Greed & Fear (The Asset Credit Divergence) 20140710

Christopher Wood christopher.wood@clsa.
com +852 2600 8516

Thursday, 10 July 2014 Page 1
The asset-credit divergence
Rotterdam
The title of the new Asia Maxima quarterly is Delirium. It describes the false euphoria in
financial markets characterised by an extreme lack of volatility. This is most evident in the
foreign exchange market where volatility has sunk to record lows. JPMorgans Global FX
Volatility Index has fallen from a recent high of 11.77 in mid-2013 to a record low of 5.29 on 3
July and is now 5.45 (see Figure 1). But the same trend of declining volatility is also clear in the
world of stocks and bonds. The CBOE S&P500 Volatility Index (VIX) is down from a peak of
80.86 in November 2008 to 10.32 on 3 July, the lowest level since February 2007. While the
Merrill Lynch Option Volatility Estimate (MOVE), which measures the volatility in the US
Treasury bond market, has also declined from 117.9 in July 2013 to 52.74 at the end of June.
Figure 1
JPMorgan Global FX Volatility Index

Source: CLSA, Bloomberg
Figure 2
Global syndicated lending

Note: Leveraged share = Share of leveraged loans in total syndicated loan signings. Source: Dealogic, BIS 84
th
Annual Report
One way of interpreting this is that central banks in the developed world have succeeded in
persuading investors that interest rates will stay very low for a very long time. It is also this
confidence in the continuation of low interest rates which has resulted in the chief feature of
current markets. That is a growing reach for yield as investors buy ever more complex debt
securities, often with leverage, to generate a greater return. This process, which has been aptly
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Prepared for EV: fsudjono@henanputihrai.com

Christopher Wood christopher.wood@clsa.com +852 2600 8516

described as a yield bubble, is to GREED & fear a direct consequence of more than five years
of zero interest rates and unconventional monetary policy. It can be chronicled by the
continuing revival of risky lending practices, which were discredited in the 2008 financial crisis
and which the BIS has again warned against in its latest just published annual report (BIS 84
th

Annual Report, 29 June 2014). The BIS annual report notes, for example, that in the
syndicated loan market credit granted to lower-rated leveraged borrowers (leverage loans)
exceeded 40% of new global signings for much of 2013, which was much higher than during
the pre-crisis period from 2005 to mid-2007 (see Figure 2).
Figure 3
US high-yield corporate bond issuance

Note: YTD14 = January-June 2014. Source: SIFMA
This revival in risky lending is worth going into in some detail to demonstrate the point since it
is in one sense truly remarkable that the appetite for aggressive debt structures has rebounded
so strongly just six years after such structures were discredited in the global financial crisis. Yet
in another sense, of course, it is quite logical since this is precisely the behaviour encouraged
by unconventional monetary policy. One obvious example is the surge in high yield issuance,
which is now back above pre-financial crisis levels. Thus, US high-yield corporate bond issuance
has risen from US$43bn in 2008 to a record US$336bn in 2013 and US$182bn in the first six
months of 2014 (see Figure 3). But as yields on more conventional subordinated debt have
come down, debt investors have increased their exposure again to structured products.
Consider, for example, collateralised loan obligations (CLOs). CLO issuance totalled US$82bn in
2013, a mere 15% below its peak level in 2006, and is forecast to reach US$100bn this year. A
further example is the renewed appetite for so-called covenant-lite loans, often coupled with
bullet repayments, where interest is rolled up and not paid to the end of the loan. Thus, US
cov-lite loan volume rose by 41% YoY to US$84bn in the year to mid-June, according to
Dealogic. Meanwhile, US leveraged loan issuance rose by 68% YoY to a record US$1.1tn in
2013 (see Figure 4).
These sorts of imprudent lending and investing practices are normally associated with credit
bubbles. But to GREED & fear an interesting feature of the Western world post-financial crisis is
that there has not been a credit bubble. Rather, credit growth has remained subdued in the
developed world post-2008, be it in America, Europe or Japan. US bank loans rose by 4.8% YoY
in June, compared with the pre-crisis average growth rate of 10%, while Japanese bank loans
rose by 2.5% YoY in June. As for the Eurozone, loans to the private sector declined by 2.0%
YoY in May (see Figure 5). Indeed, this ongoing subdued credit growth, and related
deleveraging dynamic as reflected in continuing declining velocity, is the reason why central
banks have continued to indulge in unconventional monetary policy as economic growth has
remained subpar. Thus, annualised real GDP growth in America has averaged only 2.1%
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between 2Q09 and 1Q14, while in the Eurozone it has been only 0.7% during the same period
(see Figure 6).
Figure 4
US leveraged loan issuance

Note: Data up to 9 July 2014. Source: Bloomberg
Figure 5
US, Japan and Eurozone bank loan growth

Source: Federal Reserve, Bank of Japan, ECB
Figure 6
US and Eurozone real GDP growth

Source: CLSA, Datastream
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The resulting paradox is to GREED & fear perhaps best highlighted by research done of late by
the Institute of International Finance (see IIF reports: Capital Markets Monitor, April and May
2014 issues). This research has focused on the divergent trend since the crisis in the developed
world between the credit-to-GDP ratio and what the IIF describes as the asset-to-GDP ratio,
which is defined as household wealth or assets to nominal GDP. This shows that the asset-to-
GDP ratio has shown a large positive deviation of nine percentage points from its long-term
trend in the G7 world based on IIF data. By contrast the credit-to-GDP ratio has shown a
contrasting trend. The G7 credit-to-GDP ratio, which includes all lending to the non-financial
private sector, has collapsed since the crisis to eight percentage points below its long-term
trend, down from a positive deviation of over 10 percentage points in mid-2009.
The Achilles heel in the system is, therefore, exposed by the divergent trend between asset
prices and credit growth in the developed markets. The obvious conclusion from this is that
there is a growing risk that asset prices are becoming increasingly disconnected from the
realities of the underlying economy. A similar chart to the one shown in the IIF report
highlighting the relevant divergent trends is shown below (see Figure 7). It should be noted
that the data is based on the BISs long-term series on credit to the private sector and the
central banks flow of funds data on household assets.
Figure 7
G7 credit-to-GDP gap and asset-to-GDP gap

Note: The gaps measure deviations of the credit and asset to GDP ratios from their long-term trends. Credit includes lending to
the non-financial private sector. Assets are total household assets. Source: CLSA, BIS, Datastream, CEIC Data, IIF
The above is interesting to GREED & fear because it provides a conceptual framework to help
understand what is going on in a world of quantitative easing where it has become increasingly
evident in recent years that the rich or asset owners have continued to be the chief
beneficiaries of such unorthodox monetary policies. Thus, in the world of equities, multiple
expansion not earnings has been the chief driver of equity gains in America and Europe in
recent years, whereas wages have remained subdued. On this point, price-earnings ratio
expansion contributed to an estimated 75% of the gains in the US stock market last year and
43% so far in 2014, and accounted for all the gains in Europe in both 2013 and 1H14 (see
Figure 8). By contrast, US average hourly earnings rose by only 2.0%YoY in June, while
Eurozone hourly wages rose by just 1.5%YoY in 1Q14 (see Figure 9). Similarly, in the world of
fixed-income capital gains and related yield compression have been driven by the leverage
employed in carry trades, leverage only available in a post-financial crisis world to the affluent.
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Figure 8
MSCI USA and Europe: 2013 and 1H14 performance attribution

Note: Price performance in local currency terms. Source: MSCI, Datastream, CLSA evaluator
Figure 9
US and Eurozone hourly wage growth

Source: Eurostat, US Bureau of Labour Statistics
If asset prices are increasingly disconnected from economic reality, this situation can only be
addressed either by developed economies achieving a more healthy recovery or by asset prices
correcting. Yet, the risk is that if Western economies show signs of an accelerating recovery,
market-driven interest rates will rise sharply, hurting leveraged investors in credit, while the
higher cost of servicing debt will threaten the recovery. Yet, if economies do not sustain a
growth rate acceptable to modern central bankers, then they will continue with their
unconventional monetary policies so further encouraging asset bubbles.
This is the dilemma the central bankers have created by their now orthodox unorthodox
monetary policies and it remains far from evident to GREED & fear that there is a painless way
out, as argued here on numerous occasions. Yet, investors have also to operate in the context
of the official narrative of the market consensus, and this is that the Fed is tapering this year
with a view to normalising monetary policy sometime in 2015 by raising interest rates for the
first time since June 2006.
If this is the consensus expectation, it remains the case that the most obvious way to trigger a
surge in volatility in financial markets is a good old-fashioned monetary tightening scare where
investors suddenly worry about a much more rapid pace of Fed tightening than currently
assumed. The Fed fund futures now project a 56% chance that the first Fed rate hike will
happen in June 2015 and a 85% chance that it will happen in September 2015 (see Figure 10).
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Figure 10
Fed funds rate probability based on Fed funds futures

Source: CME Group FedWatch
On this point, as mentioned before here, there is a growing possibility that wage pressures in a
structurally constrained US labour market could trigger just such a tightening scare. In this
respect, it is also the case that history shows that there is a well-established tendency for
financial markets to test a new Fed chairman in the first few months in office. Given the almost
eerie sense of calm, if not complacency, hanging over markets as reflected in record low
volatility measures, the suspicion is rising that such a test may be approaching.
Figure 11
Unemployed Americans who found jobs or leaving the labour force

Note: Data measures the labour force status flows from "unemployed" to "employed" or from "unemployed" to "not in labour
force". Source: Bureau of Labour Statistics
And the point to note here is that such a tightening in the US labour market remains possible, if
not probable, if Americas declining labour-force participation ratio is structural, not cyclical.
This declining participation rate has attracted ever growing focus in recent years with more
unemployed Americans leaving the workforce than found a job in 49 out of the past 50 months
(see Figure 11). It has also remained the subject of a lively debate among economists about
whether this phenomenon is cyclical or structural. Yellen, an academic economist specialising in
the labour market, remains firmly of the view that it is cyclical. Yet, many others, including
GREED & fear, are more persuaded by the argument that it is structural as America has entered
the European dynamic, where rising government benefits reduce the incentive to work at the
lower end of the labour market.
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If this sounds a dry academic subject, it has become critically important for markets. For if the
declining participation rate is indeed structural, then there is less slack in the labour market
than the Fed currently believes, which means, more than five years into an economic recovery
in America, that sooner or later wages should get traction. Yet in the last US jobs data while the
payroll data surged by 288,000 jobs average hourly earnings growth slowed from 2.1%YoY in
May to 2.0%YoY in June (see Figure 12).
Figure 12
US increase in nonfarm payrolls and average hourly earnings growth

Source: CLSA, US Bureau of Labour Statistics
If this traction is not yet really visible from the all-important average hourly earnings growth
data, such evidence should be forthcoming in the not too distant future if the structural
argument is correct. If so, it could have significant market impact in the context of ultra-low
volatility, where leverage has been piled on in the world of credit in the pursuit of yield. And the
impact will be all the greater precisely because Mrs Yellen is so committed to the cyclical view.
This is the most probable way there can be a monetary tightening scare in America. But to
GREED & fear it is far from evident that it requires an acceleration in US economic growth
which for now at least remains in the same annualised range of 2-2.5% it has been in since the
recovery began in 2009.
Meanwhile, GREED & fear remains unconvinced that such a sign of rising wage pressures in the
US would signal the sudden transition from a deflationary era to an inflationary one. For an
interest-rate hike at the short end, or even the perception that monetary tightening is coming
much sooner than previously expected, and any resulting related back up in long-term interest
rates, is likely to prove deflationary in the sense that an economy like Americas with continuing
high debt levels will prove ultra-sensitive to the impact of higher interest rates, as was
demonstrated last year in terms of the US housing markets stalling in the face of higher
mortgage rates.
The consequence of all of the above is that any monetary tightening scare, or related inflation
scare, is likely again to prove short lived. In this sense, evidence of rising wages pressures, if
such a development occurs, will likely turn out to be late cycle confirmation that the US
economic recovery, which began in 2009, is nearing its end, not its beginning.
And in such a macroeconomic context a dove like Yellen will want to accelerate quantitative
easing, not end it. That is unless there starts to be more vocal opposition from within the Fed,
from Congress and from the executive arm of the federal government to what by now should
be seen as the obvious negative consequences of what has been aptly described by CLSAs
Australian bank analyst Brian Johnson as QE-ternity (see CLSA research Australian banks
G.O.A.T.: Are they really the greatest of all time?, 2 June 2014).
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Increase in US nonfarm payrolls (LHS)
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Still, if this would be a development to applaud, it also remains unlikely. Much more likely is
that in such a context the policy-making establishment, otherwise known as the Davos crowd,
will look to expand quantitative easing with the result that the distinction between monetary
policy and fiscal policy will become ever more blurred. For, with the Fed already owning 23% of
outstanding Treasury bonds and buying over 70% of net Treasury debt issuance since the
beginning of 2013 (see Figure 13), without seemingly nasty inflationary ramifications, QE
advocates in a continuing low growth world will be tempted to argue again that central banks
should buy all government debt and simply cancel it. And indeed such argument is a logical
conclusion for those who, unlike GREED & fear, believe in QE.
Figure 13
Fed buying of US Treasuries and increase in Treasury debt outstanding

Note: Fed buying data up to 2 July. Treasury debt outstanding data up to June 2014. Source: Federal Reserve, SIFMA
Meetings in London and Europe over the past week indicate rising optimism on Japan. This
makes sense given growing evidence that the Topix has of late risen without the yen going
down (see Figure 14), hopefully breaking the stock markets correlation with a weak yen in
place since 2005. Thus, the correlation between the Topix and the yen has been 0.94 since
2005, compared with a correlation of 0.51 so far this year (see Figure 15).
Figure 14
Topix and Yen/US$

Source: Bloomberg
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Figure 15
Topix and Yen/US$

Source: Bloomberg
Meanwhile, it is also a positive that share buyback announcements continue. This week Casio
announced 3.16% buyback and the cancellation of 3.58% of outstanding share (or 98% of its
Treasury stock). The announcement resulted in a 7.5% rise in Casios share price on Tuesday
(see Figure 16).
Getting Japanese corporates to announce share buybacks is certainly a lot easier for Prime
Minister Shinzo Abe than structural reform of the labour market, and also likely to have much
more near term positive impact on the Japanese stock market.
Figure 16
Casio Computer share price

Source: Datastream
GREED & fear added to Indonesias weighting in the Asia Pacific ex-Japan relative-return
portfolio in yesterdays flash (see GREED & fear flash, 9 July 2014) because of Jakarta
governor Jokowis apparent win in Wednesdays presidential election. GREED & fear says
apparent because the result is still yet to be officially confirmed. This will not occur until 21-22
July. While opponent Prabowo Subianto has not yet officially conceded, with the seeming
victory a relatively close 4-5% based on exit polls (see Figure 17).
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Figure 17
Quick count survey results (Jokowi-Kalla vs Prabowo-Hatta)

Source: Various polls
A Jokowi victory is, clearly, the preferred outcome for financial markets. But it is a shame that
the victory has not been more decisive. It is also a pity that Jokowis support in parliament will
not be greater due to the incompetence of the election campaign conducted by the PDI-P party
during Aprils parliamentary campaign. As a result, Jokowi controls only 207 or 37% of the 560
parliamentary seats.
All this means this weeks election is nothing like the Indian landslide victory achieved by
Narendra Modi in India. Still it is significant nonetheless since Jokowi undoubtedly represents a
new face in Indonesian politics in a country badly in need of some new faces. Still that the old
faces can still get traction is clear from the extent to which Prabowo reduced Jokowis lead
during the five-week election campaign. Thus, Jokowis lead in surveys narrowed from around
15% in May to an average of 7.6% in early July. Indeed with negative campaigning ridiculing
him as a puppet and a closet Christian, Jokowi felt compelled to make a quite visit to Mecca
last weekend to demonstrate his religious affiliation.
The hope must be that this relatively turbulent campaign will have hardened Jokowi up for the
challenges of running Indonesia. What the market wants to see, in particular, is less public
money spent on energy subsidies and more on infrastructure. Under this fiscal years revised
budget an estimated Rp150tn will be spent on infrastructure and Rp350tn on energy subsidies.
But the official Jokowi goal is to phase out all energy subsidies over a four-year period.
The other point of focus will be whether Jokowi will be able to change existing policies to
encourage renewed exploration activity in the oil and gas area. Remember that Indonesia is on
course, on present trends, to become a net importer of oil, gas and coal by 2017. That has
ominous medium-term implications for the current account. While in the short term the current
account picture also looks potentially vulnerable given that credit growth in aggregate has
remained surprisingly strong. Thus, Indonesian bank credit rose by 17.4%YoY in May, though
down from 21.4%YoY at the end of 2013 (see Figure 18).
Much of the above is easily fixable in theory. But Indonesia is not a straightforward play so
investors are advised not to take anything for granted. This situation contrasts with India where
there is a happy coincidence that the economic cycle was bottoming out anyway just at the
same time as the most pro-business, pro investment political leader in the world today was
elected in a landslide victory.

5.6%
4.8%
3.2%
5.4%
6.7%
4.9%
6.7%
1.9%
-4.1%
-0.3%
-1.1%
-2.2%
-6%
-4%
-2%
0%
2%
4%
6%
8%


Figure 18
Indonesia bank credit growth and nominal GDP growth

Source: CLSA, CEIC Data, Bank Indonesia
Figure 19
China nominal GDP growth and PPI inflation

Source: CLSA, CEIC Data
In meetings with investors over the past week, GREED & fear has the sense that investors have
either bought old China stories for a trade or are looking for an excuse to do so. The best
reason to do this is that PPI deflation has moderated for three months in a row. Thus, China PPI
deflation has slowed from 2.3%YoY in March to 1.1%YoY in June, the smallest deflation since
April 2012. And PPI, as discussed here before, is closely correlated to nominal GDP growth (see
Figure 19).
This suggests that recent mini stimulus or stealth stimulus measures, call it whatever you
want, have created some cyclical momentum. In this respect GREED & fear would not be
surprised if the MSCI China outperforms this quarter. Still GREED & fear is not going to play this
trade and will maintain the Underweight in the Asia Pacific ex-Japan relative-return portfolio.
The aim, in theory at least, is to do relative-return asset allocation on a six-month view and
GREED & fears base case is that such outperformance is unlikely to continue for six months if
the residential property market continues to correct, as is now the case, with the latest
evidence coming from China Reality Researchs property monthly released this week (see CRR
report Property Monthly: Indicators worsen, listcos outperform, 8 July 2014). Thus, the average
selling price at the 120 CRR-tracked residential projects fell 0.4%MoM in June, compared with
the 0.1%MoM drop recorded in April and May (see Figure 20). While residential sales in 12 big
mainland cities declined by 28%YoY in June, and are 23% lower than the average monthly
sales of the previous three years (see Figure 21).
0
5
10
15
20
25
30
35
40
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Indonesia bank credit growth
Nominal GDP growth
(%YoY)
1
3
5
7
9
11
13
15
17
19
21
23
25
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
(%YoY)
(%YoY)
China Producer Price Index (PPI) inflation
Nominal GDP growth (RHS)


Figure 20
CRR Property Price Index

Note: Based on average selling prices at the 120 for-sale residential projects in 40+ 2nd and 3rd tier cities tracked by CRR.
Source: China Reality Research (CRR)
Figure 21
Change in average daily residential sales in 12 big mainland cities

Note: Adjusted to show Jan-Feb combined growth. Source: City-level Real Estate Information Centres, CRR
But GREED & fear is assuming that the central government will continue for now to allow a
market-driven correction in the residential property market, the biggest domestic sector
accounting for an estimated 12% of GDP and an even bigger share if related sectors such as
cement, construction machinery and steel are included. Cement, steel and construction sales
account for 4% of GDP.

-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
-0.8%
-0.6%
-0.4%
-0.2%
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
J
a
n
-
1
1
M
a
r
-
1
1
M
a
y
-
1
1
J
u
l
-
1
1
S
e
p
-
1
1
N
o
v
-
1
1
J
a
n
-
1
2
M
a
r
-
1
2
M
a
y
-
1
2
J
u
l
-
1
2
S
e
p
-
1
2
N
o
v
-
1
2
J
a
n
-
1
3
M
a
r
-
1
3
M
a
y
-
1
3
J
u
l
-
1
3
S
e
p
-
1
3
N
o
v
-
1
3
J
a
n
-
1
4
M
a
r
-
1
4
M
a
y
-
1
4
(%MoM) (%YoY)
%MoM %YoY (RHS)
-100%
-50%
0%
50%
100%
150%
J
a
n
-
0
9
M
a
r
-
0
9
M
a
y
-
0
9
J
u
l
-
0
9
S
e
p
-
0
9
N
o
v
-
0
9
J
a
n
-
1
0
M
a
r
-
1
0
M
a
y
-
1
0
J
u
l
-
1
0
S
e
p
-
1
0
N
o
v
-
1
0
J
a
n
-
1
1
M
a
r
-
1
1
M
a
y
-
1
1
J
u
l
-
1
1
S
e
p
-
1
1
N
o
v
-
1
1
J
a
n
-
1
2
M
a
r
-
1
2
M
a
y
-
1
2
J
u
l
-
1
2
S
e
p
-
1
2
N
o
v
-
1
2
J
a
n
-
1
3
M
a
r
-
1
3
M
a
y
-
1
3
J
u
l
-
1
3
S
e
p
-
1
3
N
o
v
-
1
3
J
a
n
-
1
4
M
a
r
-
1
4
M
a
y
-
1
4
Change in average daily residential sales
in 12 big mainland cities
(%YoY)



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