Friday, 6 April 2012

Markets update - Credit - France's "Grand Illusion"

"Europe will become united through its money or not at all."
Jacques Rueff.

It was in 1950 that French economist Jacques Rueff, made this prophecy. In 1958, he was financial counselor to President De Gaulle and was instrumental in designing France's successful 1958 reforms. We think his prophecy is about to be put to the test, given the urgent need of structural reforms for France. Our reference to Rueff and 1958 is by no means "innocent", France's current economic situation is a reminder of the dire situation France was in 1958 which saw the return of Charles de Gaulle to power.
The 1958 plan:
"Fiscal policies were focused on revenue and spending in order to bring about budgetary equilibrium. On the revenue side, so-called “sin” taxes were increased, tax loopholes were closed, and tax evaders were punished. On the spending side, social security benefits were abolished, universal handouts were minimized, and industry subsidies were reduced or eliminated."

This week's rambling title has a double reference. First reference relates to Grand Illusion being arguably one of French cinema's masterpieces (ranked 35 in Empire Magazine's "The 100 Best Films Of World Cinema" in 2010). Second reference is of course linked to the insouciant attitude French politicians have had for too long in addressing the structural weaknesses plaguing the French economy. Like our friends at Rcube Global Macro Research, we think France is indeed facing its 1958 moment and regardless of the actual winner of the upcoming presidential election, France is about to face some "rude" awakening. We recently discussed Spain's structural issues at length (see our post "Spanish Denial") so we will not revisit the subject in details following recent price action in the Spanish government bond space and the weak  Spanish auction. After our usual credit overview, we will focus our attention on France's structural issues courtesy of our Global Macro friends at Rcube.

The Credit Indices Itraxx overview - Source Bloomberg:
Credit Indices on the back of the recent sell-off in Spanish Government bonds were wider on Thursday. In fact credit indices have seen their highest weekly increase since December 2016. The Itraxx Crossover 5 year CDS index (50 high yield names, High Yield risk indicator) touched 650 bps (50 bps wider in one week) whereas Financials across the board were wider as well, with Itraxx Financial Senior 5 year index (25 European Financial Institutions Senior Debt indicator) rose to 238 bps and Itraxx Financial Subordinate 5 year index was higher by 9 bps to around 386 bps (40 bps wider in one week). Previously we indicated that since the roll date of credit indices on the 20th of March, credit has been weakening as the LTRO 1 and LTRO 2 effects are fading.

Itraxx Crossover has been rising and Eurostoxx Volatility is rising - source Bloomberg:

"One has to ask oneself if the time has not come to start taking a few chips off the table", we argued in our previous credit conversation "Spanish Denial". Effectively, the "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) is leaning fast towards the lowest level reached in 2011, touching 1.80% in the morning before heading Thursday afternoon towards 1.74% - source Bloomberg:

The current European bond picture with the recent rise in Spanish and Italian yields following market reaction after the weak Spanish auction and growing concerns on Spain - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS rising to 53 bps above Italy, with both countries widening in synch for now - 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:
Liquidity issues have been addressed this quarter, courtesy of LTRO 1  and LTRO 2 by the ECB. The rally in credit since the beginning of the year has been truly impressive; in fact, it is the second best quarter for credit in terms of excess returns to German Bunds since 1999. High Yield also had  a year to date excess return of 14.6%. The 2011 turmoil was linked to the built up in liquidity issues (as indicated in our August 2011 conversation -"It's the liquidity stupid...and why it matters again..."), the outcome in 2012 will be based on the evolution of the macro picture - The ongoing divergence between US and European PMI indexes - source Bloomberg:

Following on our chosen weekly theme, namely France, our friend at Rcube have recently published a note entitled - France, The Next Weak Link.

"Dear country of my childhood
Rocked with tender insouciance
I've kept you in my heart"
Douce France (Sweet France) - Charles Trenet

Please find enclosed their analysis, courtesy of Rcube Global Macro Research with whom we share many views on this very "French" subject.

“The Economist’s” front cover this week was titled “France in denial”. We believe that investors are currently as much in denial as the French political class....
On the 2nd of April, final PMI for the month of March came in even weaker than the first estimate, which was already a shocker. (46.2 versus 47.6 47.6, the biggest decline in 33 months).
The worrying part is that the French inventory cycle is at its weakest. It is back to levels last seen in Q3 2008. New orders have plunged while inventories are now rising fast. As a result the important new orders minus inventories spread is falling. French corporates are seeing their order book shrink while their inventory levels are spiking, as a result, production will slow down in coming weeks and months.
- source Rcube Global Macro Research

This is exactly what the message has been historically. The inventory cycle indicator has a strong lead over the French PMI, current weakness implies a sub 40 headline reading at some point during the Summer. France will, as always, be on holiday at that time, investors on the contrary, should take the warning seriously.
- source Rcube Global Macro Research

We are re-iterating here again, that French GDP growth expectations are a total fantasy. Real GDP growth is expected at +0.30% for 2012. We believe reality will be far more negative. A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy.
- source Rcube Global Macro Research

Looking only at the central state revenue and spending (which don’t take into consideration all other off balance sheet debts, which are huge)...
- source Rcube Global Macro Research
...we can see that at the moment the French state is spending almost 35% more than it receives. This means that France finances less than 2/3rd of its spending’s with tax receipts, the balance being financed with debt.

- source Rcube Global Macro Research

As interest rates have plunged since the early 1980s, debt servicing costs have actually declined over the past 15 years (around 2% of GDP today vs. 3% in 1995) while the outstanding amount of debt has more than quadrupled! The effect of rising French borrowing costs will be a financial tsunami.

This economic non sense has, we think, reached its limit given the expectations we have on French GDP for the next 6/12mths. The journey from the mid 40s to the mid 30s for the French PMI will be painful, not only for French but also for global investors. France, we are afraid, is the real issue, more than Spain or Italy. As if this was not enough, the French non-financial corporate sector is also running its largest financing gap ever.
- source Rcube Global Macro Research

As we have proven in past research, bank lending behavior can be forecasted with a high degree of confidence with regard to the financing gap. To summarize, banks increase their willingness to lend when there is no (corporate) need to borrow and vice versa. Given we have more historical data for the US, the following charts are US based, but the relationship is exactly the same elsewhere.

The larger the financing needs, the less willing commercial banks become:
- source Rcube Global Macro Research - FED, Flow of Fund.

This is why lending standards are such a powerful leading indicator for credit spreads.
- source Rcube Global Macro Research

With the French corporate financing gap so high, it is highly likely that bank's lending standards will continue to be tightened in coming quarters. The risk of a credit crunch of epic proportion in France is now quite high. French corporate credit spreads will widen significantly. The following back test shows that when non-financial French corporate's financing needs are that large, forward equity returns become negative, and inversely, when they decrease, forward returns tend to rise:
- source Rcube Global Macro Research

In addition to our friends' thorough analysis on France's "insouciance", Credit Agricole CIB in their Economic Focus published on the 2nd of April wrote the following in relation to France:
"A mixed starting point in terms of macro and fiscal performance, and a formidable challenge ahead:
The upcoming French President will likely have to deal with stagnant economic activity at best (our forecasts point to 0.2% expansion in GDP this year, below the government’s assumption of +0.5%) but, more importantly, he will be faced with a number of major structural weaknesses that have never been fully addressed over the past decade.
The IMF and the OECD, in particular, have repeatedly urged France to undergo significant structural reforms to boost its growth potential and restore a sustainable equilibrium in its public finances if the country wants to keep its social welfare model alive in the future. More recently, a report published by the Think Tank Lisbon Council in November 2011, the ‘Euro Plus Monitor’, ranked France in 13th position in terms of overall economic health among the 17 EMU member states, just ahead of Italy but slightly behind Spain, adding that “alarm bells should be ringing for France” given its weak performance relative to Eurozone triple-A countries. In the meantime, S and P downgraded France’s sovereign rating indeed to AA+ on 13 January, with further rating actions possible given the negative outlook."

France's "Grand Illusion" - Credit Agricole in their note also added:
While not alone in that case, France has been living beyond its means for many years with the illusion that domestic demand could remain the only growth engine for ever. The French consumption-based economic model has its own advantages and it is not a problem in itself. In particular, French growth has proved to be less volatile than in other export countries like Germany in the past, mostly thanks to a steady growth rate in private consumption which has helped mitigate the impact of global recessions. The cumulated output loss in the recent ‘Great Recession’ has been far smaller in France (-3.9%) than in Germany (-6.8%) or in the Eurozone on average (-5.5%). However, in a new environment characterised by a strong pressure to deleverage both in private and public sectors alongside lower gains (if not contractions) in households’ purchasing power, France may have no choice but to reduce its private consumption trend growth in the coming years. The only near-term buffer we can see comes from a high savings ratio, but unless labour market conditions improve quickly households are unlikely to use their precautionary savings to boost spending significantly.

On a final note, we  completely disagree with Standard and Poor's latest note indicating that Europe should pull out of recession in late 2012:
"Apr 04 - Although the current recession in Europe will probably extend into the third quarter, we believe the economy may pick up modestly late this year and in 2013, said Standard and Poor's today in announcing the publication of its report "No Fast Lane Out Of Europe's Recession."

As we keep insisting on in every credit conversations, the ECB Lending Surveys are key GDP Growth Indicators - source Bloomberg:
"The ECB's survey of corporate loan demand has fallen significantly since late 2010. During the 2008 banking crisis, this survey proved a useful leading indicator (by two to three quarters) of the direction of GDP evolution. Should the relationship hold true, significant further GDP downgrades for the euro zone can be expected in the coming months." - source Bloomberg

"I have tried to lift France out of the mud. But she will return to her errors and vomitings. I cannot prevent the French from being French."
Charles de Gaulle

"It is the end. But of what? The end of France? No. The end of kings? Yes."
Victor Hugo

Stay Tuned!


  1. CA says ECB lending survey for corp loan demand is pointing down but rcube says corp loans are booming?

  2. On the contrary, Rcube, I believe, is saying credit conditions are tight, and inventory levels are high on the corporate level.

    To follow closely what is happing in terms of credit conditions in France both Rcube and ourselves look at the monthly reports published by the French association of corporate treasurers (AFTE -
    March report:

    On page 6 of the report mentioned, you will see the very significant differences between on short credit (below 1 year) and longer credit (above one 1 year).
    On page 7, the search for financing have somewhat slightly improved for French Treasurers in March over Frebruary, but remains very difficult for them as displayed.

    Hope this answer your question.




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