Credit - In the doldrums

"There are many countries in the world that when they reached the middle-income stage, they witnessed serious structural problems such as growth stagnation, a widening wealth gap and increasing social unrest." - Li Keqiang 

Looking at France's recent PMI print for manufacturing coming at 48.5 but most importantly services coming at 48.8 which in the French economy represent around 80% of the GDP versus 76% for the rest of the European union and given it has been a while since we have not used our beloved maritime analogies, we thought it would be nice to re-acquainted ourselves in our chosen title this week:

"The doldrums is a colloquial expression derived from historical maritime usage, in which it refers to those parts of the Atlantic Ocean and the Pacific Ocean affected by the Intertropical Convergence Zone, a low-pressure area around the equator where the prevailing winds are calm. The low pressure is caused by the heat at the equator, which makes the air rise and travel north and south high in the atmosphere, until it subsides again in the horse latitudes. Some of that air returns to the doldrums through the trade winds. This process can lead to light or variable winds and more severe weather, in the form of squalls, thunderstorms and hurricanes." - source Wikipedia

Colloquially, the "doldrums" are a state of inactivity, mild depression, listlessness or stagnation which we think clearly characterizes for us the French situation in particular and the European situation in general. 

Therefore this week we will focus our attention on France and ask ourselves an interesting question, can you have a credit-less recovery in Europe?

In relation to France, if the Services PMI contracts at such a rapid pace, it still doesn't bode well for France's unemployment levels with president Hollande hoping to overturn the trend by year end. In that specific case the trend is definitely not the friend of French president Hollande as services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

We were not surprised either to see Germany's Flash Composite Output Index jumping to a 10-month high of 54.3 from 53.2 in October. The services index also climbed to a 9-month high of 54.5 from 52.9, the manufacturing PMI climbed to a 29-month high of 52.5 from 54.5, and the manufacturing output index increased to a 3-month high of 54.0.

The reason for Germany's racing ahead have all been explained not only in the title of a previous post of ours "Winner-take-all" in February 2013 but also in the contents should you want to dig further on the subject:

"In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down" 

We have updated the graph displaying Manufacturing PMI for both Germany and France - graph source Bloomberg:

As a reminder, in our first credit post of the year, namely the "Fabian Strategy", we sounded the alarm in relation to France being clearly in the crosshair in 2013:

The story for 2013 in Europe we think, will be France:
In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April 2012, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

Back in November 2012 in our credit conversation "Froth on the Daydream" we argued:

"Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far")."

We also indicated in  our February 2013 conversation "Winner-take-all" the following:

"While the French government has decided to revise its growth outlook for the year, the overly ambitious fiscal deficit in France of 3% will not be met and even the revised growth outlook of 0.2% to 0.3% will not be reached."

To that effect we justified our negative stance using a definitely scary graph displaying, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) which we thought was telling the story on its own at the time and still is, we think - source Bloomberg:

Of course the divergence story between Germany versus France, is not only a growth divergence story, it is also an unemployment divergence story - source Bloomberg:

We concluded our February note with this statement at the time:

"After all the "Japonification" of Europe is a story of a broken monetary policy transmission channel, leading to liquidity constraints to the private sector with and therefore no impact whatsoever to the real economy, so no potential for economic growth to resume in France in particular and Europe in general."

In relation to Europe's PMI data from November, France we think is the worrying outlier, as indicated as well by Nomura from their recent note from the 21st of November 2013 entitled "Modest recovery ongoing as trend stabilises":

"In France the PMI data for November were disappointing, suggesting the economy is losing momentum. The composite output PMI was 48.9 (from 50.5 previously), the lowest reading in five months and consistent with the three-month moving average declining marginally to 49.8 from 49.9 in October. While almost negligible in size, the fall in the three-month moving average of the French composite index is the first in eight months and it points to some possible downside risks to our French GDP forecast of 0.2% q-o-q for Q4. 

The weakness in the French data was evident in the manufacturing and services sectors. The manufacturing PMI dropped to its six-month low of 47.8 in November from 49.1 previously (consensus: 49.5). There was no bright spot in the detailed report. In particular, manufacturing new orders fell by more than 2 points to 46.1, signalling little chance of revival in the sector in the near term. Moreover, new export orders dropped by 3.6 points to 48.5 and the employment index slipped to its five-month low at 48.2.

In the services sector, the headline index declined by 2 points to 48.8 (consensus: 51). One element of concern was the sharp 4 point fall in the employment service index to 46.7, which underpins the subdued nature of the recovery in France. The new business sub-index is the only bright spot in the services report, which rose to 49.3 from 48.5. However, it remained below 50, thus not sufficient to bring the sector out of contraction in the near term." - source Nomura

and Nomura to conclude their report:

"The data also show a greater divergence in economic performance between Germany and France, with the data for France confirming the services sector remains the laggard as we have highlighted in the latest edition of our business cycle positioning tool Galileo" - source Nomura

If indeed the services sector remains the laggard, then at some point the French president will have to stop being delusional about the probability of reversing the unemployment trend before year end. It will not happen.

Moving on to the subject of the possibility of a credit-less recovery in Europe, Bruno Cavalier from French broker Oddo, came-up with an interesting report on the 20th of November. We have long argued that no credit, meant no loan growth and no loan growth meant no economic growth and no reduction of budget deficits. In his note Bruno Cavalier argues that the argument relating to the possibility of having a recovery without bank lending is incorrect in his note. He indicates that the credit ratio to GDP has fallen from 55% since 2009 to 46%. Obviously this credit ratio varies tremendously from one European country to another. For instance, since the peak figure of 1st quarter 2009, it is down by 50% in Ireland, 30% in Spain and 20% in Greece.

EMU: Loans to the private sector - graph source Thomson Reuters, ECB, Oddo Securities:

EMU: Loans to the non-financial corporations - graph source Thomson Reuters, ECB, Oddo Securities:

Bruno Cavalier quotes a report that shows that out of 388 economic recoveries identified in 50 countries on several decade from researchers of the IMF (Abiad, Dell’Ariccia & Li (2011), “Creditless recoveries”, IMF working paper 11/58). They have established that one out of five recoveries is credit-less. He indicates that often, these credit-less recoveries have been preceded by financial crisis. The work of Abiad and Dell'Ariccia, shows that although credit might be constrained, a recovery is possible. Another study by the BIS, quoted by Bruno Cavalier (Takats & Upper (2013), “Credit and growth after financial crises”, BIS working paper 416), shows that in recoveries following a financial crisis, correlation between credit and growth are non-existent for the two first years following the crisis and turn slightly positive (but weak) in the consequent two years.

The on-going financial fragmentation in Europe can be seen in the differences in loan rates between core countries and peripheral countries - graph source Thomson Reuters, ECB, Oddo Securities:

Where we agree with Bruno Cavalier from Oddo Securities is the importance of tracking Bank Lending Survey which are done on a quarterly basis by the ECB. 

EMU: Credit conditions (z-score, supply & demand mixed) - graph source Thomson Reuters, ECB, Oddo Securities:

We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions.

The divergence between US and European PMI indexes is all about credit conditions. This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will use it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg:

The widest level reached since 2008, between both PMI indexes was 8.90. Whereas investor sentiment combined with an excess of demand over supply pushed the average price of S&P/LSTA Index loans up a quarter-point to a fresh post-credit-crunch high of 98.88 cents on the dollar in 2013.

Another survey we have been using specifically on France to track financial conditions has been a monthly survey in French published by the AFTE (Association of French Corporate Treasurers). In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

In order to comprehend the opinion of French corporate treasurers on the evolution of banks' margins, the AFTE calculates a difference between the average interest rate applied to new corporate loans and the 3 months Euribor rate. The series below stopped in October and continue to indicate some stability in banks' margin on new corporate loans below one year. New credits above a one year maturity provided  to French corporate treasurers remains at elevated levels:

What has been improving though for French corporate treasurers according to the latest November survey is access to financing. There is a slight improvement in the latest survey, but conditions remain tough for French companies:

While the rebound from the lows of the end of 2011 (which was due to the acute liquidity crisis faced by the European financial system), the LTROs have somewhat improved financial conditions for French corporate treasurers, nevertheless conditions remain tough at -6.2% of negative opinions still.

The latest AFTE survey ties up with Bruno Cavalier's note indicating the difference of opinion between bankers and small to medium size enterprises (SMEs) treasurers. Bankers indicate a lack of demand, while corporate treasurers indicate that financial conditions are still too restrictive, too tight.

SMEs which cannot get or accept a bank loan because cost was too high - graph ECB, Oddo Securities:

Share of SMEs which only get part of the loan they ask for - graph ECB, Oddo Securities:

Bruno Cavalier in his note concludes that given the on-going fragmentation in Europe and the credit rationing that follows, it reflects three parameters, risk aversion, difficulties of refinancing for banks and the balance between their risks and recapitalization needs. While the ECB will remain accommodative and the upcoming Asset Quality Review (AQR) in 2014, he thinks we cannot expect a strong rebound for credit availability in the coming months or quarters, but as balance sheets get cleaned up, the following credit cycle that will follow should comfort the economic recovery.

Touching again on the subject of credit-less recovery, another paper from the World Bank published in May 2013 by Naotaka Sugawara and Juan Zalduendo entitled "Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge" made some interesting points:

"Private sector credit plays a crucial role in helping a country to recover from an economic recession. For instance, credit provided by commercial banks can re-energize the investment expenditure of enterprises and is an important option in handling household finances. While a recovery without private sector credit is possible, the empirical evidence suggests that such recoveries occur at a much slower pace. Indeed, a credit-less recovery, defined as a recovery from recession without a pick-up in real bank credit to the private sector, is not an unusual event but has been observed both among advanced and emerging economies.1 Even with different samples, the literature tends to find that the share of credit-less recoveries is around 20 to 25 percent of all recoveries." - Naotaka Sugawara and Juan Zalduendo, Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge

Growth Performance, eight quarters before and after trough - source Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge:

"In both country groups, though especially in the group of advanced economies, growth rates two years (or, eight quarters) before a trough, t-8, are similar between credit-less and credit-with events. However, the growth gap gets wider and becomes quite noticeable at least a year (i.e., four quarters) prior to the trough t. In the year the recovery occurs, credit-less episodes experience slow growth rates; however, this gap narrows after a year from the trough. By eight quarters after the trough, growth in credit-less recoveries is 1.5 percentage point lower than that in credit-with recoveries in developed countries. For emerging markets, the growth gap is even wider four and five quarters after the trough, but it also narrows during the rest of the second year following the trough. As a result, the growth differential in the group of emerging markets ends up at broadly the same level as in advanced economies." - Naotaka Sugawara and Juan Zalduendo, Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge

They concluded their paper with these points:

"Credit-less recoveries are neither rare nor insurmountable challenges. The empirical evidence suggests that such recoveries occur at a much slower pace and are only somewhat more common among emerging markets. But recoveries do eventually occur. In fact, economic performance is in large measure correlated with the depth of the correction triggered during the economic adjustment that precedes the trough; specifically, the size of the downturn and the extent of external adjustment that typically accompany a recession (from the current account adjustment to developments in exchange rates). Also, openness has a dual role. Trade openness decreases the likelihood of a credit-less recovery as trade is a more stable source of financing. Conversely, capital account openness might have a large impact by the deleveraging process that typically follows a recession. But one must also be careful as to what this implies for countries going forward as the pre-recession period might have also meant large benefits in terms of growth.

As to policies during the recession, policymakers must be aware that excessive fiscal loosening might end up exacerbating the likelihood of a credit-less recovery, though more research would be needed to understand better their medium- to long-term implications. In contrast, monetary policy seems to play a more beneficial role by not increasing the likelihood of a credit-less event, especially in advanced economies. Finally, the country choice to avail itself of an IMF-supported program is negatively correlated with the likelihood of a credit-less recovery. Seeking an IMF program tends to help countries recover with an increase in private sector credit. The relationship becomes statistically meaningful when the economic conditions at the trough are controlled for. 

And what can be concluded from the estimation about the likelihood of credit-less events in ECA? Here the model seems to suggest that indeed many countries in the ECA (Europe and Central Asia) region were likely to experience a credit-less recovery—and they indeed did. But one must also draw hope from the fact that investment—and presumably eventually growth—typically recovers 8 quarters after a trough. This would suggest that a credit-less recovery is not a reason for extreme concern. More worrisome is that the region is now facing a renewed negative external shock."

But when it comes to Europe, the situation is more complex due to the single currency than warrants the World Bank and Oddo Securities. In a Bruegel Policy Contribution of February 2013, the author Zsolt Darvas in his note entitled "Can Europe Recover Without Credit?" argues the following:

"Data from 135 countries covering five decades suggests that creditless recoveries, in which the stock of real credit does not return to the pre-crisis level for three years after the GDP trough, are not rare and are characterised by remarkable real GDP growth rates: 4.7 percent per year in middle-income countries and 3.2 percent per year in high-income countries.

• However, the implications of these historical episodes for the current European situation are limited, for two main reasons:

• First, creditless recoveries are much less common in high-income countries, than in low-income countries which are financially undeveloped. European economies heavily depend on bank loans and research suggests that loan supply played a major role in the recent weak credit performance of Europe. There are reasons to believe that, despite various efforts, normal lending has not yet been restored. Limited loan supply could be disruptive for the European economic recovery and there has been only a minor substitution of bank loans with debt securities."

• Second, creditless recoveries were associated with significant real exchange rate depreciation, which has hardly occurred so far in most of Europe. This stylised fact suggests that it might be difficult to re-establish economic growth in the absence of sizeable real exchange rate depreciation, if credit growth does not return." - Zsolt Darvas - Bruegel Policy Contribution.

One of the most important point which has sustained credit markets in Europe, has been the strong issuance levels in the bond markets and the arrival of new issuers due to the on-going deleveraging process of European Banks and the acceleration of "dis-intermediation" as large corporates become more reliable on bonds for financing rather than on bank loans which are generally more difficult to get due and service due to covenants. 

Zsolt Darvas made this very important points in his paper:

"Using US firm-level data, Becker and Ivashina (2011) interpret switching by firms from loans to

bonds as a contraction in credit supply, conditional on the issuance of new debt. They find strong evidence of substitution of loans by bonds during periods characterised by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. They also find that this substitution behaviour has predictive power for bank borrowing and investment of small (out-ofsample) firms, which are not able to issue bonds.

In a related paper, Adrian, Colla and Shin (2012) also document the shift from loans to bonds in the composition of credit in the US, and argue that the impact on real activity comes from the spike in risk premiums, rather than contraction in the total quantity of credit. Gertler (2012) adds, by sketching a simple conceptual framework, that credit spreads are a more useful indicator of credit supply disruptions than credit quantities. Gertler (2012) cites Gilchrist and Zakrajsek (2012), who conclude that the increase in spreads during the recent financial crisis was likely symptomatic of unusual financial distress, and not just the reflection of the increased default risk faced by borrowers.

Certainly, the above-mentioned studies analysed data that was available at the time of writing and therefore their sample periods end between 2009 and 2011. Since then, a number of attempts were made by European governments and the European Central Bank to help restoring normal lending and therefore the finding that credit supply was limited up to 2009 or 2011 may not

necessarily imply that such limitations exit now as well. However, European banks still suffer from a large, €400 billion, capital shortfall according to the OECD (2013); the share of non-performing loans continues to be high; bank share prices are low even after the recent increases; and banks need to meet tight capital, liquidity and leverage requirements, even though some of the Basel III requirements were relaxed in January 2013 (Basel Committee, 2013). These factors suggest that credit supply may remain constrained in the EU." - Zsolt Darvas - Bruegel Policy Contribution.

We also agree with the author's final conclusion:

"If credit growth does not return, economic recovery may prove to be difficult in the absence of sizeable real exchange rate depreciation." - Zsolt Darvas - Bruegel Policy Contribution.

For illustrative purposes, we looked at Spain's non-financial loans versus GDP growth to illustrate the case of a the credit-less recovery discussed - graph source Bloomberg:

But Spain being in the colloquial "doldrums", namely a state of inactivity, mild depression, listlessness or stagnation, some of that air returns to the doldrums through the trade winds, could lead to light or variable winds and more severe weather, in the form of squalls, thunderstorms and hurricanes ahead in Europe, when one looks at the unemployment issues particularly hindering the economic prospects for peripheral countries.

One just has to glance casually at the Spanish "Misery" index to fathom the uphill struggle face by our European politicians - graph source Bloomberg:

The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s.

So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:

"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."
 

On a final note, we think the outlook for the US could be further boosted by fall in Oil imports, making the exit strategy for the Fed as difficult as it was for the team of Apollo 13 and the heroin of visually stunning movie Gravity to land back to earth - graph source Bloomberg:

"U.S. oil imports are close to a 22-year low, a trend that is expected to continue through 2014 from increased domestic shale drilling. About 10.5 million barrels a day were imported in 2005, with about 8.5 million barrels coming from seaborne trade. That number has decreased to 5 million barrels, according to Teekay Tankers. Crude tanker ton-miles will decline, though product tankers should benefit from an increase in U.S. refined exports." - source Bloomberg.

"Happiness, to some, elation; Is, to others, mere stagnation." - Amy Lowell, American poet.

Stay tuned!