Friday, 30 March 2012

Markets update - Credit - Spanish Denial

"A moderate addiction to money may not always be hurtful; but when taken in excess it is nearly always bad for the health."
Clarence Day

"Denial (also called abnegation) is a defense mechanism postulated by Sigmund Freud, in which a person is faced with a fact that is too uncomfortable to accept and rejects it instead, insisting that it is not true despite what may be overwhelming evidence. The subject may use:
-simple denial: deny the reality of the unpleasant fact altogether
-minimisation: admit the fact but deny its seriousness (a combination of denial and rationalization)
-projection: admit both the fact and seriousness but deny responsibility.
The concept of denial is particularly important to the study of addiction." - source Wikipedia

Indeed, denial is very important in the study of "addictive behaviors" and given markets have been truly "addicted" to liquidity (money) during last quarter, the recent frenzy triggered by the expectation of QE3 made us wander this week to the side of human and market psychology.
We could ramble even more and relate the ongoing European debt troubles and social unrest to the "K├╝bler-Ross model", commonly known as "The Five Stages of Grief", but that's another subject altogether (is it really?).

So, in this weekly conversation, we will look at the fundamentals, given the Macro risk premia remains the main driver of pricing in this low yield environment. We will also look at the differences in debt compositions between Italy and Spain and the evolution (a follow up to our "stocks" and "flows" approach we discussed in our previous conversation "The Spread Also Rises"). But once again, we will first go through our credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
While the rally in credit has been of epic proportion this quarter supported by the massive liquidity injections (1 trillion euros in total) from LTRO 1 and LTRO 2 conducted by the ECB, since the index roll date of the 20th of  March, credit has been much weaker and somewhat more volatile, with Itraxx Crossover 5 year CDS index (High Yield risk gauge index, 50 names) going through the 600 bps level.

Itraxx Crossover has been rising while Eurostoxx Volatility has started to rise albeit very slowly for now - source Bloomberg:

The "Flight to quality" picture. Germany's 10 year Government bond yields well below 2% yield, towards the lowest level reached in 2011 and 5 year CDS spread for Germany still rising. We argued previously that given ongoing uncertainties surrounding the European debt situation, German Bund yield were somewhat capped to the upside as there is a natural bid for safety and safe assets such as the German 10 year bund - source Bloomberg:

The current European bond picture with the recent rise in Spanish and Italian yields following market concerns on the debt sustainability for Spain following the revised deficit target of 5.3% agreed by European leaders on the 12th of March - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS falling to 42 bps above Italy, (back to the level reached two weeks ago) - source Bloomberg:

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
The elevated level of deposits parked at the ECB and earning 0.25% are yet to alleviate our fears relating to the lack of credit transmission to the real economy which we discussed in our conversation "Money for Nothing".
While we await for the next ECB lending survey which will be published in April, as well as the IIF survey relating to emerging markets lending conditions, our friends at Rcube Global Macro Research touched on the latest Bank of England (BOE) lending survey and the picture is not encouraging to say the least, when it comes to credit flows to the real economy:

My friends at Rcube commented:
"We consider the results as negative, as credit availability has deteriorated during the quarter. While the net tightening remains small, the trend has now been in place since Q4 2010."

Rcube also made an important point in relation to cost of credit:
"More worryingly, the cost of credit is now rising fast. Lenders have reported tightening in price and non-price lending terms in Q1, expecting further tightening in Q2."

They also added:
"We would have to go back to the peak of the crisis to register such a large tightening of terms.
Therefore, both the availability and the cost of credit are currently moving in the wrong direction. This is particularly striking since risk appetite made a strong comeback in Q1."

One has to ask oneself if the time has not come to start taking a few chips off the table.

Moving back to ongoing concerns over Spain, Friday's announcement of an additional 27 billion euros of cuts as well as a 7% rise in utility bills, came 24 hours after a general strike with 1 million Spanish people demonstrating in the country. Hence the title of our post "Spanish Denial". In our previous credit conversation "The Spread Also Rises", we discussed the structural differences between Italy and Spain, and our macro approach, which can be applied, namely "stocks" versus "flows".

To illustrate further the previous point we made, we would like to illustrate the difference between Italy and Spain, by displaying the evolution of private debt versus public debt for both countries:

(click to enlarge) - As one can see, Spain has experienced a massive growth of households and corporate debt whereas the public debt as a whole has decreased since 1997 (During the boom years of 2004-08, construction & real estate activities explained more than half of the increase in bank lending to the corporate sector source IMF Article IV, 2011).

The burst of the housing bubble means there is a significant debt hangover for households, and the significant level of unemployment is not helping the deleveraging process:

Moving to Italy, the picture is indeed, rather different:
(click to enlarge) - As one can see in Italy, given there was no housing bubble burst experienced by the country, there was no massive growth of households and corporate debt. In fact household debt is one of the lowest in Europe. Whereas, the public debt as a whole has remained rather similar in terms of size since 1997.

"stocks" versus "flows": high accumulated indebtedness rather than a flow due to operational deficits.

Italian households are not saddled by debt, and still have one of the highest savings rate in Europe, a primary surplus, as well as a considerable amount of savings. Also Italian debt is mostly domestically owned:

When it comes to Net Financial Wealth of Households as a percentage of GDP, 2000 and 2007, as indicated by Eurostat, Italy is indeed a much richer country than expected, even compared to France and Spain. We could even go further in our analysis and compare Belgium to Italy, given their similar high debt to GDP levels (98.5% for Belgium, 119.6% for Italy), but very low household debt (around 53% for Belgium), very high savings rate (around 17% in 2011 in Belgium) as well as very high level of savings and a mostly domestically held government debt. Both countries enjoy massive private sector wealth, therefore foreign debt is negligible:

A wealthy private sector is significant when it comes to debt dynamics given that by broadening the tax base and introducing bigger transfers from the private sector to the public sector means the demand for government bonds in the primary market can provide a stable base as indicated by last year's report published by Danske Bank - Euro area: Why Italy is not Greece:
"The deficit in the peripherals, apart from Italy, increased sharply in 2008 and 2009. In Italy, however, it never exceeded 6% of GDP, and in 2010 the deficit of 4.6% was half that of Spain and Portugal and much better than Greece and Ireland."

Italy is not Greece. We would add, Italy is not Spain either.

Last week we argued that "The Spread Also Rises", looking at the evolution of Spanish Non-Performing loans (NPLs) on banks balance sheet, we remain overall very wary of the ongoing Spanish situation (as we previously indicated, Spanish banks ratio of non-performing loans to total loans came in at 7.61% in 2011, the highest percentage since 1994):
Source Barclays.

Bank of America Merrill Lynch argued the following in their report - Spain: Growth challenges suggest further sell-off, in relation to Spain, on the 23rd of March:
"Reversing imbalances will likely take a few years
The challenges facing Spain are threefold, in our view. It needs to:
(1) find a new growth model, where construction & real estate play a lesser role and resources move to the tradable sectors,(2) reduce leverage across sectors including, but not restricted to, real estate-related activities, and (3) bring down the c.25% unemployment rate. The rebalancing exercise will be particularly challenging as the economy faces contraction this year and subdued growth next year, due to the combination of a large fiscal adjustment and a credit squeeze. A positive force would be recovering exports, but these largely depend on euro-area growth."

Bank of America Merrill Lynch also indicated the following in relation to Spain:
"Real estate and construction sector debt represented 30% and 10% of GDP, respectively, in 2011, while real estate activities accounted for 22% of private sector credit growth, mortgages 33% and construction 8%."

The positive is that, year to date Spain has completed 44% of its bond issuance, based on the 2012 targets, well above the 30% Euro area average according to the same report by Bank of America Merrill Lynch.

On a final note, as indicated in a recent report by Barclays, the pace in the fall of Spanish real estate prices is accelerating, explaining the significant rise in Non-Performing loans on Banks Balance sheets:
Source Barclays

"Delay is the deadliest form of denial."
C. Northcote Parkinson

Stay tuned!

Saturday, 24 March 2012

Markets update - Credit - The Spread Also Rises

"There is only one side of the market and it is not the bull side or the bear side, but the right side."
Jesse Livermore

Given finally everyone and the markets are finally focusing their attention on Spain, we thought this time around it would be interesting to use an appropriate literary analogy in our title, namely Ernest Hemingway 1932's masterpiece "The Sun also Rises" in our weekly ramble.
We already explained at length our discomfort with Spain in our credit conversation "Lather, rinse, repeat" where we argued:
"Given the ongoing deleveraging, in the light of the recent Sovereign CDS convergence between Italy and Spain, we might be viewed as contrarian but looking at the ongoing deleveraging process and the sectorial composition of debt as a percentage of GDP, Spain appears to us as being in a less favorable position particularly in the lights of its housing hangover"

The worsening credit crunch, particularly in the peripheral countries warrants caution. In our credit conversation "Money for Nothing" we voiced our concerns in relation to ECB quarterly bank lending survey and the impact impaired credit channels will have on economic growth:
"Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non-Performing Loans (NPLs) on banks balance sheet."

We indicated recently that the latest Spanish banks ratio of non-performing loans to total loans came in at 7.61% in 2011, the highest percentage since 1994, the LTRO effect amounts to "Money for Nothing", at least to the real economy. Given the growing differential between Spanish Sovereign 5 year CDS and Italian Sovereign 5 year CDS we have been monitoring, in this weekly review, we will focus on the difference between both countries, namely our "stock" versus "flows core macro approach. But first our credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Since the rollover of the credit indices on the 20th of March, the Credit Indices have risen during the last three days. Itraxx Financial Senior 5 year CDS (25 European financial institutions, a gauge of financial risk, is still trading above corporate risk at 203 bps, namely Itraxx Main Europe 5 year CDS, currently at 120 bps. What really caught our interest, in the rollover of the new credit indices, was the SOVx index, which saw Cyprus, replacing Greece in the 15 members of the index. We already witnessed the impact Greece exit had on the SOVx index in our conversation "SOVx Western Europe - And Then There Were 14...".

Replacing Greece by Cyprus is the SOVx series 7 index might not be enough to preserve the 15 member's number status. On the 13th of March, Moody's rating agency joined its peer Standard and Poor's in slashing Cyprus to junk status on heightened concerns over its banking sector’s exposure to Greece. Only Fitch rating agency has maintained its rating for Cyprus one notch above junk.
"Moody’s downgrades Cyprus credit rating to junk status on fears over Greece exposure" Washington post:
"The downgrades have effectively shut Cyprus out of the international markets, prompting it to seek a €2.5 billion ($3.3 billion) low-interest loan from Russia to meet its financing needs for this year.
Moody’s said that apart from their significant Greek government bold holdings, Cypriot banks’ woes are compounded by their large Greek loan portfolios. It said those stresses on the banking system combined with weak private sector confidence and adverse external conditions will constrain the island’s growth potential in the next few years and add to the fiscal challenges facing the government."

But, Cyprus debt woes could be alleviated in the future thanks to recent exploration results undertaken by Texas-based Noble, indicating that the latest gas find could be worth in the region of 100 billion euros (gas resources in offshore area at between 5 and 8 trillion cubic feet (tcf) with a gross mean of approximately 7 billion tcf). According to Natural Gas Europe article, this is already creating tensions between Greece and Turkey:
"Amid the elation of Cyprus and Noble at the find, tensions between Cyprus and Turkey have once more come into play. Turkey has previously encroached on Cyprus's Exclusive Economic Zone (EEZ) in the Mediterranean Sea in response to the exploration of the area by Noble Energy. Turkey, which invaded Cyprus in the 70s and occupied a substantial portion of the island, refuses to acknowledge or accept the sovereignty of the Cypriot government."

Moving back to our credit overview, Itraxx Crossover has been rising while Eurostoxx Volatility has been subdued, as our friends at Rcube Global Macro Research posited in "The two main drivers of equity volatility", we do not think this disconnect is going to last long - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS widening to around 55 bps above Italy, (43 bps a week ago) - source Bloomberg:
In our conversation "Modicum of relief" we stated:
"We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy's shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%."

Spanish Banks CDS drifting wider this week as well. Spanish banks CDS have widened a lot during the last 7 days:
BBVA 5 years CDS Senior started the week at 275 bps and trades around at 357 bps.
BBVA 5 years CDS Sub started the week at 500 bps and trades around at 610 bps.
Santander 5 years CDS senior and sub moved from 265 bps and 411 bps respectively to 347 bps and 515 bps - source Bloomberg:
We discussed Spanish woes with our good credit friend:
"As expected, Spain is widening more versus Italy and the European core countries. The CDS 5 years trade at 440 bps, while it was trading at 340 bps on February 7th. The economy is not improving in Don Quixote's kingdom, and will not improve in the coming years as unemployment remains very high (24 %), particularly youth unemployment (around 50 %), the social risk is rising.
The government is trying to guarantee the debts of the Provinces which face a wall of refinancing, in exchange for more control on local finances. Considering that there are important regional elections this Sunday (Andalusia and Asturias), the game is still very open."

Our "Flight to quality" picture. Germany's 10 year Government bond yields receding below 2% yield and 5 year CDS spread for Germany now rising (ominous signs of upcoming stress in the markets?), falling back to the levels which had prevailed since the beginning of the year - source Bloomberg:

The ongoing drop in short term correlation (120 days) between the US 10 year yield and the German 10 year bund, falling below 50% to 45.77% - source Bloomberg:

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

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
Euro 3 months Libor OIS, one indicator of systemic credit risk continues to recede but very slowly, indicating that LTRO 2's impact is having a smaller impact than LTRO 2. Euribor is the rate for 3m uncollateralised interbank lending and OIS refers to a 3m swap contract whereby one exchanges EONIA(floating leg) for the 3m OIS rate (fixed leg).

The current European bond picture with Spain above 5.5% and Italian yields rising as well- source Bloomberg:

Moving back to weekly's core subject of the divergence between Spain and Italy, it is interesting to note that the tussle between Spanish Prime Minister Mariano Rajoy and European leaders have led on the 12th of March to a "deficit compromise" of 5.3% instead of the 4.4% previously agreed figure while Prime Minister Rajoy's initial deficit slippage target had been 5.8%. Spain's GDP is expected to shrink 1.7% in 2012.

"Money for Nothing" we have argued, relating to the very small impact on the real economy of the peripheral countries the second round of the LTRO will have. As indicated by Emma Ross-Ross Thomas, in Bloomberg in her article- Spain Torments Draghi on Deficit as Banks Tap Loans:
"Spanish banks increased holdings of the nation’s bonds to 202 billion euros in December, from 178 billion euros in November, Treasury data show. They borrowed 152 billion euros from the ECB in February, three times as much as they were taking a year ago."

Spain is indeed focusing more and more all the attention. Exane BNP Paribas in their recent Capital Structure Note from the 22nd of March, confirms what we have been monitoring in relation to Spanish Sovereign CDS spreads versus Italy Sovereign CDS spreads in recent months:
"Since early February, Spanish CDS are more and more expensive. The risk can and needs to be fixed.
While the cost of Italian CDS has reduced significantly, this is not the case in Spain where the cost of CDS has been increasing since early February. As feared, Spanish and Italian 5Y CDS crossed each other this month, and the trend is impressive: from a negative 100bp to a positive 50bp in less than 3 months."

Exane BNP Paribas in their notes, goes further in their analysis in relation to Italy vs Spain and the underlying factors and structural differences:
Structural difference number 1: "The money supply has been negative for a while in Spain, whereas it is still positive in Italy."

Structural difference number 2: "The Italian economy is more industrial than the Spanish one which is much more “concession-based”." - source Exane BNP Paribas:

Structural difference number 3: "The Spanish economy relies greatly on debt." Households and public administration debts (as a percentage of the GDP) - source Exane BNP Paribas:
"A large part of Spanish growth is due to the massive money supply, for example, through real estate loans. This was not sustainable growth." -  source Exane BNP Paribas
We have argued for a long time that a policy of achieving a high home ownership rate is the biggest threat for an economy, we in fact labeled this policy a "Weapon of Economic Destruction" but that's another subject.

If it were only households relying on debt in Spain...

Corporate debt as percentage of GDP - - source Exane BNP Paribas/BdF:

The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between Spain and Italy!
 The latest Cheuvreux Cross Asset Research from the 19th of March validates our macro approach we think:
"The sovereign debt constraint in Italy is that of a stock - a high accumulated indebtedness - rather than a flow due to operational deficits. Accordingly, the arithmetic of sovereign sustainability in Italy is much more sensitive to the ratio of the cost of debt to trend nominal GDP growth than in Spain. Consequently, Italy has derived enormous benefit from the LTRO-induced collapse of its debt servicing costs over the last three months. Our perception is that spreads of Italian debt over their equivalent German reference will continue to tighten through the weeks ahead, by as much as 50bpts for maturities to 3 years. In this context, and even assuming that GDP might decline by up to 2% this year, we think it unlikely that significant new measures of austerity will be required in order to meet the government's financial commitments. By comparison, it cannot yet be said that Spanish public finances are on a sustainable trajectory."

Cheuvreux also stated the following in their recent note relating to the divergence between both countries:
"The legacy of the years of cheap credit is far more damaging in Spain than in Italy. Spain is faced with a prolonged period of private sector de-leveraging in order to unwind the effects of a boom of residential and non residential investment that never occurred in Italy. There are three notable consequences. First, there are greater constraints upon the revival of domestic demand in Spain. Second, there is a greater degree of regulatory and fiscal risk, over a longer period, for Spanish corporates than for their Italian counterparts. Third, there is higher risk of deterioration of company balance sheets in Spain due to impaired assets than in Italy."

"Stocks" versus "flows"...

Hence the contrarian views we had taken in relation to Spain versus Italy, which seems so far to be confirmed by ongoing market movements. Indeed, "The Spread Also Rises"...

On a final note we will leave you with yet another Bloomberg Chart of the day from the 20th of March indicating that the ECB loans are helping Spain to mask its financial weakness:
"The CHART OF THE DAY shows that Spanish five-year note yields tumbled after the European Central Bank said on Dec. 8 that it would provide financial institutions with unlimited loans, offering them the chance to reinvest the cash in higher-returning government bonds. While yields have declined, the cost of credit-default swaps on the debt is higher than the day before the central bank announcement.
“The ECB’s non-standard measures are providing an important liquidity solution to what remains a solvency problem,” said Richard McGuire, a senior fixed-income strategist at Rabobank International in London. The loan provision “hides rather than addresses the systemic weakness driving the crisis,” he said." - source Bloomberg.

"In bull-fighting they speak of the terrain of the bull and the terrain of the bull-fighter. As long as a bull-fighter stays in his own terrain he is comparatively safe. Each time he enters into the terrain of the bull he is in great danger."
Chapter 18, The Sun Also Rises, Ernest Hemingway

Stay Tuned!

Wednesday, 21 March 2012

Treasuries vs Equities and Forex volatility - A Tale of Three volatilities.

"By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third by experience, which is the bitterest."

Given lately, we have been conversing on volatility (The two main drivers of equity volatility)  as well as the recent sell-off in US treasuries, we thought this time around we would entertain you with some interesting points made by our good cross-asset friend with whom we regularly discuss our macro and market interests.

Below you’ll find a historical chart showing the relative valuations of benchmark indicators for short-term implied vols in the three main asset classes (equities / forex / rates):
-Rates : Merril Lynch’s MOVE Index showing the trend in 1-mth atm implied volatility 2 / 5 / 10 and 30Y Treasuries options.
-FX : Credit Suisse’s CVIX Index showing the trend in FX main pairs atm 3month implied volatility.
-Equities : SPX 3mth options atm implied volatility (much more reliable than the VIX which is currently polluted by several technical factors).
At the bottom you can see UST 10 year yield evolution post QE2.
Source Bloomberg - (click graph to enlarge)

As indicated by our cross-asset friend:
Since the start of the bond market correction that started last week, we can clearly notice a disconnection between Treasuries volatilities (up quite strongly) and risky assets volatilities (equities and Forex volatilities remaining at the low end of their recent range).

If the bond market’s move truly is the start of a long rates repricing for “good” reasons (namely finally validating the huge risky assets run-up of these last 4 months on better macro data) then it makes sense to see a risk transfer from the equities/forex sphere to the bond market’s sphere. As a matter of fact, we noticed this kind of discrepancy during a rather similar period : in Q4 of 2010, following the QE2 announcement, where we saw 10 year yield move up 100 bps, SPX and most risky assets rallyed hard with the same type of cross-asset vols opposite moves.

However these kind of disconnections in cross-asset vol markets generally do not last long. A correction in risky assets or a larger bond market rout would effectively probably see SPX and forex short volatilities move up rather quickly. We’re talking short-term volatility here so obviously timing is key to put on recorrelation trades as you need to be right pretty fast...
To be continued !

"Three things cannot be long hidden: the sun, the moon, and the truth."

Stay Tuned!

Monday, 19 March 2012

The two main drivers of equity volatility

"Fear tends to manifest itself much more quickly than greed, so volatile markets tend to be on the downside. In up markets, volatility tends to gradually decline."
Philip Roth

In recent conversations, we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):
"We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012."

Given many pundits have been discussing the steepness of the VIX curve and the inconsistency of the implied volatility with credit spreads, we thought this time around, we would focus our attention on "European Equity Volatility" and the European counterpart of VIX, namely V2X, courtesy of our Global Macro friends at Rcube and join the "passionate debate".

But first some interesting charts -1 year evolution of VIX versus its European counterpart V2X - source Bloomberg:
The highest point reached by VIX in 2011 was 48 whereas V2X was 51. VIX is below 15, around 14.96 and V2X at 19.16, highlighting as well the disconnect between US and Europe in relation to risk perception.

10 year German Bund yield versus 10 year US Treasury note yield - source Bloomberg:
Correlation still falling between German 10 year Bund and US 10 year note.

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

Moving back to the title of our post, we completely agree with the recent note from our good friends at Rcube Global Macro Research namely that:
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates.

For credit availability, we use the central banks’ credit surveys. For the Eurozone, the % of banks tightening their lending standards spiked to 35% in Q4. In itself, this argues for a higher volatility regime from now on."

Hence, another reason, we think, (like our friends do), of tracking the lending surveys from the ECB:

Source Rcube Global Macro Research - 19th March 2012

Clearly as indicated by Rcube:
"Equity volatility is also logically driven by the direction and the magnitude of revisions of forward earnings estimates. In 2010 and again last year, equity vol spiked while earnings forecasts remained strong."

This previously helped my Rcube friends to identify that the spikes in volatility were not sustainable:
"We therefore used them as selling opportunities (unfortunately not aggressively enough this year). Nowadays, earnings’ forecasts estimates are slowly weakening."

V2X and Eurostoxx 50 Earning Revision - source Rcube Global Macro Research - 19th March 2012:

Rcube also added in their note:
"A combination of weaker earnings forecasts and tighter credit access is pushing the fair value of our European equity volatility model higher."

And according to our friends at Rcube:
"The deviation from fair value is plummeting and could get close to triggering buy signals if earnings based information deteriorate further."
Source Rcube Global Macro Research - 19th March 2012

Our friends at Rcube also indicated in their note:
"Recent data regarding the European credit channel showed that LTRO could be positively modifying bank lending behavior. Last week, the French Treasurers’ Association survey showed that both the cost of credit lines and their availability had improved. Nevertheless, it remains too timid to have a meaningful impact on the model."
Source Rcube Global Macro Research - 19th March 2012

In relation to the VIX, for the V2X, our Rcube friends also agree with many VIX pundits, namely that:
 "The V2X term structure is so steep that it doesn't yet make sense to go long volatility. We're currently near all-time highs regarding the term structure".
Source Rcube Global Macro Research - 19th March 2012

So, clearly, the steepness of the V2X makes it very expensive to go long volatility in Europe as well.

In fact, our friends at Rcube have measured the average return of going long the VSTOXX Short-Term Future index:

"The following back test shows that in the fourth quartile, the average return of going long the VSTOXX Short‐Term Futures Index is around ‐8% on a 1 month horizon."
Source Rcube Global Macro Research - 19th March 2012

We already touched on the relationship between credit and equities (A tale of two markets - Credit versus Equities). As indicated by Rcube, availability of credit can be tracked via the ECB lending surveys and can be used to give clear indication of the  "sustainability" level of volatility in conjunction with revisions in earnings forecast estimates.

"Just as a cautious businessman avoids investing all his capital in one concern, so wisdom would probably admonish us also not to anticipate all our happiness from one quarter alone."
Sigmund Freud

Stay Tuned!

Sunday, 18 March 2012

Markets update - Credit - Plain sailing until a White Squall?

"It takes a real storm in the average person's life to make him realize how much worrying he has done over the squalls."
Bruce Barton

While, the rally so far this year in risky assets has been very solid, we thought this week, we would venture in our usual ramblings towards sailing analogies. Indeed, the "slush funds" courtesy of LTRO 1 and LTRO 2, have avoided what would have been a very nasty financial disaster in the making with the growing liquidity issues we witnessed in 2011. But, although, plain sailing has been so far the course in 2012, it does not mean problems in Europe have gone away, as the saying goes in true maritime style: "You may tell that to the marines, but the sailors will not believe it".

Looking at the US data so far in 2012, it appears to us that there is indeed a different "cut of jib" between the US ship and the European one.
Indeed, while, the ECB intervention via LTROs has "pushed the boat out" (Push the boat out, to, a boat work term used to imply paying for a "round of drinks" - Royal Navy Slang) and avoided many financial institutions to "walk the plank", in this week credit conversation, we will discuss the interesting disconnect between German 10 year Bond Yields and US Treasury 10 years yields, as well as some of our previous calls, namely credit flows in European peripheral countries and goodwill write-downs.

Time for our usual credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:
One week on and the Markit Itraxx Crossover index (European High Yield names - 40 most liquid sub-investment grade entities) is 50 bps tighter, following on the continuous rally seen in risky assets. SOVx Western Europe is now around 224 bps (14 countries left, following Greece credit event, out of the original 15). The 20th of March will see a rebalancing of all Markit Europe Itraxx Credit indices (every 6 months), with Bouygues SA, Rolls-Royce PLC and HSBC Bank PLC all added to the larger index for Investment Grade, namely Itraxx Main Europe CDS index (125 Investment Grade and above companies). HSBC will replace Banco Popolare (BSPC) in both the Itraxx Main Europe index comprising 125 names and the Itraxx Financial Senior CDS index (25 European Financial institutions).

The trend is your friend - Itraxx Crossover falling in tandem with Eurostoxx Volatility - source Bloomberg:

Itraxx Financial Senior 5 year CDS spread falling with the Eurostoxx surging and volatility falling as well, indicating the strength of the rally so far year to date and the positive impact of the 2 LTROs on Financials in Europe - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS widening to around 43 bps above Italy, (27 bps a week ago) - source Bloomberg:

Our"Flight to quality" picture. Germany's 10 year Government bond yields spiking above 2% yield and 5 year CDS spread for Germany still falling, ending somewhat the capped in the rise in yield which had prevailed since the beginning of the year - source Bloomberg:

What we have been monitoring closely has been the acceleration of the drop in the correlation between the US 10 year yield and the German 10 year bund, falling below 60%. Since the end of December 2011, the correlation has been falling significantly - source Bloomberg:
Could this disconnect be a manifestation of the reasons behind the growth difference between the US and Europe data we have been wondering recently? ("Shipping is a leading deflationary indicator").

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
Given the ECB has "pushed the boat out" with its two LTRO rounds, it is no surprise to see a much improved liquidity picture.

The current European bond picture with Spain yields rising above Italy10 year government yields - source Bloomberg:
While Total Return fund managers have enjoyed a steady rally in German bunds for the last 6 months, the latest rise in German bund might see some of them concerned about their holdings of long dated corporated  bonds. It could entice them to reduce their duration and sell some of their long dated corporate bonds exposure in the rally to ease the pressure.

While it still "Plain sailing" so far in 2012, European political uncertainties in conjunction with weak lending surveys could indeed trigger a "White Squall". As we argued in our conversation "Ecce Creditor":
"Going forward, we think you should be focusing on the ECB's monthly lending surveys, loan-to-deposit levels, deposits flights from peripheral countries as well as the rise in nonperforming loans."

Back in our conversation "Modicum of relief" we argued:
"Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process."

The latest quarterly BIS March 2012 report has indeed confirmed our November call ("Leda and the (Greek) Swan and why Europe matters more for Emerging Markets"), namely that the deleveraging in European banks has affected more significantly Emerging Markets in Central and Eastern Europe:
"European banks also cut lending to emerging markets. Their consolidated foreign claims on emerging Europe, Latin America and Asia had already started to fall in the third quarter of 2011. New syndicated and large bilateral loans from EU banking groups to emerging market borrowers then fell in the final quarter of the year. This was in contrast to lending to western Europe and other developed countries, which was essentially unchanged. At the same time, banks tightened terms on new loans to corporations and households in emerging markets. The more pervasive tightening in emerging Europe than elsewhere may have reflected the widespread ownership of banks in the region by EU banking groups. Reduced lending to emerging Europe may also reflect lower demand, however, as the region’s economic growth forecasts fell by more than those for any other during the final quarter of 2011."
"Emerging Europe, the region most dependent on euro area banks for foreign credit, saw the largest drop (Graph 3, bottom left-hand panel). The $35 billion (4.3%) overall decline was led by a $21 billion (4.6%) fall in interbank claims. Lending to non-banks also shrank (–$15 billion or –3.9%).
The countries most affected were Poland (–$13 billion or –8.6%), Hungary (–$5.5 billion or –7.0%) and Turkey (–$9.1 billion or –5.1%). Euro area banks account for more than 80% of all foreign credit to the first two of these countries. They are also responsible for approximately two thirds of all foreign claims on Turkey, whose susceptibility to sudden capital withdrawals is further increased by the fact that more than half of all international claims on its residents have a maturity of less than one year." - source BIS - Quarterly report, March 2012.

In our conversation "Modicum of relief", we indicated why Hungary has been our pet subject ("Hungarian dances") as a very good case study for systemic risk diagnosis:
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios."

Moving to the subject of Goodwill write-downs, one of our previous warnings came in our conversation form November 2011 in "Goodwill Hunting Redux":
"Tip for “banks friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."

Yes, UniCredit started, and it was not a surprise for us to see Italy's second largest bank Intesa posting a fourth quarter loss of Eur 10.1 billion on Goodwill write-down on the 15th of March:
Intesa Reports Fourth-Quarter Loss After Goodwill Writedown, by Sonia Sirletti and Francesca Cinelli, Bloomberg
"Intesa Sanpaolo SpA, Italy’s second-biggest bank, posted a fourth-quarter net loss because of a 10.2 billion-euro ($13.3 billion) writedown of goodwill related to mergers and acquisitions.
The net loss was 10.1 billion euros, compared with net income of 505 million euros a year earlier. Excluding one-time items, the quarterly profit was 265 million euros, the Milan-based lender said in a statement. Analysts expected profit of 633 million euros, according to the average of 10 estimates compiled by Bloomberg. The bank cut its dividend by 3 cents to 5 cents per share.
Intesa joined UniCredit SpA, the country’s biggest bank by assets, in reducing the value of intangible assets related to acquisitions. The lender’s purchases included a 29.6 billion-euro takeover of Sanpaolo IMI, merged into Banca Intesa in 2007."

Intesa's stock price evolution year on year  as of 16th of March 2012 - source Bloomberg:

Intesa took 11 billion euro from the LTRO to cover its 2012 wholesale funding needs.
Yet again "analysts" had not included the potential writedown in their forecasts (it was already the case for BBVA's writedown we discussed in our post "Money for Nothing"). Another fine job by analysts... (Analysts expected profit of 633 million euros, according to the average of 10 estimates compiled by Bloomberg).
What is concerning us in Intesa's case is that loan loss provisions more than doubled to 2 billion euros in the quarter. Rising Nonperforming loans (NPLs) will be a drag on Intesa's ability to provide support to the real economy via credit channels namely loans.

On a final note given Portugal has been on the receiving end lately in our conversations ("SOVx Western Europe - And Then There Were 14..."), we will leave you with Bloomberg's Chart of the Day from the 16th, indicating that Portuguese banks will contract credit conditions further to meet comitments made to secure the 78 billion euro aid program, providing fewer loans to the real economy (businesses) and therefore impacting economic growth in the process.
"The CHART OF THE DAY shows that a slowdown in savings growth may make it harder for banks to reduce the ratio of loans to deposits to 120 percent as pledged in the bailout. Deposits rose 0.4 percent in January, the same as the previous month and a fraction of the 1.4 percent pace in November. That’s putting pressure on banks to trim the ratio by curbing new lending.
“The pace of deposits growth seems to be stabilizing,” Andre Rodrigues, an analyst at Caixa Banco de Investimento in Lisbon. If banks are to reach the expected loans-to-deposit ratio by 2014 “it will have to be done mainly through loans.”
Portugal’s five biggest banks had a combined median loan-to-deposit ratio of about 140 percent at the end of 2011, with Banco BPI SA having the lowest at 109 percent. Banco Comercial Portugues SA, Portugal’s second biggest by market value, with the highest ratio, of 145 percent.
The loan-to-deposit goal may end up countering efforts by the European Central Bank and the Portuguese government to get banks to step up lending." - source Bloomberg

By now you can probably "Fathom out" (To ascertain something; to deduce from the facts) in true Royal Navy slang fashion, the consequences a credit crunch will have on Portugal's economy.

"I could not tread these perilous paths in safety, if I did not keep a saving sense of humor."
Horatio Nelson

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