Monday, 3 December 2012

Credit - The Regret Theory

"In history as in human life, regret does not bring back a lost moment and a thousand years will not recover something lost in a single hour."  - Stefan Zweig

This year, we have on numerous occasions touched on game theory in our posts (The European iterated prisoner's dilemma, Agree to Disagree) and we also used an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept (Schedule Chicken). We even ventured towards computational analogies in our title selection process (Bankers' algorithm). Given the latest raft of European PMIs, pointing to a continued (albeit much smaller) divergence between the United-States Growth and Europe (Growth divergence between the USA and Europe), reason being the lack of credit provided to the real economy due to:
-inappropriate European Banking Association decision of imposing banks to reach a 9% Core Tier 1 ratio by June 2012 
-unrealistic budget deficit targets (A Deficit Target Too Far), 

We came to the conclusion that we ought to use in our title a reference to the Regret decision theory.

The divergence between US and European PMI indexes - source Bloomberg:

The Regret theory (also called opportunity loss) being defined as the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen by our European politicians. The Regret theory is also a model of choice under uncertainty defined as the difference between the outcome yielded by a given choice (credit crunch, economic recession) and the best outcome (muddle through) that could have been achieved in that state of nature (deflationary forces at play). 

As far as Europe is concerned, one can wonder what would have been the "economic outcome" if a different course of action would have been undertaken. On that matter we wonder why our "European elites" did not use the minimax regret approach being a decision rule used in decision theory, game theory, statistics and philosophy for minimizing the possible loss for a worst case (maximum loss) scenario. One approach is to treat this as a game against nature (deflation in our case) and using a similar mindset as "Murphy's law" ("Anything that can possibly go wrong, does"), taking an approach which minimizes the maximum expected loss, but we ramble again...

And what could possibly go wrong in relation to European growth in 2013? After all, one might posit it is only a game of confidence. Well, looking at consumer confidence in Europe, "Murphy junior" would certainly comment that his father is probably too optimistic when looking at European Consumer Confidence.

European consumer confidence indicators for some European countries - source Bloomberg:

We already looked at the link between consumer confidence and consumption back in our June conversation "Yogurts, European Consumer Confidence and Consumption" where we undertook at an interesting exercise following Yogurt giant Danone profitability warning announcement (affected by Spanish woes), namely plotting Danone share price against consumer confidence - source Bloomberg:
We wrote at the time:
"Yogurts matter as an indicator? One has to wonder...
As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit."

In relation to European Consumption, Consumer Confidence is key. The latest data relating to car sales in Europe, confirms the deflationary forces at play in Europe with car registrations falling plunging 19.2% in November in France on a monthly basis and 13.8% in the first 11 months of the year and Italian care sales by 20.1% in November (for a lengthy analysis on the subject of the car market in Europe please check - "The European Clunker - European car sales, a clear indicator of deflation").
As far as 2013 is concerned, European car sales are at risk on weaker consumer consumption as indicated by Bloomberg:
"Bears suggest discounting by automakers may not be enough to boost unit sales in Europe. Austerity in Europe is straining disposable incomes, with consumer household expenditure falling for three consecutive quarters. Car sales in Europe fell 4.2% yoy in the first three quarters of 2012 and any sustained recovery will be challenging as economic pressures mount." - source Bloomberg

One could also look at car sales and European Consumer confidence since 2007, the relationship seems pretty clear even though the cash for clunkers program have indeed been highly supportive of car sales whenever consumer confidence needed some government "artificial boost" - source Bloomberg:

Weak economy, low consumer confidence and high unemployment are indeed the deflationary forces at play plaguing European consumption and impacting car sales in the process. 2012 will be the fifth consecutive year of declines in the European car market below 12.8 million units, 20% below pre-crisis levels.

Strong macro drivers such as consumer confidence set the trends for the demand in the auto sector but for consumption levels as well.

France Consumer Confidence and Household Consumption YoY since 2001 - source Bloomberg:

For instance, another indicator of the divergence between Europe and the United States, comes from the auto sector where demand for US light vehicle sales were up 7% year over year in October and 14% year to date, whereas Europe was the only region to decline in 2012, down 4.6% in October and down 6.9% in 10 months. Even China, passenger car sales were up 6.4% in October and nearly 7% year to date. In Europe the European Automobile Manufacturers Association, or ACEA, indicated in November car sales decreased 6.9 percent to 10.7 million cars. The ACEA indicated Europe’s car sales would reach a 17-year low in 2012. It also estimates that as much as 30 percent of production capacity is not used.

We think our European politicians would be wise to look at the minimax regret approach given Intrade is now putting a 30.6% chance of breakup of the Euro by December 31st 2013 as reported by Stephen Rose from Bloomberg on the 3rd of December: 
"Following is a table listing the odds that one country currently using the Euro will change its official currency by the expiration date, based on bets made at"

Europe is still a story of deleveraging and as pointed out by a recent note from Credit Agricole Cheuvreux from the 29th of November entitled "EU, The Road through purgatory", should our European politicians decide to tackle the minimax regret approach, there are indeed four possible recipes: "There are four basic recipes for deleveraging: austerity, inflation, growth, and default. The optimal is growth but Europe as whole cannot export its way out of its challenges and nor does it need to. Europe overall runs a current account surplus; the challenge lies in the balance within the Union. Europe needs further debt restructuring, inflation and a rebound in consumption (domestic growth). Deflation is the key risk here, but Draghi appears to understand this danger and has proved a better lateral thinker than his predecessor." - source Credit Agricole Cheuvreux.

Yes, our "Generous Gambler" aka Mario Draghi has been clearly a better lateral thinker in preventing a financial meltdown following the acute liquidity crisis of the financial sector in 2011. But as far as our Regret Theory is concerned, we previously indicated that in the case of Europe, causation implied correlation:
"Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth."

Looking at the prospect for the younger generation of Europeans and high level of youth unemployment, maybe Murphy junior is correct in assessing his father's law after all:
-source CA-Cheuvreux / Eurostat.
"These unemployment trends are very worrisome and if they are not reversed in the short term they may lead to increased social tensions and structurally higher long-term unemployment, which has negative effects on a country's growth prospects as part of the workforce becomes impaired. Also, youth unemployment leads to emigration, which will have a negative impact on demographics, as will be seen in most European countries in the medium term." - source Credit Agricole Cheuvreux.

Deleveraging leads to lower domestic consumption while tax rates are increasing with a shift from income taxes to consumption taxes:
"As taxes increase, and penalise an already fragile economy, consumption decreases exponentially and corporate investment is postponed, which leads to lower tax intakes. This means that more taxes are levied on the economy to try to cover the shortfall and a vicious circle is perpetuated." - source Credit Agricole Cheuvreux.

Maybe the minimax regret approach is the right approach after all. Oh well...

On a final note and in relation to struggling peripheral countries, Spain has indeed very apt in avoiding "tapping out" for help in this European fight of the Century, given it has so far managed to retain market access with timely sales as indicated by Bloomberg Chart of the Day:
"The CHART OF THE DAY shows Spain, which has auctioned about 82 billion euros ($106.7 billion) of bonds this year, sold the most debt when borrowing costs were at their lowest. That’s allowed it to retain market access and so far avoid a sovereign bailout even as 10-year rates surged to a euro-era record. “Spain has been smart in timing the issuance in the market,” said Alessandro Giansanti, a senior rates strategist at ING Groep NV in Amsterdam. “A loss of market access in July this year could have easily driven Spanish yields to the 8 to 9 percent area.” The nation’s 10-year bond yielded about 5.32 percent on Nov. 30, down from 7.75 percent on July 25. The yield touched 5.20 percent last week, the lowest since March 20. Spain sold the biggest proportion of its debt in January, when the 10-year yield averaged 5.30 percent, and auctioned the lowest amount of bonds in August, when yields ranged from 6.15 percent to 7.44 percent. The Treasury completed its program of medium- and long-term debt sales earlier this month, and has used subsequent auctions to raise funds for 2013." - source Bloomberg

"Uncertainty is the worst of all evils until the moment when reality makes us regret uncertainty."
- Alphonse Karr, French critic

Stay Tuned!

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