Sunday, 28 July 2013

Credit - Cloud Nine

cloud nine: "A state of happiness, elation or bliss".

Following up from our previous conversation where we made a previous "meteorology" veiled reference in our chosen title, looking at the "improved" European data and markets in conjunction with the European weather, we thought we would continue with this line of referencing in this week's conversation.

For now, in Europe, looks like there is indeed a state of elation or "Cloud Nine", at least in the credit space. There is some form of normalization in spreads, having seen this week the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds, tightening by 5 bps in the cash market to 153 bps, also with High Yield debt issuance surging again, signaling the busiest July on record from an issuance perspective as reported by Bloomberg with the average yield investors demand to hold junk bonds falling 42 basis points so far this month to 5.68 percent, near the lowest in seven weeks, Bank of America Merrill Lynch index data show.

Indeed, the credit markets are back into "Cloud Nine" following the devastation from May and June thanks to the QE tapering bomb, which we previously nicknamed the "Daisy Cutter". 

No doubt the latest PMI releases point to some form of stabilization or respite for the time being in the European space as indicated by the improving PMI data.

US PMI versus Europe PMI from 2008 onwards. Graph - source Bloomberg:
But stabilization, doesn't equate expansion, and while the latest European PMI read has scrapped back just above the 50 line, this near term comfort or "cloud nine" moment, is only a respite given nothing has really materially change in the European space. 

So in this week's conversation we would like to focus our attention again on the elusive credit growth plaguing European economies due to encumbered European banks balance sheet with legacy assets as well as why we think it is in the interest of the US to start normalizing rates, therefore tapering.

The elusive credit growth:
Yes, we hate sounding like a broken record but Europe in our views is still a story of broken credit transmission to the real economy. 

On that point we agree with Bank of America Merrill Lynch's take on the Europe story so far from their note from the 9th of July entitled "European banks: it's tough out there":
"Not enough credit in the system
What Europe is struggling with is a lack of lending. This is in different countries driven by a fear of new regulation; a need to bring funding structures into line with new expectations; provisioning shortfalls; or new business margins being unattractive. Obvious undercapitalisation is rare; indeed, it has almost been driven underground. But there is no point regulators tightening the rules overall if
they are not universally applied. They will not achieve what is sought. The AQR* is an opportunity – already being applied in an unnecessarily leisurely fashion – to finally get ahead.
2013 – or perhaps 2014 as well
With it, 2013 is a lost year for lending. If it is not rigorous enough, 2014 will be lost too. It seems difficult to imagine that the political agenda will last that long." - source Bank of America Merrill Lynch

*AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase. 

Should the AQR indicate a shortfall in capital, then there is potential for bail-in rules to be applied as indicated by Bank of America Merrill Lynch's note:
"Bail-in would be painful but would position Spain for sustained recovery 
Should the AQR indicate a shortfall in capital, we believe it may be that the EU’s proposed bail-in rules would need to be applied. With many Spanish banks having run down subordinated debt through exchanges over recent years and having very limited amounts of senior debt outstanding after years of difficult funding markets, the risk of depositor bail-in could rapidly loom large.
The challenge in potentially bailing in banks that were declared well capitalised by the current authorities would in our view be a political challenge of significant proportion. However, we see it as likely to be necessary if the aim is to build a banking system that will lend to solvent borrowers at reasonable prices. We do not believe that even the major Spanish banks are well positioned to do this at present, with high loan to deposit ratios, or their capital tied up overseas or in equity holdings.
We believe that the price would be worth paying, as a banking system that had truly put all its legacy issues behind it would be best placed to restart lending, which would avoid the creation of new bad debts through weak economic performance and unnecessary company and individual bankruptcies. We discuss recent meetings in Spain and our conclusion that credit withdrawal from the economy is likely to be ongoing later in this report." - source Bank of America Merrill Lynch.

We agree with Bank of America's take, namely that until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending. 

So while credit markets are basking in "cloud nine" as displayed by the recovery in spreads over this week and the re-opening of the issuance market, the latest lending survey data coming out of the ECB point to much different picture as indicated by Jeff Black in Bloomberg on the 25th of July in his article "ECB Says Bank Loans to Private Sector Shrink Most on Record":
"Lending to companies and households in the 17-member euro area fell the most on record in June in a sign the region is still struggling to shake off its longest-ever recession.
Loans to the private sector dropped 1.6 percent from a year earlier, the Frankfurt-based European Central Bank said today. That’s the 14th monthly decline and the biggest since the start of the single currency in 1999.
“The weak economy is still weighing on demand for loans and the ECB needs to figure out how to support that,” said Annalisa Piazza, a fixed-income analyst at Newedge Group in London. “There are still substantial reasons for the ECB to maintain the current accommodative stance.” 
ECB President Mario Draghi pledged last month to keep interest rates low for an extended period of time amid a subdued economic outlook and “weaker and weaker” credit flows. While euro-area banks loosened credit standards for loans to consumers in the three months ended June for the first time since the end of 2007, they continued to tighten them for corporate and home loans, an ECB report showed yesterday.
The rate of growth in M3 money supply, which the ECB uses as an indicator for future inflation, fell to 2.3 percent in June from 2.9 percent in May, according to today’s data. That’s below all 30 estimates in a Bloomberg survey of economists.
M3 grew 2.8 percent in past three months from the same period a year earlier. M3 is the broadest gauge of money supply and includes cash in circulation, some forms of savings and money-market holdings." - source Bloomberg

No loan, no growth, no growth, no reduction of budget deficits.

Is lending going to improve in Europe going forward?

We do not believe it will and so does Bank of America Merrill Lynch in their 9th of July paper on European banks:
"While funding markets are open, high debt costs compared with realisable margins on new business mean that banks have made little use of the term markets. With all the pressures from regulators to fund more conservatively, a lack of term issuance has to be in our view a lead indicator of further balance sheet shrinkage. Without a significant change in new business spreads which remains elusive (Chart 20), we believe that banks will be shrinking across the euro area for some time to come. This will naturally be deflationary for the economy.
Is it going to be possible to get around the banks and provide credit to the economy through other channels? We believe not. - source Bank of America Merrill Lynch.

Last week we made the following point:
While the ECB has recently tweaked its collateral framework as additional policy support, as part of the intent towards re-launching the ABS market to improve SME funding conditions, we think it is too little, too late and that the credit transmission mechanism has been broken in Europe, leading to a surge in bankruptcies as well as unemployment.

The credit transmission mechanism channel is broken as indicated by Bank of America Merrill Lynch graph depicting euro area loans to the private sector adjusted for sales and securitization:
"Schemes to kick-start securitisation of small business loans will in our view struggle to gain traction. Given high levels of non-performing loans in the SME sector, a government-backed or ECB “first loss” piece would likely have to be over 20% of the principal extended, a figure too high for northern European support to be forthcoming." - source Bank of America Merrill Lynch.

Encumbered European banks balance sheet with legacy assets:
Problems on European banks balance sheet, not only have not gone away but in some cases have yet to peak, so while credit markets are enjoying a "cloud nine" respite, the deleveraging of European banks balance sheet has much further to go as displayed by Bank of America Merrill Lynch's graph depicting the list of potentially troubled credit ranging from  13% of loans on banks' books to 40% in Ireland:
"On this basis, all the southern economies have double-digit proportions of their balance sheets in need of close attention. Given ongoing economic weakness in the region, we believe this will tend to create pressure on banks to shrink, in order to conserve capital ratios." - source Bank of America Merrill Lynch.

Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments as per Bank of America Merrill Lynch's graph below:
"Foreign ownership of the debt has stabilised but YTD has risen only marginally. Spanish banks have taken up the majority of the increase in recent months, continuing a trend since 2008 (Chart 28).
In addition, regions and municipalities have taken significant amounts of loans from the banks, as have the various funds set up to pay off arrears accumulated by parts of government. These collectively saw banks’ exposures to government rise by a further €20 billion in 2012; more lies ahead in our view.
Crowding out is likely to continue, for two reasons. First, the pretax margin available in taking government exposure is potentially equivalent to, or above, that of lending because there is almost no marginal cost, credit losses are likely assumed to be zero. Furthermore, a government bond position can be repo funded with a 5% or less haircut even for longer dated exposures. This is a fraction of the discount required to repo fund mortgage or SME exposures, even when such finance is available.
Leverage ratios may bind here too
The trade off between loans and government exposures is also set to be intensified with the introduction of leverage ratios. The zero risk weighting of government bonds made them 'free' from a capital perspective, but a 3% leverage constraint implies an equivalent 30% risk weight based on a target common equity tier. One ratio of 10%. based on the proposed 8% of liabilities bail-in requirement, the effective risk weight would likely be higher."  - source Bank of America Merrill Lynch.

Where we disagree with Bank of America Merrill Lynch's recent note is on their take about the recent improvement in the Macro Data in Europe which according to them could lead to potential increase in credit demand. We do agree though that banks are a leveraged play on recovering economy (so far US banks have outperformed both equity wise and credit wise):
"Macro data in Europe has been, at least, less bad in recent months. Banks are, always and everywhere, leveraged macro plays. This predisposes us to be more positive on the European banking system. Better GDP improves potential credit demand and drives higher asset prices, a key contributor to bad debt charges.
However, better GDP is a necessary but not sufficient condition for a more positive view. There remain several constraints :
- Legacy assets. We believe these are likely to be dominant issues for many banks in Spain and Portugal. The past is not yet behind them
- Non-performing loan generation has been elevated recently in Italy and Spain. While the pace should slow with sustained GDP recovery, provision coverage has lagged new NPL formation, suggesting that more recent problem loans will also need to be addressed
- Returns are not sufficiently high to encourage banks to grow."  - source Bank of America Merrill Lynch.

So far the ECB has limited the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields staying around the 1.60% level at 1.64% and French yields now around 2.25% slightly higher from last week - source Bloomberg:
But how long can the summer lull last?

Probably until the fall, where there is a significant possibility of seeing renewed political risk in conjunction with austerity fatigue. On that note we agree with Nomura's take from the 25th of July from their geopolitics not entitled "Red October":
"- In contrast to 2012, markets have been barely troubled by political risk this year, with the focus very much on the fundamentals and, latterly, the Federal Reserve together with monetary tightening in China.
- However, the autumn (or "fall", as the Americans would have it) may see politics-related risk rising in several geographies, notably the eurozone but also East Asia, the Middle East and the US.
- Although we see a systemic event as a tail risk, we still think that politics has the potential to move markets non-negligibly in the coming weeks, with October currently looking particularly risky." - source Nomura

While the summer lull and "cloud nine" seems to be prevailing, as we argued last week, in conjunction with our friends from Rcube latest call on global weakening earnings momentum, there are significant indicators that are starting to flash warning signs, at least credit wise we think from a European perspective as like anyone else we look at PMIs in Europe but we prefer to focus on credit availability and financing conditions.

First, Europe's largest engineering company Siemens has cuts its profitability forecast amid market slowdown and won't achieve its 2014 margin target of at least 12%, leading for an early exit of its CEO Peter Löscher.

Second, one particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. As indicated in our conversation "The European crisis: The Greatest Show on Earth", :
"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."

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 12th of July points to a deterioration in the Terms of Payments:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?
Delays in "Terms of Payment" as indicated in their July survey have been reporting an increase by corporate treasurers. Overall +27.6% of corporate treasurers reported an increase compared to the previous month, a clear deterioration in the trend. The record in 2008 was 40%.

On top of that French treasurers are clearly indicating in the latest report a deterioration in their operating cash flow position in the latest AFTE report:
The monthly question asked to French Corporate Treasurers is as follows:
How do you assess the current situation of the operating cash flow of your business:
easy, normal or difficult?

A deterioration that does not bode well for France's level of unemployment which should continue to rise given a deterioration of operating cash flows could lead to a rise in the number of bankruptcies in France which continue to rise as per the below graph from Natixis:

So we recommend continuing to monitor closely the French corporate treasurers' survey in the coming months.

Moving on to the subject of why we think it is in the interest of the US to start normalizing rates, therefore tapering, we have long argued that we have more issue with ZIRP policies than QE.

Let us explain.

If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2.

The only way the Fed can start raising interest rate is by first starting its "tapering" dance (following its "twist"...). To do that you need to contract the monetary base first, which is not trivial to say the least.

Looking at the recent bout of volatility with the ML MOVE index jumping from early May from 48 bps to a record 117 bps in a couple of weeks which crushed the fixed income space, it will not be an easy exit for sure - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

On a final note, we recently took the liberty of plotting not only the rise of the S&P index (blue) versus NYSE Margin debt (red) but we also added S&P EBITDA growth (yellow) as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:
The much vaunted stability courtesy of Bernanke's wealth effect looks to us increasingly unstable.

Sometimes when we look at the chosen path taken by our central bankers, thinking they can "print" their way out of trouble and the pernicious destructive effects ZIRP policies have on capitalism (lack of a price for capital therefore it cannot be "efficiently" deployed but only mis-allocated) and labor, we sometimes feel like Zweig must have felt in Petropolis...
Oh well...

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself."  
Stefan Zweig (1881-1942)

Stay tuned!

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