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!

Credit - When causation implies correlation

"All human actions have one or more of these seven causes: chance, nature, compulsions, habit, reason, passion, desire." - Aristotle 

Looking at the dismal economic figures coming out of Europe as of late (PMI, consumer confidence, unemployment in Spain, IFO, etc.), we could not resist using in our title a veil reference to the phrase used in science and statistics "Correlation does not imply causation". 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 as displayed by the below Bloomberg graph displaying loan growth in in the Euro Zone with the Euro Zone Money Multiplier at multi-year low:

"Third quarter bank results will shed further light on the outlook and appetite for euro zone bank lending. The money multiplier remains at multi-year lows and recent regulatory steps to soften or defer the implementation of new liquidity and capital rules underscore the pressing need for banks' loan supply to improve, release cash to the economy and support growth" - source Bloomberg.

Yes, some will counter us, by saying that the opposite assumption which we used in our title, that correlation proves causation is a questionable cause of logical fallacy also called "cum hoc ergo propter hoc" ("with this, therefore because of this"). Well, truth is, the economic contraction in Europe is a consequence of the first event sometimes describe in latin as "post hoc ergo propter hoc" (after this, therefore because of this) namely rapid credit contraction due to accelerated bank deleveraging courtesy of the EBA (European Banking Association) objective for most European banks to reach a Core Tier 1 capital of 9% by June 2012.
So dear readers, no, we do not think it is a logical fallacy, "post hoc" supposedly being a "tempting error" because the temporal sequence in Europe appears to be integral to causality namely credit contraction:
A occurred, then B occurred
Therefore, A caused B

Of course as of late, our "Generous Gambler" aka Mario Draghi, ECB's president, has defended is latest OMT (Outright Monetary Transactions) bond buying plan on the 24th of October in front of the German parliament with a warning about deflation risks:
"In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries"
and added:
"In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it."

Arguably our dexterous "Generous Gambler" has indeed been highly successful in propelling Spanish bonds gains above Germany as indicated by Bloomberg:

"Investors who held onto Spanish bonds this year as the price of the securities whipsawed amid the euro-area debt crisis stand to earn more than those who sought refuge in German bunds. The CHART OF THE DAY shows Spanish debt has handed investors a 4.2 percent return since Jan. 3, rebounding from an 8.7 percent loss in the period through July, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. German bunds, perceived as Europe’s safest sovereign debt, have earned 2.7 percent this year. The Iberian nation’s securities have surged since the European Central Bank said it will buy bonds." - source Bloomberg

Making us reminding ourselves part of the great poem from Charles Baudelaire which we have used in numerous conversations:
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

The most recent table of monthly purchases of sovereign debt is a clear indicator of the faith many investors have put in our "Generous Gambler" - source Bloomberg:

"Euro zone banks purchased an aggregate 33.3 billion euros of sovereign debt in September, following sales of 24.9 billion euros in the preceding two months as yields fell and gains were taken. The ECB commitment to do "whatever it takes" drove the Spanish 10-year yield down to 5.5% from August highs above 7%, and recent bank purchases reflect this new-found confidence." - source Bloomberg

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

Our generous gambler also argued the following: 
"OMTs will not lead to disguised financing of governments. All this is fully consistent with the Treaty’s prohibition on monetary financing. Moreover, they will focus on shorter maturities and leave room for market discipline."

But he also said the following:
"The ECB intervenes only in countries where the economy and public finances are on a sustainable path."

Our "Generous Gambler" is indeed kept on a tight leash for now, a German one that is, courtesy of the Banker's Algorithm.

Our "Banker's Algorithm" comes into play when you think about on-going Spanish deflationary vicious spiral given our computational reference which we touched again last week:

"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!
For Spain, it is "request denied" courtesy of the Bankers' algorithm."

Question being now, can Europe survive in the current form (number of countries) without making material sacrifices? One has to wonder...

By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner" of the last European summit in June (number 19...) we argued in our conversation "Europe - The Game of the Century". On the 18th of October, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:
"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Given the IMF has cut its euro-region growth forecast for 2013 from 0.7% to 0.2% with the European economy potentially shrinking by 0.4% in 2012 instead of the "projected" 0.1% by the ECB, in this week's conversation we will look at correlations and causation on our European ship given the increasing risks of "Mutiny on the Euro Bounty" in 2013 which we have been highlighting since April this year:
"As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth."

"Prosperity makes friends, adversity tries them." - Publilius Syrus

Unemployment figures in Germany which will be published next week and will be key. So will be economic data from Germany. In September 2011, in our conversation "Much ado about nothing" we argued:
"And given Merkel's big u-turn relating to the Japanese nuclear disaster in 2011, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, we would really follow closely the German economy in general and the German labour market in particular. "

There is indeed a growing rift between France and Germany in relation to the course that needs to be taken in relation to Europe due to a growing divergence in the political agenda for both France and Germany. We agree with the latest report from Nicolas Doisy - Politoscope number 10  from Cheuvreux which validates our recent analysis Merkel and our Banker's algorithm:
"Delaying the euro federal Big Bang again: the Franco-German “phoney war” (redux):
-While it should be starting, Europe's federal Big Bang is stalling again due to diverging political agendas in Germany and France with regard to the euro institutions. The disagreement is partly real (i.e. of substance) and partly fake (i.e. purely motivated by domestic politics) and likely to drag on for months… if not years.
 -Merkel has timed her agenda in 2013 with a view to the full monty (re-election and a euro to her liking) and thus intends to frame the debate to her advantage. To keep her options open, Merkel wants to have the final say on any decision regarding Spain and the euro: this is why she uses the federal agenda as a red herring.
-To secure her chances for re-election, Merkel needs to keep the Eurozone quiet during the coming year: this is why she has agreed to the ECB's OMT for Spain. For as long as she is leading the electoral polls, she is sure to keep both France and the SPD in check: this is why she is skilfully nurturing German anti-euro feelings.
-Hollande's options are limited, as he can only bank on the SPD or market pressure to break the deadlock: he thus also uses this debate to keep his own left in check. His only potential ace is to use next year's recession in the Eurozone to table his "growth" agenda again, so as to get a more lenient fiscal treatment by Germany. 
-All in all, this Franco-German divide over institutional options looks very likely to lead to a two-speed Eurozone as the periphery will continue entering its debt-deflation." - source Cheuvreux.

Moving on to France and the subject of when causation implies correlation, we noted from the same interesting note from Cheuvreux the following interesting correlation. Namely that Hollande's popularity is 100% correlated with the rise in unemployment since he has taken office: 5,000 more unemployed = 1% less popularity for Hollande, so that (theoretically), according to Cheuvreux's analysis, he should be ousted when unemployment reaches 3.2 million:

"Hollande's first option out of this diplomatic deadlock could be for the social democrats to win next year's election or the leadership of another Grand Coalition. However, after supporting France's stance very vocally on several occasions in the winter of 2011, the SPD has gone mute on the issue of Eurobonds in particular. This clearly is a sign that Merkel has so far won the battle of public opinion on the euro issue." - source Nicolas Doisy - Cheuvreux.

Following up on François Hollande's political strategy of hoping for the social democrats to win next year's election, we could not resist, (given our post title) but refer to "Mierscheid law"!
The Mierscheid law was a satirical forecast published in German magazine Vorwärts on 14 July 1983 which forecasted that the Social Democratic Party of Germany (SPD)'s share of popular based on the size of steel production in Western Germany: "The Vote share of the SPD equals the Index of the crude steel production in the western federal states - measured in millions of tonnes - in the year of the federal election".

"The last corroboration of the law was in the 2002 election, where the West German crude steel production was 38.6 million tonnes, and the vote share of the SPD 38.5%. For the early election in 2005 the vote share was 38.4%, with a mean crude steel value of 40.0 million tonnes. Over the last ten elections, the two values were within two units nine times, and within one unit seven times." - source Wikipedia

- source - the full Wiki.

With German confidence falling to the lowest level in more than two and half years and Europe's composite PMI falling to 45.8 from 46.1 in September, the IFO institute's business climate index unexpectedly dropped to 100.0 from 101.4 in September, indeed accelerated deleveraging and generalized austerity is increasing the causation of economic woes and the correlation with worsening economic outlook. We feel comfortable with our recent call of growing divergence between the growth differential between USA and Europe as indicated by the recent PMI.

We also believe that as economic woes weight on both Germany and France in 2013, so will increasing political rifts arise in the process. We do agree with Nicolas Doisy's take from Cheuvreux, namely that there is indeed a new "phoney war" evolving between both countries:
"This (peaceful) remake of the Franco-German phoney war obeys a purely political logic and forces the Eurozone to continue walking along the abyss for another year. Unfortunately, it can only add to the uncertainty surrounding the fate of the Eurozone by leaving deflationary Spain very much on the hook: there is no clear prospect of Eurobonds any time soon, be it to recapitalise Spanish banks or help Spain's government. Beyond, this phoney war could well turn into another "battle of Stalingrad" when the actual size of the Spanish problem is fully revealed, right after the German election (if not before). It is thus to be hoped that another Grand Coalition wins in Germany, as seems to be the preference of the German electorate. Such an outcome would have the advantage of creating the conditions of a de facto national unity government in Germany. In any event, this Franco-German great divide over institutional options looks very much apt at leading to a two-speed Eurozone of sorts in the not-so-distant future. Indeed, it appears clearly from this debate that the core issue is what to make of the periphery. This amounts to raising the question: (where and how) does the periphery belong in the Eurozone? While still implicit, this theme will surely rise to the front in near future." - source Cheuvreux - Nicolas Doisy

Indeed, what to make of the periphery in general and Spain in particular given the recent Spanish banks earnings which clearly indicate that Oliver Wyman's nightmare scenario could as well play out which therefore clearly justify the retention in the allocation process of our European Banker's algorithm?
Caixabank, the third biggest bank saw its profit fall 42% as it accelerated loss recognition tied up to real estate with 4.41 billion euros of provisions in the first nine months to fully cover the required 2.44 billion euros from the first RDL (Royal Decree Law) and 600 million of the 2.1 billion euros in charges needed from RDL2 passed in May. Bad loans jumped to 8.42% in September from 5.58% in June and 4.9% in December 2011.
It was a similar story for Spanish giant Santander, with third quarter profit felling 94% due to the necessary purge in real estate exposure needed with net income falling to 100 millions euros from 1.8 billion euro a year earlier. Bad loans as a proportion of total lending rose to 4.33% from 4.11% in June. The bad-loan ratio across the Spanish business climbed to 6.38% from 5.98% in June and 5.15% a year earlier.

The rise in bad loans are all a reflection of the rise from bad loans in the construction sector as reported by Bloomberg:

"September's Spanish stress test projected aggregate losses of 270 billion euros for the banks under its adverse scenario, with a 43% loss on real estate developers, identical to Santander's 3Q real estate non-performing loan ratio. Spain's construction and real estate bad debt topped 100 billion euros at 1H and may rise faster and further than stress estimates." - source Bloomberg

No wonder the Banker's algorithm is reluctant in allocating "resources". In that context, the bad bank SAREB which need to be in place by December, will have as much as 90 billion euros of asset based on their transfer price, initially comprising land, developer loans and residential units that went bad according to Bloomberg article "Spain Bad Bank Seen Too Big to Work With $117 Billion: Mortgages" by Sharon Smyth from the 25th of October.
"The Bank of Spain has yet to fix transfer valuations for the assets based on the stress tests of Spanish lenders carried out by management consultants Oliver Wyman and published on Sept. 28. The 90 billion euro number is based on transfer prices, so the original value of the assets is likely to be higher.
In comparison, Ireland’s National Asset Management Agency, set up in 2009, spent 32 billion euros on mortgages with a face value of 74 billion euros to cleanse its banking system.
Lenders that take state aid will have to transfer to the bad bank foreclosed property of more than 100,000 euros, real estate and builder loans of more than 250,000 euros and controlling stakes in property firms, according to the Economy Ministry official. A decree to regulate the entity should be passed on Nov. 16. It may be amplified in the future to include loans to consumers, small and medium enterprises and retail mortgages." - source Bloomberg.

In relation to Bankia, we argued in May 2012 in our conversation "The Tempest the following" with our good credit friend:
"A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The ECB is now pushing for inflicting losses on junior debtholders as reported by Emma Ross-Thomas, Esteban Duarte and Ben Sills from Bloomberg on October 25 - ECB is Said to Push Bankia Losses as Spain Purges Assets:
"The European Central Bank and European Commission want investors including preference shareholders to swap their securities for new shares to reduce the cost to the taxpayer, according to two people who asked not to be named because the discussions are private. Profit at Banco Santander SA, Spain’s biggest lender, slumped in the first nine months as it took a 14.5 billion-euro charge on real estate losses.
Confronting the toxic legacy of Spain’s 10-year building boom is imposing political costs on Prime Minister Mariano Rajoy as he faces a separatist challenge in Catalonia, protests on the streets of Madrid and a battle to avoid a full bailout." - source Bloomberg.

Back in our May conversation we indicated:
"Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted."

and we added:
"Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets."

When causation implies correlation...

Credit wise, for Spanish banks, the rise in the issuance for "Puttable bonds" is a cause for concern we think. Puttable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option. As reported by Bloomberg by Esteban Duarte and John Glover on the 25th of October in their article "Santander Seeks Salvation in Puttable Bonds":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg

Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag.

Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs (the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights

On a final note, looking at the our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), falling again towards 1.55% versus 5 year Germany Sovereign CDS which has cratered below 25 bps, by avoiding increasing so far Germany's liabilities, Chancellor Merkel has in effect alleviated concerns on Germany's exposure to European woes we think - source Bloomberg:

It's deflation (デフレ) in Europe.

"Correlation is not causation but it is sure a hint" - Edward Tufte - professor emeritus of political science, statistics and computer science at Yale University.

 Stay tuned!