For us it seems that so far our "Generous Gambler" aka Mario Draghi has been very apt in applying some of General Sun-Tzu's greatest concepts:
“The supreme art of war is to subdue the enemy without fighting.” ― Sun Tzu, The Art of War
But first our usual credit overview!
As far as Spanish banks third quarter provisioning are concerned, the recent surge in non-performing loans (NPLs) is seriously raising question on the adequacy of the level of provisioning.
Back in February in our conversation "Money for Nothing", in relation to Spain we argued the following:
"What analysts should be concerned about is that BBVA’s bad loans as a proportion of total lending has remained little changed at 4.07 percent in the fourth quarter of 2011. They also should be concerned as well that its Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be “stable from now on.”Really?". Evolution of NPLs in Spain, source Bloomberg:
Sorry Mister Angelo Cano, but, we cannot really see the stability in asset quality...and we tried. Spanish Non Performing Loans rate - source Bloomberg:
We "agree" to "disagree" on that point. Assessing the impact of Spanish real estate prices on bank loans is not that difficult given that a large portion are real-estate related as indicated by Bloomberg data:
The Spanish house price index collated by Tinsa, Spain's largest home appraiser, is sometimes thought to better reflect reality than official figures.
The chart shows an annualized price drop of 10.1 percent on the official index and 14.2 percent on the Tinsa index. Both show price declines accelerating relative to 2011.
To put these numbers in context, the recently released Oliver Wyman stress test exercise uses a base case move of minus 5.6 percent in the house price index for 2012, followed by minus 2.8 percent in 2013 and minus 1.5 percent in 2014. The adverse case scenario uses minus 19.9 percent in 2012, minus 4.5 percent in 2013, and minus 2.0 percent in 2014.
With a visible acceleration of the drop in house prices as banks attempt to sell properties and fiscal consolidation takes hold, the adverse case might start to look optimistic." - source Bloomberg
"Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid." - Santander CEO Alfredo Saenz April 2012
As far as Spanish woes are concerned, we think the latest European summit has not dealt with the growing Spanish issues, courtesy of the "Banker's algorithm" concept:
"The Banker's algorithm is run by the operating system whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."
So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state! Indeed the worst-case scenario is playing out for Spain as indicated as well by Bloomberg article by Charles Penty from the 18th of October entitled - Spain Banks Face Pain as Worst-Case Scenario Turns Real:
"Spain’s request for 100 billion euros of European Union financial aid to shore up its banks is increasing concern about the nation’s growing liabilities. Standard & Poor’s downgraded the country’s debt rating by two levels to BBB-, one step above junk, from BBB+ on Oct. 10, saying it wasn’t clear who will bear the cost of recapitalizing banks."
Under Oliver Wyman’s worst-case projection, an economic contraction of 4.1 percent in 2012, 2.1 percent in 2013 and 0.3 percent in 2014 would contribute to 270 billion euros of credit losses and a 59.3 billion-euro capital shortfall for banks...
But maybe we are saying something stupid...
“If you wait by the river long enough, the bodies of your enemies will float by.” ― Sun Tzu
Request denied courtesy of the Bankers' algorithm:
"It is necessary that before we buy bonds, countries will apply to ESM" - European Central Bank Executive Board member Joerg Asmussen - 22nd of October 2012.
He also added:
"Let me say clearly, there is no automatism between an ESM application and our purchases".
Moving on to the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge), the divergence is back - source Bloomberg:
“Appear weak when you are strong, and strong when you are weak.” ― Sun Tzu, The Art of War
Back in July, in our conversation "The Game of The Century", we argued that Angela Merkel had been the big winner so far in this European game of chess, given that:
"By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...). Question being for us now, can Europe survive in the current form (number of countries) without making material sacrifices in true Bobby Fischer fashion? One has to wonder."
Moving on to the subject of looking at different indicators which could clearly indicate if effectively a proper rebound is on the way and if the credit bell has arguably rung three times which would mean an acceleration in global economic growth led by the US economy, we noticed recently a significant rebound in the Baltic Dry Index - source Bloomberg:
Why the rebound? As we have argued in our conversation "The link between consumer spending, housing, credit and shipping":
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".
We also indicated:
"The on-going "green shoots" in US housing, the impact on the Containership industry led by consumer spending and consumer confidence is very significant"
Given consumer confidence in the US climbed to 83.1 in October according to the preliminary University of Michigan report (a 5 year high), improved sentiment and personal finances, could lead to a sustained level of optimism which could help jumpstart spending which accounts for 70% of the US economy. If the improving housing market leads to a rise in consumer spending, the GDP could surprise to the upside we think.
As far as containerized traffic is concerned as represented by the Baltic Dry Index, a change in consumer spending would have a direct impact on global traffic volume and economic growth. Looking at the Asia-Originated Containerized freight, on the 21st of September, it was up by 25%, although below May levels according to Bloomberg:
Whereas the US consumer confidence seems to be rising, falling European Confidence is hurting Air Travel Demand as indicated by Bloomberg:
One of the most important indicator we think in relation to our Credit Chadburn and the growth divergence between the US and Europe is the evolution of the Loans-to-Deposit ratio progress as displayed by Morgan Stanley in their recent report entitled - Tracking Deleveraging - from the 19th of October:
Another important point for the US chadburn, we think, comes from Citi's US Credit Strategy note from the 10th of October indicating the following:
"Bond vs. dividend yields: Back in ’07 the average HG non-financial bond was yielding 6.2%, while stocks for the same issuers offered a dividend yield of 1.9% (difference of 4.3%). The difference is now a negative 0.2% (2.7% vs. 2.9%), even before adjusting for factors such as high dollar prices. At some point the marginal dollar should flow from credit into equities, and it’s hard to see why we are not fairly close now."
In relation to US credit in general and US HY in particular, Goldman Sachs in their recent note from the 17th of October entitled - Assessing the interplay of macro surprises and spread products made some very interesting points:
"Macro surprises matter for spread products but in different ways.
We investigate the impact of macro surprises on the corporate bond and Agency MBS markets.
We find that for both investment grade corporate bonds and Agency MBS, it is total returns (or equivalently yields) that respond to macro surprises.
For high yield bonds, it is the spreads that respond to macro surprises.
This difference reflects a trade-off between the ‘rates effect’, where positive surprises cause a back-up in rates, and the ‘spread effect’, where positive surprises lower the default premium.
For investment grade bonds and Agency MBS, the ‘rates effect’ largely dominates the ‘spread effect’, while for high yield bonds the two effects cancel out.
The impact is broader and larger since the global financial crisis Focusing on the post-global financial crisis (GFC) sample period, we document that the impact of macro surprises on both the corporate bond and Agency MBS markets has become larger and broader.
Recent spread rally driven by declining premia, not better data.
Looking at the recent spread rally, we find that both high yield bonds and Agency MBS have outperformed the macro data, confirming our view that the rally has been driven mostly by risk premia compression as opposed to a better macro picture.
The relationship with macro surprises is reasonably robust for both corporate bond spreads and MBS yields: CCC and B spreads are negatively related to the surprises, while the inverse pattern prevails for CMM yields.
The intuition conveyed is simple: positive surprises lift growth expectations and thus cause the default risk premium to compress and Treasury yields to back up. The result is tighter corporate bond spreads and wider MBS yields.
Three key findings: Not all macro indicators are created equal (unsurprisingly).
-For both the credit and mortgage markets, labour market indicators (non-farm payrolls, initial claims, the ADP employment report and the unemployment rate) tend to have the strongest impact. Survey data (such as the ISM – both manufacturing and nonmanufacturing – and Philly Fed) and hard data (such as retail sales and durable goods) also appear to have a significant impact on daily moves in credit spreads and total returns, as well as on CMM yields.
-In spread terms, only high yield is sensitive to macro surprises. Moreover, the response of high yield spreads to macro surprises is monotonic in ratings: the lower the rating, the stronger the response. By contrast, investment grade credit spreads are virtually unresponsive to macro surprises for both financials and non-financials.
-Lastly, CMM yields respond to macro surprises in a way that is almost identical to 10-year Treasury yields. This is consistent with the notion that agency MBS and 10-year Treasury securities are close substitutes of each other."
On a final note, falling bond yields and the Fed's purchases of MBS (mortgage-backed securities) will erode further US banks profitability in the next few quarters according to David A. George, a Robert W. Baird and Co. analyst as indicated by Bloomberg Chart of the Day:
"A sailing ship is no democracy; you don't caucus a crew as to where you'll go anymore than you inquire when they'd like to shorten sail." - Sterling Hayden, American actor.