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Friday, 8 February 2013

Investment Sector Outlook for 2013: “Credit is a Lover on the Re-bound?”



FPM considers the macro speculation that policy makers’ credit cycle stimulus is in musical terms at a moderata end in 2013. The high flying segments of the credit asset class are behaviourally like a spurned or unreciprocated lover on the rebound to the next ‘pick-me-up’ lover. FPM’s analogy is that eventually this new quickly formed, on the bounce love-affair is checked. And in the end not lasting or enduring, as it was a hastily formed affair from hurt ego and pride following a more secure stable relationship or courting. We feel the stellar ‘dead-cat bounce’ from credit-bubble bursting in 2007-08 should unwind. Especially so in mortgage credits and leveraged loans. Not forgetting that these segments of credit were in greater proportion the underlying constituents of structured products dubbed ‘toxic’ CDOs, CLOs et al. The credit collapse should eventually be precipitated by the un-leashing of inflation expectations. Turning off credit stimulus is the first step. This view rhymes with some professionals predicting a strong equity market rally. Also, in this article we review our credit opinions expressed in September 2011 in “Credit Markets @Optimistic Workout Inflexion Point”. The hedge funds we recommended in that article, such as the Chenavari ABS Toro and the CQS ABS funds FPM put on “Review / Redemption” rating.

Our view is based on policy-lead from the US Federal Reserve and understanding of cyclicality in capital markets. The Fed’s minutes of its recent Federal Open Market Committee’s (FOMC) December 11-12 meetings hinted at reversal of policy by some of its members. Particularly toward halting the policy of monthly purchases of US$45 bn in Treasuries and US$30 bn in mortgage related securities.  Minute extracts:

“Several others [of the FOMC members] thought it would probably be appropriate to slow or to stop purchases well before the end of 2013… citing concerns about financial stability or the size of the balance sheet, which has grown from $869 billion in 2007 to over $2 trillion.”

In hindsight, policy makers or establishmentarianism turning off the bankers’ credit tap has been inevitable, or put another way long-time coming. Especially when considering the subsequent bargaining in ‘fiscal-cliff’ discussions at end-December 2012: whether to continue Bush-era tax holidays for all except US$400,000+ earners. In budgeting terms, something often has to give, or philosophically “be sacrificed”. FPM are aware that until final budget and national debt discussions are concluded in late February /early March there might yet be other compromises in American austerity drives. Set your calendar alarms to March 1st announcements on this.

After all, how long can the prime-and-pump machine churn-on towards inducing improved confidence and sentiment in economic activities and capital markets. The Great Depression could not be one if it was over in five year! Despite reserve-currencies ‘printing-money’ and the associated moral hazards in an increasingly interconnected global economy, concerted economic policy response has been credit expansion.  Inflation could still well be a scenario for debt devaluation. Inflations has been abated/ repressed or even manipulated in reserve-countries. Statistically, inflation is failing to measure a relevant representative basket of goods and services. Multiple academia and statistical research have distortedly indoctrinated professionals and public that ‘perceived inflation’ was higher than ‘actual’ reported cost of living because the basket constituents that were rising were repeat purchase items like food and other living day essentials. So price of cars or other durable goods and services deflating would be less noticeable, yet these heavily-weighted goods in the inflation basket more influence the ‘actual’ inflation. So like manipulation in LIBOR, we may understand that inflation measurement baskets are not representative to most of the population, who do not buy new cars repeatedly! Admittedly there are other prevalent inflation-mitigation factors than simply a pacifying behavioural finance explanation for biased inflation data. For example, China and other developing countries are globally exporting deflation through the activation of lower cost-base economy and globalisation trends in general.

The above mentioned moral hazard comes from the value of money becoming meaningless.  Capital is meant to be a finite resource in most economic models, even in an open economy.
Yet modern finance practice has advocated printing money aggressively to stave-off recessions and depressions. Castles in the air capital can be written-down to realign assets at fair value. Remember that majority of capital is ultimately quantified and recorded in global accounting and banking systems as assets and liabilities in global forex terms at any one time – excepting “fringe economy” / black-economy activities.

Writing-off of all bad debts based on bubble-valuation of certain house and financial asset prices was not an option for the banks at the onset of the financial crisis. Propping-up valuations interferes with laissez-faire market principles. Cited in ‘main stream media’ due to the strategic importance of housing and financial sectors to the wider economies (…remember even the short-term commercial paper markets froze at height of crisis due to the helm of the then capitalism masters). Even though some $600-800 bn of ‘bad vintage’ subprime was inevitably written-down signalling the catalytic economic downturn. Almost like a script from past crisis. Write-downs are no longer an option, as bank-sponsored toxic assets are now in the hands of taxpayers as collateral for government guarantees and loans. Unsecured lending is not feasible with fragile confidence in counterparty-risk. The better quality credit tranches have been hand-picked by cash-rich investors like Blackstone, Blackrock and other asset managers at fire-sale or heavy discount prices. For now it seems to be a pirate’s or vulture’s bonanza for them and their investors. FPM envisages a probable scenario in which these re-capitalised assets and their underlying debt obligations become distressed as the government credit taps is turned-off. As general interest rates tick higher so will bad debt problems.

If the ‘toxic or legacy asset’ collateral against which Governments have been lending to banks do not continue to perform in line with overall reasonable economic expectation when ‘Quantitative Easing’ stops, then another wave of write-downs and blowup-entities should follow. Fear may persist keeping capital expenditure and corporate deal making shallow. FPM certainly believes in this probability of ‘multiple-dip recession’ cycle started in 2007-08. Markets are reflecting this in sideway trending benchmarks with intermittent bull-runs, flash-crashes and dips. Economists Reinhart and Rogoff have suggested a 10-year of de-leveraging process.

Remember that allegedly towards fiscal-boosting the economy amid a bubble-de-leveraging cycle, the emergent alternative media libertarians (enabled by blogging and internet at large), have slavishly and bearishly flagged and criticised policy maker plaster-fixes. Government will no doubt have assets and liabilities in their ‘bail-out’ accounts that do not match, and therefore require further deficit-funding to keep fundamental balance sheet integrity. Together with ‘austerity’ impact and other public repression possibly causing populist uprising in mainstream European Union and American states, geopolitical risks are high on the cards. Already this is occurring in fringe states. Where protests and demonstrations occurs in UK and US, authorities have only been too quick to quosh it. Witness ‘Occupy Movements’ in London, New York and other cities.

If only vigorous and unabated expansion of fiscal and national deficits of global Governments could continue! To bring the vividness through a comparably simpler model, think of pension funding mis-match in assets and liabilities for settling retirement policies and the consequences on retirees. Many pension-dependent hopes and expectations have again been dashed in these too often de-leveraging cycles. Resulting in postponing retirement or reduced perpetuity income in effect living poorer than promised. Even if retirees were money-wise and fortunate to have multiple assets such as properties and investment portfolios they will still feel wealth destruction. Less retirement homes in the sun are being bought in affordability terms to settling for a mere sunshine holiday.

This is why we believe banks and other financial intermediaries are siphoning off / farming-out money to other institutions as investments. Hedge fund and buy-out firms are filling the void of traditional bank lending and securitisation. This shift in liabilities has hidden risks too. Consider the effect and implications of Volker rule as evidence. The global banks themselves have still to maintain sufficient ‘individual bank-tested’ reserve capital to insure against future non-performing loans and gradually correcting house and financial asset prices. Hence why traditional global banking prospects have and are in the mire (in spite of upbeat ad hoc quarterly earnings reports). Alternative financial firms are rampantly being established as the shadow banking system. If Volker is acting in a  middle-man / double-agent role between financial and government interests, then who is serving? The newly-established asset managers mentioned above and host of others are known to FPM via its Fund Manager Transactions proposals.

Following on from our last thought-leader: Investment Sector Outlook for 2013: “Volatility in Vogue”, some of the above mentioned political market-interference has caused Vix-measured implied-volatility to drop to a five-year low in S&P 500 equities. And no doubt other financial and capital asset volatilities have also markedly diminished. Simply from lower economic activity caused by current and future macro economic uncertainties.  These fundamental uncertainties are referred to in financial cant as ‘sentiment and confidence’. Whether one is a consumer, investor in capital, Government employee or importer/ exporter (gdp=c+i+g+[x-m]), doubt causes catharsis or stagnation until resolve is found in endeavours to carry on economic transactions. The current economic stagnation, or euphemistically anaemic growth, is a macro fundamental fact which has been alleviated to-date by Governments, and therefore by implication future taxpayers. Though we are economically not out of the woods, policy-makers can no longer interfere with free money or ‘crowd-out’ capital investors by effectively capping interest rates. Fundamentally disrupting creative-destruction by controlling the price of capital to save Strategically Important Financial Intermediaries at the expense is taxpayer is moral obliquity and lacking sense. FPM believe policy-makers’ job is done after having successfully prevented economic freefall post-Lehmans 2008, now we feel they should let go off the economic reins and let free markets indulge in creative-destruction. FPM has less care for QE supporting banks and more will for interest rates to rise - yes it does matter whether one is a still net lender or borrower after maelstrom of the past five years.

As if to affirm direction for the economy at this forward-looking time in the Gregorian calendar, we in the UK have seen the headlines about the almost final demise of yet another long standing high-street retailer. His Masters Voice or HMV, a music and media distributor with a 90-years history and currently 230 stores employing 4,000 staff went into administration. This was after failing to secure a £300 mn credit line from its suppliers in a last ditch effort. The bank had breached its banking loan covenants in December. This circumstance surrounding its failure, not too dissimilar to the closure of the venerable Kodak company at the beginning of 2012, not only highlights flaws in its commercial raison d’etre but to us reflects a ‘zombie’ company unable to improve deteriorating asset values on balance sheet while outweighed by its liabilities. Creditor call was triggered without recourse to sufficient internal restructuring. We hope restructuring of the old business is possible in administration and emerging as a leaner brand. We had witnessed other UK high-street brands disappear, mostly new arrivals but also back in 2008 an age-old Woolworths. Behavioural finance suggests that when investors are apathetic to corporate and market foundering news over time then they are also expectant of real good news.  

So we have ultimately predicated that the credit asset class will become increasingly volatile before an eventual correction in prices from a) speculation and eventuality about the inevitable interest rate hikes and b) subsequent credit-quality concerns and defaults in the economy overall and c) triggers / catalysts in distressed credit sectors that have thus far re-bounded and propped-with-stimulus. Such as sovereign debt in European fringe countries with contagion into Spanish and French sovereign debt concerns, student loans in US, credit and consumer loans, commercial mortgages, leveraged loans.

Credit souring is as inevitable as re-bound affair not lasting. Lastly we leave you with a vogue investor’s voice on the credit cycle. Ray Dalio, founder of US$120 bn AuM Bridgewater Associates, speaking at a conference in December 2012 said “The biggest opportunity will be shorting bond markets around the world”. He also suggested that interest rates will rise in late 2013.


FOR A TELL-TALE PERFORMANCE ANALYSIS OF 20 SELECT CREDIT / BOND ETFS,
PLEASE DO CONTACT US: kristian.siva@gmail.com

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