The Vasa Ship

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by: Macronomics

"In the ocean of baseness, the deeper we get, the easier the sinking."

- James Russell Lowell, American poet

When in Paris on 5th January to present our winning Saxo Bank community from their latest Outrageous Predictions for 2016 to their French clients, we had a very interesting meeting with Steen Jakobsen, their chief economist, who, at the time, suggested we look into the Vasa ship as an interesting analogy for a post title. This time around, curiosity did not kill the cat, and we waited - we must confess - for the right time to use this very interesting analogy in our musings. Given the ongoing onslaught in risk asset classes (except for our comforting long US bonds, long gold miners and other positions), and also because, as always, credit leads equities (this means to lower levels, that is), we decided it was the right time to use Steen's suggestion in this Macro and Credit-related musing of ours.

So why the Vasa ship for our chosen title?

The Vasa ship was a Swedish warship built between 1626 and 1628 on the orders of the King of Sweden Gustavus Adolphus as part of the military expansion he initiated in a war with Poland-Lithuania (1621-1629). The ship is famous for having foundered and sank after sailing only about 1,300 meters (1,400 yards) into her maiden voyage on 10th August, 1628. Richly decorated as a symbol of the king's ambitions for Sweden and himself, upon completion the Vasa ship was one of the most powerfully armed vessels in the world (like the Bank of Japan). However, it had a massive design flaw. Vasa was dangerously unstable and top-heavy, with too much weight in the upper structure of the hull (total amount of debt in the world). Despite this lack of stability, she was ordered to sea and floundered only a few minutes after encountering a wind stronger than a breeze. In similar fashion, the Bank of Japan's attempt in playing the Negative Interest Rate Policy game (NIRP) card sounds to us eerily familiar and akin to the tragic fate of the Vasa ship. Kuroda's attempt floundered straight from inception, with the Japanese yen rising to 114 and the Nikkei rout continuing, seeing the index lose another 2.31% on 10th February to 15,713.39.

The fatal order to sail was the result of a combination of factors. One being the king's impatience in seeing the Vasa ship become the flagship of the reserve squadron at Älvsnabben in the Stockholm Archipelago. The other was the king's subordinates lack of political courage to openly discuss the ship's structural problems or to have the maiden voyage postponed. Although an inquiry was organized by the Swedish Privy Council to find those responsible for the disaster, in the end, no one was punished for the fiasco. In similar fashion, we think the central bankers at the Bank of Japan, the Fed, the SNB, and the ECB responsible for the mess we are in will not be punished for the upcoming fiasco, but we ramble again...

In this week's conversation, we will look again at the dangerous evolution we are seeing from idiosyncratic "sucker punches" towards "systemic" risk. We will also look at why, in similar fashion to the Vasa ship, new monetary policies such as NIRP will fail because of dangerously unstable markets and their top-heavy load (global world debt).

Synopsis:

  • Central bankers' tricks are losing their "magic"
  • Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"
  • Final chart - Don't catch falling knives

Central bankers' tricks are losing their "magic"

As we pointed out recently in our conversation "Under pressure", our Generous Gamblers aka our central bankers are losing their magic, we think:

"Additional easing monetary policies, but as shown recently in the various iterations of QE in the US, the Fed is getting "less bang for the buck". Basically the "magic" of our "Generous gamblers" is losing its power on driving asset prices to new heights. "Overmedication" could in fact lead in the end to "overdoses", we think."

- Source: Macronomics, January 2016

We also added:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.

The correlation between macro variables such as 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. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis."

- Source: Macronomics, January 2016

It was bound to happen as per the Vasa ship (positive correlations leading to instability). From the inception of "unorthodox" monetary policies, the biggest issue which has yet to be addressed - as brilliantly pointed out by William R. White, the chairman of the Economic and Development Review Committee (EDRC) at the OECD in Paris in a Bloomberg interview, in similar fashion to the Vasa ship, which was dangerously unstable because of too much weight in the upper structure of the hull - is the total amount of debt in the world.

In the light of Mr. William White's great interview, we would like to rehash the quotes we have used in our March 2012 conversation "Shipping is a leading deflationary indicator", particularly in the lights of the very concerning comments made by AP Moller-Maersk's (OTCPK:AMKAF) CEO on the current state of affairs of his company, seeing a situation worse than 2008:

"He who rejects change is the architect of decay. The only human institution which rejects progress is the cemetery."

- Harold Wilson

"He who rejects restructuring is the architect of default."

- Macronomics

This is why Mr. White's comments are so to the point. The longer you delay the restructuring, the lower the recovery value will be.

But, when it comes to central bankers losing their magic, the latest "results" in the markets from the Bank of Japan's implementation of NIRP speak for themselves. This is does not come as a surprise whatsoever. It was bound to happen, and it is clearly pointed out by Bank of America Merrill Lynch in their FX Vol Trader note from 10th February, entitled "Central Banks puts expire":

"Key takeaways

• As confidence in central bank puts erode, market participants are adjusting by paying for their own protection.
• Hedge demand has pushed vols indiscriminately higher. We view this as excessive and prefer to fade the move.

Markets adjusting to less stimulus

The painful adjustments taking place across global financial markets can partially be attributed to the re-pricing of central bank expectations. With Fed QE quickly becoming a distant memory and both the ECB and BOJ failing to deliver expansion packages, the market has been forced to learn to stand on its own two feet. As implicit central bank puts expire, the market must now pay for protection out of pocket, reflected in the structural shift in long-dated EURUSD and USDJPY risk reversals, which have both turned for USD puts (Chart 1).



Like most forms of insurance, by the time the accident is being assessed, further coverage will be expensive. The demand for options has pushed FX vols towards the highs of the past couple of years. In our view, the indiscriminate demand for vol across all currencies and tenors is excessive and we prefer to fade the move."

Markets anxious, buying vol indiscriminately

Concerns about the health of the US economy and the European banking sector wreaked havoc on global markets this week. The broad anxiety is reflected in the indiscriminate vol purchases across currencies and tenors (Page 5, Table 3).



Gamma in general is performing, but our core view has been that barring some sort of crisis, it will be difficult to sustain volatility without a core divergence story."

- Source: Bank of America Merrill Lynch

Also, as we posited in back in November 2014 in our conversation "Chekhov's gun", the changes in the communication of monetary policy have indeed taken a turn for the worse. This was clearly demonstrated by the SNB in 2015 and the surprise NIRP implementation by the Bank of Japan:

"What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:

"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants. Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered "acceptable" for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members.

Kuroda abandons forward guidance

It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time. Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants. But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ's toolkit. When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making "steady progress" towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed

The BOJ governor's decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market-including forward guidance-is essential when winding down such a policy, as the IMF has repeatedly warned. There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharply higher. The Fed's intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation. In summary, the BOJ's shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed."

- Source: Richard Koo, Nomura Research Institute


To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured."

- Source: Macronomics, November 2014

Exactly! The Bank of Japan has painted itself in a corner (and soon the Fed will as well). The shock announcement of NIRP has led to an unexpected outcome and more "sucker punches" delivered in the form of falling Japanese equities and a sudden "risk reversal" on the Japanese yen. Remember, we told you in December in our conversation "Charles law" that significant "risk reversal" opportunities would happen in 2016:

"We don't see conditions improving either in 2016 and last Monday was once again an illustration of "Blue Monday" in the works we think. With liquidity deteriorating and hydrogen having been used by our "generous gamblers" as a lifting agent in "asset balloons", there is indeed no surprises in seeing a significant rise in idiosyncratic risk leading to significant price movements. 2015 saw an increase in the number of "sucker punches" inflicted to the "cross-asset" crowd. By no means 2016 is going to be different."

- Source: Macronomics, 15th December, 2015

When it comes to the latest "sucker punch" delivered to the Japanese yen courtesy of Kuroda's NIRP, we read with interest Richard Koo, chief economist at the Nomura Research Institute, in his latest note from 2nd February:

"Negative interest rates an act of desperation driven by failure of past accommodation

In my view, however, the adoption of negative interest rates is an act of desperation born out of despair over the inability of quantitative easing and inflation targeting to produce the desired results. That monetary policy has come this far is a clear indication that both ECB President Mario Draghi and BOJ Governor Haruhiko Kuroda have fundamentally misunderstood the ongoing recession.

To begin with, despite the all-out efforts of central banks in Japan, the US, the UK and Europe, neither quantitative easing nor inflation targeting were able to achieve their initial objectives.

The BOJ has now pushed back the date when it expects to achieve its inflation target from "around the second half of fiscal 2016" to "around the first half of fiscal 2017," which would be fully four years into the Kuroda/Iwata era.

Failure of monetary easing symbolizes crisis in macroeconomics

This failure clearly demonstrates that the Japanese economy envisioned by Mr. Kuroda and Mr. Iwata at the time of their appointments when they pledged to step down if they failed to achieve 2% inflation in two years was very different from the reality. In short, their models were wrong.

The same mistake has been made repeatedly in the US, the UK and Europe. In each case the monetary authorities undertook extreme quantitative easing measures in an attempt to achieve inflation targets, yet price growth continues to run far below the target levels.

In view of the fact that some of the most talented, well-educated economists in these countries are working for these central banks, it is hard not to conclude that this global policy failure is less a reflection on the abilities of Mr. Kuroda and Mr. Draghi than a signal of a crisis in the discipline of macroeconomics itself.

Conditions in today's real economy do not conform to macroeconomic assumptions

The definitive difference between the economics that they (and we) studied as university students and the actual economic experience of the US and Europe since 2008 and Japan since 1990 is that traditional economics assumes the private sector is everywhere and always trying to maximize profit. But today the private sector is trying to clean up its balance sheet by minimizing debt.

In terms of financial markets, traditional economics means there will always be borrowers as long as interest rates are lowered far enough. In today's world, there are no borrowers no matter how low interest rates are taken.

Traditional economic theory and econometric models assume the private sector is always forward-looking and is always seeking to maximize profit. As such, there will always be someone willing to borrow money to invest as long as real interest rates are low enough. Given that assumption, the focus of economic policy is naturally going to be on the central bank's monetary policy.

And if we assume that the private sector is always trying to maximize profit, fiscal policy (under which the government borrows money to spend) wastes precious private-sector savings and raises the risk that the private sector-which can use funds more effectively than the government-will not receive all the money it needs. That is the primary reason why fiscal deficits are so unpopular.

Traditional economics never envisioned a debt-minimizing private sector

The private sector will always seek to minimize debt after the collapse of a debt-financed bubble. Yet traditional economics not only did not foresee this kind of situation, but does not even have a term to describe it.

Traditional economics did not envision the sort of world we have been living in since 2008 because such conditions were never observed in western economies between the 1940s, when the discipline of macroeconomics as born, and 2008.

Until 2008, in other words, there were always willing private-sector borrowers in the US and Europe who responded to changes in interest rates. In such a world, monetary policy is effective and fiscal stimulus generally frowned upon since it has the potential to crowd out private investment.

Interest rates no longer relevant once people start minimizing debt

But after a debt-financed bubble collapses, the debt remains while asset prices fall, leaving many borrowers technically insolvent or at least struggling.

This is a frightening situation for a company to be in, inasmuch as its banks can shut it down at any moment. After all, banks are not allowed to roll-over loans to bankrupt borrowers, and all financing, including trade credits could disappear once the creditors and suppliers realize the true state of the borrower's balance sheet. For a household, too, it is a dangerous state of affairs in which assets that had been set aside for emergencies or retirement suddenly disappear. The overriding priority for these businesses and households, therefore, is getting out of this situation as quickly as possible.

Emerging from this debt overhang requires businesses and households alike to focus on saving more and paying down debt. Whether interest rates are zero or even negative, people will continue minimizing debt until they have dug themselves out of the hole. The probability of their behavior changing because of a shift in interest rates is negligible.

When this state happens throughout the private sector, not only do private-sector borrowers disappear, but the private sector in aggregate may begin saving instead of borrowing.

Central bank cannot control inflation during a balance sheet recession

Once the private sector begins saving (and paying down debt) in aggregate, the money multiplier turns negative at the margin. The money supply-the money available for the private sector to use-not only does not increase but can actually decrease, regardless of how much base money the central bank supplies.

When the balance sheet-constrained private sector chooses to minimize debt in spite of zero interest rates, the liquidity supplied by the central bank cannot come out of financial institutions and enter into the real economy due to lack of borrowers. I have dubbed this state of affairs a balance sheet recession, a term that is now heard quite frequently. Unfortunately, the vast majority of people-including Mr. Kuroda and Mr. Iwata-remain unaware of this economic malaise.

Those who do not recognize that balance sheet problems are keeping potential borrowers from borrowing believe the recession is attributable to insufficient monetary easing by the central bank. That leads them to espouse policies such as quantitative easing and negative interest rates. But no matter how far these policies are pursued, there is no reason why the economy should recover until the private sector overcomes its balance sheet problems and turns forward-looking again.

Professor Paul Krugman, who was the first to recommend that this state of affairs be addressed with inflation targeting and quantitative easing, has proposed that a 4% target should be adopted if a 2% target does not work. But the current situation is not one that can be addressed with such trivial adjustments. Interestingly, even Professor Krugman has come to admit that non-conventional monetary easing adopted up to now were "not a game changing tool." ("Krugman: 'Meh' is grade Fed gets on QE," published on Nov 9, 2015 on Market Watch.)

The theory that inflation is a monetary phenomenon that can be controlled by the central bank, since the central bank controls the supply of money, is valid in a world in which there is an ample supply of private-sector borrowers. But it is mere nonsense in the post-bubble-collapse world of a balance sheet recession, where this condition is not satisfied.

Gulf between real world and economy as envisioned by economists continues to widen

In that sense, the economies of Japan, the US, the UK and Europe now fall completely outside the realm of traditional economics, yet the vast majority of policymakers and economic agents continue to operate as though this were not the case, and the textbook world envisioned by economists still existed. This misunderstanding has complicated the situation greatly.

In other words, the equity and forex markets have responded directly to central banks' negative interest rates and quantitative easing, but businesses and households in these countries refused until quite recently to borrow any money at all. The implication is that the exchange rates and share prices set by these markets are on very shaky ground.

As noted in the last issue of this report, forex traders over the past seven years have orchestrated heavy sell-offs of the currencies of countries announcing quantitative easing programs based on the assumption that the money supply in those countries would increase far more than the money supply of non-QE nations. But in reality, the money supply in all countries has been essentially stagnant as businesses and households continue to pay down debt.

In the same way, stock prices have appreciated each time further monetary easing measures have been announced, based on the assumption that those measures would increase the money supply and lift the economy. But the money supply has not grown meaningfully in any of these countries.

Although the forex and equity markets responded sharply to the BOJ's negative interest rate announcement, the changes in the real economy that would justify such moves and nowhere to be seen. At some point, therefore, I would not be surprised to see a reaction in the forex and equity markets that helped to fill the gap between expectations and the real economy"

- Source: Richard Koo, Nomura Research Institute

In similar fashion to the ill-fated design of the Vasa ship, the Bank of Japan has induced much more volatility in an already fragile situation. The best illustration of an economy "rebooting" after a total collapse of its financial sector remains Iceland, we think. The pill was hard to swallow, but in the end, both inflation (2.10% as of January) and unemployment have been tamed (from 9.20% in May 2010 to a low of 2.30% in December 2015):

Click to enlarge

Click to enlarge

Source: TradingEconomics.com

The major issue that seems to lack the attention of our "Generous Gamblers" is that you have to choose your battle wisely. They cannot ignite inflation and reduce unemployment at the same time without an increase in wages, and this would mean corporate earnings would have to revert to the mean. Unfortunately, CEOs seems to care these days more about their own bottom line rather through buybacks in order to trigger their alluring stock options. As we posited in the "Pigou effect" last year, real wage growth is the Fed's greatest headache. We quoted Sir Jimmy Goldsmith at the time from the lengthy but thoughtful reply called "The Response" (link provided) to the critics of his great book "The Trap", which was eerily prescient:

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. "

- Sir Jimmy Goldsmith

And lowering the standard of living of one's own nation has indeed been the results of the repeated foolhardiness of the Fed and its zealous "put".

Real wage growth is the issue for the US economy, as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level."

- Source: Macronomics, 22nd July, 2014

Of course, as underlined by William White in his stunning interview, another solution to make the marginal utility of debt go positive would be to restructure private debts (Iceland) so that the ailing US households (14.24% of the population receiving Food Stamps) could indeed save more, invest and consume again - which is, in essence, the purpose of good allocation of debt to the real economy. Not into inane speculative endeavors which have been extensively encouraged by the various iterations of QEs and their inefficient "Wealth Effect" to the "real economy". - Sir James Goldsmith

When it comes to understanding credit and the buildup in a liquidity crisis (which, we reminded you a couple of days back, always leads to a financial crisis), we would like to use again a previous extract from our conversation "Pigou effect" from Sir Jimmy Goldsmith in his work "The Response":

"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.

But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.

Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent."

- Sir Jimmy Goldsmith - "The Response"

Since 2008, the losses have not gone away, as we reminded you as well. European banks even with LTROs and QEs Nonperforming Loans (NPLs) have not gone away, and there are still around €1 trillion of NPLs sitting on their balance sheets...

If you think NPLs are going to go away when we have mounting signs of headwinds for European growth with December Industrial Production coming at -1.6% (+0.2% expected) for France, Italy -0.7% (+0.3% expected) and even the UK -1.1% (-0.1% expected), then think again.

In the current environment, where we are seeing financial conditions tightening rapidly across the world, as pointed out recently by the BIS for Emerging Markets and by the latest Fed US Senior Loan Officer Quarterly Survey, it means lack of credit will slow growth, and therefore will not help whatsoever the reduction of these NPLs. Furthermore, the stupidity is compounded by NIRP, because banks cannot be profitable with a massive reduction in Net Interest Margins (NIM). That simple. So please spare us the "value beta play" mantra, because so many are trading under book value (most of the time, banks' balance sheets are such a black box that you have a hard time detecting what's being hidden). We are not buying it.

This brings us to our second point related to credit given our "2007" feeling. Credit is always leading equities, and what we have been commenting throughout our musings as we watched the credit cycle unfold is in effect happening - and we think it is still a cause for concern, as the contagion is in effect spreading.

Credit - The tide has turned, and we are moving from "idiosyncratic" risk to "systemic risk"

What we have been indicating during last summer were the many signs of the credit cycle maturing. The record wave of M&A in 2015 coincides clearly with the late stage of the cycle. This has been clearly illustrated by our friend Cyril Castelli from Rcube (he finally joined the Twitter family, and you can reach him there: @CyrilRcube):

"The M&A cycle leads the credit cycle. M&A mania => weaker balance sheets =>tighter bank lending => wider credit spreads"

Source: Rcube; @CyrilRcube

When it comes to the potential "overshoot" in US High Yield, our friend Cyril Castelli from Rcube illustrated this potential as well:

"Excess leverage explains the US high yield crash. High Yield always overshoot. It won't be different this time."

Source: Rcube; @CyrilRcube

We agree with our friend, and given that initial spreads explain nearly half of 5-year forward returns, and that spreads themselves are a very good indicator of long-term forward returns for both static and rolling investors, and given credit investors likely suffer from bipolar disorder and are afflicted by a severe case of myopia - as they focus on current default rates, rather than trying to estimate realistic future default rates - we will still tight until we see much more of an overshoot. Although it doesn't mean that they are not an "opportunistic" short-term High Yield / distressed name out there, but this necessitates some solid credit analysis in the first place. Relative value arbitrageurs did enjoy outsize returns ever since 2008 precisely because of the "uneconomic" distortions created in markets by central bank liquidity operations. The Barnegat fund, a New Jersey-based hedge which launched after the collapse of LTCM - the world's most notorious relative value arbitrageur - returned 132.68 per cent in 2009, thanks to "the largest arbitrage ever" in the US bond market, caused by the Fed's quantitative easing. But this time around, it looks like the Fed is running low in terms of "ammunitions", particularly at the time when "idiosyncratic" risk is moving towards "systemic" risk.

This brings us to the continuous drift in credit. Not only are seeing a continuation of the flattening of the US yield curve, but credit is also affected given that, according to CMA part of S&P Capital IQ, the 1-year CDX HY index is wider month to date by 81 bps, and the basis (the difference between the index and the single-name constituents) is still very high at 79 bps apart:

Source: CMA part of S&P Capital IQ

More interestingly, the continuous drift in credit is starting to point towards a more systemic risk environment, as pointed out recently by Bank of America Merrill Lynch in its Credit Derivatives Strategist note from 8th February, entitled "The tide has turned":

"Connecting the dots

Does the recent weakness resemble the 2008 global financial crisis sell-off or the 2011/12 European crisis one? Are we still in an idiosyncratic risk world, or are recent developments pointing to a more systemic risk environment?

Our analysis shows that: (i) the recent sell-off in bank stocks and senior financials CDS, (ii) the continued weakness in EM/oil names and (iii) the fact that the recent sell-off is not driven by the tail anymore and it is more widespread, points to one conclusion: that the tide is turning. Risks are not idiosyncratic anymore; systemic risk is rising.

Currently the level of our selloff depth indicator - that has been steadily increasing over the past weeks - is the highest since the taper tantrum and is quickly approaching levels seen in 2008/9 and 2011/12.



In chart 1 we present the % of the iTraxx Main portfolio (125 constituents in total) that has moved more than 10bp wider over a 4-week period, while the broader market (average spread of the pool) credit spreads are also heading north.
o The higher the % of the index that contributes to a sell off the more systemic is the nature of the move wider.
o The lower the % of the index that contributes to the market weakness the more the idiosyncratic is the nature of the sell-off.

• Bank stocks are back to levels seen in 2012. The recent sell-off of bank stocks has added more pressure to financials credit spreads. Risks remain to the downside for the sector. Bail-in fears (see underperformance of Italian names over the past couple weeks), the ECB looking at NPLs (an area of focus this year), EM exposed fins still under pressure, Brexit risks looming for the UK names and weak Q4 earnings season (in particular for DB and CS), keep fins CDS better bid. With bank stocks at these levels, iTraxx Senior Fins will remain the key hedging instrument against increasing pressure in high-beta banks paper.





• US non-manufacturing econ data - even though still on expansionary levels -are deteriorating at the fast pace since 2008/9 period (chart 4).



Additionally, our rates strategy team points that their model shows that the OIS curve (adjusted for the zero-bound effect) is already inverted and therefore may already be pricing a recession

• Oil prices are back at the $30 area; same as in 2008 (chart 5).



• Equity markets are punishing high risk (vs. low risk) stocks. The underperformance is the highest in years; only slightly away from the 2009 lows (chart 6).



• The iTraxx Main constituents (5y CDS spreads) distribution exhibits extreme levels of skewness and kurtosis. Both these metrics measure the asymmetry of the portfolio's distribution. High level of skewness and kurtosis are typical characteristics of a fat-tailed distribution that prices high level of idiosyncratic risk.

o The higher (more positive) the skewness the thicker the tail on the wide end.



o The higher the kurtosis, the thicker the tail and the higher the concentration around the index level, leaving not many names in between.



However, both these metrics have started to move lower over the past couple of weeks.

This clearly indicates a shift in market risks: from predominantly idiosyncratic as in 2008/9 (few wide names underperform, on balance), to more systemic risks as in 2011/12 (a broader widening). Note that financials did not feature even on the 50 widest names back in 2008. However, they dominated the widest names list in 2012.

Weakness is now a broader issue - it is not the widest names that underperform.

We analyse the performance of single names CDS since the recent tights (early December'15). We find that the names that have underperformed (in %-move terms) are not necessarily coming from the tail. In fact we see a widespread weakness in names across the credit spectrum (chart 9).

- Source: Bank of America Merrill Lynch

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up."

- F. Scott Fitzgerald

As we posited in our conversation "Le Chiffre" aka Mario Draghi, and given the market's anticipation for the ECB's next moves:

"QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.

Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations".

- Source: Macronomics, October 2015

It seems that at least the European credit Vasa ship's structural flaws come from deeply impaired banks balance sheet bloated by significant NPLs, which have yet to be addressed. Italy, in particular, is a base case - as illustrated by Richard Koo earlier in the failings of QE - when one looks at the Aggregate retail loan books, as displayed in the Société Générale November 2015 European Banks note entitled "A wake-up call":


Source: Société Générale

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.

And no earnings, thanks to NIRP, means now no reduction in Italian NPLs - which, according to Euromoney's article entitled "Italy's bad bad bank" from February 2016, have now been bundled up into a new variety of CDOs:

"Italian banks have already started setting up bad debt securitization platforms. Italy's third biggest bank, Monte dei Paschi di Siena (MPS), sold a €1 billion portfolio of NPLs into a securitization vehicle financed by affiliates of Deutsche Bank in December. The state will now guarantee the senior debt of such operations. It is unlikely ever to have to honour the guarantee, as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans.

The guarantee should attract a much broader array of investors to bonds issued by such vehicles, even if the banks still have to hold onto most of the riskiest tranches. However, the price could put off all but those banks with the highest funding costs. The state's fee for the guarantee will be based on CDS of issuers with similar ratings to the SPV tranche. To make sure the banks are not tempted to sit back and forget about the underlying loans, the price will rise over time - initially being based on three-year CDS, then five-year, then seven. As research from Milan-based Banca Akros points out, that's hardly encouraging, given the time it takes to realise collateral in Italy."

- Source: Euromoney

It looks to us like a nice new Vasa ship in the making...

Before we move on to our traditional final chart, here is another one courtesy of our friend Cyril Castelli from Rcube (from his Twitter page @CyrilRcube), showing that not only is AP Moller-Maersk a leading deflationary indicator, but as we discussed in our post "The Cantillon Effects", the use of fine art might is an effective means to measure "bubbles", as art is removed from the capital structure of the economy. The performance of Sotheby's (NYSE:BID), the world's biggest publicly traded auction house, has always been a good leading indicator and has led many global market crises by three to six months:

"Art & Shipping stocks lead the economic cycle. Recent price action of Sotheby's & Maersk is similar to 2000 & 2008."

Source: Rcube; @CyrilRcube

If you think we are bound for a "strong economic rebound", then you might want to hold off buying AP Moller-Maersk and Sotheby's because, as per our final chart shows, it is never great to catch falling knives.

Final chart - Don't catch falling knives

Whereas we keep hearing about some tremendous values offered by some levels reached by some equities, given the points we have made on credit leading equities and credit moving from "idiosyncratic" risk to more "systemic" risk, we thought we would point out Société Générale's take on "falling knives" in the below chart from their Global Style Counselling" note from 9th February, entitled "We love a bargain but should you buy falling knives?":

"Performance of falling knives

We start our analysis with a simple exercise, where we look at the relative performance of a strategy that buys companies that have seen 1) 20%, 2) 30%, 3) 40% and 4) 50% declines from their 12-month peak. As our portfolios might only include a handful of companies in some periods, we only take into account periods where we have at least 20 companies, and otherwise we assume a zero return. All portfolios are then rebalanced on a monthly basis, and our universe is based on FTSE World stocks since 1990.

As the chart below shows, despite some periods of strong outperformance (these periods are often referred to as the "dash to trash"), all portfolios eventually underperformed the market.

Source: Société Générale

Then again, you might want to check if indeed your "falling knife" doesn't boast the same structural flaws as the Vasa ship...

"Beware of little lending. A small leak will sink a great European ship."

- Martin T., Macronomics

Us thinking of Italy again...

Stay tuned!