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The big disconnect between leverage and spreads

Matt King from Citigroup usually serves up nice presentations, but his past few highlighting the increasingly problematic increase in leverage among non-financial corporates is particularly illuminating. The latest installment is full of illuminating charts, but it will suffice to focus on the one below, 

Source: Citgroup, Matt King (March 2014)


Since 1988 there has been a relative close, and logical, correlation between higher corporate leverage and higher spreads, but not this time around. It is difficult to find a clearer picture of the effect of a structurally low interest rate regime (ZIRP) run simultaneously by global major central banks.

One of the most obvious consequences of persistently low interest rates in the past 2-3 years has been the increase in leverage for non-financial corporates (with access to the debt markets). A new bubble is brewing and if you look at the sectors of the economy that have responded to low interest rates (i.e. who have had room to lever up) the picture falls squarely on non-financial corporates. 

Yet, when presenting this view to clients in the past 6-12 months I have received strong push back. Net debt is still low I am told and corporate cash balances have improved. All this is true, but I have already given a hint to my rebuttal. We need to look at non-financial corporates and indeed, we need to drill down to sector level. 

First of all, let us quickly dispense with the notion that US corporates are sitting on large cash balances. This is true when judged from afar, but cash reserves are very concentrated. 


The reason for this skew is mainly banks and the likes of General Electric, Berkshire Hathaway, Apple etc. This is simply to say then that the notion of US corporates being awash with cash does not hold up to scrutiny as a general market characteristic. This is supported by the expecteced relationship between higher net debt and a lower liquidity position (measured by the Quick Ratio). 


So while the market based information is telling us that spreads and leverage are now disconnected, fundamentals remain in-line with theory. Companies with higher net debt also have poorer liquidity positions [1]. The final piece of evidence I would like to point to just how distorted overall net debt data is by the financial sector.


Including the financial sector will consequently give a picture of steadily declining leverage to new lows in the past 5 years. However, this is deeply misleading. If we strip out financials (which in any case is logical as their balance sheets look completely different from non-financial corporates') net debt per share has ascended new highs in the past 2-3 years. Mind you, these figures are both indexed and inflation adjusted so there is no nominal money illusion to blame for the results either. 

There are now more corporate bonds outstanding in the US than there are mortgage backed securities. This is a significant data point. The heart of the next crisis and debt bubble will be non-financial corporate debt (particularly in the energy and materials sector). Investors should take note. 


[1] - The relationship between net debt per share and the Quick Ratio is non-linear due to the fact that the Quick Ratio is bounded by zero at its lower bound (while net debt per share is unbounded). 


Negative current account in Japan makes a short JGB trade worth considering 

Investors are slowly but surely adjusting to a world where markets and becoming more uncorrelated and (macro)risks are now local instead of global. We are now living in a bottom-up world and global macroeconomists with a Cassandra bent are set to become an endangered species. Or so at least is the refrain from the Street researchers that I am following.

Apart for some important qualifiers (see below) I tend to agree with this. I certainly never bought the recent misplaced worries about current account deficits in Brazil, India and Indonesia as the potential source of a new Eurozone type crisis. Current account deficits are perfectly normal for these EM economies and indeed welcome in a world where everyone wants to export their way to growth. As I argue below, investors have been focusing on the wrong deficits.

The notion of a less correlated world is an interesting narrative in itself because it is starting to emerge as a serious alternative to the Zero Hedge view of the world. In fact, it is worth pondering whether the recent 12 months’ impressive melt-up in developed market equity market isn’t, in part, a contrarian response to the growing fraction of Armageddon Preppers  that has infiltrated financial market commentary.

For investors the transition to a world dominated more by bottom-up and local themes would constitute a more benign investment environment relative to a world where the future of financial markets rest on the whims of Greek bureaucrats’ dealings with the IMF. This is the good news, the bad news is that I don’t think investors can completely disregard global macro risks. Specifically, I see two “local” macro risks with the potential to global; a capital outflows crisis in China and the growing CA deficit in Japan (and its consequences for the JPY and JGB).

In this post I deal with the latter. 


Japanese current acount makes no economic sense

There are two reasons why the current account deficit in Japan should command investors’ attention. In the first instance, it is important because it points to further and strong JPY depreciation. Secondly, because it is a necessary but not sufficient condition for the JGB market to blow up (yields to rise sharply in Japan).

Edward has already dealt with the challenges that Abenomics face over at AFOE. I agree with the main sentiment; especially this.

(…) it seems to me Japan’s problem set is overdetermined in that we always seem to be facing at least one more problem than we have remedies at hand.

Turning to my own narrative, the first point above may seem less controversial. Every serious and non-serious macro trader has been short the JPY in the past 12-18 months. I would suggest that trade will continue to perform nicely, but a negative current account suggests that the JPY could now be on the cusp of weakening with a speed and to a level that will garner serious attention from the other G7 economies and market participants. This is to say that so far the short-JPY trade has been lucrative idiosyncratic trade driven by a local macroeconomic experiment in Japan. A negative current account could be what makes a weakening JPY a systemic risk for the global economy through its impact on Japan’s economy. To put this in a language market participants can understand, so far the short JPY has been a risk-on trade with the USDJPY being very correlated to the US 10y yield and Nikkei 225. With a current account deficit my contention is the JPY would weaken sharply even in an environment where stocks sold off and US 10y notes rallied.

Remember that the rest of the world has so far accepted the experiment that is Abenomics not only because Japan has been running a current account deficit (thus making it more reasonable for Japan to weaken its currency), but also because the depreciation has so far been orderly. With a growing negative current account, the wheels are now set in motion for a decidedly disorderly depreciation of the JPY and one that could ultimately be life threatening for the Japanese economy.

In simple terms, Japan’s current account deficit is "perfectly" in line with a rapidly ageing economy that is supposed to dissave. However, it is also the first example of its kind. We simply do not know how an economy with no discernible future investment yield and opportunities react to the need to import foreign capital to pay for consumption and investment through, as is currently the case, a big and growing budget deficit. My guess is that all known theories of life cycle economics are about to run out of line as it becomes clear that negative current account dynamics do not make sense for a rapidly ageing economy. Either the currency weakens up to the point at which the current account is closed (that is rapidly and violently!) or bond yields start to rise (in similar violent and rapid fashion). Neither scenario is going to be pretty.

The biggest push-back I continue to get here is that the BOJ will simply continue to buy all the JGBs and thus that bond yields will not be affected. This certainly looks like where we are going. A case in point has been the amazing statements from the Government’s Pension Investment Fund (GPIF) signalling their intent to sell bonds and buy more equity.

This puts an incredible onus on the BOJ. Not only is the Japanese pension industry now dissaving (i.e. structural net sellers of bonds to fund retirement redemptions), but if they also start to liquidate their stock of JGBs to rotate into stocks who will pick up that flow. Remember here that Japan is currently running, by far, the biggest budget deficit in the world. There are only two constituents that can pick up this flow really; foreigners and the BOJ. This has customarily been the main reason for expecting ever more aggressive monetary easing and essentially that the BOJ would become the JGB market. This is certainly where we are going but a negative current account changes dynamics significantly

In essence, the notion of the BOJ buying up all JGBs does not necessarily apply in the case of a current account deficit. More specifically, no matter the speed of the printing press in Japan foreigners need to finance the current account per definition and if the deficit is structural it is difficult to imagine this would not include buying JGBs (thus, presumably demanding a higher yield for their effort). The BOJ could, in theory, buy every single JGB but this would then de-facto be done in order to shield the JGB market from foreign influence and higher yields.

The presence of a negative current account thus creates a veil between the BOJ and its objectives. It can still achieve its objectives, but it would require a drastic radicalisation of its bond buying programme and thus a likely very aggressive nominal target for JPY weakness. This would, in the first instance, call for accelerated JPY weakness but investors should not automatically assume that the BOJ can control this process.

This brings us to the second point stated above. A negative current account deficit is thus the first step towards a rout in the JGB market. While it is true that Japan has its own currency and will likely use it aggressively as an adjustment mechanism the key question is the speed with which such an adjustment will work. Investors should not take this lightly. If inverted yield curves in the Eurozone periphery proved to be a significant global source of tail risk, a similar development in Japan would be equivalent to a global financial nuclear disaster.

Many commentators have noted here that as soon as Japan turns back nuclear power the current account will stabilise, but this is far from certain. And even if this was the case, the speed with which such a change materialises in the current account balance could easily be enough to upset the cart.

The investment implications are clear in my view. Being short the JPY makes imminent sense and investors should add to position. The traditional risk-on/risk-off dynamics would suggest that a market sell-off should be correlated with JPY appreciation. My view is that the negative current account changes that dynamic. I would also suggest buying OTM put options on the short end of the JGB curve. Being short JGBs has so far been a widow maker, but a negative current account deficit changes the risk/reward ratio drastically for such a trade. Investors should take note. 


And the award for EM safe haven of choice goes to ...

... China!

At least this is the conclusion from some fascinating number crunching from JPMorgan's Flow & Liquidity team in their report last week. I had a feeling that this was the case looking at the surge in Chinese FX reserve growth (capital inflows) in the past 6-12 months, but it is still interesting to see such clear evidence from the data.

Here is F&L on the outflow data;

(...) around $80bn of capital left these 22 EM economies [read: essentially EM ex China and the Middle East] cumulatively since last May. This $80bn outflow is likely understated by $20bn due to the 1.6% decline in the dollar between the end of May and end of February, as a weaker dollar pushes up the dollar value of non-USD denominated reserves. Adjusting for this leaves us with around $100bn of estimated capital outflow from these 22 EM countries between May and February.

This estimate of $100bn worth of EM outflows since the tapering scare began in May/June last year is not the controversial number. The main question is then where the money went and here it gets very interesting.

This capital outflow does not necessarily reflect capital leaving the EM universe as a whole. In fact it seems that China, perceived as safe haven, has attracted a similar amount over that period. Using similar calculations of FX reserve changes adjusted for current account flows, we arrive at a $125bn cumulative capital inflow into China between May and December, as the outflows of last May/June more than reversed in subsequent months. Of this $125bn figure, around $25bn reflects the 2% decline in the dollar between the end of May and end of December. This leaves us with around $100bn of estimated capital inflow into China between May and December.

What is particularly interesting about these numbers is that the breakdown reveals that only a small fraction of this, $20bn according to JPM, reflects net FDI. The rest represent so-called hot money flows in the form of portfolio flows and short term flows into demand deposits (to take advantage of sharply higher interest rates in China).

With the CNY just having seen its strongest bout of volatility in a long time last week it may seem rather inopportune to publish a note on the inexorable and inevitable rise of the CNY. Personally, I would be wary taking the consensus view at face value here. In fact, on many accounts the CNY looks overvalued here and this is exactly what the market is also telling us I think (at least in the short run). CNY volatility and weakness are also the two main markers I would be watching for signs of capital outflows and ultimately how China could become a big headache for the rest of the world. 

All this however does not detract from the fact that JPM gets the completely unofficial award this week for the best sell side data crunching exercise. The tapering scare that emerged last summer has been linked to all kinds of bad outcomes for emerging markets as a whole. Clearly, this is not an accurate description and something which investors should not lose focus of.

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