday to an eight month low, falling as much as 4.6% after the disappointing employment data in the US (Non-farm payrolls coming at 69K with jobless rate at 8.2% from 8.1%. Crude futures declined to 83.59 dollars a barrel after touching 82.56 dollars, the lowest intraday level since the 7th of October according to Bloomberg. Brent for July delivery fell 3% to 98.78 dollars a barrel. The European benchmark has fallen about 8% this year. The SPX 500 Index declined 1.8 percent and touched 1,286.63, the lowest intraday level since the 13th of January validating our recent comments on the relationship.

"Mind the gap" because the Euro Swap Curve is the flattest it has been  since the Lehman collapse according to Bloomberg:
"The gap between short- and long-term euro-denominated interest-rate swaps is the narrowest since the months following the collapse of Lehman Brothers Holdings Inc. as Europe’s debt and banking system crisis worsens. The top panel of the CHART OF THE DAY shows the difference between rates on two- and 10-year euro-denominated interest-rate swaps fell last month to the least since December 2008. The bottom panel is the so-called euro FRA/OIS spread, or the forward market projections for the gap between three-month Euribor and expectations for the euro overnight index average, known as Eonia." - source Bloomberg

Eonia index:
"The Eonia index is a gauge of the cost for banks in Europe to borrow from each other overnight in euros, similar to the U.S. effective federal funds rate. Euribor is the rate at which European banks say they see each other lending in euros, according to the European Banking Federation." - source Bloomberg.

As a reminder and from the same Bloomberg article:
"In November, the FRA/OIS spread surged to a 33-month high as concern over contagion from the sovereign crisis drove Italian debt yields to levels that forced Greece, Portugal and Ireland to seek bailouts. The 10-year German bund yields fell yesterday to a record low on concern European leaders won’t agree on measures to contain the debt crisis. If funding conditions in the European banking sector worsen to levels reached in the fourth quarter the two-year swap rate could increase and cause the swap curve to “flatten significantly” according to Societe Generale strategist Sandrine Ungari."

German 2 year notes falling in negative territory versus 10 year Bund - source Bloomberg:

The current European bond, from convergence to divergence with Spain experiencing a serious bout of volatility in conjunction with Italy and core countries experiencing an important drop in yields with France and Belgium even touching record low yield levels (France at 2.21%) - source Bloomberg:
While Italian bond yields dropped 21 bps to 5.69%, Spanish yields only receded 9 bps to 6.47% at mid-day as many pundits are speculating on an activation of the SMP (Securities Market Programme) by the ECB.

As far as credit is concerned as one market maker puts it:
"We keep waiting for capitulation in the credit space. It hasn't happened yet for several reasons:
-Hedge Funds are short and reducing.
-Real Money (Asset Managers) have not capitulated yet on cash bonds given they hedge using index and futures but the German Bund is saving them given the bund is up 11 points and if credit spread are wider by 2.5 points, they are still doing well (German Bund moving up a point a day versus Itraxx Crossover - HY risk gauge- moving 20 bps or Itraxx Main Europe - Investment Grade risk gauge-  by 5bps).
-Credit was the first to react and now all other markets have followed suit. But Credit has stopped widening as we are expecting intervention and credit is mostly correct."

Following up on our assertion: "In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar" ("Risk-Off Correlations - When Opposites attract"),  dollar is indeed the big winner in this "Risk-Off" environment.
The dollar posted its biggest monthly gain since May 2011, beating everything in its path, bonds, stocks, commodities as investors sought refuge in the U.S. It climbed 5.5%. And as Douglas Borthwick, head of foreign-exchange trading at Faros Trading LLC in Stamford, Connecticut, said  in a May 29 interview with Trish Regan and Adam Johnson on Bloomberg Television’s “Street Smart.” in relation to investors seeking the safety of the dollar:
“They’re forced into owning the dollar,” he said. “Not because they like it or they think the dollar is going to rally, but because there’s nothing out there for them to buy.”

Which brings us to the main theme of our "River of No Returns" conversation namely the consequences of asset scarcity.
Torsten Slok, (Deutsche Bank Chief International Economist)in his latest presentation entitled "The Pension Challenge" puts forward some very important points we think:
"- The number of highly rated bonds has declined, implying fewer risk-free assets to buy for real money managers.
- In addition, central banks (Fed, ECB, BoE, BoJ) buying government bonds has lowered supply of risk-free bonds real money managers can buy (for example, the Fed currently holds 30% of all 5-10 year US Treasuries outstanding).
- New issuance of fixed income spread products (i.e. credit and mortgages) has declined. One reason is that the housing recovery has continued to be weak and as a result fewer new mortgages are originated. Another reason is that corporates have strong balance sheets and as a result they don’t need to issue new debt.
- There are three long-term risks to global growth including: a) long-term growth consequences of European debt challenges, b) long-term growth consequences of US fiscal challenges, and c) long-term growth consequences of China’s housing bubble and demographic problems.
- Bottom line: More demand for risk-free assets and less supply of risk-free assets combined with three significant long-term risks to global growth imply that interest rates are likely to stay low for many more years."
Hence our river of "No Returns" title and analogy in these treacherous river/markets.

One as to ask oneself if stock markets have not been driven by baby-boomers first saving for retirement, and then retiring as indicated by Deutsche Bank Chief International Economist Torsten Slok:

When it comes to outstanding "risk-free" assets globally, the pool is dwindling according to Deutsche Bank:

In fact there are fewer risk-free assets outstanding, as we posited in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!", welcome to a credit world!

As far as we can see we are still in the D world of Deflation and Deleveraging meaning that we think credit assets will undoubtedly outperform their equities peers. This is exactly what we have argued in "Deleveraging - Bad for equities but good for credit assets".

In fact Bank of America Merrill Lynch seems to be validating our assertions given that they have written recently the following:
"In Europe, a lot indicates that equities have "died":
- The market cap of the Italian Financial sector is now the same as the market cap of Colgate-Palmolive ($47bn).
-The market cap of all euro-zone Financials ($361bn) is less than that of Canadian Financials ($377bn)
-The market cap of Spain and Italy equities combined ($396bn) barely exceeds that of Taiwan ($368bn).
-The market cap of Portugal equities ($16.4bn) is the same as that of Whole Foods, the 191st largest stock in the S and P 500.
-The market cap of Greece equities ($5.8bn) is the same as that of TripAdvisor, the 400th largest company in the S and P 500.
The CDS of Portugal exceeds Venezuela's, the CDS of Italy exceeds Lebanon's and the CDS of Spain substantially exceeds Iraq's."

In consolation for our equities friends, we can only point out that hopefully "there's life (and value) after default!"

On a final note we would like our equities friends to meditate on the following two graphs, one is from Morgan Stanley relating to the high Beta in Consumer Discretionary equities from their highlights of their May 23rd Consumer conference, the second is from Societe Generale in relation to the Global IT sector and Nasdaq following the "interesting" IPO from Facebook from their Multi Asset Snapshot - "Nasdaq still running, but low on batteries":

Morgan Stanley:
"While 56.5% of Discretionary Stocks have a Beta greater than 1.1."
"Consensus EPS growth estimates for 2013 are highest in discretionary. Analysts are embedding 16.7% 2013 EPS growth for the sector, with revenue growth of 5.7%."
- source Morgan Stanley.

Morgan Stanley also indicates:
"Can we count on more dis-savings driving the consumer spend? Can the high end continue to spend at the rate it has? Several investors have been positing to us that consumer deleveraging is “basically” over, and that wealth creation through the equity market will have a self-reinforcing positive effect on the market. We find it difficult to forecast that the saving rate will go lower."
And low growth is bad for "Forward Earnings in Different EPS Growth Environments.":
"There is a popular thesis that when interest rates are low the multiple is usually high. We don’t subscribe to this thesis. In fact, we believe it is quite the opposite. As we have written about extensively, extreme 10-year real yields have historically been coincident with lower price-to-forward earnings multiples for the S and P 500." - source Morgan Stanley.

"Earnings, like trees, don’t grow to the sky:
The IBES consensus indicates analysts expect strong and resilient earnings growth (+46% for
the next three years) from US Technology stocks
, sustaining their recent track record. We believe that this is too optimistic and highly at risk given 1) the weak global macro-economic framework and 2) sector return on equity is already at all-time highs."
- source Societe Generale
"With 46% earnings growth forecast for the next 3 years, the consensus looks very optimistic at a time when the macro framework is an increasing concern (see Samsung CEO interview) and IT stocks’ return on equity (RoE) is at an all-time high of 25%. Given these inflated expectations, we expect to see profit warnings." - source Societe Generale.

We agree with Societe Generale and Morgan Stanley, namely that high expectations + strong consensus = danger. So while you are navigating these treacherous river/markets of "No Returns", starving for earnings should not be your favorite choice (in true Matt Calder fashion).

"A consensus means that everyone agrees to say collectively what no one believes individually."
Abba Eban - Diplomat.

Stay tuned!

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