Monday 14 July 2014

Credit - The European Polyneuropathy

"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies." - Groucho Marx

Following up on our June conversation "Deus Deceptor" where we indicated our deep concerns relating to France's economic situation, we think it is time for us to revisit our negative stance on France. On a side note we share Charles Gave from Gavekal latest views on this very "French" subject. Given it is the 14th of July and France's national day, it is time, we think to look at the growing evidence of a slowdown and turmoil brewing in the quarters ahead.

In relation to our chosen title, with problems brewing at the core of Europe, in France in particular, and continuity in banking woes in the periphery, we thought our title should reflect the continuation of European woes using a medical analogy such as "Polyneuropathy" which is a damage or disease affecting peripheral nerves, which can be acute or chronic, but we ramble again...

In this week's conversation we will discuss France in general and peripheral European banking woes in particular. (we already discussed France in 2012 in our conversation "France's Grand Illusion").

As we posited back in June on our main subject France:
The story for  the remainder of 2014 in Europe is still France:
This is what we argued in January 2013 and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress

France should be seen as the new barometer for Euro Risk. With Industrial Production at -3.7% (implying a negative GDP print, see below), the French government is seriously in denial when it comes to growth assumptions: 1% in 2014 (down from 1.2%) and 2% in 2015 is way over optimistic we think. 

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 48.2 for Services PMI is indicating contraction (the lowest level reached in February 2009  was at 40.2).

France appears to us as the weakest link if we take for example World Manufacturing PMI (50 = no change on prior month) as an illustration of the troubles brewing ahead as illustrated by our friends from Rcube Global Asset Management with France standing clearly at the bottom:

Another worrying trend illustrated by our friends at Rcube Global Asset Management lies in the growing financing gap between France versus Europe:
Or one could also look at the Corporate Financing Gap as a percentage of GDP in various European countries as displayed by Rcube Global Asset Management:
"Investment will keep plunging since French corporates' debt to value added ratio is so high. Furthermore, the French corporate financing gap is massive (as per above chart). It means that French companies' financing needs are extremely high, not only historically, but also compared to other countries in both Europe and the rest of the world. With France in such a difficult situation, the ECB will be under increased pressure to join the WE club

Corporate margins are thus decreasing, and are the weakest in Europe:

The high corporate debt to added value ratio suggest also that investment will soon turn negative

The French housing sector looks also mispriced compared to the rest of core EU:

We would like to add some more illustrations on France being the weakest link in Core Europe.

The recent evolutions of European house prices in some European countries seem to illustrate the start of a weakness in French real estate prices - graph source Bloomberg:
In blue: France
In red: United Kingdom
In yellow: Spain

Also, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - graph source Bloomberg:
An industrial production at -3.3% equals zero growth. With industrial production at -3.7% you can expect a negative GDP print for France.

As we argued back in June:
"If the Services PMI contracts, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can do that well as long when they are entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will continue to linger.

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."

We have also plotted France Consumer Confidence against GDP and the evolution of the French government debt to GDP (inverted) - graph source Bloomberg:
Deteriorating Debt to GDP level rising while French Consumer Confidence Indicator sliding, it doesn't bode well for growth and unemployment levels.

On numerous occasions we have discussed France and our growing concerns such as in our conversation "In the doldrums" where we touched the subject surrounding credit-less recoveries:
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 another conversation "Squaring the Circle" 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." - Macronomics

The reasons 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

On the topic of France and the "overvalued"  Euro, French Industry Minister Arnaud Montebourg has most recently validated our Groucho Marx quote from above as indicated by his latest staunch attack on the ECB as reported by Mark Deen and Helene Fouquet on their July 10 article in Bloomberg entitled "France's Montebourg Hits Out at ECB in Campaign-Style Speech":
French Industry Minister Arnaud Montebourg hit out at the European Central Bank, calling on it to buy bonds and weaken the euro in order to boost growth.
“We have the most depressed region in the world with a currency that has appreciated the most globally and a European Central Bank that has not respected its mandate,” Montebourg told an audience of executives in Paris, citing the risk of deflation. “No one should leave the economy in the hands of moralists and accountants.”
The remarks were made against the backdrop of a screen reading “economic patriotism” and “fight for growth” in a packed and darkened room that resembled Montebourg’s campaign meetings in the Socialist primaries of 2011 in which he placed third. He pledged to run again after his defeat to Francois Hollande. France’s next presidential election is due in 2017.
With a French economy that has barely grown in two years and euro-area inflation that remains at less than half the ECB’s target level, Montebourg is taking aim at policies that he says are letting France and Europe behind the rest of the world. “Growth is a political problem that will be achieved through political action,” he said. “To allow unemployment to remain high is to help the National Front and destroy Europe.” The National Front, which led the European parliamentary elections in France, is an anti-euro, anti-immigration party. “I only have one enemy; it’s conformism,” Montebourg said. Conformism “is not a candidate, it is ruling” the country, he said.
Hollande’s approval rating at less than 20 percent is at a record low for a French president" - source Bloomberg

From our conversation  "Squaring the Circle" here is the simple answer to Arnaud Montebourg's euro concerns in a very self-explanatory diagram:
As pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:
"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance. - Martin Sibileau
Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

As a reminder from our previous conversation  "Squaring the Circle":
As a side note and in relation to the EU private sector seeking USD funding as displayed in Martin's chart above, in 2012 over a third of the US Investment Grade supply (net issuance in $430 billions) was from non-US issuers up from 25% in 2011. In 2013 we have seen about a third of the new issuance from non-domestic issuers (estimated net issuance for 2013 $400 billions).

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have increasingly diverged as displayed in the below Bloomberg chart:
But it looks to us that what the market is pricing indeed is a trigger at some point of QE in Europe because when it comes to the European Polyneuropathy, we think our friend's Martin Sibileau's above diagram depicts clearly the situation particularly when ones take into account that a huge amount of euro denominated assets remain to be sold. For instance, Société Générale reported on the 7th of July reported in a specific report on European banks entitled "Rise of the "zombie" assets", non-core banking represents a €1.5 trillion industry:
"Non-core banking: A €1.5trn industry 
European banks have become highly skilled in separating off the unwanted, the unsellable, and the unexplainable. Across our coverage, there is now €1.5trn of non-core banking balance sheet, consuming €80bn of tangible equity. These operations have had a major impact on profitability, dragging a full 4ppts off sector ROTE in 2013. Cleaning up the non-core will have a major bearing on when profitability will creep higher for the sector, in our view.
The major operations 
Five banks account for €1trn of the non-core balance sheet currently. This is where we believe restructuring the “bad parts” of the book has the most potential to drive profitability higher. These banks are UBS, Barclays, CBK, ING, and UCG. We are seeing progress, with ING recently completing the NN Group IPO and CBK disposing of a block of assets.
Raising the bid for “bad” assets 
We believe that the combination of ECB liquidity, lower funding costs, and improving confidence should raise the level of attractiveness for noncore operations. We have seen more robust financials IPO deal flow, and decent returns for distressed debt funds. This should help banks to run down the “bad”, and focus on the
Further assets could become non-strategic 
We expect restructuring and consolidation to become a major theme for European banks after the AQR. This could bring further operations into question, particularly if the disposal process becomes easier (or even profitable). There is the potential for further restructuring at CS (CIB), DBK, and UCG (CEE)." - source Société Générale.

We can also point out that European banks need to sell another $795 billion worth of property assets as reported by Bloomberg by Neil Callanan and Patrick Gower on the 14th of July in their article entitled "European Banks needs $795 billion Problem Property Loan Solution":
"European banks and asset managers plan to sell or restructure 584 billion euros ($795 billion) of riskier real estate as they try to clean up their balance sheets, Cushman & Wakefield Inc. said.
The region’s lenders, asset managers and bad banks, such as Spain’s Sareb, sold 40.9 billion euros of loans tied to property in the first six months, 611 percent more than a year earlier, the New York-based broker said in a report today. Transactions including foreclosure sales will reach a record 60 billion euros this year, Cushman & Wakefield estimates.
Lenders such as Royal Bank of Scotland Plc are accelerating loan-portfolio sales as borrowing costs fall from a year ago and economic sentiment improves. Lone Star Funds and Cerberus Capital Management LP are among U.S. investors that are taking advantage as sellers opt to offer bigger groups of loans, making it more difficult for smaller firms to make purchases, Cushman & Wakefield said." - source Bloomberg

As we have argued in our conversation "Mutiny on the Euro Bounty" in April 2012:
"More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship..."

Unless of course Mario Draghi goes for the nuclear option, Quantitative Easing, that is.

And as indicated by Martin Sibileau from his note from the 17th of October "The EU must not recapitalize banks":
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

Of course it is! QE being the only card left but we have our doubt Germany will agree to play that card.

Moving on to the subject of lowering value of European peripheral banks liabilities generating further losses to same banks, needing more capital, the Banco Espirito Santo is a clear illustration once more of the above diagram. 
We already touched at length in our past credit conversations on the liability exercise management taken by many weaker peripheral banks in relation to raising capital to reach the 9% Core Tier 1 Capital target set up by the European Banking Association for June 2012 (see our conversations, "Peripheral Banks, Kneecap Recap", "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

In fact in our conversation "Peripheral Banks, Kneecap Recap", Banco Espirito Santo was prominently featured given October 18 2011 Banco Espirito Santo had announced a capital increase in effect via its bond tender which meant at the time a 83.5% dilution for shareholders. This was followed by another capital increase of 1 billion euro announced mid-April, to be completed by early May (see our conversation "All Quiet on the Western Front").

We argued at the time:
"We believe additional debt to equity swaps will have to happen for weaker peripheral banks, similar to what we witnessed with Banco Espirito Santo in October 2011, as well as for German bank Commerzbank ("Schedule Chicken" - 25th of February 2012)."

As our good credit friend said in November 2011: 
"The path will be very painful for both shareholders and bondholders."

The BES (Banco Espirito Santo) situation, is indeed a reflection of the European Polyneuropathy and is by no mean without "consequences" as shown in the above diagram from Martin Sibileau and the effect of "margin calls" given that Espirito Santo's board as not only appointed a new CEO but its largest shareholder was forced to sell a stake in the Portuguese bank to meet a margin call on loans as reported on the 14th of July in Bloomberg by Joao Lima: in his article entitled "Espirito Santo Owner Sells Stake to Meet Margin Call on Loan":
"Banco Espirito Santo SA’s largest shareholder was forced to sell a stake in the Portuguese bank to meet a margin call on a loan, heightening market concerns about the group’s finances. Espirito Santo Financial Group SA said today it sold 4.99 percent of the bank, reducing its holding to 20.1 percent, to meet the call on the loan taken out during the bank’s 1.04 billion-euro ($1.4 billion) rights offering in June. Banco Espirito Santo, Portugal’s second-biggest lender by market value, fell as much as 11.9 percent in Lisbon trading.
The sale came as Chief Executive Officer Ricardo Salgado, the 70-year-old great-grandson of the bank’s founder, was replaced by Vitor Bento after the Bank of Portugal urged the lender to speed up changes to its executive management. The Espirito Santo family’s hold on the bank slipped further as
Moreira Rato, 42, head of the government’s debt agency, was named as chief financial officer.
Banco Espirito Santo roiled global markets on July 10 after another parent company, Espirito Santo International SA, missed some payments on commercial paper. The stock plunged 36 percent last week and its credit rating was cut by Standard & Poor’s and Moody’s Investors Service on July 11. German Chancellor Angela Merkel said at the weekend the market turmoil caused by the Portuguese bank underlined the euro region’s fragility." - source Bloomberg.

Of course what has started in earnest is the application of "bail-in resolutions" of subordinated bondholders of weaker European financial institutions if one looks at the BES story - graph source Bloomberg:
"Banco Espirito Santo's June capital raise boosted its regulatory capital buffer to 2.1 billion euros ($2.9 billion), according to a press release from the bank. This buffer may be considerably smaller under the macroeconomic assumptions of the adverse scenario in the forthcoming ECB stress tests. Concerns will also mount on the application of bail-in rules for bank debt, suggesting that investors may re-examine reported capital and debt prices for periphery lenders." - source Bloomberg

It isn't only happening in Portugal if one follows the events surrounding Austrian Hypo Aldria issues given the first Chamber of Austria's parliament, the Nationalrat, has given the green light to wipe-out subordinated lenders despite the debt being guaranteed by the state of Carinthia. When the game changes, you can expect politicians to change the rules. This is what makes the difference between "implicit" guarantees from "explicit" guarantees (The German Constitution is more than an "explicit guarantee" as stated above). The rest of Hypo Aldria's network such as its Balkan banking network has been put on for sale. Yet another effect of "margin calls".

For now it seems subordinated bondholders and shareholders are getting the "kneecap" treatment to raise much needed capital with the surge of "margin calls". When one looks at the debt distribution of Banco Espirito Santo with a small cushion of perpetual subordinated debt, one can legitimately wonder if senior bondholders will not suffer at some point a similar "treatment" - graph source Bloomberg:
"The reopening of senior subordinated debt markets to many periphery banks and nations has alleviated funding and deposit-cost pressures since 2013, though recent discussions on bail-in rules and the ECB stress tests have damped investor appetite. Banco Espirito Santo's plummeting debt value and share price suggest the cost of refinancing its 2.76 billion euros ($3.76 billion) of senior subordinated notes maturing in 2015 will have risen, likely also driving up funding costs for peers." - source Bloomberg

It appears to us that the cost of maintaining "zombie" entities afloat is getting pricier by the day. On a final note given European Growth and Consumer Confidence go hand in hand, we think we have reached a plateau as per the below Bloomberg graph:

"If there must be trouble, let it be in my day, that my child may have peace." - Thomas Paine

Stay tuned!

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