Tuesday 24 April 2012

Markets - Credit - The Charge of the Light Euro Brigade

Lord Cardigan: [returning from the charge] "Has anybody seen my regiment?"
The Charge of the Light Brigade - 1968 movie inspired from the real historical events.

Staying on the theme of military blunders, we thought this time around we would venture towards the infamous Charge of the Light Brigade, a charge of the British cavalry led by Lord Cardigan against Russian forces during the Battle of Balaclava on 25 October 1854 in the Crimean War. The charge was the result of a miscommunication in such a way that the brigade attempted a much more difficult objective than intended by the overall commander Lord Raglan.  The charge was aimed at the wrong target leading to the near annihilation of the Light Brigade. Previously we discussed in our conversation "A Deficit Target Too Far" how overly ambitious were the budget deficits targets set up by European leaders.
Looking at the lackluster European PMI figures recently released, we thought this title would therefore be more than an appropriate analogy. While the historical charge produced no decisive gains and resulted in very high casualties, the austerity measures imposed to the peripheral countries are pushing them towards a deflationary spiral, with high economic casualties in the process and rising unemployment.

The divergence between US and European PMI indexes has been increasing to the widest difference since 2008 - source Bloomberg:

This divergence can as well be seen in the perception of credit risk for Investment Grade. There is a growing divergence between the CDX IG 5 year CDS index and the European Itraxx Main Europe CDS 5 year index (125 Investment Grade entities), reaching a spread difference of 48 bps and steadily rising towards the highest point reached of 64 bps in September 2011:
This difference in investment grade credit is as well significant between core European countries and Peripheral countries, reflecting the correlation with Sovereign risk.

As indicated by Jonathan Tyce from Bloomberg:
"Pressure to deliver on austerity measures increased as the Eurogroup and IMF boosted war chests. While the euro zone budget deficit fell to 4.1% (from 6.2%) in 2011 as austerity measures took hold, gearing is rising, with debt-to-GDP two points higher at 87.2%. Should sovereign fears overwhelm, gearing concerns may outweigh the benefits of austerity."
Austerity measures announced - "The Charge of the Light Euro Brigade"- source Bloomberg:
When it comes to Spanish bad debts at 18 years high, it is still tracking unemployment - Source Bloomberg:
"Spanish banking system bad debt reached an eighteen-year high in February with doubtful loans now exceeding 140 billion euros. ECB data show total capital and reserves of Spanish monetary financial institutions at 380 billion euros in February, 100 billion higher yoy. As bad debt rises, concerns will increase that a larger capital cushion will be required." - source Bloomberg.

CreditSights in their recent Euro Financial Movers report from the 22nd of April indicated the following in relation to Spanish Banks:
"Spanish banks are increasingly coming under the microscope. NPLs are rising, sovereign risk indicators are deteriorating again, and CaixaBank's 1Q12 results were hit hard by real estate provisions.
One way or another, Spain was the driver of news in the European banking sector last week as concerns over the country's finances intensified. New data from the Bank of Spain on doubtful loans statistics showed that non performing loans for the banking system rose to 9.2% in February, more than doubling on a yearly basis, another indicator of how fragile the system is. Meanwhile, latest statistics showed that Spanish banks increased their holdings of Spanish government bonds by €41 bln between the end of November 2011 and the end of January 2012, on the back of the 3-year LTRO. This increase in government bonds holdings by domestic banks in both Spain and Italy coincided with a dramatic decline in the foreign holdings of those two countries' government bonds. BBVA (-2%) had gross sovereign exposure to Spain of €56.5 bln at end-2011, of which around half was direct exposure to local authorities and half was in sovereign bonds. However, despite the latest ECB data, the bank tells us there is unlikely to be a huge change in this figure when it reports its 1Q12 results on 25 April (see below). In its FY11 conference call, Santander (-2%) disclosed that it had a net sovereign exposure to Spain of around €25-€30 bln, later confirmed to be towards the lower end of this range."

The current European bond picture with the recent rise in Spanish and Italian yields  - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS falling to 35 bps above Italy, with both countries widening in synch for now - source Bloomberg:

In another recent note, CreditSights made the following key points relating to the ongoing recycling process of ECB reserves in Italy and Spain:
"-The ECB’s provisions of liquidity to Italian and Spanish banks has partly been used by those banks to increase their holdings of domestic government bonds
-Spanish and Italian banks have increased their holdings by 41 billion euro and 19 billion euro between the end of November and the end of January following the first three year LTRO. That increase in holdings by domestic banks has coincided with a dramatic decline in foreign holdings of those two countries’ government bonds. The result is an increase in concentration of government bond holdings within those two countries banks.
-The repayment of a government bond sees the holders receiving deposits with their domestic central bank as a payment; i.e central bank reserve. Given that Italian and Spanish banks have so far proved willing to buy government bonds with any excess reserves, then if they are increasingly the holder of those bonds then they may continue to be willing to recycle any reserves they receive back into government bonds.
-That means that funding the interest-expense component of the budget deficit and refinancing any maturities may have been made easier as a result of an increasing proportion of government bonds now being held by domestic banks.
-And given that Italy’s budget deficit is entirely the product of needing to fund the government interest expense, that concentration of risk may favour Italy versus Spain which has a substantial primary budget deficit to fund."
We agree with CreditSights, namely that from a pure budget deficit point of view, Italy appears to us in a more favorable situation than Spain, validating therefore our more negative stance on the latter.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) is still pointing towards the lowest level reached in 2011- source Bloomberg:
We previously saw a spike in Germany's sovereign CDS back on the 29th of November 2011 ("The Eye of The storm"), prior to the German "failed" auction which lead to a significant widening of the German Bund yield above 2.30%, when Germany's sovereign 5 year CDS went above the 100 bps level.

Moving back to the "Charge of the Light Euro Brigade" towards austerity, as recession and the debt crisis worsen, according to Citigroup and as reported by Bloomberg article from Lorenzo Totaro from the 19th of April, peripheral countries face additional downgrades, in this deflationary spiral:
"Spain and Italy will be downgraded by Moody’s Investors Service and Standard and Poor’s this year as the recession and debt crisis worsen, economists and strategists at Citigroup Inc. said.
Their credit ratings, along with those of Ireland and Portugal, will be lowered at least one level over the next two to three quarters, Citigroup said in a report published late yesterday. “Deficits will overshoot official forecasts in all the peripheral Economic Monetary Union countries this year and in 2013,” according to the report.
“Spain will need to enter some form of a Troika program” this year, Citigroup economists including London-based Juergen Michels wrote, referring to the aid package for Greece monitored by the European Union, the European Central Bank and the International Monetary Fund. Prime Minister Mariano Rajoy has repeatedly said that Spain won’t need a bailout."
Indeed, as we argued recently in our conversation "A Deficit Target Too Far", similar to Operation Market Garden of September 1944 as per our rambling, the targets are undoubtedly overly ambitious.

In relation to potential rating dowgrades, both Italy and Spain were put on negative watch on February 13, when Moody's downgraded six European countries (Italy from A3 to A2 and Spain to A3 from A1). Moody's move closely followed Standard and Poor's ratings cut for 9 European countries.

From the same article, Citigroup is expecting the following in relation to ratings action:
"By year-end, Italy may be downgraded one level to BBB by S and P and to Baa1 by Moody’s, as the economy probably shrinks more than the government’s forecasted contraction of 1.2 percent for 2012, the Citigroup analysts said. “The falling public support for Monti in opinion polls suggests that the government will have increasing difficulties in going ahead with the implementation of structural reforms,” according to the report. Over the next two to three years, “we expect Italy’s rating by S and P to go down by two notches in total and to settle at BBB- and its Moody’s rating to go down by three notches to settle at Baa3.”

While Lord Cardigan's nearly annihilated Light Brigade (following their fateful charge of Russian artillery guns) were rescued by the French light cavalry, the Chasseurs d'Afrique (they cleared the Fedyukhin Heights to ensure the Light Brigade would not be hit by fire from that flank and later provided cover for the remaining elements), despite the headlines of a USD 430 billion additional funding for the IMF, as Nomura put it in their  recent report (EM to the rescue? Not quite yet), the additional resources available upfront will likely be smaller meaning no meaningful cavalry to rescue our Light Euro Brigade:
"However, of the USD434.3bn committed we think only some USD95.3bn is what one might call ‘real’ and new contributions from non-eurozone countries that are available up front. They include Japan (which is recommitting USD50bn that was already available to the IMF, but was due to be returned, and an additional, new USD10bn). USD200bn is then ‘recycled’ eurozone commitments that cannot be made available to the EFSF or ESM, but which member states are happy to commit to the IMF. This brings the total new funds available to USD295.3bn.
Some Asian countries have promised money (such as Indonesia, Malaysia and Thailand), but they are consulting locally and the amount may only total around USD20bn between them. The Czech Republic has also committed USD2.0bn, but is awaiting a guarantee agreement between its central bank and the government for any potential losses.
On top of this is an additional USD72.0bn from the BRICS. However, this money is dependent on progress on quota reform at the June G20 meeting. There has been no indication of the different contributions between the countries for this amount. As such, as with previous meetings of the BRICS or G20, up-front commitment is still unclear. Similarly, USD15.0bn from the UK that will be subject to IMF quota reforms is being ratified."

And Nomura to conclude their note:
"So, overall the view six months ago that EMs could save the day has hardly come to fruition yet, with difficult progression on quotas required and very few committing money up front. Other developed countries remain dominant in size and number.
In our view, EMs will want to ensure that the IMF retains its original mandate of helping sovereign countries with balance of payments problems by pushing for meaningful reforms through conditionality. There is already much concern in the IMF about the distraction of the eurozone from the plight of many EMs globally. The recent World Economic Outlook and its fiscal and financial cousins highlighted the issues for many of the EMs (in particular deleveraging) so the risks are well known. EMs also remain divided overall on global monetary system reforms and on pushing a joint front on IFIs as demonstrated by the leadership ‘contest’ for the new World Bank President. Unlike with the IMF leadership succession, there was a very credible candidate available for the World Bank in Ngozi Okonjo-Iweala, yet the BRICS failed to join together to support her. Perhaps on IMF funding issues it is easier for the current stance by EMs as the US has not already contributed. That may mean that any progress in EMs providing backstop facilities to the eurozone will remain slow at best, and fail to materialise at worst."
Oh dear...

On a final note, in relation to the results from the first round of the presidential election in France, we were not surprise by the score of Marine Le Pen's National Front. It was not a Black Swan. It was indeed well expected. Economic crisis lead to rise in populism throughout history.
France’s Lead in Asylum Seekers Boosts Le Pen: Chart of the Day - source Bloomberg:
"The CHART OF THE DAY shows that under President Nicolas Sarkozy, France received 6.1 applicants for every $1 of gross domestic product per capita. The U.S. placed second with 5.9, followed by Germany at 4.4, Turkey at 4.1 and the U.K. at 4, according to data from the Office of the United Nations High Commissioner for Refugees." - source Bloomberg

In July 2010 in our conversation - "I promise to pay the bearer on demand...- Panics and Populism", we argued the following:
"Populism movements are deeply correlated to Panics and Depression throughout human history.
The emergence of the Tea Party movement in the US in 2009 is reminiscent of the rise of the Greenback Party, which was active between 1874 and 1884, following the US civil war. The Greenback Party was born because of the Great Depression of 1873."
We would add that the same process of rise in populist movements and extremism happened in Europe in the 1930s.

We also argued:
"The over expansion of credit and loosening of credit standards seem to always led us to economic crisis.
The panic of 1873 was followed by a similar panic in 1893 in the US.
Similar to 1873, the crisis was caused by railroad overbuilding and unsound railroad financing which led to a series of bank failures. Compounding market overbuilding and a railroad bubble was a run on the gold supply and a policy of using both gold and silver metals as a peg for the US Dollar value. Until the Great Depression, the Panic of '93 was the worst depression the United States had ever experienced.
The market overbuilding and the real estate bubble led to the financial crisis of 2007 which started with subprime."

"Those who cannot remember the past are condemned to repeat it."
George Santayana (16 December 1863 – 26 September 1952)

Stay Tuned!

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