The elusive credit growth:
Is lending going to improve in Europe going forward?
We do not believe it will and so does Bank of America Merrill Lynch in their 9th of July paper on European banks:
"While funding markets are open, high debt costs compared with realisable margins on new business mean that banks have made little use of the term markets. With all the pressures from regulators to fund more conservatively, a lack of term issuance has to be in our view a lead indicator of further balance sheet shrinkage. Without a significant change in new business spreads which remains elusive (Chart 20), we believe that banks will be shrinking across the euro area for some time to come. This will naturally be deflationary for the economy.
Last week we made the following point:
While the ECB has recently tweaked its collateral framework as additional policy support, as part of the intent towards re-launching the ABS market to improve SME funding conditions, we think it is too little, too late and that the credit transmission mechanism has been broken in Europe, leading to a surge in bankruptcies as well as unemployment.
The credit transmission mechanism channel is broken as indicated by Bank of America Merrill Lynch graph depicting euro area loans to the private sector adjusted for sales and securitization:
Encumbered European banks balance sheet with legacy assets:
Problems on European banks balance sheet, not only have not gone away but in some cases have yet to peak, so while credit markets are enjoying a "cloud nine" respite, the deleveraging of European banks balance sheet has much further to go as displayed by Bank of America Merrill Lynch's graph depicting the list of potentially troubled credit ranging from 13% of loans on banks' books to 40% in Ireland:
Given ongoing economic weakness in the region, we believe this will tend to create pressure on banks to shrink, in order to conserve capital ratios." - source Bank of America Merrill Lynch.
Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments as per Bank of America Merrill Lynch's graph below:
"Foreign ownership of the debt has stabilised but YTD has risen only marginally. Spanish banks have taken up the majority of the increase in recent months, continuing a trend since 2008 (Chart 28).
Crowding out is likely to continue, for two reasons. First, the pretax margin available in taking government exposure is potentially equivalent to, or above, that of lending because there is almost no marginal cost, credit losses are likely assumed to be zero. Furthermore, a government bond position can be repo funded with a 5% or less haircut even for longer dated exposures. This is a fraction of the discount required to repo fund mortgage or SME exposures, even when such finance is available.
Leverage ratios may bind here too
The trade off between loans and government exposures is also set to be intensified with the introduction of leverage ratios. The zero risk weighting of government bonds made them 'free' from a capital perspective, but a 3% leverage constraint implies an equivalent 30% risk weight based on a target common equity tier. One ratio of 10%. based on the proposed 8% of liabilities bail-in requirement, the effective risk weight would likely be higher." - source Bank of America Merrill Lynch.
Where we disagree with Bank of America Merrill Lynch's recent note is on their take about the recent improvement in the Macro Data in Europe which according to them could lead to potential increase in credit demand. We do agree though that banks are a leveraged play on recovering economy (so far US banks have outperformed both equity wise and credit wise):
"Macro data in Europe has been, at least, less bad in recent months. Banks are, always and everywhere, leveraged macro plays. This predisposes us to be more positive on the European banking system. Better GDP improves potential credit demand and drives higher asset prices, a key contributor to bad debt charges.
However, better GDP is a necessary but not sufficient condition for a more positive view. There remain several constraints :
- Legacy assets. We believe these are likely to be dominant issues for many banks in Spain and Portugal. The past is not yet behind them
- Non-performing loan generation has been elevated recently in Italy and Spain. While the pace should slow with sustained GDP recovery, provision coverage has lagged new NPL formation, suggesting that more recent problem loans will also need to be addressed
- Returns are not sufficiently high to encourage banks to grow." - source Bank of America Merrill Lynch.
So far the ECB has limited the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields staying around the 1.60% level at 1.64% and French yields now around 2.25% slightly higher from last week - source Bloomberg:
Probably until the fall, where there is a significant possibility of seeing renewed political risk in conjunction with austerity fatigue. On that note we agree with Nomura's take from the 25th of July from their geopolitics not entitled "Red October":
"- In contrast to 2012, markets have been barely troubled by political risk this year, with the focus very much on the fundamentals and, latterly, the Federal Reserve together with monetary tightening in China.
- However, the autumn (or "fall", as the Americans would have it) may see politics-related risk rising in several geographies, notably the eurozone but also East Asia, the Middle East and the US.
- Although we see a systemic event as a tail risk, we still think that politics has the potential to move markets non-negligibly in the coming weeks, with October currently looking particularly risky." - source Nomura
While the summer lull and "cloud nine" seems to be prevailing, as we argued last week, in conjunction with our friends from Rcube latest call on global weakening earnings momentum, there are significant indicators that are starting to flash warning signs, at least credit wise we think from a European perspective as like anyone else we look at PMIs in Europe but we prefer to focus on credit availability and financing conditions.
First, Europe's largest engineering company Siemens has cuts its profitability forecast amid market slowdown and won't achieve its 2014 margin target of at least 12%, leading for an early exit of its CEO Peter Löscher.
Second, one particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. As indicated in our conversation "The European crisis: The Greatest Show on Earth", :
One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 12th of July points to a deterioration in the Terms of Payments:
A deterioration that does not bode well for France's level of unemployment which should continue to rise given a deterioration of operating cash flows could lead to a rise in the number of bankruptcies in France which continue to rise as per the below graph from Natixis:
Moving on to the subject of why we think it is in the interest of the US to start normalizing rates, therefore tapering, we have long argued that we have more issue with ZIRP policies than QE.
Let us explain.
If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2.
The only way the Fed can start raising interest rate is by first starting its "tapering" dance (following its "twist"...). To do that you need to contract the monetary base first, which is not trivial to say the least.
Looking at the recent bout of volatility with the ML MOVE index jumping from early May from 48 bps to a record 117 bps in a couple of weeks which crushed the fixed income space, it will not be an easy exit for sure - graph source Bloomberg: