Tuesday 30 August 2016

Macro and Credit - The Law of the Maximum

"Capitalism believes that its remit is exclusively to make maximum short-term profits." -  Jeremy Grantham
While watching "market's gyrations" in anticipation of the gathering of "The Cult of the Supreme Beings" aka central bankers at Jackson Hole and the much anticipated speech of Janet Yellen in conjunction with French dairy farmers protesting against low prices and their fight with industry giant Lactalis, we decided we would make yet again a reference to the French Revolution as per our latest musings when it came to choosing this week's title analogy. The Law of the Maximum was a law created during the course of the French Revolution as an extension of the Law of Suspects on 29 September 1793. It succeeded the 4 May 1793 "loi du maximum" which had the same purpose: setting price limits, deterring price gouging, and allowing for the continued flow of food supply to the people of France. Numerous food crisis during the French Revolution which led to speculation on a grand scale were linked to the "inflationary" bias of the much dreaded heavy issuance of "assignats" which lost rapidly their value, a subject we discussed in our previous conversations. According to Andrew Dickson White, Professor of History at Cornell, the ever greater and ultimately uncontrolled issuance of paper money authorized by the National Assembly was at the root of France's economic failure and most certainly the cause of its increasingly rampant inflation. This is as well confirmed by French economist Florin Aftalion 1987 in his seminal book entitled "The French Revolution - An Economic Interpretation" we have been quoting as of late.  What we find of interest with our title, from a historical perspective is that with the repeal of "The Law of The Maximum" in December of 1794 came inflation, mass economic strife and riots that ultimately lead to the rise of the Directory and the end of the Thermidorian period. As per our last conversation, not only did "The Cult of the Supreme Being" contributed to the Thermidorian Reaction and the ultimate demise of Maximilien Robespierre, its instigator, but, "The Law of the Maximum" was as well an important factor. By now, you probably understand our "pre-revolutionary" mindset when it comes to the selection of our recent title analogies. We would posit that NIRP, to some extent is akin to "The Law of the Maximum" and creating as such a very strong "hoarding" mentality leading to the unintended consequence for some consumers to increase their savings and company to delay "investing". In our last conversation we argued, while as well the Law of the Maximum encourages even more the search for short-term profits as highlighted above in our introductory Jeremy Grantham quote:
"No offense to the Supreme Being Cult members out there, but, in our book, NIRP is insanity as there cannot be productivity and economic growth without accumulation of capital, because simply put, NIRP is killing capital (savings)." - source Macronomics, August 2016.
In this week's conversation we will revisit again the lack of "credit impulse" and "credit growth" in Southern Europe in conjunction with our "japanification" theme given that the "capitalization weakness of some European banks have yet to be addressed.


  • Macro and Credit - Thanks to NIRP, for European banks, "japanification" is at play
  • Macro and Credit  - ECB and NPLs? Either put up or shut up
  • Final chart: US Investment Grade credit, great returns for less risk, we told you so...

  • Macro and Credit - Thanks to NIRP, for European banks, "japanification" is at play
While like many pundits we have repeatedly pointed out that the credit transmission mechanism was broken in Southern Europe because these specific European banks were capital constrained. Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
Back in September 2015, we pointed out the following in our long conversation "Availability heuristic":
Before we delve more into the nitty-gritty of our second point, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 
"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org
We have always wondered in relation to the global rounds of quantitative easings the following:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think." - source Macronomics, September 2015
What is very clear to us is that the Fed and the ECB have been following different path, which obviously have led to different "growth" outcomes in recent years. The lack of "credit impulse" in Italy for instance, leading to lack of economic growth is entirely due to the capital constraints put on already stretched balance sheets of Southern European banks which had no choice but to collapse their loan books, in effect, the credit crunch in Europe was a self-inflicting wound. The "japanification" outcome of the European banking sector is well described by Deutsche Bank in their European Banks Strategy note from the 25th of August entitled "More Japan than US playbook":
"Our core investment thesis for European banks remains unchanged: the net interest income outlook remains at the forefront; litigation and regulation are more idiosyncratic while politics remains an unknown. In this context, we continue to favour Nordic, Benelux and French banks, remain Underweight Italian banks and avoid UK and Spanish banks, as well as Wealth Managers.
More Japanese, than US Playbook
The lower-for-even-longer rate environment remains a critical headwind with the sector. Margin compression over the past year should be seen in the context of a multi-year trend similar to Japan and the US through extended QE. Indeed, our economists anticipate a 9-12 month extension of QE in September and complementary moves to ensure a sufficient supply of bonds.
Indeed, a 5% change in NII has a 10% impact on PBT ie amplified by a factor of c2x, all else being equal. Our Margin Monitor continues to demonstrate a steady grind of back-book (ie stock) spreads (4bps pq) implying NIM erosion of c7% pa. Moreover, front-book (ie flow) spread compression accelerated to 8bps pq.

Recent credit impulse metrics do not suggest a meaningful pick-up in credit growth (see Figures 32 and 33).

With euro area credit growth of ‘only’ c1%, further NII pressure seems inevitable. In other words, the euro area experience appears much more like the Japanese than the US playbook where loan growth compensated for NIM pressure.

More Value Trap, Than Value
Year-to-date, the sector is down c25% vs earnings downgrades of c23%. In other words, the sector performance predominantly reflects earnings trends rather than a valuation de-rating. Furthermore, relative sector performance continues to demonstrate a strong correlation with 10yr Bund yields, or the rate environment more broadly. The decline in swap rates will also continue to have implications for pension deficits and capital ratios.

Following c6% decline in 2016E, consensus expectations are for c1-2% pa NII growth over 2017-18E. Thus, further reductions in consensus earnings expectations seem inevitable. Hence, we continue to believe that the sector – despite trading at an optically cheap PTBV multiple of 0.8x – is more value trap, than value.
Risks Rising for the UK; Nordic and Benelux Offer US Playbook
Much of European banking reflects the Japanese playbook namely ongoing margin compression only partly offset by credit growth. If anything, we believe that the recent combo of 25bps rate cut and launch of Term Funding Scheme by the Bank of England could imply that the UK may follow the euro area experience of TLTRO. Beyond the near-term positive of deposit and funding costs decline, asset spread compression and lack of meaningful credit pick-up has weighed. Hence, we continue to avoid the UK with earnings risks rising." - source Deutsche Bank
We could not agree more, in our "playbook" European Bank stocks are more a trap than a value play hence our continue distaste for the sector. We would stick to "credit" when it comes to banks, rather than side with the many sell-side pundits that keep trying to sell us the "optically cheap" fallacious argument.

Furthermore, the growth outlook for Southern Europe is much more linked to the ability for their banks to provide credit to corporates and in particular Small to Medium Enterprises (SMEs). This is as well clearly illustrated in the below Deutsche Bank chart from their report:
- source Deutsche Bank
This leads us to our second point about the need to deal swiftly with Nonperforming loans and "capital constrained" banks (the politically correct of describing them...).

  • Macro and Credit  - ECB and NPLs? Either put up or shut up
In our previous conversation and in relation to the aforementioned different growth outcome and trajectories between Europe and the United States, we indicated the following:
"We keep hammering this, but, our "core" macro approach lies in distinguishing "stocks" from "flows". When it comes to dealing swiftly with "stocks" of Nonperforming loans (NPLs) such as in Italy via "flows" of liquidity, it looks to us that the "Supreme Beings" do not understand that "liquidity" doesn't equate solvency.", source Macronomics, August 2016
Yet, the Nonperforming loans issues (NPLs) which are particularly acute in Italy have yet to be addressed, making it difficult for the "credit impulse" to be restored and therefore hindering any significant positive growth outcome for the likes of Italy and even Portugal. This is clearly indicated as well by Société Générale from their "On Our Minds" note from the 26th of August entitled "Bank loan take-up shows weak transmission of monetary policy":
"There have been encouraging signs in the growth in euro area lending to the private sector – with acceleration to 1.4% yoy in July from 0.6% the previous year. Interest rate spreads have narrowed materially, but signs of financial fragmentation remain in the volume of new bank loans. The bulk of the flow of loans to households and firms comes from the two largest countries, Germany and France. The transmission of monetary policy is thus not yet sufficiently uniform. Unsurprisingly, the countries where banks are struggling to increase their net lending also have the highest NPL ratios. Hence, fixing these weaknesses should be a key priority for euro area policymakers (SSM, EC and national authorities) in the coming years. All this could help rebuild some confidence in the euro area banking sector, although we still believe that credit demand will continue to be dampened by high political uncertainty (e.g. referendum in Italy this autumn, political gridlock in Spain, elections in France and Germany), low growth prospects and necessary deleveraging in some countries. Moreover, the process of disintermediation is accelerating: this weighs on bank profitability, while SMEs have little access to credit. To our minds, the need for government actions remains decisive: reforms capable of boosting potential growth and communication aimed at reducing policy uncertainty.
Over the past few months, there have been two noteworthy trends. First, loan take-up is highly fragmented. The bulk of the flow of loans to households and firms comes from the two largest countries, Germany and France. In some smaller countries (Portugal, Austria) loan take-up by SMEs has actually fallen, despite lower interest rates.

Second, the ECB CSPP has triggered a strong recovery in corporate bond issuance and this is weighing on the flow of bank credit to large firms.
Fragmentation still there in loan take-up
Since 2012, ECB policy has eased bank funding conditions (e.g. low money market rates, QE,TLTRO I and II). Between 2012 and 2014, the pass-through to end-customers was disappointing. Since 2014, however, the improvement in peripheral country bank lending costs has been very impressive (chart 1).

Interest rates paid by end-consumers and corporates have fallen markedly, including for peripheral banks. Discrepancies in lending rates between core and peripheral countries have narrowed significantly. There is no doubt that the transmission of monetary policy through the euro banking channel has improved.
In terms of loan take-up, the outcome is less clear. While growth in lending to the private sector recovered gradually in 2015-16 and stood at 1.7% yoy in July, this recovery has been more heterogeneous and has come mainly from core banks, German and French institutions in particular (chart 4).

For instance, small loan volumes to non-financial corporations (NFCs, <€1m) have decreased in Portugal, Italy and Austria, despite large drops in interest rates in Portugal and Austria (chart 2). In contrast, this flow of credit to SMEs has experienced double-digit growth in France, Germany and Ireland, and this despite unchanged interest rates.
High NPLs still a hurdle for supply of loans
Part of this fragmentation reflects various credit risks, and these are unlikely to decline in the near term. The heterogeneity in bank strength is illustrated by comparing NPLs. For a number of member states, a still-large stock of NPLs and weak profitability remain headwinds to credit supply in an operating environment of low interest rates and low nominal economic growth. NPL figures support the view that the banking systems in Greece, Italy and Portugal are still unsound, whereas recent developments have been encouraging in Spain and Ireland. Italian banks represent 31.7% of the euro area total stock of NPLs, twice the size of Italy in euro area GDP. Greece (1.7% of euro area GDP) also represents 8.9% of euro area NPLs. Austrian banks (4.2% of euro area NPLs vs 3.0% of euro area GDP) and Portugal (3.9% of NPLs vs 1.7% of GDP) are also overrepresented.

During the latest ECB press conference, President Mario Draghi spent some time discussing his views on a better framework for dealing with NPLs. Firstly, there needs to be a strong supervisory approach; secondly, a fully functional NPL market; and thirdly, more government action (legislation that promotes securitisation, review of bankruptcy laws and, interestingly, a public backstop). However, the time horizon for these changes is several years. Hence, the SSM and national regulators will have to implement a comprehensive approach to deal with the banking fragilities in the coming months." - source Société Générale
Back in July we re-iterated our stance in relation to what the ECB should do in order to restore the credit transmission mechanism to Southern Europe in our conversation "Confusion":
"The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":
"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016
 As highlighted above by Société Générale, time is running out and we do not think the ECB has several years when looking at the situation in Italy or the recent cash injection by Portugal in its ailing CGD bank of €2.7 billion. While the Italian situation has been well commented and documented including by ourselves in April this year, Banco Novo situation has yet to be resolved. This is clearly indicated by credit markets in both cash prices and synthetic (CDS) prices as described by Datagrapple in their 26th of August post:

"After Portugal’s state-owned bank Caixa Geral de Depositos’ recapitalization plan early in the week, we had a brief respite on the Portuguese banks. However, the situation at Banco Novo is unclear. Banco Novo is the good bank created in August 2014 out of Banco Espirito Santo (BES) - transferring BES’s good assets. Two years later, Banco Novo’s short dated senior debt is now trading at distressed levels - around 70cts on the dollar. The CDS is trading at 30% upfront plus 5% for a one year protection. This CDS is one of the most technical and, let’s say, controversial special situations of the CDS market, with contracts outstanding under 2 different rules (2003 and 2014) already offering different definitions of what constitutes a credit event not to mention the further complication even if under 2014 rules of what is determined to be a Government intervention or not (ref Banco Novo transfer of bonds announced end-15). According to the attached Grapple, the probability of a credit event within a year has moved from 25% to 50% over the last month. The situation is turning sour. For an outsider, buying a pool of assets from a distressed bank is an investment decision whilst buying a distressed bank’s stress resilience could be more like an act of faith." - source Datagrapple
So either "Le Chiffre" aka Mario Draghi put up, meaning monetizing the lot, or he should shut up because in our book, no matter how charming the bluff he has pulled in the past with his July 2012 "whatever it takes" moment and his OMT, when it comes to ailing Southern Europe banks, it is decision time. The members of "The Cult of the Supreme Beings" might be numerous, but, saving Southern Europe banks requires more than an act of faith we think and haven't even mentioned German banks with some of their struggle with shipping loans such as HSH Nordbank, do not get us started....

As we posited in our conversation "Le Chiffre" aka Mario Draghi and given the market's anticipation for the ECB's next moves:
"QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.
Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations". - source Macronomics, October 2015
So all in all, from an allocation perspective we continue to favor style over substance, namely Investment Grade credit and particularly US over High Yield, this has bee, our call since late 2015. As well when it comes to Investment Grade, we favor nonfinancials and it isn't a question of volatility but, more and more a question of recovery value in the end. When it comes to sleeping well at night we prefer the comfort of "smart alpha" rather than "dumb beta" as per our final chart.

  • Final chart: US Investment Grade credit, great returns for less risk, we told you so...
When it comes to the Law of the Maximum, in our investment book we prefer sticking with the most favorable risk/return asset class when it comes to credit. We were not surprised to see in Société Générale's Credit Strategy Weekly note from the 26th of August entitled "The five things that credit investors need to do this autumn" that indeed, when it comes to risk and returns US Investment Grade continues to be enticing in a lower for longer world (no matter how charming the Fed's bluff is these days...):
"Risk/return performance is impressive: Chart 11 plots the returns (horizontal axis) against the risk (vertical axis) of IG and HY credit, equities and sovereigns in the US, Europe and EM. The best performers have been sterling IG and US high yield this year. EM stocks have generated as much return, but with four times as much risk. IG returns in either US domestic bonds or EM corporates in USD have been close to the performance of the US stock market, but again with less risk. European returns have been the lowest, and close to sovereigns, but much better than European stocks, which are still posting losses for the year.
- source Société Générale
Credit wise, we do indeed continue to like US Investment Grade, at least US Investors do not have to compete with the likes of the ECB and the Bank of England for now...This for us is the Law of the Maximum until the Fed jumps in that is...

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald
Stay tuned!

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