Macro and Credit - Respite

"I decided that there was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it." - Paul Samuelson

Looking with interest at the strong rebound in high beta in credit markets in conjunction with oil prices, with bad news (European macro) becoming good news for asset prices thanks to central banking intervention and dovish tilt, when it came to selecting our title analogy, we decided to steer towards a legal one "Respite". A "Respite" is a delay in the imposition of sentence but in no way modifies a sentence or addresses questions of due process, guilt or innocence. The pardon power of the United States Constitution has been broadly interpreted to include a variety of specific powers. Among those powers are: pardons, conditional pardons, commutations of sentence, conditional commutations of sentence, remissions of fines and forfeitures, respites and amnesties. Historically, presidents have granted most respites for periods of 30 to 90 days and have renewed (extended) such delays when it seemed necessary. We therefore wonder how long the current "respite" and "rebound" in asset prices will last but we ramble again...

In this week's conversation, we would like to look at the most recent bounce in asset prices in the light of the weakening tone from the macro data coming recently from Europe and indicative of the dreaded "R" word, "R" for recession. So, is good news bad news again?

Synopsis:

• Macro and Credit - Bad News is the new Good News...
• Final charts -  Macro matters again...

• Macro and Credit - Bad News is the new Good News...

With Germany on track for "technical" recession, with Italy and France slowing down markedly and with Industrial Production falling depicting a bleak picture overall for Europe (German Industrial Production fell by 4.7% in December, the biggest decline since December 2009), the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture:

- Graph source Bloomberg

Industrial production has been falling in Europe off the proverbial cliff and regardless of the continuation of the "yellow jackets" movement in France, we continue to believe that France's budget deficit for 2019 could be "North" of 4.5%. The services industry in France has been cratering and people tend to forget that services represent 80% in GDP for France versus an average of 76% in the European Union. So, yes, we do believe there is more downside from there for the European macro picture. We are not the only ones sounding the alarm. We read with interest Bank of America Merrill Lynch Europe Economic Weekly note from the 11th of January entitled "The "R" club is recruiting":

"December PMIs: closer to 50, but risks still to the downside

The final print of Euro area composite PMI came in at 51.1, down from 52.7 in November, and the weakest level in four years. A slowdown was reported in both sectors, with manufacturing PMI down to 51.4 from 51.7 in November and service PMI at 51.7 from 53.4 previously. The decline was driven mainly by core countries: French business sentiment was hit by the ‘gilets jaunes’ protests in December (PMIs for both monitored sectors fell below the 50-threshold), and in Germany manufacturing weakness is spilling over to the services sector. On the flipside, Italian PMIs recorded a small improvement in December, with composite PMI back at 50 (no-change threshold), after two months in contractionary territory. With composite PMI averaging below-50 (49.5) in Q4, growth momentum for Italy remains weak. However this improvement (in particular in the new orders balance) suggests some stabilisation in Q1.

Meanwhile hard data for 4Q is not helping either. Industrial production prints were particularly negative. We insist, the weakness goes beyond one offs. Trade data did not help either, neither in Germany nor in France. External demand lacks traction, consequence of the lagged impact of the NEER strengthening and Chinese weakness.

We still think that the Euro area data trough is only for 1Q19, foreign demand permitting. It is then when our China colleagues expect the region to start improving and, given the usual lags, when the negative impact of the NEER should start fading. But remember that Europe typically lags the rest of the world by a few months, and continued weakness in China and the ugly US manufacturing ISM print in December would suggest that foreign demand input to the Euro area is still a drag (Chart 1).

It is crucial for us to see whether the drop in US PMI was a one-off and when the impact of policy support will materialize in China. Meanwhile, we have to rely on low oil prices as a tailwind helping purchasing power and corporate profit margins in the Euro area (Chart 2).

- source Bank of America Merrill Lynch

Obviously given Germany is an export driven powerhouse, no wonder the trade war narrative which has prevailed over most of the course of 2018 has had the desired effect of not only pushing the German DAX index into bear market territory but also has had the effect of plunging Germany into technical recession.

Given the bloodbath experienced during the "Slaughter" Claus bear market of December, it is not surprising to see some sort of strong rebound in "high beta" land and for credit markets to rally particularly on the back of rising oil prices given the exposure of the US High Yield sector we have discussed in recent conversations. 

When it comes to the "Respite" and intensity of the rally in US credit, Bank of America Merrill Lynch in their High Yield Strategy note from the 11th of January entitled "HY Energy: Any Value Left Here?" made some interesting comments:

"Intensity of risk rally reaches historical records

An incredibly strong rally in credit has taken HY spreads down to 450bps from 540bps levels reached in early January. HYG has rallied 5.4% from its low prints around Christmas, the strongest such 10-day rally since Oct 2011 (post-US downgrade rebound) and March 2009 (post-GFC recovery). CCCs have outperformed BBs by 230bps in this move, and Energy was the strongest sector contributor.

As we outlined in our Jan 2 piece, a tactical bounce was likely from the oversold late- December levels as the market has done so in every episode of previous 200bp/3mo widenings. We also noted there that the average rally was 170bps within subsequent three-month horizons in such earlier episodes, and so a 90bp move so far provides a material down-payment towards that. While the market can continue to trend tighter in coming weeks, we think a pullback is possible and even likely here, just given the intensity of the move so far. In the 12 year history of HYG, it has only managed to post stronger 10-day gain in two instances: in 2011 when the market rallied from 900bps levels, and in 2009, when the market was coming out of the global financial crisis (GFC) with 1,800bps spreads. Spreads are not in 900s this time around and this is not 2009.

We continue to think that 500bps is an appropriate risk-neutral level of HY spreads here and the likely trading range around that is going to be +/-100bps. As such we view the current 450bps as somewhat tight and prefer to reduce our risk exposures towards more neutral levels from an earlier overweight. We will be looking to extend this to an outright underweight if the market continues to grind tighter from here towards 400bps levels.

We would be surprised if the index tightening deep into 3-handles in coming months. Similarly, we are inclined to move closer to home with our recent tactical CCC overweight given the move so far, which we viewed purely as a short-term reaction to oversold levels and not a fundamentally-driven position. In rates, the reversal in the 10yr yield from 2.55% low print on Jan 3rd to 2.75% recently makes us more interested in adding duration risk here again. We continue to see decent longer-term fundamental value in rates at current levels as inflation fears of 2018 fade into oblivion.

All changes to positioning described above should be viewed as a tactical reaction to very strong moves in the markets since early January, not as changes to our fundamental view this could be a turn in the credit cycle. No question, the return of risk appetite helps decrease the probability of irreversible tightening in financial conditions, but we think it would be too premature to argue conclusively that this is an all-clear signal.

Tactical rallies are perfectly natural after deep selloffs, but we will need more hard evidence that the damage to economic momentum so far is reversible. What will ultimately determine the course of history here is the direction of earnings growth. Our +10–12% US EPS growth estimate for next year provides us with the strongest argument that this cycle could roll on. However, we remain cognizant that this is a model estimate and models could be wrong. We also know that earnings growth in recent years was largely driven by technology, and recent downbeat outlooks from heavyweights like Apple and Samsung do not help this case. The best course of action here, we think, is to stay open-minded on the question of a cyclical turn." - source Bank of America Merrill Lynch

As we stated in various conversations including our last, we tend to behave like any good behavioral psychologist in the sense that we would rather focus on the flows than on the stock. On that note we continue to monitor very closely fund flows when it comes to the validation of the recent "Respite" seen in the market and it is not a case of confirmation bias from our side. 

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian".  When it comes to fund flows we read with great interest Bank of America Merrill Lynch Follow the Flow note from the 11th of January entitled "Is the worst finally behind us?":

"Some signs of relief

This year has started on a positive note. Despite further weakness on the macroeconomic data front across the globe, risk assets managed to rebound. Light positioning and the end of year sell-off allowed investors to buy the dip. Flows have shown signs of relative stabilisation with fixed income funds seeing inflows and equity funds suffering the smallest outflows in a while. However, we feel that this rally will be short lived as macro continues to disappoint and spreads need to head wider before they tighten again.

Over the past week…

High grade funds suffered another outflow, making this one the 22nd week of outflows over the past 23 weeks. However, this week’s outflow is the second smallest observed over that period. High yield funds recorded another outflow, the 15th in a row, but also the smallest in a while. Looking into the domicile breakdown, European focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Global-focused funds only marginally suffered.

Government bond funds recorded a large inflow this week, the largest in 27 weeks and the 5th over the past 6 weeks. Meanwhile, Money Market funds recorded another sizable inflow. All in all, Fixed Income funds recorded an inflow, putting an end to 18 consecutive weeks of outflows.

European equity funds saw some relief, recording a very marginal outflow this week. Still, this makes it the 18th consecutive week of outflows. During the past 44 weeks, European equity funds experienced 43 weeks of outflows. Chart 1: Risk assets fund flows managed to record a rebound in the first week

Global EM debt shifted back into positive territory this week with a sizable inflow, thus ending a series of 13 consecutive weeks of outflows. This confirms the improving trend observed recently. Commodity funds recorded another inflow, the 5th in a row.

On the duration front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while long-term funds experienced a decent inflow." - source Bank of America Merrill Lynch.

Following the December rout, it is all about damage assessment we think at this stage. The macro picture continues to display a deceleration in both global trade and global growth, now we think, it is all about the earnings picture and given the large standard deviation moves seen in some instances such as Apple, Delta Airlines, Macy's and many more, we are left wondering if indeed this rally can sustain itself on the back of a more dovish tilt from the Fed.

If indeed from a macro perspective at least in Europe it's the "R" word, for "Recession" in many instances, then we wonder if the "D" word, for "Deflation" when it comes to looking at the savage earnings revisions seen so far at a very rapid pace:

- graph source Bloomberg

On the question of the "Deflation" and earnings we read with interest the latest article on Asia Times from our esteemed former colleague David P. Goldman in his article from the 11th of January entitled "How widespread is creeping deflation in the US stock market?":

"Companies with challenged business models account for nearly two-thirds of the S&P 500's top 50 earners

"Investors are waiting for guidance from the US-China trade negotiations, but most of all they are waiting for indications of how the economic disruptions of the past few months will affect earnings.

The slightest hint of squishier earnings guidance provokes brutal punishment. Wednesday it was telecom providers, today retailers. Fragile business models make most US market leaders risky. That’s why I don’t think a dovish Fed is enough to sustain a market rally.

Department stores led declines today, with Target bringing up the rear in the S&P 100 (-4%) and department stores taking the bottom slots in S&P 500 performance – Macy’s (-19%), L Brands (-7%), Kohls (-7%), Nordstrom (-5.4%).

Airlines took yet another beating, with American Airlines down 6.2%. It’s all about pricing power. Consumers are still spending, with real personal consumption expenditures up 1.9% year-on-year as of November, and more workers are earning a paycheck. Consumer debt service comprises the lowest percentage of personal income since the data were collected.

Yet consumer names have been battered. Apartment real estate investment trusts face falling rents, airlines face passenger pushback on price, aging brands face competition from cheaper generics, and tech companies face resistance to overpriced products, for example, Apple.

Roughly two-thirds of the top 50 S&P 500 companies (ranked by earnings before interest, taxes, depreciation and amortization) face a serious challenge to their business models.

The complete annotated ranking is shown below. Economic growth is not the only issue worrying the stock market. Most of the market leaders are aging monopolies that risk losing their grip on customers.

The biggest exception to this rule is Amazon, which is doing most of the disrupting. But the fact that Amazon is able to disrupt everyone else depends on the willingness of Amazon shareholders to live without earnings. It now trades at around 110 times trailing earnings. Netflix trades at 95 times trailing earnings.

Deflation and value destruction are bad for equity markets. Amazon eats the retail market, and the department stores crash, along with CVS, and the REITs that own the properties from which the retailers rent.

Huawei crushes Apple in the Chinese market. Sprint, T-mobile and even more aggressive discounters erode the earnings of AT&T and Verizon. Proctor and Gamble, Johnson and Johnson, General Mills, Campbell’s and Kraft-Heinz have to sell their products on an Amazon web page that conveniently flashes an ad for a generic alternative.

Taken together, companies with challenged business models generate nearly two-thirds of the earnings among the top 50 members of the S&P 500.

(click to enlarge)

- source Asia Times - David P. Goldman

Now if higher profits were somewhat "juiced" up by stock buybacks, then indeed no wonder earnings revision have been savage so far. Back in October last year in our conversation "The Armstrong limit", we quoted as well another article from David P. Goldman and discussed the "profit illusion". 

In our macro book, the "velocity" in "earnings revisions" regardless of the "Respite" due to "bad news" being "good news" again in forcing the hand of our "generous gamblers" aka our central bankers, mean that the growth outlook for the US is also at risk. This is pointed out by Bank of America Merrill Lynch in their US Economic Weekly note from the 11th of January entitled "Earnings downgrades =  GDP downgrades" and we are not even mentioning the ongoing government shutdown at this stage:

"Earnings downgrades = GDP downgrades

• Earnings estimates continue to be slashed, which suggest that further downward revisions to GDP growth are forthcoming.
• While the direction of revisions is relevant, be careful relating actual earnings growth to economic performance.
• After controlling for oil prices and the services share of the economy, economic and earnings growth become much less correlated.

Resetting expectations

Earnings estimates for 2019 are being slashed. Just this week, Macy's and Barnes & Nobles made news by cutting their profit estimates while American Airlines warned that earnings may fall short of expectations. It seems that analyst estimates may still be too optimistic even after a slew of downward revisions over the past few months. According to Savita Subramanian and team, the consensus EPS growth is 7% for this year, which is down from the 10% forecast just three months ago

What does this tell us about the economy? It is intuitive for earnings estimates to correlate with economic growth as earnings are a function of expected revenue growth. A simple scatter plot of annual EPS growth and nominal GDP growth shows the positive correlation (Chart 1) but with very low significance.

This means there is more to the story. We see three reasons that earnings will differ from US economic growth:

1. S&P 500 has greater sensitivity to global growth with 46% of sales coming from foreign markets. In contrast, only 12% of US growth is from exports.
2. Oil prices have a different impact on the S&P 500 than on the overall economy. There is a clear positive correlation for the market – higher oil prices boost earnings for energy companies. The impact on the US economy is slightly negative.
3. The S&P 500 has a greater concentration of manufacturing

We run a series of models to determine how much these factors influence the relationship between earnings and GDP growth. We first start with a regression of earnings growth as a function of US and global GDP growth which shows a statistically positive relationship between GDP growth and earnings. We then include oil prices which show up as a positive relationship with earnings and reduce the significance of US and global GDP growth. Swings in oil prices can overwhelm the impact of growth. Think back to 2015 when the decline in oil prices led to an earnings recession without an economic one. Adding in the change in services share of the economy ends up leaving US and global GDP growth as insignificant. This tells us that as the economy becomes more services based, the relationship between earnings and US growth weakens.

The sensitivity to global growth and oil prices allows earnings growth to be much more volatile with a standard deviation of 17% vs. nominal GDP growth of 2.5% (Chart 2).

This could also be explained by the fact that the sample for aggregated earnings change overtime, thus creating a bias that does not reflect the whole economy.

We revise together

While the relationship between GDP growth and earnings growth is complicated, as we argue above, we still can take signal from the forecasts for earnings. We find that the direction of earnings revisions can tell us something important about the direction of GDP revisions. As Chart 3 shows, the consensus forecast for earnings and GDP growth tend to be revised in tandem.

Looking at the evolution of forecast for the current year earnings and GDP growth over the past four years, the direction is consistent. The outlier was in 2015 when earnings were slashed more dramatically than GDP and the latter actually ended up being revised higher at the very end of the year.

Collecting all data

Given the high degree of uncertainty about the outlook, we should look at all sources of information. As Fed Chair Powell has made clear in recent remarks, on the one hand, the economic data continue to point to a solid expansion. But on the other hand, market measures have deteriorated with a sharp sell-off in equities and a flattening in the yield curve. We consider earnings estimates to be a mix of both economic and market signals.

We think they are pointing to a moderation in growth but not a contraction. We should heed Powell’s advice. Have patience until we see who is right – the data or the markets." - source Bank of America Merrill Lynch

Where we disagree with Bank of America Merrill Lynch's take is with the "solid expansion" narrative. A flattening curve in our book is not positive for banks and cyclicals such as housing and autos have already turned.  Also as briefly pointed out, a sustained shutdown is likely to be another drag on US growth which will therefore push the Fed's hand further into "dovish" territory". In that context, and if inflows return into credit markets, then high beta credit as well as Investment Grade could continue to thrive in the near term given Fed Chair Powell indicated in the latest FOMC minutes a willingness to be patient with future rate hikes. 4Q US GDP might disappoint we think.

If 2018, with liquidity being reduced thanks to central banks was volatile, 2019 marks we think the return of "macro" and given the rise in dispersion it also marks the return of active management we think as per our final charts below.

• Final charts -  Macro matters again...

With global liquidity supply on reduction mode and with 2018 marking the return of volatility, with rising dispersion and more and more large standard deviation moves, 2019 will continue to indicate a return of macro as an important factor for returns. This means that active management, should benefit from this trend. Our final charts come from Bank of America Merrill Lynch note Why They Did What They Did from the 9th of January entitled "What's past is prologue":

Macro mattered more than fundamentals in 2018

Based on the ~40 macro factors and ~50 quantitative factors we track, macro factors had higher explanatory power on stocks’ 2018 returns than fundamental factors (average R-squared of 5% for macro factors vs. 1% for fundamental factors).

And the top 10 factors with the highest explanatory power were all macro factors – in particular, credit spreads, commodities, the USD, consumer confidence, and the VIX.
As for fundamental factors, one of the most explanatory factors on returns in both 2018 and 4Q was Beta.

Stocks less sensitive to macro (idiosyncratic stocks) have outperformed

• Some stocks tend to move more with macro factors (i.e. high systematic risk) while others move less (i.e. more idiosyncratic). In our recent report we grouped BofAML-covered US stocks based on their overall macroeconomic (i.e. multivariate) impact using a principal components (PC) regression.

• The results from the screen and a backtest of its performance over time suggested that idiosyncratic stocks (those with a below-median regression Rsquared) have outperformed systematic stocks (those with an above-median regression R-squared) since the crisis (including last year), primarily due to lower annualized volatility of the former with slightly better annual returns.

• Segments of the S&P 500 most exposed to risks around trade – in particular, multinationals with high China exposure and stocks in industries with high import costs—have seen multiples compress most (by ~20%) since trade tensions began to rise last February.

- source Bank of America Merrill Lynch

While investors have been enjoying a welcome respite in the early days of 2019, with "bad news" becoming "good news" at least from a "dovish" Fed narrative, we do not buy the strong expansion narrative put forward by many sell-side pundits, though if indeed flows return to credit markets, Investment Grade credit could thrive again at least in the near term from a "Keynesian" perspective. There is no doubt that growth is decelerating and our concern is that cooler head can prevail avoiding us from moving from the "R" word of recession towards the "D" word of depression, but that's a story for another day. Enjoy the ride while it last.

"The only safe ship in a storm is leadership." -  Faye Wattleton, sociologist

Stay tuned ! 

Chart of the Day - Europe Air Cargo vs PMI pointing to economic slowdown

"Admire a small ship, but put your freight in a large one; for the larger the load, the greater will be the profit upon profit." - Hesiod 

We previously indicated that Air Traffic is a good indicator of economic activity (see our post "Air Traffic is pointing to additional economic activity" - 15th May 2013). Looking at the negative Italian GDP print at -0.3% YoY as well as the -3.2% print for German factory orders, we decided to have a look again at Air Cargo, in particular towards Europe International Cargo vs PMI as displayed by Deutsche Bank in their "Air Cargo Market Analysis note from the 6th of August 2014:

"We are seeing Europe materially lag the peer group. Other key cargo markets are reporting improving growth trends whereas Europe's data to June is still in decline."

- source Deutsche Bank

Europe Domestic Cargo vs PMI is as well pointing towards weaker economic activity ahead:

Europe represents a market share of 26% of the International Air Cargo Market and 23% of the Domestic Air Cargo Market.

Both points to additional weaker economic activity in Europe we think. There is indeed a big disconnect between PMIs and Air Cargo.

"A man who has never gone to school may steal from a freight car; but if he has a university education, he may steal the whole railroad." - Theodore Roosevelt

Stay tuned!

Credit - The Magnus Effect

"As long as the world is turning and spinning, we're gonna be dizzy and we're gonna make mistakes." - Mel Brooks

While looking at the disappointing US macro data (ISM and nonfarm payrolls), we reminded ourselves of the Magnus effect, which the commonly observed effect in which a spinning ball curves away from its principal flight path. Our analogy refers somewhat to golf given backspin generates lift by deforming the airflow around the ball, in a similar manner to an airplane wing. This is called the Magnus effect. A ball moving through air experiences two major aerodynamic forces, lift and drag. Modern golf balls called Dimpled balls fly farther than non-dimpled balls due to the combination of these two effects. In relation to our chosen title and the analogy with economy, looking at the performance of the US 10 year treasuries since the beginning of the year is directly countering the thesis that the American economy has truly achieved "escape velocity". When it comes to lift and drag, no doubt to us that the US economy recent economic data is more indicative of "stalling momentum" rather than "escape velocity momentum" when ones look at the recent ISM new orders index (-13.2 points to 51.2, the largest decline since December 1980) as well as pending home sales.

We argued in the past that the growth divergence between US and Europe were due to a difference in credit conditions. In this short post we will look at the reverse in the divergence between US growth and Europe in conjunction with the significant flows out of Emerging Markets Equities seen in recent weeks.

The divergence between US and European PMI indexes is all about credit conditions. This is why the US was ahead of the curve when it comes to economic growth compared to Europe since December 2011. We have discussed this before, the US PMI versus Europe - source Bloomberg:

The Fed’s January Senior Loan Officer Opinion Survey released this week indicated weaker demand in mortgages over the past quarter. A net 28.2% and 45.7% of banks reported weaker demand for prime and non-traditional residential mortgages, the worst data since April 2011 and January 2009 respectively.

Of course when it comes to "Magnus effect" and major aerodynamic forces, some Emerging Markets have suffered the full force of outflows as "tourist" investors have been leaving in drove. For instance EM retail outflows represented -18 billion $ year to date according to JP Morgan's recent EM Fixed Income Flows Weekly:

"EM equity retail outflows persisted with $6.5bn of outflows this week, comparable to last week's $6.4bn in redemptions as the MSCI EM extended YTD losses to -8.4%. Meanwhile, EM woes drive flight-to quality as US bond funds experienced a surge in demand as inflows reached $14.6bn, the largest single weekly inflow in EFPR's history." - source JP Morgan

What is of interest as well have been the outflows from the famous Japanese Double-Deckers which favorite "carry" currency has long been the Brazilian real as indicated as well in JP Morgan's note:

"Japanese funds experienced outflows of $254mn with dedicated local Brazil funds accounting for most of this (-$222mn)." - source JP Morgan

The reason behind the depreciation of the Brazilian Real in 2011 was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again. It looks to us that, in similar fashion to what happened in 2011, a similar exit by these Japanese retail funds is adding pressure on the Brazilian currency:

In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011.

But when it comes to Brazil, not only the Japanese outflows have been putting additional pressure on the currency but the slack in industrial production is as well putting some pressure as indicated by Bloomberg's recent Chart of the Day:

"The biggest monthly plunge in Brazil’s industrial output since December 2008 shows policy makers’ confidence that a weaker real will stimulate manufacturing is proving misguided.

The CHART OF THE DAY tracks Brazil’s industrial production index, the real on a percentage-change basis and exports on a rolling six-month average. Output fell in December by the most in five years even as the exchange rate weakened 34 percent since the manufacturing index reached a record-high in May 2011.

The currency is the biggest decliner against the U.S. dollar in the last three years among 16 major currencies tracked by Bloomberg after the South African rand.

President Dilma Rousseff said on Feb. 3 that a weaker real would help drive exports this year, an affirmation of Finance Minister Guido Mantega’s comments in September that a currency drop would make Brazilian products more competitive and boost manufacturing. Goldman Sachs Group Inc.’s Alberto Ramos said the government’s optimism isn’t warranted, as companies are hampered by rising labor costs and lack of incentives to modernize.

“The bottom line is that we expect the industrial sector to underperform,” said Ramos, Goldman’s New York-based chief Latin American economist. “It is a sector that is still facing significant foreign competition and cost-competitiveness issues, which will handicap performance.”

The country’s main manufactured exports and destination by value last year included passenger cars to Argentina and Mexico and automobile parts to Argentina and the U.S., according to Trade Ministry data. Brazil, which is the world’s largest emerging market behind China, saw its economy contract in the third quarter by the most since 2009 as investments dropped.

Fiat SpA is one manufacturer that has seen financial results hindered by Brazil operations. The carmaker’s 2013 trading profit in Latin America dropped 41 percent largely from price increases in Brazil, Chief Financial Officer Richard Palmer said in a Jan. 29 earnings call." - source Bloomberg.

When it comes to outflows as well, it is worth noticing the significant outflows from equities, putting somewhat a dent to the "Great Rotation" story from bonds to equities as indicated by Bank of America Merrill Lynch's note from the 6th of February entitled "Stampeding Bears":

"The bottom-line: big capitulation out of stocks into US Treasuries…marks end of Jan/Feb correction

The big numbers: largest weekly equity fund outflow since Aug’11 ($28bn); largest equity ETF outflow since Feb’09 ($26bn); largest bond fund inflow since Apr’10 ($15bn)

The caveat: our trading rules not yet flashing “strong buy”… Bull & Bear index now down to 4.2 (hit 1.8 late-June – Chart 1); Global Breadth index now up to 44% (hit 96% late-June – Chart 3) and…

…EM Flow Trading Rule: another $7-8bn outflow next week triggers contrarian buy-signal (last buy-signal on 6/27/13 followed by 14% rally in EEM next 3 months)" 

- source Bank of America Merrill Lynch

As far as equity flows are concerned, the "reverse osmosis" namely the tapering impact on some Emerging Markets have led to the following as detailed in Bank of America Merrill Lynch's note:

"Equity Flows

$6.5bn outflows from EM equity funds (15 straight weeks of outflows = longest outflow streak on record – Table 3)

4-week outflows from EM equities = 2.1% of AUM; another $7-8bn outflows next week would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)

Huge $24bn outflows from US equity funds (almost all via ETF’s SPY, IVV, IJH – but see above for caveat on Good Harbor)

Business as usual for Europe (32 straight weeks of inflows) and Japan (7 straight weeks of inflows)" - source Bank of America Merrill Lynch

Whereas Fixed Income Flows,such as the ones seen in US Treasuries, shows the asset class hasn't lost its appeal:

"Monster $13.2bn inflows to Govt/Tsy funds (caveat: $10bn inflows likely due to Good Harbor rebalancing from SPY to SHY, IEI & UST)" - source Bank of America Merrill Lynch

When it comes to Emerging Markets woes, not all countries in the Emerging Markets suffer from acute imbalances and as far as the long term trend is concern in true "Angus Maddison" fashion, the future is brighter for many Emerging countries than it look in the near term. Just wait for the "tourists" to exit and value will come back, no doubt to the fore-front.

"There's no limit to how complicated things can get, on account of one thing always leading to another." - E. B. White, American writer

Stay tuned!

Credit - House of pain and House of cards

"Criticism may not be agreeable, but it is necessary. It fulfills the same function as pain in the human body. It calls attention to an unhealthy state of things." -   Winston Churchill

While looking at the action this week in the credit space in general and, in the banking space in particular, we initially thought about "House of pain" as the main title for our post, given the goodwill writedowns we witnessed and expected in the banking space (for example 2.7 billion EUR for Crédit Agricole) as well as the nationalisation of Dutch bank SNS in conjunction with the total wipe-out of subordinated bondholders. 

Goodwill writedowns and subordinated bondholders' pending punishments have long been a "pet subject" of ours in various conversations such as "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.

After all, in the banking space, and in this deflationary environment, it is has been all about the "survival of the unfittest".

In a "Central Banks" world dominated by the "Sorcerer's apprentice" aka Dr Ben Bernanke and our "Generous Gambler" aka Mario Draghi, the "creative destruction" in a Schumpeter way has been prevented by "all means". It has in effect maintained various "zombie" financial institutions standing up until they finally paid the piper such as SNS bank.

In relation to the added "House of cards" part of our title, when one looks at the record-low yield touched of 5.61% touched by the US High-Yield index on the 24th of January and that Barclays's index for lower junk-rated companies dropped to a record 7.87% for issues with ratings about Caa from Moody's Investors Services and CCC from Standard & Poor's being the lowest since London-based Barclays began the indexes in 1983 as reported by Bloomberg, we thought we had to extend our aforementioned title.

As reported by Bill Rochelle from Bloomberg in his article "Junk, Nortel, Madoff, Hostess, A123, ResCap" published on the 30th of January, credit investors have to keep dancing until the music stops, and rest assured, at some point it will.

We therefore have to agree with David Tawil, co-founder of Maglan Capital LP which was interviewed by Bloomberg:

"Some of the refinancing deals getting done now are starting to get laughable, in the sense of the credit quality of the borrower and the low interest rates,” Tawil said in an interview. “The government has incentivized lenders to lend to unworthy borrowers,” and even for credit-worthy companies, “rates are unjustifiably low,” he said. HD Supply Inc., the wholesale-supply business once owned by Home Depot Inc., is an example of a low-rated company benefiting from rock-bottom rates. Yesterday, Atlanta-based HD was selling $1.28 billion in senior unsecured notes in a private placement rated CCC+ by Standard &Poor’s. The new debt was expected to yield about 7.375 percent. Proceeds will be used to refinance existing debt. While companies gain, “the government has left the unemployed out in the cold during this free-money fest,” Tawil said." - source Bloomberg

On one hand we have the "House of pain" in the banking space and on the other hand, the credit space is increasingly looking wobbly hence the "House of cards" reference.

In our usual credit overview we will look at the "House of Pain" in the credit and banking space and the "unintended consequences" for remaining subordinated bondholders with the latest SNS case and the "House of cards" in the credit space.

The indicator we have been tracking in relation to "Risk-On" and "Risk-Off" phases, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes and this week it did change course which warrants caution, we think - source Bloomberg:

Back in our conversation "River of No Returns" in June 2012, we indicated that in "Risk Off" periods we had noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation is falling to significantly lower level. The correlation between both the German Bund and US 10 year note has risen this week above 74%, indicative of a potential "regime change" from "Risk-On" to "Risk-Off".

Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).

Another indicator we have been following in various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is now broken with Swedish yields rising - source Bloomberg:

Sweden is one of only 7 remaining AAA rating countries with stable outlook. As we posited on the 3rd of January, Sweden has indicated it's done with the "easing policy" hence the normalisation of Swedish government bond yields versus their German counterpart. Riksbank, Sweden's central bank has clearly decided to hold the line in 2013.

In relation to credit indexes, the Itraxx Crossover index (European High Yield risk gauge for 50 European entities) versus the Itraxx Main index (Investment Grade risk gauge in Europe for 125 entities) is indeed very tight, indicative of the spread compression we have seen in recent months - source Bloomberg:

Core European Investment Grade credit is definitely in the "expensive territory" area.

While the difference between the US PMI and the European PMI is a "credit" story, the divergence between both PMI's will remain in 2013 - source Bloomberg:

 The ISM in the US rose to 53.1 in January from 50.2 a month earlier whereas in Europe Markit's PMI gauge rose to 47.9 from 46.1 in December indicative of manufacturing contraction, albeit recession.

Not a surprise as the US leveraged loan cash price index versus its European peer picture has an uncanning resemblance with the evolution of the PMI index - source Bloomberg:

The weakness in the credit space this week in Europe saw the widening by 25 bps of the Itraxx Financial Subordinate index (high beta financials) in conjunction with a weakness seen in cash with the IBoxx Euro Corporate index (commonly used as a benchmark for credit funds) giving away 6 bps, marking somewhat a pause in the continuous rally in credit in Europe we have seen in Europe since last summer.

Unsurprisingly, the continued weakness in PMI in Europe has led to a reversal in the risk gauge in Europe in investment grade credit indices seeing the Itraxx Main Europe underperforming versus its US equivalent CDX IG, indicative of the weaker tone in the European space, now 23 bps apart and climbing - source Bloomberg:

As far as investment grade is concerned, as indicated by Bank of America Merrill Lynch recent note entitled "Dude, where's my return?" from the 23rd of January, investment grade credit has indeed been in the "House of pain": "What if you have been used to fat returns for years, but one day wake up after the party and can’t find returns? For nearly three months – since the end of October last year – stocks are up more than 6% and high yield corporate credit in excess of 4% (Figure 7). However, the total return on high grade corporate bonds over the same period is zero (and that was before Friday’s big move higher in interest rates). Such a positive environment for risk assets with higher interest rates highlights our outlook for mediocre total returns in high grade this year – at best. We now consider it most likely that total returns will fall short of our low 1.6% target, as the risk of the rotation out of bonds, into equities starting in 2013 has increased enough to become our base case." - source BAML.

- source BofA Merrill Lynch Global Research

Bank of America Merrill Lynch also added in their note:
"A disorderly rotation out of bonds, into equities – where interest rates increase significantly, leading to massive outflows from high grade bond funds and much wider credit spreads – is the biggest risk to investment grade this year and the one we are getting increasingly concerned about. Thus high grade credit spreads and 10-year swap spreads share the property that significant increases in interest rates can lead to spread widening." - source BAML

Given that about half of HG (High Grade) investors consider themselves total return investors according to BAML, rising interest rates could cause a selling stampede following the rise of the retail investor through mutual funds and ETFs, a move from the "House of pain" to the "House of cards" that is, but we digress.

The European bond picture, with Spanish 10 year yields rising towards 5.17%, whereas Italian 10 year yields below 5% hovering around 4.25% and German government yields rising towards 1.70% levels, hurting investment grade bond investors in the process with other core European bonds yields rising as well - source Bloomberg:

Moving on to the subject of the "House of pain" in the banking sector this week, as we pointed out last week in our conversation "The Donk bet":
"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."

For instance Deutsche Bank reported a larger than expected 4Q12 losses of 2.6 billion Euros including 1.9 billion euros in goodwill impairments. It was a similar story for Crédit Agricole which reported 2.68 billion euros of goodwill write-downs in the fourth quarter. We indicated last week that the bank had 16.9 billion euros worth of goodwill on its balance sheet as of the end of September:

"The European Securities and Markets Authority called on Jan. 21 for improvements in disclosures after reviewing 800 billion euros of goodwill assets at 235 companies in 23 countries across Europe. Goodwill is an accounting convention that represents the amount paid for an acquisition over and above the fair value of its net assets. While writing down goodwill doesn’t deplete capital, it reduces profit and signals a company overpaid for acquisitions. Deutsche Bank AG, Germany’s largest bank, yesterday took 1.9 billion euros of write-downs on goodwill and other intangible assets. ArcelorMittal, the world’s largest steelmaker, said in December it will write down the goodwill in its European businesses by about $4." - source Bloomberg, Credit Agricole to Book EU2.68 Billion in Goodwill Writedowns.

So how do goodwill impairments affects credit you might rightly ask?

A previous article from Standard &Poor's written in March 2012 dealt with this precise point - Why U.S. And European Banks’ Goodwill Assets Are Under Pressure:

"How Impairments Affect Credit:

While companies may downplay impairment charges as noncash, nonrecurring accounting charges, they often have implications for an issuer's credit quality. An impairment charge often signals that a business unit to which the intangible asset relates is suffering some level of stress; as a result, management's view of future operating performance (e.g., revenue and earnings projections) of the unit and perhaps the organization as a whole needs to be reevaluated. An impairment charge can also be a reflection on management, which may need further examination in our analysis. It could mean management at the time of the acquisition misjudged the extent of some synergies during an acquisition, or executed poorly on some plans that seemed to justify a higher-than-market purchase price. A management change may also sometimes precede an impairment charge, because the charge allows certain balance-sheet metrics to be reset (e.g., removing goodwill may improve the quality of assets on the balance sheet). Such an event could affect future M&A activity. 

Headline and reputation risk from impairment write-downs is another factor that could have consequences, particularly when the impairment charges are unusually large or unexpected. For example, a bank's ability to tap the equity or debt markets may be constrained if the capital markets react poorly to its recognition of a significant impairment charge. Such an issue could spill over and adversely affect operating performance. An impairment charge, especially when significant, could affect a company's existing and future dividend policy. In addition, while we believe most debt covenants exclude charges related to noncash impairment charges, some covenants could be affected. Lastly, in rare circumstances, outsized impairments and resulting losses may have a direct or indirect impact on the servicing of hybrid capital instruments, a risk that may affect our ratings on these instruments." - source Standard & Poor's

"House of Pain" - Potential goodwill impairments impact, a few examples as per S&P's article as of December 2011:

- source Standard & Poor's

To bring some solace to banks, the world's biggest mining and steel companies have already wiped out50 billion dollars off project valuations in 2012 according to Bloomberg's article "Writedowns Near $50 Billion as M&A Haunts Mine CEOs" from Thomas Biesheuvel and Jesse Riseborough on the 30th of January:

"The world’s biggest mining and steel companies have wiped about $50 billion off project valuations in the past year and the purge is poised to continue this earnings season as managers reassess expensive takeovers. Anglo American Plc, Vale SA and Rio Tinto Group led the writedowns as declining metal prices, rising project costs and slowing demand forced reviews. Glencore International Plc may write down some nickel and copper assets acquired through its takeover of Xstrata Plc, Liberum Capital Ltd. has said. BHP Billiton Ltd. may trim aluminum operation valuations, according to Goldman Sachs Group Inc. and Sanford C. Bernstein Ltd. Executives and shareholders are paying the price for a $1.1 trillion M&A binge over a decade. Failed deals in aluminum and coal caused $14 billion in writedowns at Rio and cost Chief Executive Officer Tom Albanese his job this month. Cost overruns contributed to Cynthia Carroll’s departure as CEO of Anglo American, which slashed $4 billion off the value of its Minas- Rio iron-ore project in Brazil yesterday. She leaves in April." - source Bloomberg

The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.

On Friday the Minister of Finance in the Netherlands has issued a Decree by which the state expropriates "the securities and capital components of SNS Reaal NV and SNS Bank NV in connection with the stability of the financial system, and to take immediate measures with regards to SNS Reaal NV".

Meaning Tier 1 bonds and LT2s losses equates to 100% as indicated by BNP Paribas's European credit note published on the 1st of February - Nationalisation and Expropriation in the EU: The SNS Case.

"We understand that, as of 8.30am today, the property of SNS Reaal NV and SNS Bank NV have

been transferred to the Dutch State. So, effectively, subordinated bondholders are currently suffering a100% loss on their investment. The paper from the Finance Ministry stipulates in Article 50 that the

expropriation makes it possible for the sub debt to be exchanged into equity in order to improve the solvency of the entity, but this would be equity owned by the Dutch state." - source BNP Paribas

As we discussed in our conversation "Kneecap Recap" in May 2012, the liability management exercises of bond tenders were opportunities for the subordinated bondholders to "get to the exit while they can" and take their losses...

Why is the SNS case significant? From the same BNP Paribas note:

"-The SNS intervention clearly pushes the envelope on how far national authorities are willing (and able) to go in the resolution of a failing financial institution.

-This action is the harshest we have seen since Amagerbanken in Denmark and certainly the harshest treatment to bondholders (including LT2) for any large European bank

- Northern Rock had nationalised some preference shares in the past (which had no recovery so far), but the other hybrids were not nationalised and in fact offered a generous LME later on." - source BNP Paribas

The budget deficit of the Netherlands will widen by 0.6% in 2013 as a result of the SNS intervention and the previous forecast was for a budget deficit of 3.3% of GDP in 2013.

The broad picture for European subordinated bondholders from the BNP Paribas note:

"We believe the SNS precedent, while very important, has limited read across to other European jurisdictions. That said it does change the realm of what is possible. To put it in mathematical terms, prior to this precedent the downside recovery for LT2 (using the Irish precedent) was generally assumed to be 20%. This should now be 0%. Also, given the SNS precedent one could argue the probability of this outcome in the distressed situations has gone up. Therefore investors are justified to demand higher yield, which will put pressure on the prices of subordinated debt securities for special situations such as Bankia and other distressed Cajas, Monte dei Paschi and HSH Nordbank. But we still believe every situation is different and needs to be analysed in the context of the country, circumstances of the bailout and perhaps even holders of the bonds. For instance we have seen a very different attitude to bondholder burden-sharing in Spain where due to large retail ownership of the preferred shares the government has tried to minimize the losses for these investors (although retail investors are also invested in some SNS subordinated bonds). Last but not least, the SNS precedent reinforces our view that EU policy makers are in no mood to impose senior burden-sharing at this point in time" - source BNP Paribas

Why the change in recovery rate from 20% to 0% matters in the CDS space?

As we pointed out in "European Derecho", implied recovery rates matter enormously in relation to the determination of the payout for subordinated CDS referencing LT2 debt:

"Fixing the recovery of subordinated debt and taking the spreads on senior and sub debt observed in the market, it becomes possible to solve for a recovery rate on senior." - source Morgan Stanley

In relation to LT2, as a reminder from our September 2011 credit conversation "Credit - Crash Test for Dummies":
"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."

If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS.

On top of that, a nationalisation, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.

As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).

So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well...

On a final note, while goodwill impairments are bad news for European banks, as indicated by Bloomberg's recent Chart of the Day, goodwill may as well be bad news for US asset values:

"Paying too much for takeovers represents a risk to the value of U.S. companies, according to Erin Lyons, a Citigroup Inc. credit strategist. The CHART OF THE DAY tracks goodwill, or the amount by which purchase prices exceeded asset values, for companies in the Standard &Poor’s 500 Index during the past decade. Lyons had a similar chart in a report two days ago. Goodwill more than doubled to $245.9 billion, and climbed to 7.8 percent of assets from 5.2 percent in the 10-year period, according to quarterly S&P 500 data compiled by Bloomberg. The chart displays dollar amounts and percentages. “In some cases, companies are realizing that paying a high premium for acquisitions may not have been worth it,” Lyons, based in New York, wrote in the report. Cliffs Natural Resources Inc., the biggest U.S. iron-ore producer, said last week that it will write down $1 billion of goodwill from a deal completed in 2011. Caterpillar Inc., the world’s largest maker of construction and mining equipment, disclosed a $580 million writedown earlier in January on a Chinese unit acquired last year. Three S&P 500 companies -- Frontier Communications Corp., Nasdaq OMX Group Inc. and L-3 Communications Holdings Inc. -- have more goodwill than market value, based on Bloomberg’s data. They were among 44 companies listed on U.S. exchanges that Lyons named as potential candidates for writedowns."  - source Bloomberg

"The worst pain a man can suffer: to have insight into much and power over nothing." - Herodotus

Stay tuned!

Credit - The Regret Theory

"In history as in human life, regret does not bring back a lost moment and a thousand years will not recover something lost in a single hour."  - Stefan Zweig

This year, we have on numerous occasions touched on game theory in our posts (The European iterated prisoner's dilemma, Agree to Disagree) and we also used an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept (Schedule Chicken). We even ventured towards computational analogies in our title selection process (Bankers' algorithm). Given the latest raft of European PMIs, pointing to a continued (albeit much smaller) divergence between the United-States Growth and Europe (Growth divergence between the USA and Europe), reason being the lack of credit provided to the real economy due to:
-inappropriate European Banking Association decision of imposing banks to reach a 9% Core Tier 1 ratio by June 2012 
-unrealistic budget deficit targets (A Deficit Target Too Far), 

We came to the conclusion that we ought to use in our title a reference to the Regret decision theory.

The divergence between US and European PMI indexes - source Bloomberg:

The Regret theory (also called opportunity loss) being defined as the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen by our European politicians. The Regret theory is also a model of choice under uncertainty defined as the difference between the outcome yielded by a given choice (credit crunch, economic recession) and the best outcome (muddle through) that could have been achieved in that state of nature (deflationary forces at play). 

As far as Europe is concerned, one can wonder what would have been the "economic outcome" if a different course of action would have been undertaken. On that matter we wonder why our "European elites" did not use the minimax regret approach being a decision rule used in decision theory, game theory, statistics and philosophy for minimizing the possible loss for a worst case (maximum loss) scenario. One approach is to treat this as a game against nature (deflation in our case) and using a similar mindset as "Murphy's law" ("Anything that can possibly go wrong, does"), taking an approach which minimizes the maximum expected loss, but we ramble again...

And what could possibly go wrong in relation to European growth in 2013? After all, one might posit it is only a game of confidence. Well, looking at consumer confidence in Europe, "Murphy junior" would certainly comment that his father is probably too optimistic when looking at European Consumer Confidence.

European consumer confidence indicators for some European countries - source Bloomberg:

We already looked at the link between consumer confidence and consumption back in our June conversation "Yogurts, European Consumer Confidence and Consumption" where we undertook at an interesting exercise following Yogurt giant Danone profitability warning announcement (affected by Spanish woes), namely plotting Danone share price against consumer confidence - source Bloomberg:

We wrote at the time:
"Yogurts matter as an indicator? One has to wonder...

As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit."

In relation to European Consumption, Consumer Confidence is key. The latest data relating to car sales in Europe, confirms the deflationary forces at play in Europe with car registrations falling plunging 19.2% in November in France on a monthly basis and 13.8% in the first 11 months of the year and Italian care sales by 20.1% in November (for a lengthy analysis on the subject of the car market in Europe please check - "The European Clunker - European car sales, a clear indicator of deflation").
As far as 2013 is concerned, European car sales are at risk on weaker consumer consumption as indicated by Bloomberg:

"Bears suggest discounting by automakers may not be enough to boost unit sales in Europe. Austerity in Europe is straining disposable incomes, with consumer household expenditure falling for three consecutive quarters. Car sales in Europe fell 4.2% yoy in the first three quarters of 2012 and any sustained recovery will be challenging as economic pressures mount." - source Bloomberg

One could also look at car sales and European Consumer confidence since 2007, the relationship seems pretty clear even though the cash for clunkers program have indeed been highly supportive of car sales whenever consumer confidence needed some government "artificial boost" - source Bloomberg:

Weak economy, low consumer confidence and high unemployment are indeed the deflationary forces at play plaguing European consumption and impacting car sales in the process. 2012 will be the fifth consecutive year of declines in the European car market below 12.8 million units, 20% below pre-crisis levels.

Strong macro drivers such as consumer confidence set the trends for the demand in the auto sector but for consumption levels as well.

France Consumer Confidence and Household Consumption YoY since 2001 - source Bloomberg:

For instance, another indicator of the divergence between Europe and the United States, comes from the auto sector where demand for US light vehicle sales were up 7% year over year in October and 14% year to date, whereas Europe was the only region to decline in 2012, down 4.6% in October and down 6.9% in 10 months. Even China, passenger car sales were up 6.4% in October and nearly 7% year to date. In Europe the European Automobile Manufacturers Association, or ACEA, indicated in November car sales decreased 6.9 percent to 10.7 million cars. The ACEA indicated Europe’s car sales would reach a 17-year low in 2012. It also estimates that as much as 30 percent of production capacity is not used.

We think our European politicians would be wise to look at the minimax regret approach given Intrade is now putting a 30.6% chance of breakup of the Euro by December 31st 2013 as reported by Stephen Rose from Bloomberg on the 3rd of December: 
"Following is a table listing the odds that one country currently using the Euro will change its official currency by the expiration date, based on bets made at Intrade.com."

Europe is still a story of deleveraging and as pointed out by a recent note from Credit Agricole Cheuvreux from the 29th of November entitled "EU, The Road through purgatory", should our European politicians decide to tackle the minimax regret approach, there are indeed four possible recipes: "There are four basic recipes for deleveraging: austerity, inflation, growth, and default. The optimal is growth but Europe as whole cannot export its way out of its challenges and nor does it need to. Europe overall runs a current account surplus; the challenge lies in the balance within the Union. Europe needs further debt restructuring, inflation and a rebound in consumption (domestic growth). Deflation is the key risk here, but Draghi appears to understand this danger and has proved a better lateral thinker than his predecessor." - source Credit Agricole Cheuvreux.

Yes, our "Generous Gambler" aka Mario Draghi has been clearly a better lateral thinker in preventing a financial meltdown following the acute liquidity crisis of the financial sector in 2011. But as far as our Regret Theory is concerned, we previously indicated that in the case of Europe, causation implied correlation:
"Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth."


Looking at the prospect for the younger generation of Europeans and high level of youth unemployment, maybe Murphy junior is correct in assessing his father's law after all:

-source CA-Cheuvreux / Eurostat.
"These unemployment trends are very worrisome and if they are not reversed in the short term they may lead to increased social tensions and structurally higher long-term unemployment, which has negative effects on a country's growth prospects as part of the workforce becomes impaired. Also, youth unemployment leads to emigration, which will have a negative impact on demographics, as will be seen in most European countries in the medium term." - source Credit Agricole Cheuvreux.

Deleveraging leads to lower domestic consumption while tax rates are increasing with a shift from income taxes to consumption taxes:
"As taxes increase, and penalise an already fragile economy, consumption decreases exponentially and corporate investment is postponed, which leads to lower tax intakes. This means that more taxes are levied on the economy to try to cover the shortfall and a vicious circle is perpetuated." - source Credit Agricole Cheuvreux.

Maybe the minimax regret approach is the right approach after all. Oh well...

On a final note and in relation to struggling peripheral countries, Spain has indeed very apt in avoiding "tapping out" for help in this European fight of the Century, given it has so far managed to retain market access with timely sales as indicated by Bloomberg Chart of the Day:

"The CHART OF THE DAY shows Spain, which has auctioned about 82 billion euros ($106.7 billion) of bonds this year, sold the most debt when borrowing costs were at their lowest. That’s allowed it to retain market access and so far avoid a sovereign bailout even as 10-year rates surged to a euro-era record. “Spain has been smart in timing the issuance in the market,” said Alessandro Giansanti, a senior rates strategist at ING Groep NV in Amsterdam. “A loss of market access in July this year could have easily driven Spanish yields to the 8 to 9 percent area.” The nation’s 10-year bond yielded about 5.32 percent on Nov. 30, down from 7.75 percent on July 25. The yield touched 5.20 percent last week, the lowest since March 20. Spain sold the biggest proportion of its debt in January, when the 10-year yield averaged 5.30 percent, and auctioned the lowest amount of bonds in August, when yields ranged from 6.15 percent to 7.44 percent. The Treasury completed its program of medium- and long-term debt sales earlier this month, and has used subsequent auctions to raise funds for 2013." - source Bloomberg

"Uncertainty is the worst of all evils until the moment when reality makes us regret uncertainty."

- Alphonse Karr, French critic

Stay Tuned!