Government Investment Officers Conference March 24, 2016

Transcription

1 Government Investment Officers Conference March 24, 2016 A 21 st Century Look at Risk Management Lessons of the Post-Lehman Era 1 Larry McDonald Managing Director, Global Head of Macro Strategy, ACG Analytics, The Bear Traps report Founder New York Times Bestselling Author of A Colossal Failure of Common Sense, The Inside Story of the Collapse of Lehman Brothers

2 2 Lehman Brothers Stock Chart

3 3 Lehman Brothers Board Members Corporate Governless They had an average age of 70 overseeing $750 billion of systemic risk

4 The Metamorphosis: Credit Contagion Patterns The Pattern: US Epicenter The Mortgage Backed Securities yield blowout, leaked over to US financials, then to US Corporate bonds, then to EU Financials, then to EU Corporate bonds, then to EU & US Equities 4 The Pattern: Europe Epicenter Sovereign Credit Spread Blowout, Greece, Italy, or Spain: leaking over to EU Financials, over to EU Corporates, on to US Financials, on to US High Yield, over to US Inv Grade, on to US Equities The Pattern: Asia Epicenter The global risk epicenter has moved to Asia. It is critical to focus on our systemic risk indicators; Shibor, 7 Day Repo Rates in China, itraxx Asia (ex Japan), HSBC 5 Year CDS vs JP Morgan, Standard Chartered 5 Year CDS vs Morgan Stanley

5 5 Our 21 Lehman Systemic Risk Indicators Asian corporate credit started to move significantly wider starting in late June and through July. The S&P rolled over on August 17 th. From earlier July to late July, stocks were moving higher while Asian credit was weakening. The closer you are to the epicenter of the risk, the more accurate the indicator. Asia corporate credit versus US equities

6 6 If you listened to Asian credit, you could have avoided much of the nasty 14% plunge in the S&P 500. Asian credit is currently the best judge and jury when analyzing and measuring the sustainability of US equity rallies. The Fed has kept rates at 0% for 6 years. As the result, there's $50+ trillion of new global debt. Of the $50T, $9T is in dollar dominated debt and a large portion of this new leverage is in Asia, EM sovereigns, corporates, commodities and materials. Asia financials versus US equities

7 7 US Economy is a Smaller Piece of the Pie, Why China will Take more Action China s growth is weakest quarter since the 2009 global financial crisis. However, their debt to GDP has spiked to almost 300% in 2016 vs 160% prior to the financial crisis in US shrinking contribution to global growth: 1996: 28.3% 1997: 29.6% 1998: 47% 2016: 20.9% 2017: 17.4% 2018: 15.7% (WSJ) Total debt in China: 2015: $35 trillion 2005: $5 trillion 2000: $2 trillion

8 8 Risk Indicators High Yield rolled over on Sept 9 th U.S equities continued higher (didn t roll until Sept 16 th -17 th ). Next Notice the underperformance of HY through July while equities marched higher. We made mention of this on CNBC in a heated debate. High yield versus US equities

9 9 Watch CNH Volatility, A Leading Indicator for US Equities China is a major trading partner of the US / Eurozone and the CNY-CNH spread blowing out in December 2015 (something we warned about in our Bear Traps reports) has caused a lot of distrust among banks. Today, 18% of the street is now calling for a large devaluation in the yuan compared to only 5% just six months ago and 0% a year ago. China's recent industrial production figures are at the lowest level since the '90s and their nominal GDP number at 5.8% was the weakest in 40 years. It won't be long before we see the CNY-CNH spread widen resulting in a weaker yuan.

10 10 Measuring Fear Feb 11 The VIX index (fear index) heads into backwardation (front month more expensive than the outer months). Investors are paying up for front month protection as they get more and more nervous. Equity Put/Call ratio near all-time highs Feb 11. Bonds Overbought $7T of negative bond yields: 2016: $7T 2015: $1.4T 2014: $175B 2013: $0 2012: $0

11 11 Buying Volatility into Holiday Shortened Weeks Get long volatility (Long Puts on the S&P or Long VIX futures, Long VIX ETFs) during weeks in which holidays fall, has been a profitable trading strategy. Last 15 years, buying the VIX the day before Thanksgiving and sold it the Monday after, it was higher 14 times. The average return was 8% (cash not futures). 4th of July, Christmas and Thanksgiving weeks. 3 Year Chart of the VIX Index

12 12 Central Banks Deploying the Fire Hose on Volatility Heading into Fed meetings, being short volatility had paid 6 of the last six gatherings. Central banks are bringing out the fire hose 3-4 times prior to the show's final stage performance. Lessons from , stress in the financial conditions had central bankers reaching into their bag of tricks. VIX Index and FOMC Meetings ECB, PBOC, FOMC Fire Hose* = Since Feb 11 S&P500: or 10.1% VIX: 22 to 16 CDX IG: 124 to 96bps CDX HY: 600 to 481bps * As of March 4, 2016

13 13 In July, the curve was in contango and compared to August and early Sept when it was in backwardation. August 27 th VIX Futures Curve hadn t come in, as opposed to October 15th, 2014 the market plunged 9.5%, we witnessed the VIX curve immediately normalize within 24 hours. VIX futures curve

14 14 Extreme Levels of Panic: February 11th vs Current Complacency Feb 11 - AAII Investor Sentiment Bullishness near all-time lows (18%). Lowest level since Mar 09 even though credit contagion was NOT at the 2011 highs. Today - 52 week highs minus stocks making 52 lows is near the recent top = Complacency.

15 15 SELL the Financials / Banks "We need to increase loss reserves by $1.5B if oil prices hold at $25 a barrel over 18 months. - JP Morgan, February, 2016 $320 - $345B of debt across the top 20 banks. Their books are NOT properly marked for lower oil. Financials ETF vs WTI The truth bleeds out one drop at a time, it took over 60 months to get the truth about mortgage losses, we expect a similar truth bleed on oil. Oil leads to the downside which is followed by the financial sector (see chart). The same applies to the S&P 500. At both oil bottoms, the correlation with stocks was near one. Oil Companies: A Deteriorating CreditProfile The credit profile of the energy space is deteriorating at a fast pace; 146 downgrades vs just seven upgrades in 2016.

16 16 Bank s Levered to Energy Citi Group has loans outstanding of roughly 9.1% or $54 billion. In 2007, the Street said look at earnings ex-financials. This brings us back to late 2006, first moment the ABX (mortgage index) traded below 90. All the US banks had to mark their Mortgage Backed Securities - MBS assets lower. They hid their losses from the investors as long as they could. How Leveraged is the US Energy Sector to Oil? $90B leveraged loans outstanding $255B high-yield bonds exposure As 2007 meets 2016, this time it s with losses tied to energy and commodities. There will be many bankruptcies in the oil space to come.

17 17 Credit Leads Equities Junk of the Junk not Enjoying the Ride. % Bonds Rated CCC or Lower below 80 cents on the Dollar: March 14, 2016: 60% December 31, 2015: 55% December 31, 2014: 25% US Corporate Bonds Moving from Investment Grade to Junk, otherwise known as "fallen angels." 2016: 53 year to date 2015: 39 full year 2014: 28 full year We ve had a 50% surge, but 60% of CCC rated paper is still below 80. CCC rated energy bonds have under-performed crude and oil related equities. We view this as a strong sell signal. Credit isn't buying what equities are telling investors. A look at the Barcap Credit Index still shows a nearly 1000bps spread between the CCCs (15.2% yield) and the BBs (5.6% yield). This needs to come in another bps for us to trust an energy equity rally.

18 18 Central banks creating catastrophic, unprecedented bond volatility In Q2 Last Year, German 10 year bond yields backed up from 0.07% to 0.98% Number of US Companies rated AAA: 2015: : : : : : : : : : : 53 Bloomberg AAA rated corporates -5.44%, worst quarter ever, previous record was -2.32%.

19 The Infamous Last Words Smart risk management is never putting yourself in a position where you can t live to fight another day. Dick Fuld, Former CEO, Lehman Brothers, April 2008 We finished the year, and we reported that we had $17 billion of cash sitting at the bank s parent company as a liquidity cushion. As the year has gone on, that liquidity cushion has been virtually unchanged. Alan Schwartz, Former CEO, Bear Stearns, March Just one week before futures brokerage, MF Global, filed for bankruptcy, the firm s Chief Financial Officer told analysts at Standard & Poor s that its capital position had never been stronger. Henri Steenkamp, Former CFO, MF Global, October 2011 Today I want to send a message of optimism to all Greeks. Our road, our path, will be more stabilized. Our country will be in a better situation. We will be stronger. George Papandreou, Former Prime Minister of Greece, July 2009 We re very proud to be part of the Eurozone. But this comes with obligations and it is crucial we show the world we can live up to those obligations. George Papandreou, Former Prime Minister of Greece, November 2, 2011 Portugal Prime Minister said that Portuguese bondholders will never face a haircut on their investment as it is happening in Greece, adding the country is doing everything in its power to fulfill all the requirements under its 78 billion bailout program. Portugal s debt is perfectly sustainable. Pedro Passos Coelho, Prime Minister of Portugal, January 2012

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