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!

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