Global risk has reversed course rather dramatically this morning as the PBOC reduced the reserve ratio for domestic banks by 50bps. Then, just in, the Fed, BoE, BoC, ECB, BoJ and SNB all joined in to reduce the U$ o/n swap rate by 50bps (this makes U$ borrowing cheaper for other CB's and Commercial banks (most of which were downgraded last night. End result - the DAX has swung almost 200pts, UU$ dropped about 50cents, IG17s rallied 5bps and HY17s rallied about 1pt to start.
I have said it more than a few times on BNN: there are only three ways out of the current sovereign debt crisis in Europe, and only the last two are permanent:
1. Turn the current Monetary Union into a Fiscal Union as well. There is no way the current account surplus country that is Germany will back the ECB, or anything else, until they have guarantees that the current account deficit nations will follow-thru on fiscal austerity. Short of German troops entering Greece et al to enfore fiscal austerity, this is pretty good news...WSJ on Sat 11/26/11...
This can be seen as a very large band aid solution - more like a tensor bandage that could last several years. Long enough for a period of nomalacy at least.
2. Massive haircuts on the debt. The implications for the private sector are enormous but it sure does get rid of the debt....premanently.
3. Massive central bank money printing with ensuing debt purchases. The implications with this are for hyperinflation. While every central banker and politician the world over would love a whiff of inflation, hyperinflation, where Brent goes to $200bl, would not be great for economic growth....in fact it would strangle it by the throat.
More of the same as last Friday...today I see a dealer has put out a report on the Attraction of Dividends. I can't believe that anyone, never mind an aging investor base, would look to the bottom of the capital structure - equities - where volatility is shockingly high, and use dividend paying equities to drive portfolio yield. Let's not forget a couple of things: 1) Dividends are simply a promise to pay - they can be cut by the issuer with no repercussions at all. Compare that to HY bonds that are backed by an indenture that is a legal document that states, among other protective covenants, that the issuer MUST pay us coupon interest every 6 months and 2) Equities are way more volatile than HY bonds. BAML research states that C$ HY over the past 5 yrs has annual returns of about 12% with volatiltiy of 9% while the TSX itself has annual returns of about 4% and volatility of about 17%. Even TD bank (or any other bank stock in Canada for that mater) has a dividend yield of <4% and volatility of about 15%. Crazy. Why not invest in C$ HY, move near the top of the capital structure of the issuer, be closer to the assets of the compay, decrease the volatility or risk of your returns, be backed by an indenture with protective covenants and get paid to wait??
"Excuse me sir, but do you really think you should be driving yield in your portfolio with this stock?"
This past Friday, I attended Superior Plus's fifth annual investor day. The room was largely filled with analysts and institutional investors like High Rock. There were four 70-something investors sitting together, chomping at the bit to get a hold of the microphone to tell management just how upset they were with a recent 50% cut to their dividend. Two of them spoke for the others. Well, during a break, I just could help myself - and wanted to help them. I approached cautiously and apologized in advance for saying, "excuse me sir, but do you really think this is how you should be driving yield in your portfolio at your age?" I went on to tell him that although management refuses to admit it, the reason for the dividend cut was that the senior unsecured bond (which we own) has a Restricted Payment limitation which effectively forced the dividend cut to make room in that restricted payments basket so they could upstream cash to the holding company where this troublesome near term convertible bond was issued from. If that covenant didn't exist, no way would they have cut their dividend, I then went on to say that, in my view, a highly levered company like Superior Plus (5.2x Leverage) in an economy growing at 1.5% is not the type of equity investment that a 70-somehting investor should be assuming for yield. The same senior unsecured bond, with such protective covenants, yields about 9%. Why on earth would an aging investor look to the very bottom part of the capital structure of Superior Plus for yield? Crazy. The good news is that those investors understood what I was saying very quickly. There are a lot of Superior Plus situations out there - and a lot of investors still looking to equities to drive yield in their portfolio....but that is changing as per recent fund flows.
Risk assets really seem to want to do better in here - high yield in the USA and Canada specifically. Flows into the asset class are enormous right now as investors begin to realize that the asset class provides the best risk-adjusted returns of all. The 5-week inflow into US HY mutual funds has been about $10.5bln. This has come at the expense of equities. Combine that with extremely low dealer inventories and we are setting up nicely for a credit rally into year-end.
New governments in the two most problem states in the EZ (Greece and Italy) seem to be enough to drive risk assets higher. Today, equities led the charge, while credit rallied but lagged a bit. Some sign posts are still urging caution: 3mos TED Spread at recent wides, 2yr US$ swap spreads at recent wides, 3mos Libor at recent wides while goverenment bonds in Canada and the US (FTQ - flight to quality assets) didn't seem to want to sell off much.
Risk assets (mainly stocks) seem to want to do better over the past few sessions - and that in light of what I would consider to be morey negaitve news than postive out of Europe. And gold is climbing on some of that negative news. Sure feels like markets want to do better and it is usually a good sign when markets respond positively to negative news. Credit hasn't participated much over the past few sessions, however, but I think some of that is due to the massive new issue calendar that is currently going on. The flows into US$ HY funds over the past 3 weeks (a record ~$7bln) are likely to continue to provide a very strong base....good evidence of our macro them of aging investors looking for true yield during a prolonged period of low interest rates.