Month: February 2016

Back before everyone became a junk bond expert, we repeatedly showed what in our opinion was the scariest chart for not only the US, but global stock markets: the unprecedented divergence between the stocks and junk bonds, suggesting that if the recent past is prologue, then the S&P 500 is in for a world of pain as it tracks HY credit far lower.

 

Since then, these fears have been realized and the market tumbled, unleashing even more central bank jawboning and intervention.

That, however, has done nothing to fill what amount to a staggering gap, and as JPM notes today, the “credit backdrop has deteriorated; the gap with equities remains stark“

Here is what else JPM says as it lays out what were the three scariest charts for stocks in the summer of 2015 and which remains the scariest charts for stocks as we enter February 2016:

• One of the big supports for equities for a long time was the strength in credit.
• The rollover in HY credit is thus not a healthy sign for equity performance. The two don’t tend to diverge for too long

 

Where things get worse is that as JPM notes, “the increase in HY credit spreads is not just because of Energy, all 21 subsectors have seen widening; US lending standards are tightening again” and in fact “HY spreads have doubled over the past year, with broad participation.“

 

JPM leaves off with two final concerns: “the signal from HY credit is a concern for the stage of the cycle we are in…”

• The best leading indicators for recession were: credit spreads, shape of the yield curve and profit margins.
• HY credit spreads are pointing to an increasing risk of a downturn.
• The current move in HY spreads is approaching the average of the last three slowdowns.

 

And just as troubling, HY contagion has spread to Investment Grade, that all important source of debt-funded buybacks.

• The move up in high-grade spreads paint a very similar picture.
• HG spreads have widened by 100 bp since their trough in June’14. Spreads typically have troughed six months prior to the start of a recession.

But once again the focal point will be energy where despite record low interest rates, the powder key is set to explode any moment for one simple reason: every incremental dollar of cash flows goes to satisfy bond holders, cash flows which decline with every passing day.

 

And the punchline, or the biggest irony in all of this, is that it is the Fed’s own policies and the pursuit of the strong dollar, at least until the Fed relents and unleashes NIRP and more QE, which are pushing the US straight into the next global crash…

… a crash which would not be there had the Fed not intervened in 2008/9 and blown yet another bubble to mitigate the collapse and natural implosion of the previous housing and debt bubble, which in turn was blown to offset the bursting of the dot com bubble.

We can only hope the bursting of the next, and biggest yet, bubble also takes away the almost thoroughly discredited central bankers with it…

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Last summer we outlined how Chinese banks obscure trillions in credit risk.

The powers that be in Beijing aren’t particularly keen on allowing the banking sector to report “real” data on souring loans – especially given the fragile state of the country’s economy. In some cases, the Politburo will pressure banks to simply roll over bad debt, effectively kicking the can.

In addition, banks carry around 40% of their credit risk outside of “official loans.” Here’s what Fitch had to say last year:

“Off-balance-sheet financing (I.e. trust loans, entrusted loans, acceptances and bills) accounted for 18% of official TSF stock at end-2014, up from less than 2% just over a decade ago,” Fitch wrote. “Of the off-balance-sheet exposure reported at individual banks, this is equivalent to 15% of total assets for state commercial banks and 25% for mid-tier commercial banks, on a weighted average basis. These ratios would be even higher if we included entrusted loans (see Figure 2), although this information is not disclosed at all banks. Fitch estimates that around 38% of credit is outside bank loans.”

In many cases, channel loans (so credit extended by banks via non-bank intermediaries) are carried as “investments classified as receivables” on the balance sheet. 

Now, as more Chinese firms lose access to traditional financing amid rising defaults and increasing economic turmoil, banks are increasingly turning to channel loans as a way of extending credit.

In turn, the amount of “investment receivables” on many mid-tier banks’ books is soaring to dizzying levels. “Mid-tier Chinese banks are increasingly using complex instruments to make new loans and restructure existing loans that are then shown as low-risk investments on their balance sheets, masking the scale and risks of their lending to China’s slowing economy,” Reuters reports. “The size of this ‘shadow loan’ book rose by a third in the first half of 2015 to an estimated $1.8 trillion, equivalent to 16.5 percent of all commercial loans in China.”

Specifically, the banks are using DAMPs and TBRs, but more important than the intricacies of the structures is what the practice means for the market’s ability to acurately assess credit risk in China. “The concern is that the lack of transparency and mis-categorization of credit assets potentially hide considerable non-performing loans,” UBS’ Jason Bedford warns.

But that’s not all. Investment receivables only carry a 25% risk weighting, which means the banks aren’t holding adequate reserves to backstop losses on loans that by their very nature are more risky than traditional financing. “Banks must also make provision of at least 2.5 percent for their loan books as a prudent estimate of potential defaults, while provisions for these products ranged between just 0.02 and 0.35 percent of the capital value at the main Chinese banks at the end of June,” Reuters goes on to note.

Just how large is this exposure, you ask? In a word: huge. At Industrial Bank for instance, the size of the “investment receivables” book doubled during 2015 and now sits at a massive $267 billion or, as Reuters adds, more than its entire loan book and equivalent to “the total assets in the Philippine banking system.”

And it’s not just Industrial Bank. At the aptly named “Evergrowing Bank”, investment receivables are CNY290 billion, a figure which is also larger than the bank’s pile of traditional loans.

“In the past banks (made loans and) held assets. Now banks manage assets,” Zhang Changgong deputy governor of China Zheshang Bank (where investment receivables also doubled last year) says.

Fair enough, but that’s just semantics. You can call them “assets” or “investments” or “receivables” or whatever the hell else, but at the end of the day, these are loans. And the bank shoulders the entirety of the credit risk. “To structure these deals, a bank typically engages a friendly trust, securities, or asset management company to set up a financing arrangement for a bank client,” Reuters writes. “The bank then buys the beneficiary rights to the investment product using a special purpose vehicle.” 

Right. Of course if you hold the beneficiary rights, common sense says you also shoulder the vast majority of the risk. Or, as one senior executive told Reuters on the condition of anonymity, “if the originating bank does not promise to pay from its own pocket should any default happens, no trust company would agree to collaborate.”

What should jump out at you here is that this is just about the worst case scenario at every turn. Banks are piling up exposure to the riskiest subset of borrowers at a time when economic fundamentals are deteriorating on a near daily basis. Meanwhile, this exposure is being carried on a line item that allows the banks to avoid provisioning for the losses that will almost certainly materialize in the not-so-distant future. At one bank, this one line item is larger than the entire Philippine banking system.

Of course this also reflects a theme we’ve been discussing for quite some time: namely that China is trying to deleverage and re-leverage at the same time. The channel loans described above are part and parcel of the shadow banking system which ground to a halt after years of explosive growth. Now, Beijing can’t decide if it’s better to kick the can by allowing banks to mask bad debt and pile up still more exposure outside of their traditional loan books or crack down, let the whole thing unwind, and start from scratch after the misallocated capital has been purged. 

Whatever the case, this cannot last forever, and when the unwind finally comes and trillions in defaults on channel loans, trusts, and WMPs ripple through China’s economy, even the NBR won’t be able to say “7% growth” with a straight face.

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There will be two key themes for investors seeking to shake off the abysmal “as goes January” blues:

• The first is that as earnings season comes to a close, companies will gradually emerge from their quiet periods and resume buybacks, even if the investment grade market is now far less conducive to making equity stakeholders richer through incremental leverage. As such it will be interesting to see how single stocks react to new buyback announcements over the coming weeks;
• The second, and even more important theme, will be that after a turbulent on the central bank news front month, February will unveil an eerie quiet emerging from the world’s central planners. As Bloomberg notes, “February lacks a single scheduled opportunity for the Federal Reserve, European Central Bank or Bank of Japan to reset monetary policy, in part because some policy makers decided last year to meet less frequently.”  Kazuhiko Ogata, chief Japan economist at Credit Agricole SA in Tokyo said that “February is like an air pocket as no major central bank is scheduled to hold a meeting”

First, here is Goldman’s David Kostin explaining that it is only a matter of days before corporations take controls of their own stock price using the method we all know so well: stock buybacks:

Corporates appear on track to resume buyback activity in early February, providing an important source of demand for US equities. Just 4% of repurchases happen in January, making it the slowest month of the year for buyback executions (see Exhibit 4). This lack of demand has contributed to recent market weakness and volatility, in our view, particularly with investor positioning at extremely low levels. After registering a 3 on a scale of 0-100 last week, this week our Sentiment Indicator came in at a 6. By February  5, more than 75% of S&P 500 equity cap will have reported earnings and will be able to resume discretionary buybacks. Management teams have continued to express their commitment to share repurchases during 4Q earnings calls, providing evidence that corporates remain confident despite near-term economic uncertainty. Recent buyback announcements include SLB ($10 bn), GM ($4 bn), and FDX ($3 bn), while AIG announced it plans to return $25 bn to shareholders in the next two years through a combination of buybacks and dividends.

 

Of course, saying that there has been no buyback activity in January would be a lie: as Credit Suisse’ trading desk admitted in late January, “Our Buyback Desk Is Very Busy.” The question then becomes how many companies violated their quiet period and pulled forward buybacks which would have otherwise taken place in February. We will find out soon.

In any event, that was the good news. The bad news is that after a blistering January filled with constant central bank jawboning (Draghi), inaction (Yellen) and action (Kuroda), February will bring 4 weeks in which central banks will no longer hold the market’s hand. This is what Bloomberg said:

February lacks a single scheduled opportunity for the Federal Reserve, European Central Bank or Bank of Japan to reset monetary policy, in part because some policy makers decided last year to meet less frequently. That leaves investors to navigate any new threat to the global economy on their own after central bankers helped to limit losses in the worst January for stocks since 2009.

 

Unless central banks spring surprise action this month, investors are prey to any further slide in commodities or ructions emanating from China, beset by deteriorating growth and a lack of clarity on policy makers’ intentions.

 

The gap will give [central banks] more time to ascertain just how their economies will be affected by the recent slide in stocks and commodities, as well as China’s economic slowdown. Between now and March, if market convulsions subside, focus could turn to underlying signs of stability in the top economies. Fed officials said last Wednesday they are “closely monitoring global economic and financial developments.”

 

Leaving investors to their own devices for a few weeks could also be in order given that some central bankers themselves have questioned the potency of even more monetary stimulus. They also argue that it’s not their job to prop up asset markets — even if they have the reputation for doing so.

The reduction in meetings was in part so that the ECB and BOJ could act more transparently by publishing more reviews of their economies and decision-making. ECB President Mario Draghi also said last April that the previous “frequency of our meetings leads the public and the market to expect action.”

According to some, the central bank silence could be good news:“When you’re approaching central bank meetings, their proximity is frequently a source of volatility and uncertainty, but if there’s no imminent meeting you don’t get quite so worked up,”  said ING Bank international economist Rob Carnell. “Markets can get confused over direction, so look for a steer — but I’d like to hope things settle down and they aren’t as hung up on whatever the data tends to be and what it means.”

Others disagree: ““February is like an air pocket as no major central bank is scheduled to hold a meeting,” said Kazuhiko Ogata, chief Japan economist at Credit Agricole SA in Tokyo. “That creates a risk of further wild ups-and-downs in global markets.””

There is a wild card: the People’s Bank of China doesn’t have scheduled policy meetings, leaving it out as a wild card – though its actions have sometimes roiled global stock markets rather than helped them. In case the furious selloff in the Shanghai Composite continues, as it did overnight following the worst January in years, expect China’s central bank to pull a BOJ and “surprise” with at least some intervention, although just like the BOJ, whose action halflife is now measured in hours, this too latest panic by a central bank to “calm” markets will achieve an initial bounce, followed by an even far more pronounced selloff as credibility of central bankers around the globe evaporates with every passing day.

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Submitted by James Howard Kunstler via Kunstler.com,

Why would anybody suppose that the Peoples Bank of China might want to tell the truth about anything that was within their power to lie about? Especially the soundness of any loan portfolio vested unto the grasp of its tentacles? Of course, most of what China has done in speeding toward the wall of financial crack-up, it learned from watching US bankers slime their way into Too Big To Fail nirvana — most particularly the array of swindles, dodges, and frauds constructed in the half-light of shadow banking to hedge the sudden, catastrophic appearance of reality-based price discovery.

When so many loans end up networked as collateral in some kind of bet against previous bets against other previous bets, you can be sure that cascading contagion will follow. And so that is exactly what’s happening as China’s rocket ride into Modernity falls back to earth. Like most historical fiascos, it seemed like a good idea at the time: take a nation of about a billion people living in the equivalent of the Twelfth Century, introduce the magic of money printing, spend a gazillion of it on CAT and Kubota earth-moving machines, build the biggest cement industry the world has ever seen, purchase whole factory set-ups, and flood the rest of the world with stuff. Then the trouble starts when you try to defeat the business cycles associated with over-production and saturated markets.

Poor China and poor us. Escape velocity has failed. Which raises the question: escape from what, exactly? Answer: the implacable limits of life on earth. The metaphor for all this, of course, is the old journey-into-space idea, which still persists in the salesmanship of Elon Musk, the ragged remnants of NASA, and even the nightmares of Stephen Hawking. Get off this messed-up home planet and light out of the territories, say Mars. Of course, this is a vain and stupid idea, since we already have a planet engineered to perfection for all the life systems associated with the human project. We just can’t respect its limits.

So now, that dynamic duo, Nature and Reality, the actual owners of the planet, have showed up to read the riot act to the renters throwing a wild party. The fourth and perhaps ultimate financial crisis of the last twenty years begins to express itself in terms that only the raptors and vultures can see from on high. George Soros, Kyle Bass, and the other flocking shadow banking scavengers prepare to short the living shit out of the old Middle Kingdom. The immortal words of G.W. Bush ring in their ears: “This sucker is going down,” and they are sure to win big by betting on the obvious. Trouble is, this sucker could go down so much further than they imagined, that whatever fortunes they gain from its descent will be foiled by the destruction of the very economic system needed for them to enjoy their gains.

For instance, when banking systems go down, governments usually follow, and when governments go down, societies often unravel. It doesn’t take a great effort of imagination to see China’s one party politburo leadership machine lose the respect of its governed masses, and then its control of events, followed by a Great Struggle among the regions and factions to restore some kind of order. And when the smoke clears there will a whole lot of nearly worthless concrete and steel, and a vast loss of notional wealth, and China will be lucky to land back in some approximation of the Twelfth Century.

It must be interesting for China to watch the horrifying disintegration of America’s political party structure currently on view, with the mad bull called Trump rampaging across the land and the designated inevitable Mz It’s-My-Turn hijacking her collective for the greater glory of Goldman Sachs. The last time China got the vapors politically — the so-called Cultural Revolution of the 1960s — the country went batshit crazy. Surely some of the ruling party remembers that with requisite terror.

Or maybe this is China and the USA’s Thelma and Louise moment. Pedal to the metal, they drive into the abyss of history holding hands. Remember, audiences loved that!

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Amid denied rumors of production cuts (and Goldman’s dismissal), crude oil prices have jumped “August 2015 Andy Hall squeeze style” to 3-week highs. This ‘change’ in trend has hedge funds calling the bottom once again adding to bullish oil bets at the fastest pace since 2010 in the last week. However, most ironically, it appears the weak longs are being squeezed today as WTI crashes 6%.

 

Still, it seems many are looking for a short-squeeze initiated bottom here… (as Bloomberg reports)

“A lot of the shorts got scared out,” said Tom Finlon, Jupiter, Florida-based director of Energy Analytics Group LLC. “We could be forming a bottom here.”

 

“There’s still a good amount of short-covering taking place after we fell to our lows,” said John Kilduff, a partner at Again Capital LLC, a New York-based hedge fund that focuses on energy.

Speculators’ net-long position in WTI increased 35 percent in
the week ended Jan. 26 to 110,432 contracts of futures and options, the
biggest percentage gain since October 2010, data from the U.S.
Commodity Futures Trading Commission show. Longs, or wagers on rising
prices, increased by 23,031 to 289,181 and short positions dropped by
5,444 contracts to 178,749.

 

Short positions in WTI fell 11 percent from a record in the two weeks ended Jan. 26.

The last time aggregate net speculative bets rose this much was the end of April and marked a stable plateau before re-plunging for new lows…

 

“There’s hope that Russia will enter into an agreement with OPEC to cut production,” said James Williams, an economist at WTRG Economics, an energy-research firm in London, Arkansas. “But the probability is very low.”

A production cut of 1 million barrels a day would put the oil market “in a rough balance in the first half and probably in deficit in the second half,” said Bart Melek, head of commodity strategy at TD Securities in Toronto. “But it can’t possibly just be Russia.”

In other markets, net bearish wagers on U.S. ultra low sulfur diesel dropped 15 percent to 21,445 contracts. Diesel futures gained 6.5 percent in the period. Net bullish bets on Nymex gasoline fell 13 percent to 17,382 contracts as futures rose 2 percent.

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Back in 2012 and then again in 2013, after repeatedly observing just how broken markets have become as a result of central bank intervention, a topic that back then was still taboo and is now wholeheartedly accepted even by the Davos billionaires (whose mood the WSJ summarized as “irritated, bordering on affronted, with what they say has been central-bank intervention that has gone on too long“) we presented what may have been the best alpha trade around and how to best outperform the “market” in a world in which not only fundamentals no longer matter, but in which hedge fund herding has led to relentless losses for the active investor community for 7 years in a row as a result of the omnipresence of central banks who have made hedging pointless: just do the opposite of what everyone is doing, and go long the most shorted stocks.

From our September 2013 post:

In a world in which nothing has changed from a year ago, and where fundamentals still don’t matter, what is one to do to generate an outside market return? Simple: more of the same and punish those who still believe in an efficient, capital-allocating marketplace and keep bidding up the most shorted names.

As we documented both before and since, this trade has continued to generate alpha even as the smartest people in the room sat down during long idea dinners and scrambled to come up with ways to justify their 2 and 20 (and in the case of Bill Ackman last week, blamed precisely the same idea dinners for their underperformance).

Today, none other than Bank of America’s chief equity quant Savita Subramanian throws in the towel and admits that the best trade over the past several years has been precisely what we first suggested in 2012: do the opposite of what the crowd does. To wit:

We continue to urge investors to watch positioning: over the last several years, during which active inflows were weak to negative but passive inflows were heavy, the strategy of buying the 10 most underweight stocks and selling the 10 most overweight stocks at the beginning of each year has outperformed; this simple trade has produced alpha in excess of the typical long-short equity hedge fund.

Indeed… and while BofA won’t go so far as to admit going long the most hated names leads to even higher alpha, the principle is the same: since fundamentals don’t matter, and since cash flow remains (or remained until the recent tremors in the energy space) irrelvant, the only catalyst is to wait and watch as grouped positioning unwinds.

Here is more from Bank of America:

Over the last several years, with outflows from active funds into passive funds, buying the most underweight stocks has been a source of alpha, and so far this year has generated over 5ppt alpha.

 

While clearly late to the party, BofA believes the trade will still work:

Why positioning will likely continue to drive alpha

 

Flows out of active into passive have been extreme for the last several years, suggesting to some that the rotation may be close to over. Unfortunately, we think there is more to come. After the last few years of declining alpha from active funds coupled with strong years for the benchmark, outflows from active to passive have accelerated. And close to 70% of large cap AUM still resides in active funds, suggesting we are likely far from critical mass in passive. Moreover, regardless of flows, crowded stocks have chronically underperformed – stocks that are 3x or greater than the benchmark weight have underperformed by 12ppt ann. based on data back to 2008.

So as our relatively under the radar idea that has resulted in substantial alpha for those who put it on becomes mainstream, here is BofA with its listing of the most concentrated stocks:

We highlight the top 5 stocks within each sector by concentrated ownership. We assess concentrated ownership by two measures:

1. Percentage of shares held by the top 10 holders; and
2. The Herfindahl measure of concentration index (the sum of the squares of the percentage holdings of each individual fund).

Stocks that are rated UNDERPERFORM are highlighted as having particularly high sell-off risk.

Here is the full list:

 

Finally, putting all this together, this is what BofA believes is the “trade for today” based on its proprietary index of most overweight (sell) and most underweight (buy) stocks among the active investor community.

 

* * *

We conclude with one big caveat: this strategy only works as long as the market is broken and as long as central banks, such as the BOJ and its NIRP stunner on Friday, remain the predominant “activists” in the market. However, if and when normality returns, if fundamentals once again matter, if the Fed and its central bank peers won’t inject trillions in liquidity every time there is a 10% correction or push global bond yields to record lows, the trade will lose.

However, we are confident that even the most P&L-focused managers will be eager to part with a few basis points if it means that the market may finally return to its former rational self, one where picking winners and selling losers is what it is all about, and not this farce where the only thing that matters is which central banks will inject liquidity or how much in capital outflows will any given emerging market soak up this month to cover losses from waning commodity export revenues.

For now, we are hardly in danger of entering the Untwilight Zone any time soon.

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Whether front-running or fear-based (or both), the actions of BoJ's Kuroda last week have driven global bond yields into freefall with JPM's global index at 9-month lows and BofA's at 12-month lows. Overnight saw short-end JGBs push below the BoJ's -10bps threshold and 10Y rates push towards NIRP to record lows. German bonds extending their epic voyage into fantasy and hit new record lows across the curve with 5Y at -32bps.

 

Bond yields across the globe are collapsing…

 

With Japanese and German bonds now negative to 9 years and 8 years respectively…

 

“Banks will allocate more money to non-cash-type of investments, and the first priority will be the bond market,” said Hajime Nagata, a bond investor in Tokyo at Diam Co., which oversees $143 billion. “The market is expecting that Japanese investors will allocate more to foreign fixed income.”

As Bloomberg reports,

In the bond market’s view, the chance of a Federal Reserve interest-rate increase this year is practically a toss-up after the Bank of Japan’s surprise policy move.

 

Derivatives traders see less than 60 percent odds that the Fed will raise its benchmark even once this year, let alone the four quarter-point increases that policy makers projected in December.

Not exactly "buy stocks and increase wealth" confidence-inspiring stuff eh?

 

Charts: Bloomberg

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