Macro and Credit - White noise

"The real man smiles in trouble, gathers strength from distress, and grows brave by reflection." -Thomas Paine

Watching with interest, the return of volatility and consequent rise in Italian Government bond yields, in conjunction with trouble brewing yet again in Spain, following the continuous pressure and Turkey and other Emerging Markets, when it came to selecting our title analogy we decided to go for a signal processing analogy namely "White noise". In signal processing, white noise is a random signal having equal intensity at different frequencies, giving it a constant power spectral density. The term is used, with this or similar meanings, in many scientific and technical disciplines, such as physics, acoustic engineering, telecommunications, and statistical forecasting. White noise refers to a statistical model for signals and signal sources, rather than to any specific signal. White noise draws its name from white light, although light that appears white generally does not have a flat power spectral density over the visible band. White noise is as well interesting thanks to its statistical properties. Being uncorrelated in time does not restrict the values a signal can take. Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off). In statistics and econometrics one often assumes that an observed series of data values is the sum of a series of values generated by a deterministic linear process, depending on certain independent (explanatory) variables, and on a series of random noise values. Then regression analysis is used to infer the parameters of the model process from the observed data, e.g. by ordinary least squares, and to test the null hypothesis that each of the parameters is zero against the alternative hypothesis that it is non-zero. Hypothesis testing typically assumes that the noise values are mutually uncorrelated with zero mean and have the same Gaussian probability distribution – in other words, that the noise is white. If there is non-zero correlation between the noise values underlying different observations then the estimated model parameters are still unbiased, but estimates of their uncertainties (such as confidence intervals) will be biased (not accurate on average). This is also true if the noise is heteroskedastic – that is, if it has different variances for different data points. While causation of Emerging Markets sell-off can be attributed to  "Mack the Knife" aka rising US dollar and positive US real rates, it doesn't imply correlation with the sudden surge in Italian government bond yields, following the rise of a so called "populist" government at the helm of Italy. It is not that Italian issues went away, it is that there were just hiding in plain sight thanks to the strong support of the ECB with its QE program. Now that a less accommodative government has been elected in Italy, the status quo of the sustainability of the European project and European debt are being questioned again. The constant power spectral density of the ECB's QE is fading, hence the aforementioned reduction in the "White noise" and stability in European yields we think. We recently argued the following on our Twitter account: 

"Both rising US dollar and Gold may mean we have entered a period where non-yielding assets are preferable to assets such as some sovereign debts promising a yield yet future size of payment and or return of principal are starting to become "questionable". - source Macronomics, 24th of May.

As the central banks put is fading, what basically has been hiding in plain sight, has been the sustainability of the European project. Investors are therefore moving back into assessing the "return of capital" rather than the "return on capital". It seems to us that the "White noise" which in effect had hidden the reality of "risk" thanks to volatility being repressed thanks to central banking meddling is indeed making somewhat a comeback to center stage yet again given the recent bout of volatility seen on Italian bond prices and yields. When it comes to Italy's latest political turmoil we have to confide that we are not surprised whatsoever. We warned about this playing out exactly last year during our interview on "Futures Radio Show" hosted by Anthony Crudele:

"The biggest risk in Europe is still Italy because the growth is not there" - source Macronomics, May 2017 on Futures Radio Show.

On the anniversary of us voicing our concerns on Italy in this week's conversation, we would like to look at debt sustainability with rising rates as well as the risk of deceleration we are seeing in global growth as of late. 

Synopsis:

• Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 
• Final chart - Decline in PMI's doesn't bode well for the US bond bears

• Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 

The latest ructions in both Emerging Markets and Italian Government bond yields are a reminder that once "White noise" starts to dissipate with QT and a fading central banks put, then indeed solvency issues can return with a vengeance, such is the case with Turkey and fears on Italian debt sustainability. It is a subject we already touched in a long conversation we had back in September 2011 in our post "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!". In this conversation we quoted the work of Dr Jochen Felsenheimer, prior to set up "assénagon" and now with XAIA Asset Management, was previously head of the Credit Strategy and Structured Credit Research team at Unicredit and co-author of the book "Active Credit Portfolio Management:

"Competing systems between countries in a world of globalisation and fully integrated capital markets restrict a country's room for manoeuvre in that mobile factors of production seek out the state infrastructure which give them the best possible reward. The state can only counter the migration of workers and relocation of whole production sites with economic measures, for example the creation of an effective infrastructure (e.g. education) or tax incentives. Accordingly, a government's outgoings - and also its income - are not just determined by domestic economic developments, but also by other countries' economic strategies. Countries are in competition with each other - just like companies. And this is particularly true within a currency union, which is fully reflected in the different tax policies of the individual member states." - Dr Jochen Felsenheimer.

At the time we added that the name of the current game was maintaining, at all cost, rates as low as possible, to avoid government bankruptcies hence the ECB's QE. Dr Jochen Felsenheimer which we quoted at the time also made the following comments in the letter we quoted extensively in our conversation in 2011:

 "In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer

The ECB has been able to provide protection against a run, alas temporarily. While the ECB acted as a lender of last resort, doing so exacerbated political tensions and is not a lasting solution as we can see unfolding right now in Italy. 

The concept of "solvency" is very sensitive to the government’s cost of funding (Turkey), and therefore to swings in market confidence.  A government with even a very large level of debt can appear entirely solvent if funded cheaply enough, which is the case for various European countries we think. There is no reassurance that solvent government will always be kept liquid, forget "leverage", end of the day in credit markets "liquidity" matters and we should all know by now that "liquidity" is indeed a "coward". We commented at the time in 2011 that liquidity, matters, because the major implication of the disappearance of risk-free interest rates is that it weakens in the process the quality of the "fiscal backstop" enjoyed by banks, particularly in peripheral countries which have extensively played the "carry trade". Therefore the sovereign/banks nexus has not been reduced by the ECB's actions, on the contrary. Net Interest Margins (NIM) for peripheral banks has been replaced by "carry trades" thanks to the ECB. There is a direct relationship between the credit quality of the government and the cost and availability of bank funding. You probably understand more our Twitter quote from above regarding the risk for the "return of principal" when it comes to some sovereign debt which again are starting to become "questionable" hence the "repricing" for some Emerging Markets and Italy as well.

If indeed we are moving towards a repricing of risk on the back of "solvency" issues it is because the "risk-free" status of some European government bonds is coming back into center stage. We can see it in the credit markets as pointed out by Bank of America Merrill Lynch European Credit Strategist note from the 24th of May entitled "Corporates safer than governments":

"The not so dolce vita

2017 was a year of “buy the dip” galore in Euro credit markets. Few of the risks that bubbled to the surface last year caused spreads to sell-off for any notable length of time. In fact, the longest consecutive streak of spread widening in 2017 was a mere 3 days (Aug 9th – 11th). What held the market together so well? The constant stream of retail investor inflows into European credit (IG inflows in 49 out of 52 weeks).

This year, however, it’s been more of an uphill struggle for spreads. “Buy the dip” behaviour has been decidedly absent whenever risks have weighed on the market (note that spreads widened for 7 consecutive days in March). And new issuance continues to knock secondary bonds, something that was rarely seen last year.

What happened to TINA (There Is No Alternative)?

What’s changed, then, from 2017 to now? Simply, that the retail inflows in Europe have been much more muted over the last few months…and these were the “glue” of the credit market last year. What about TINA…and the reach for yield? We think the Euro credit inflow story is partly being disrupted by the attractive rates of return available on “cash” proxies in the US market. As Chart 1 shows, given the cheapening in the frontend of the US fixed-income market, US bill yields now offer more attractive returns for investors than the dividend yields on US stocks – something that has not been the case for over a decade.

Accordingly, we think some European retail inflows may be leaking into the US market at the moment, especially given the recent USD strength.

QE…and a classic liquidity trap?

But we don’t think this dynamic will stymie the inflow story forever. In fact, we remain confident that retail inflows into European credit funds will pick up steam over the weeks ahead.

As Chart 2 shows, domestic savings rates across major Euro Area countries have been rising noticeably of late, while declining in other countries such as the US and UK. Even with all the restorative work that Draghi and the ECB have done, European consumers’ penchant for conservatism and saving has not moderated.

In a classic “liquidity trap” scenario, we wonder whether low/negative rates in the Euro Area may simply be encouraging a greater effort by consumers to save for the future (and note that the Fed and BoE never cut rates below zero).

Whatever the driver, more money is being saved in Europe, and yet the prospect of material rate increases by the ECB remains a distant thing: the market has pushed back lately on rate hike expectations, with cumulative ECB depo hikes of 40bp now seen in over 2yrs time.

In this respect, Draghi is still fighting a “war on cash” in Europe. We believe this was the pre-eminent reason retail inflows into credit were so consistent last year…and we believe that this story is far from over.

The not so Dolce Vita

The ructions in Italy have contributed to another dose of high-grade spread widening over the last week: 8bp for high-grade and almost 20bp for high-yield. Testament to the weaker inflows at present, the move in credit is larger than that seen last March, pre the French Presidential election. Back then, the market was also on tenterhooks given Marine Le Pen’s manifesto pledge to redenominate France’s debt stock into a new currency, and to hold a referendum on EU membership.

5% of high-grade

For now, the ink isn’t yet dry on Italy’s first populist government – there are still the hurdles of designating a Prime Minister (at the time of writing), the President’s “blessing” on the government programme, and confidence votes in the Italian parliament. But assuming a 5-Star/Lega coalition government takes power, is this a source of systemic risk for Euro credit? We think not for the high-grade market. While Italy has a larger outstanding stock of sovereign debt than France, the picture is much different when it comes to high-grade. In fact, Italian IG credit represents just 5.4% of the market now…and that number continues to shrink as Italian corporates remain focused on deleveraging.

Where systemic risk from Italy may be of greater concern is in high-yield, as Italian credit represents 17% of ICE BofAML’s Euro high-yield index (we elaborate more on this here).

The plunge protection team

And true to form, the sell-off in the corporate bonds over the last week has been a much shallower version of what historically one would have expected to see. Chart 4 shows corporate bond spreads for peripheral financials versus 10yr BTP spreads.

They have been well correlated since early 2011. But credit spreads have moved much less over the last week than the move in BTPs would imply (and see here for a similar picture for Itraxx Main).

Populism…for real

The Le Pen populism experience quickly came and went for credit markets last year. Her insistence on drastic ideas such as “Frexit” appeared to stymie her support heading into the first round of the French Presidential elections. Her policies did not resonate with a French electorate that were broadly in favour of the EU and its institutions.

But political uncertainty, and populist sentiment in Italy, is likely to have longevity in our view. The hallmarks of populism – voter frustration and wealth inequality – are clear to see. Strong and stable governments have not been a hallmark of Italian politics since the proclamation of the Italian Republic in 1946: the country has had 65 governments.

The hallmarks of populism

Although the Italian economy has returned to growth over the last few years the magnitude of the recovery is still tepid. The IMF forecast Italy to grow at 1.5% this year, one of the lowest growth rates among Advanced Economies (the UK’s projected growth rate is 1.6% this year and Japan is forecast to grow at just 1.2%, according to the IMF).

In fact, the Italian electorate has seen little in the way of wealth gains since the creation of the Eurozone. Chart 5 shows GDP per capita trends for Italy and Germany. While GDP per capita is much higher in Germany, for Italy it remains marginally below where it was upon the creation of the Euro.

According to Eurostat, almost 29% of the Italian population were at risk of poverty or social exclusion in 2015 (and almost 34% of children were at risk). Hence the Citizenship Income mentioned in the 5-Star/Lega Government Contract.

Successive governments, of late, have focused on the fiscal side of the economy with less emphasis on structural reforms to unlock Italy’s growth potential. This has hindered private entrepreneurialism and the expansion of the corporate sector. As Chart 6 shows, Italy still has a large number of SMEs (and “micro firms”) making up its industrial base.

Sluggish long-term investment has partly contributed to this state of affairs. As Chart 7 highlights, capex intensity in Italy remains well below the levels seen between 2000- 2005, while the capex recovery has been a lot healthier in France and Germany.

A vibrant banking sector – that supports SME lending – is of course a prerequisite for greater levels of credit growth in Italy. And while Italian banks have made a lot of progress in reducing their NPLs recently (especially over the last few quarters), Chart 8 shows that there is still work to be done.

Italian banks continue to have the largest stock of non-performing loans across the European banking space. For more on the structural challenges facing Italy see our economists’ in-depth note here.

Such a backdrop is fertile ground for populist politics. Unlike in France, however, populist narratives are likely to fall on more receptive ears in Italy. As the charts below show, the Italian electorate is much less enamored with the EU than in other Eurozone countries.

Companies safer than governments?

The unknown in all of this will be the ECB. QE has been a powerful tool at controlling spreads and yields in the European fixed-income market over the last few years. But Draghi has not had to buy debt securities when Euro Area member countries have been less committed to fiscal consolidation.

And as Chart 11 shows, the ECB has been almost the only net buyer of Italian sovereign debt over the last 12m. Their impetus remains crucial.

Will higher political uncertainty in Italy alter the balance of the ECB’s asset purchases from here until year-end? Time will tell. However, in the credit market we’ve been struck by the extreme relative value gap that’s opened up between Italian credit and Italian sovereign debt during the last week. Italian credit spreads have held up incredibly well vis-à-vis BTPs, amid the volatility.

Chart 12 shows the volume of French, Italian and Spanish credits that are currently yielding less than their respective, maturity-matched, sovereign debt. Notice for Italy that close to a staggering 90% of credits now yield less than BTPs.

And while in periods of political uncertainty the market has often taken that view that corporates are “safer” than governments, this is by far a historical high for Italy (and for any Eurozone country for that matter). Moreover many Italian companies are actually “domestic” and thus have little in the way of a safety net from foreign revenues.

CSPP > PSPP?

How has there managed to be such a substantial outperformance of Italian credits over the last few weeks? We believe a large part of this is because the ECB has upped the intensity of its CSPP purchases lately, especially with regards to Italian issuers. This gives us confidence that the ECB remains committed to buying corporate bonds for as long as politically possible. See our recent note for more of our thoughts on CSPP, the “stealth” taper, and the programme’s longevity.

Yet, Chart 12 also suggests that credit investors should tread carefully with respect to Italian credits at present. While corporate credit richness versus government debt can persist, we learnt during the peripheral crisis of 2011-2012 that eventually tight credits will reprice wider vs. govt debt (the best example of this was Telefonica).

As a guide for investors, Tables 1 and 2 at the end of the note highlight which Italian credits trade the richest versus BTPs.

Respect the law

For the last year, the Euro credit market has not had to worry about the risk of Eurozone breakup. That ended last week, as the first draft of the 5-Star/Lega Contratto contained a reference to a Euro exit mechanism. However, in subsequent versions this was removed.

Nonetheless, as the front-page chart highlights, the market still appears nervous with regards to Eurozone break-up risk. Note the spread between 2014 and 2003 sovereign CDS contracts (The ISDA “basis”) remains high for Italy, and has ticked up again for Spain and France lately.

The 2014 sovereign CDS contracts provide greater optionality for protection buyers, relative to the 2003 contracts, both in terms of whether the CDS contracts trigger upon a redenomination event and also in terms of their expected recovery rates.

Know your bond

If redenomination concerns remain, what should credit investors look for in terms of Italian corporate bonds? In the charts below, we run a simple screen from Bloomberg on the governing law of corporate bonds in our high-grade and high-yield indices. Chart 13 shows the analysis by country and Chart 14 shows the analysis by Italian credit sector.

We rank Chart 13 by the country with the highest share of foreign law bonds (to the left) to the lowest share of foreign law bonds (to the right).

For Italy, the Bloomberg screen suggests that just 10% of Italian corporate bonds (IG and HY combined) are domiciled under domestic law (Chart 13). This is a very different situation to last March when around 60% of French corporate bonds were domiciled under domestic law.

While a legal analysis of the redenomination risks of Italian corporate bonds is outside the scope of this note, what we learnt from the Greek crisis in 2011 and 2012 was that investor focus gravitated towards the governing law of bonds (where foreign law bonds were perceived by the market to be more secure)." - source Bank of America Merrill Lynch

Of course, as everyone know and given the latest news on the Italian front, the European technocrats in Brussels have shot themselves in the foot by interfering with Italian democracy which will led to bolster even more anti-european sentiment. In October 2016 in our conversation "Empire Days" we pointed out that the statu quo was falling in Europe and we also reminded ourselves what we discussed in our November 2014 "Chekhov's gun" the 30's model could be the outcome:

"Our take on QE in Europe can be summarized as follows: 

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014

It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "statu quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016

Obviously the path taken has been the road to growth / disillusion / social tensions and short-term road to heaven for financial assets as well as goldilocks period for credit. Now we are moving towards longer-term violent social wake-up calls in various parts of Europe. 

We really enjoyed our friend Kevin Muir latest excellent musing on Italian woes on his blog The Macro Tourist. He made some very interesting points in his must read note and we really enjoyed his bar-fighting economics analogy:

"Total French, Italian and Spanish assets are multiples of German assets. Italian Government BTPs are almost 400 billion and there are another 200 billion of other Italian debt securities. 600 billion represents almost 20% of German GDP. And that’s only Italy. What are the chances that an Ital-exit is confined to one nation?

Remember back to the 1930s. Nations that devalued early and aggressively generally did better economically during the ensuing depression - I like to call this bar-fighting economics - hit first and hit hard.

The ECB’s balance sheet expansion has put Germany in an extremely difficult place. They cannot afford to cut back on the expansion for fear of another Euro-crisis, yet the more QE they do, they more Germany is on the hook.

I hate to break it to Germany, but it’s even worse than it looks.

Don’t forget that ECB balance sheet expansion is only one the methods that imbalances within the European Union are stabilized. There is another potentially even more scary mechanism that occurs behind the scenes without much fanfare. Although the ECB is Europe’s Central Bank, each member nation still has their own Central Bank. Since monetary policy is set for the Union as a whole, there are times when capital leaves one European nation in favour of another. Individual Central Banks cannot raise rates to counter these flows, so the ECB stands in as an intermediary.
Let’s say capital flees Italy and heads to Germany, to facilitate the flows, the Italian Central Bank borrows money from the ECB while the German Central Bank deposits excess reserves with the GDP, thus allowing it all to balance. The individual country net borrowing/lending amounts are known as Target 2 Reserves." - source  The Macro Tourist, Kevin Muir

Target 2 issues have been a subject which has been well documented and discussed by many financial pundits. We won't delve more into this subject. But, as pointed out by Kevin Muir in his very interesting note, as a creditor Italy and being a very large one, Italy is in a much better position than the arrogant technocrats in Brussels think it is. In our book, it is always very dangerous to have a wounded animal cornered, it's a recipe for trouble. The latest European blunder thanks to the Italian president most likely instructed by Brussels to muddle with the elections result will likely lead to a more nefarious outcome down the line. Charles Gave on French blog "Institut des Libertés" made some very interesting comments when it comes to Italy's macro position:

• Italy now runs a current account surplus of 3.5% of GDP, 

• Italy has a primary surplus of 2 % of GDP, 

• Italy has extended the duration of its debt in the last few years and so is less vulnerable to a rise in long rates, 

• 72% of Italian debt is now owned by Italian entities

There has never been a better time for Italy to quit the euro. Come the autumn a fresh euro crisis is possible." - source Institut des Libertés - Charles Gave

Another expression we could propose relating to the excellent bar-fighting economics analogy from Kevin Muir and Target 2 would be as follows:

 "He who leaves the bar early doesn't pick up the bar tab" - source Macronomics

It is always about first mover advantage anyway, hence our previous positive stance on Brexit from a macro perspective when everyone and their dog were predicting a calamitous fall in growth following the outcome of the referendum.

When it comes to credit and Italian troubles, European High Yield needs to be underweight as it is at risk as pointed out by UBS in their Global Macro Strategy note from the 23rd of May entitled "How big a risk to EUR, credit and stocks":

"Credit: HY more exposed than IG to Italian stress

Italy is a risk but more so for HY cash vs. IG, in our view, where the Italian exposure is about 20% vs. 5%. As long as the risk of Italy challenging the integrity of Eurozone remains low (i.e. higher risk premium but no crisis scenario), we think the disruption in credit should remain mostly contained to Italian corps.

In a scenario of modest additional stress (c. 40bps BTP spread widening), we estimate that EUR IG and HY should widen 5-10bps and 25-30bps respectively from here, based on our fair value models and the recent performance. Our models are based on multi-linear regressions which also take into account other factors such as global growth, credit risk and conditions, as well as the ECB's CSPP.

In fact, peripheral spread widening of 30-40bps is likely the threshold when the relationship between corporate credit and peripheral spreads becomes non-linear, in our view (see Figure 5 and Figure 6). This is the threshold beyond which Italian risk should also affect EUR corporate credit markets more significantly outside of Italian issuers.

Given the uncertainties, we shift our preference for EUR HY vs. IG to neutral and prefer exposure to HY via its CDS index (Xover) which has a much lower Italian exposure at 7%. We recommend investors underweight Italian corps in IG and HY financials (largely Italian banks) and move up the HY curve from single B names to BB non-fins." - source UBS

We have recommended in our recent musings to reduce your beta exposure and to adopt a more defensive stance. If high beta is a risk and you don't like volatility, then again you are much better-off favoring non-financials over financials and you should probably maintain very low exposure to subordinated debt from peripheral financial issuers. At our former shop, a large European Asset Manager we recommended launching a Euro Corporate Bond Funds ex Financials. While the fund unfortunately did not gathered much attention AUM wise, performance wise it has been very good thanks to its low volatility profile and solid credit management. It is still boasting 4 stars according to Morningstar most recent ranking. Should Italian woes escalate high beta exposure will be hit much more, particularly financials. In that instance, for a long term credit investor, having less exposure to financials makes much more sense and we are not even discussing recovery values at this stage.  

Don't ask us about our opinion on having exposure to European banks equities again, because you will get the same answer from us. From a risk-reward perspective and long term investment prospect, it's just doesn't make sense whatsoever to get exposed to them regardless of the cheap book value argument put forward by some snake-oil sell-side salesman. You have been much more rewarded by sticking to credit exposure on European banks, rather than equities in Europe. End of the rant.

As well, we also pointed out in recent conversations that US cash had made a return into the allocation tool box and given the rise in political uncertainties and volatility, one should think about rising its cash level for protective measure. Cash can be "king" particularly with rising US yields and a strengthening US dollar marking the return of "Mack the Knife". Gold continue with it's safe harbor status. As we indicated in our earlier quoted tweet, both the dollar and gold can rise when we move in a situation where investors are moving from being more concerned about "return of capital". One would also be wise to seek refuge again in the Swiss franc (CHF) we think particularly versus the Euro (EUR). As well, a short covering on 10 year US Treasury Notes could be in the making (in size...). Watch that space because we think long end is enticing even zero coupon 25 years plus (ETF ZROZ) should we see an acceleration in the "risk-off" environment.

Moving back to "solvency" risk and sustainability of debt, namely "return of capital", as pointed out corporate credit in many instances could be "safer" than "sovereign" risk. Back in our conversation  "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!" we quoted again Dr Jochen Felsenheimer on macro and credit (our focus):

"In the end, all investors face the same problem - the whole world is a credit investment. And it is difficult to negotiate this problem with the classical theory of economics. Short selling bans, Eurobonds and ratings agency bashing will not provide a remedy here either." - Dr Jochen Felsenheimer

We added at the time that confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues. This brings us to the trajectory of European debt in general and Italy in particular. On this very subject we read Deutsche Bank's Euroland Strategy note from the 25th of May entitled "Pricing debt (un)sustainability" with great interest:

"Default risk pricing and bond relative value

Rising concerns over Italy’s debt sustainability can also be seen in the spreads between high coupon and low coupon bonds on the BTP curve. Over periods of stress, high coupon bonds which typically trade at a higher cash price tend to underperform lower coupon neighbours. One potential explanation for this is the risk that upon a hypothetical default the recovery rate will be based on the par value of the bond rather than the cash price an investor paid. Related to this, lower coupon, more recently issued bonds are also more likely to have CAC clauses compared to neighbours issued pre-2013.

Moreover, in times of stress participants seeking to release cash (for example insurers or pension funds with broad portfolios) might prefer to reduce holdings of higher price bonds (high coupon). Finally, even in normal times higher cash bonds may trade at a slight discount, reflecting the lower liquidity in some of these issues.

This effect is apparent in the charts below showing the positive correlations of z-spread (left) and yield differentials (right) between high and low coupon bond pairs and the IT-DE 10Y spread (which proxies for market pricing of BTP risk). As the BTP Bund spread has widened, high cash bonds across the curve (but particularly from 10Y+) have underperformed.

The non-linear dynamics of some of the bond pairs as spreads have widened are noteworthy. At the the 30Y point, the 44s-47s spread had remained elevated into the latest stress, with the 44s only beginning to underperform after the initial widening move. This may partially reflect the relatively large maturity gap between the two bonds, with 10s30s flattening at first outweighing the high cash price/low cash price effect on the bond spread.

- source Deutsche Bank

From a convexity perspective we find it very amusing that "yield hogs" when facing "redenomination/restructuring risk" see their high coupon bonds underperforming lower coupon neighbours, or to put it simply when non-linearity delivers a sucker punch to greedy investors...

While the "risk-off" mentality is prevailing thanks to Italian woes, confidence matters when it comes to "solvency" and debt "sustainability" yet, given the overstretched positioning in US Treasury Notes, if there is a continuation of troubles in European bond markets, then again, it will be interesting to see what our Japanese friends will do when it comes to their bond allocation. Our final chart deal with the current slowdown in the global economy which represents for us a clear threat to the US bond bears current positioning.

• Final chart - Decline in PMI's doesn't bode well for the US bond bears

While we have been reluctant so far to dip our toes back into the long end of the US yield curve, given the most recent surge in European woes and extreme short positioning, we think there is a potential for a violent short covering move. Our final chart comes from CITI Global Economic and Strategy Outlook note from the 23rd of May and displays the decline from recent peak in Manufacturing PMI pointing towards a slowdown:

There is more evidence that global economic growth is slowing. Some of the drags are likely temporary, such as some payback from unusually fast growth in H2 2017 (e.g. real retail sales in the US grew by 8% annualized in Q4), and adverse weather impacts across Western Europe, Japan and the US, while the positive effects of fiscal stimulus in the US will ramp up over the course of the year. But declining business sentiment, some tightening of financial conditions and the rise in oil prices are likely to have a more persistent (if moderate) dampening effect on global growth, notably on moderating momentum in business capex (Figure 2)." - source CITI

As far as White Noise is concerned, being uncorrelated in time does not restrict the values a signal can take (Italy back in crisis mode + slowing global economic growth). Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off) can makes confidence turn on a dime. For financial markets as well as consumers, end of the day "confidence matters" for credit growth. Have we reached peak consumer confidence?

"What we obtain too cheap, we esteem too lightly; it is dearness only that gives everything its value. " - Thomas Paine

Stay tuned!

Macro and Credit - Circus Maximus

"I can calculate the motion of heavenly bodies, but not the madness of people." -  Isaac Newton

Watching with interest new records being broken in equities reaching new highs, with credit "carrying on" thanks to uninterrupted inflows into funds ($6.5bn of inflow into European IG credit funds and High grade funds recorded another week of inflows; their 21st in a row according to Bank of America Merrill Lynch), we reminded ourselves for our title analogy of the Circus Maximus, the ancient Roman chariot racing stadium and mass entertainment venue located in Rome, which was the first and largest stadium in ancient Rome and its later Empire. It measured 621 meters (2,037 feet) in length and 118 meters in width and could accommodate over 150,000 spectators. In its fully developed form, it became the model for circuses throughout the Roman Empire. While we have been quite comfortable riding the uninterrupted bullish tide from our short term "Keynesian" perspective as indicated in our earlier musings of 2017, as of late, we indicated that tactically we were reducing our beta exposure credit wise and that we would rather stick to quality given that not only we feel that the credit cycle is slowly but surely turning, but, it feels like when it comes to the abundant generosity from our "Generous Gamblers" aka central bankers, when it comes to the Fed and the latest FOMC, it feels like the tide is turning. We posited in the past the following quote, which was a derivation of Verbal Kint's quote in the Usual Suspects movie:

"The greatest trick central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

We have used in the past as a title for a post a reference to the great text from Charles Baudelaire called the "Generous Gambler". This poem appears to be the 29th poem of Charles Baudelaire masterpiece Spleen de Paris from 1869.

As one knows, the "Devil is in the details" and if indeed the Fed is serious with its hiking plan and balance sheet reduction, then it does indicates that, regardless of the slowly turning credit cycle and the flattening of the yield curve, there is an increasing possibility of the liquidity tide to turn, you have been warned. For now in all markets it's "Circus Maximus" as we move towards the euphoria stage, with additional melt-up in asset prices, in the final innings of this great credit cycle we think.

In this week's conversation, we would like to look at why credit is "carrying on" and why we prefer for the moment playing it safe via Investment Grade in case volatility heats up in the near future.

Synopsis:

• Macro and Credit - If you love low volatility, stick to investment grade credit
• Final charts - Italy? It's getting complicated

• Macro and Credit - If you love low volatility, stick to investment grade credit

Reminiscences of a flow credit operator comes to mind in true 2007 fashion these days given the continuous inflows into Investment Grade funds, in conjunction of continuous tightening in credit spreads. Discussing recently with another credit pundit on a macro chat platform, we reminded ourselves of the 2007 spread compression with the current situation:

Him - "I've had banks pretty much telling me I can name my price in itraxx tranches, off the back of structured stuff they've issued to retail."

Me - "Not surprising, this is playing out like 2007, structured products issuance leads to relentless selling in CDS which is compressing even more spreads and market makers can't recycle in the market because the only takers would be loan books buying protection. Lather, rinse, repeat..."

Of course both of us like many others, have seen this movie before. As we pointed out in our recent musing, when it comes to High Yield and in particular European High Yield, given the tightness of the spreads relative to Investment Grade, we have switched to being tactically negative, underweight that is. Sure, some would argue that, it's all about the carry and that given the ECB's supportive stance, it's all about "carrying on" through the summer lull. We have a hard time seeing the relative attractiveness in Europe of € High Yield versus € Investment Grade credit as pointed out by Deutsche Bank in their European Credit Update note from the 13th of June entitled "Carry is King...For Now":

"Credit Valuations and Spread Forecasts

Despite the change in view we still think it will be difficult to see much spread tightening. More specifically, we would argue that valuations appear to be more stretched for EUR HY relative to EUR IG credit. Looking at our often used analysis in Figure 2, showing where spreads currently trade relative to their own histories, we can see that EUR HY spreads are generally at the top of the list.

More specifically BB and B spreads are well into their tightest quartile, in fact for Bs current spread levels are now close to the tightest decile through history. In addition looking at Figure 3 we can see that the HY/IG spread ratio remains around the all time lows having seen HY outperform on a relative basis since September last year.

We should stress here that we think the outperformance would be on a risk-adjusted basis. Given that we think carry will be driving returns from here, the extra yield available (although low in absolute terms) could see absolute outperformance. One other thing to potentially consider is the stark difference in duration of EUR IG vs. HY. The duration to maturity on the IG index is 5.4 years while for the HY index it is 4.1 years. This also does not take into account the fact that many HY bonds are trading to their call date rather than to maturity and therefore the duration of the HY index is likely to be even lower in practice. This could create some further benefit for IG if we do see more spread compression.

The recent trends in ECB QE could also benefit this view. The ECB appears to have trimmed corporate purchases less than government bond purchases as shown in Figure 4.

(For more details, see our report “CSPP Trimmed Less Than PSPP, with a Record Share of Primary Purchases” available at goo.gl/2pgpdM.) In addition, the latest ECB communication has implied that the overall withdrawal of QE could be even slower. Combined with the Italian election risk seemingly pushed back into Q1 2018, these latest developments are conducive to low volatility and tight spreads. In fact, as the market repriced QE for longer with a relatively increased emphasis on corporate purchases so far, CSPP-eligible bonds have again started to mildly outperform ineligible ones (Figure 5).

With the change in view we have also updated our year-end spread targets and what they translate to in terms of excess returns (Figure 6).

We have also trimmed our view on defaults given the combination of the positive macro data and continued low yield environment. The change in view is focused on the next few months and we will likely review this again as we move towards Q4. We have effectively pushed out our moderate widening view given the events of the last few days. And while we now expect the carry environment to last longer than we originally thought, the moderate widening stage might set in before the year end. Our end-2017 forecasts should therefore be seen with that caveat in mind.

Note that the forecast performance is risk-unadjusted. While higher-beta HY may outperform lower-beta IG in absolute terms, we expect the latter to outperform in risk-adjusted terms as mentioned earlier. On the margin, we expect the following relative performance adjusted for risk, which is in line with our previous published views:

• IG outperforms HY

• Financials to outperform non-financials

• Senior financials outperform subordinated financials

• EUR credit outperforms GBP credit

The UK elections have only reinforced our view that more macro uncertainty currently hangs over the UK economic outlook than over the eurozone, which makes us relatively more cautious on GBP credit.
The above cash bond excess returns are over government benchmarks. The total returns will additionally depend on the performance of government bonds." - source Deutsche Bank

This ties up nicely with our recent call in favoring style over substance, quality that is, over yield chasing from a tactical perspective. While the Italian elections probability has been postponed and has therefore moved from a "known unknown" towards a "known known", there is still a potential from a geopolitical exogenous factor to reignite in very short order some volatility, which would therefore put a spanner in the summer lull and "carry on" mantra. But as the Circus Maximus goes on, with very supportive inflows into the asset class, the carry trade continues to be the trade du jour for fixed income asset allocators. On this subject we read with interest Société Générale Credit Wrap-up from the 14th of June entitled "Why fixed income allocators are loving credit":

"Market thoughts

Risk-adjusted returns have become an important tool for fixed income allocation in recent years. Volatility and correlations tend to follow regimes, meaning that the past can be a decent approximation of the future under most conditions. Yields give a reasonable sense of what returns could be, unless the market moves sharply in one direction or another. Thus, dividing current yields by historical volatility is a useful tool for knowing which fixed income classes look most attractive at the moment.

Such calculations flatter the credit markets. Chart 1 uses the risk adjusted yield from our quant team (which they define as current yield divided by the standard deviation of yield over the past year) across a range of fixed income asset classes.

The horizontal axis shows the current level, and the vertical axis shows the change in the level since the end of 2016. Credit has suddenly jumped to the top of the pack, ahead of emerging markets, thanks largely to the very low level of volatility in returns since the start of the year.

But past performance is no guarantee of future returns, as every careful reader of financial boilerplates knows. Will corporate bond volatility remain low?

In the short term, yes, quite possibly, and this is one of the reasons we are bullish on the asset class into 4Q (as explained in Why credit markets could test the summer of 2014 tights). In the longer term, however, two factors worry us. First, the level of equity implied volatility is near 30-year trough levels. It could stay there for a while (as we explained in How this period of low volatility will end), but volatility always eventually gets driven higher by credit problems, and rising leverage – mostly notably in China – could be the trigger once again by early next year.

Second, the low level of credit volatility has been driven by a very high negative correlation between government bond yields and credit spreads. In Why government yield/credit spread correlations will likely reverse next year, we noted that there are fundamental reasons for thinking that this correlation could change in 2018. If it does, then the volatility of corporate bonds will necessarily rise because yields will not be a shock-absorber for spreads and vice versa.

Therefore, a word of warning. 2H may bring further inflows into credit from other parts of the fixed income world as asset allocators look at indicators like this one and draw optimistic conclusions. This may however spell the final phase of the credit market rally, for lower spreads and changing correlations could make the risk-adjusted yields look much less enticing come 2018." - source Société Générale.

We agree with the above, namely that from a risk/reward perspective, we have moved at least in European High Yield space from expensive levels to very expensive. While we had some confidence in the rally so far in the first part of the year, no doubt we could see additional melt-up in asset prices, credit included but it remains to be seen how enticing the risk-adjusted yields will look in 2018 in the Circus Maximus. The pain from rising yields and the continuation of the flattening of the yield curve will probably come to bite at a later stage.

When it comes to Deutsche Bank's recommendation in playing Senior financials versus subordinated financials, it makes sense, given the latest Banco Popular bloodbath. On this subject we read with interest Euromoney's article from the 13th of June entitled "Spain’s bank rescue could make tier 2 less Popular":

"Both AT1 and tier-2 investors lost everything when Banco Santander rescued Banco Popular, while senior bondholders were untouched. The rescue has shown that when banks in Europe get into trouble it is liquidity, not capital, that matters and that the fate of subordinated bondholders is anything but predictable.

There is no doubt that the AT1 market took the surprise bail-in of Banco Popular’s subordinated debt and equity in its stride. Despite its tier-1 and tier-2 debt trading at around 50c and above 70c, respectively, the day before, both became worthless when Spain’s Fondo de Reestructuración Ordenada Bancaria placed the bank into resolution on Wednesday, imposing losses of around €3.3 billion on debt and equity investors. The market has been patting itself on the back ever since, calling the sale of Banco Popular to Banco Santander for €1 a textbook outcome. Peripheral bank AT1s barely stirred. According to CreditSights, these bonds traded down over the course of the following week, but many by less than a point. 

Overall, the AT1 market has been trading close to 12-month highs, the memory of the market disruption caused by questions over Deutsche Bank’s ability to meet coupon payments on its AT1 paper in the first quarter of last year seemingly a faint one. Even peripheral names only fell to around 85% to 90% of those 12-month highs after Popular’s wipeout. Sorely needed This was a sorely needed win for the EU’s Bank Recovery and Resolution Directive (BRRD) after its shaky start with Novo Banco at the beginning of 2016 and the protracted horse trading over state support to Italy’s troubled MPS ever since.

The overnight move by the Single Resolution Board (SRB) saw Popular’s AT1s pushed past their CET1 triggers by the extra provisioning that Santander has demanded to take on Popular’s €36.8 billion of non-performing assets – just 45% of which were covered by provisions. So far, so good. However, there are a few things about this bail-in that are not exactly text book as well. The whole point of contingent convertible tier-1 debt is that it has triggers: Popular’s were set at 5.125% and 7%. It has two AT1 deals outstanding – a €500 million 11.5% low trigger deal and a €750 million 8.25% high trigger deal.

In the bank’s Q1 2017 presentation, its CET1 was 10.02% ­– still a long way from both of those, although its fully loaded CET1 ratio was closer to 7.33%. However, Popular had never missed a coupon payment on any of these notes: if this situation had really been played by the book that is what should have happened first. This is what the hoo-ha over Deutsche Bank’s available distributable items was all about last year. Banco Popular's situation has shown that the fate of subordinated bondholders actually has very little to do with the precise structure of the instruments that they are holding. Neither of Popular’s tier-1 notes had breached their triggers before the SRB decided that the bank had become non-viable late on Wednesday. Indeed, European Central Bank (ECB) vice-president Vitor Constâncio has clearly stated that the bank’s solvency was not the issue.

“The reasons that triggered that decision [to deem the bank non-viable] were related to the liquidity problems,” he explains. “There was a bank run. It was not a matter of assessing the developments of solvency as such, but the liquidity issue.”

There certainly was a bank run. €20 billion left Banco Popular’s coffers between the end of March and June 5 – the same day that its chairman Emilio Saracho declared that he did not plan to request emergency assistance from ECB because it was not necessary. The sale to Santander is understood to have been put together in less than 24 hours.

It was thus depositor withdrawals that caused the SRB to deem the bank to be failing or likely to fail under Article 18 (1) of the Single Resolution Mechanism Regulation. This meant that it had hit the point of non-viability (PONV). 

Investors in AT1 instruments should, therefore, be paying much closer attention to the PONV language in their documentation than to trigger language. When a takeover deal that blows through the latter is hammered out overnight there is not a lot that you can do.
The market has long muttered about the death spiral effects in the CoCo market – whereby debt investors that are converted into equity on breach of a trigger are forced to immediately sell that equity and accelerate the demise of the institution. This is the first time that there has been any principal or coupon loss in the AT1 market and there was no sign of a death spiral. 

However, that was only because the bondholders didn’t have time to be converted into anything that could be sold: Popular’s AT1s and tier 2s were converted into shares that were immediately written down to zero. The market has spent too much time fretting over the impact of CET1 triggers that – if Popular is a textbook case – will never get to be hit.

The wipeout of Popular’s equity and AT1 investors is unquestionably the BRRD doing what it was designed to do and investors will not have been surprised by their treatment.

Pimco is understood to have been holding €279 million of the AT1s at the end of March – the giant US money manager also held more than €100 million of Novo Banco senior bonds that were bailed in under its disputed resolution.

However, the fallout from Popular’s demise might be more keenly felt by its tier-2 investors.

The deal with Santander means that Popular’s tier-2 investors were dealt with in exactly the same way as its AT1 investors – they were written down to zero – although the tier-2 investors got the €1. This in effect removes any distinction between the two asset classes in resolution.

The temptation to wipe out anything that you can in resolution is understandable as it makes the bank more attractive to a potential buyer, but if this will always happen then why buy tier 2? You are getting paid more for the same risk with AT1.

All eyes are now on the tier-2 bonds of two other Spanish lenders: Liberbank, whose 6.875% €300 million tier-2 bonds traded below 81c on Friday – while a short selling ban was placed on its shares on Monday.

Another lender, Cajamar, also has a €300 million 7.75% tier-2 bond outstanding that is now trading below 90c. Popular’s tier 2s were trading at between 70c and 80c immediately before they became worthless.

What is key here is that Popular had yet to issue any new style bail-inable senior debt. If banks want investors to buy their tier-2 debt then in future, a resolution such as this might need to involve – very different – haircuts for both tier 2 and senior debt rather than oblivion for one and protection for the other; Popular’s senior bonds were up from 90c to 104c after the deal.

Although this takeover is a neat and straightforward demonstration of what investors can expect under BRRD, there needs to be a closer examination of the loss-absorbing hierarchy of tier 1 and tier 2 in the process. If they are the same then you don’t have a repayment waterfall – you have a lake." - source Euromoney

Of course, we would argue that no matter how much liquidity via LTROs the ECB has injected, liquidity doesn't amount to solvency hence the importance lessons in dealing swiftly with nonperforming loans as done by the Fed, while the ECB has been following a path more akin to Japan (here comes our "japanification" analogy). But, from a technical perspective on the subject discussed in details by Euromoney, there is a technical aspect that needs to be discussed namely protection offered only to some subordinated bondholders via the CDS market:

"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."

A typical LT2 Structure is as follows:
10 years, non-callable for 5 years (10-NC5)
-Final maturity is hard, meaning no get out clauses.
-No coupon deferral. A coupon deferral would constitute a credit event and therefore trigger a credit event and the relating CDS.
-Ratings: 1 notch below senior debt (Moody's / S&P).
-More standardised structure than Tier 1 or UT2. Given regulatory capital treatment decreases as it moves towards maturity (as it gets closer to 5 years to maturity) so many deals structured have had callable features, meaning the issuer can decide to call the bond.

As a reminder the Dutch bank SNS resolution in 2013 meant that Tier 1 bonds and LT2 losses equated to 100%. At the time the SNS intervention clearly pushed the envelope on how national authorities and now the ECB being the European regulator are willing (and able) to go in the resolution of a failing financial institution. The downside recovery for LT2 (using Irish precedents) was generally assumed to be 20%. This should have been understood to be 0% back in 2013, but yet again investors have been blind. Why the change in recovery rate from 20% to 0% matters in the CDS space?

If the recovery rate for LT2 subordinated bonds is zero (again for Banco Popular and in similar fashion to the SNS case), 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. Subordinated debt should in essence trade much wider to Senior! Particularly if liquidity, not capital, matters and if the fate of subordinated bondholders is anything but predictable.

Here is your "known unknown". Yet in Banco Popular's case the short end of the CDS curve was already inverted before the takeover for €1 was announced so while in the above article we read that there was no sign of a death spiral, this is not entirely correct. If indeed AT1 are known unknowns, and are American options like short gamma trades, who really cares about the capital threshold trigger aka the strike price seriously? We don't and continue to dislike these bonds but hey, some might enjoy nonlinearity, we are not big fans.

For those who have been following us, we have been pretty vocal on the evident lack of resolution of the nonperforming loan issues (NPLs) plaguing the Italian banking sector. On a side note we did at the end of last month a podcast on the Futures Radio Show in which we discussed Italy, being for us the biggest risk in Europe.
The on-going issues plaguing the oldest bank in the world namely BMPS aka Banca Monte dei Paschi di Siena can be seen in the CDS market and the NPLs have yet to be meaningfully tackled as indicated in the recent blog post from DataGrapple from the 19th of June entitled "A Tricky Task Just Got More Difficult":

"On Friday, it emerged that Fortress Investment Group and Elliott Capital Management had dropped out of talks to buy bad loans from MONTE ( Banca Monte dei Paschi ) complicating the rescue plan for the lender backed by the Italian government. They were the only international bidders for the riskier tranches of MONTE’s bad loan securitization. That leaves Atlante, the fund set up to help the struggling Italian banking sector, as the only potential buyer and jeopardizes the asset sale, which is a key part of the plan to restructure the bank with a capital injection from the state, after MONTE failed to shore up capital privately. Ultimately, it could also make similar rescue plans for two other northern Italian lenders, Veneto Banca Spa and Popolare Vicenza Spa, much more difficult to pull off. Surprisingly, if MONTE’s 5-year risk premium was marked aggressively wider - insuring senior debt now costs 330bps per year, while insuring subordinated costs 73.5% upfront -, it did not feed through the whole Italian banking sector and most names were actually unchanged to a tad tighter." -source DataGrapple

And guess what 73.5% upfront Subordinated CDS still seems pretty cheap if you ascertain the fact that your recovery value on the subordinated bonds will probably be a big fat zero...Just a thought. So while you might want to continue playing the Circus Maximus credit show, when it comes to favoring Senior Financials over Subordinated bonds, use your credit skills wisely.

If you indeed love low volatility, stick to investment grade credit because as the party continues flow wise in that space, the feeble crowd aka retail is now joining the party with both hands according to Bank of America Merrill Lynch Credit Market Strategist note from the 16th of June entitled "ECB+BOJ&Fed, redux":

"Retail taking over from foreigners

US high grade corporate bonds have returned 4.2% this year driven by 7.3% in the backend. With the timing of the decline in interest rates, not surprisingly about two-thirds of this performance has accrued in 2Q. These stellar returns are now attracting retail money to HG bond funds and ETFs in the usual way (chasing performance). As we have often highlighted, in the first part of the year we had record inflows without supporting preceding performance necessary to attract retail inflows – in fact HG lost almost 3% in 4Q 2016 (Figure 2).

Our view remains that foreign investors were responsible for the big acceleration in HG bond fund/ETF inflows to begin the year, as the timing coincided with a big decline in the cost of dollar hedging (Figure 3).

Furthermore these inflows accelerated more at the end of the Chinese New Year." - source Bank of America Merrill Lynch

It looks to us that indeed Circus Maximus is getting crowded, but for now everyone in the credit "karaoke" is singing "carry on" so you probably got to keep dancing...

In our final charts below and given our take in the podcast, we continue to view Italy as the biggest European risk even though elections have so far been postponed. Growth is not meaningful enough, we think to alleviate the slowing but still growing very large nonperforming loans problem on Italian banks' balance sheets.

• Final charts - Italy? It's getting complicated

While we won't go through the debt trajectory of Italy and the dismal growth experienced in recent years, for our final charts we would like to point to charts from a recent presentation done by French broker Exane on the 12th of June. They point out to IMF work showing that the NPL ratio drops significantly when GDP growth reaches 1.2% (and particularly when this trend is sustained for a few years). Their charts below also display the relationship with the 2-10 Italian yield curve. This indicates that Italian banks are very sensitive to a surge in yields in the short-end which makes very interesting in the light of the willingness in tapering as of late from the ECB:

Italy: GDP Growth versus NPL ratio

Italy: NPL ratio versus 2-10 yield curve

- source Exane

According to them, YoY growth for Italy is likely to enable a significant decline in NPLs. Yet they indicate that while there is hope for a relaunch of the European project, the situation of the banking sector remains a concern and is still plaguing credit conditions for the corporate sector. They conclude their slide in their French presentation by saying that for the sustainability of the Italian debt, it's getting complicated. We could not agree more: "Troppo complicato!"

"Too much sanity may be madness and the maddest of all, to see life as it is and not as it should be." - Miguel de Cervantes

Stay tuned!