Macro and Credit - The Zeigarnik effect

"Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical." -  David Einhorn

Looking with interest at the continuation of the rally in both equities and credit, including the high beta space while looking at the continuation in worsening macro data coming out of Europe, when it came to selecting our title analogy, thanks our fondness for behavioral psychology, we decided to go for the "Zeigarnik" effect given most investors are focusing these days on the uncompleted task of the Fed's balance sheet reduction. In psychology, the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks. In Gestalt psychology, the Zeigarnik effect has been used to demonstrate the general presence of Gestalt phenomena: not just appearing as perceptual effects, but also present in cognition. If a task is interrupted, the reduction of tension is impeded. Through continuous tension, the content is made more easily accessible, and can be easily remembered. The Zeigarnik effect suggests that students who suspend their study, during which they do unrelated activities (such as studying unrelated subjects or playing games), will remember material better than students who complete study sessions without a break (McKinney 1935; Zeigarnik, 1927). The results of the study of the "Zeigarnik effect" suggest that a desire to complete a task can cause it to be retained in a person’s memory until it has been completed, and that the finality of its completion enables the process of forgetting it to take place. In similar fashion the desire of the Fed to complete its balance sheet reduction could generate we think, a "Zeigarnik effect" in investors mind. After all it seems to us that the Fed's balance sheet contraction is more influential on assets prices than rates hike, hence the importance of the "Zeigarnik effect" but we ramble again...

In this week's conversation, we would like to look at the state of credit markets and US in particular given the significant rise in leverage in recent years versus Europe, as well as the state of the US consumer. 

Synopsis:

• Macro and Credit - R is for "recession" and D is for "deleveraging". 
• Final charts - Central banks to markets: let's be friends again...

• Macro and Credit - R is for "recession" and D is for "deleveraging". 

The central banking cavalry came late to the rescue with both the Fed and the PBOC coming to support risk assets in general and high beta in particular. Given the even weaker tone coming out of Europe we think it won't take long until we see more support coming from the ECB particularly given the grim growth outlook for the likes of Italy and its continuing ailing financial sector. Given that the European Banking Union remain "unfinished business", it is we think another case of "Zeigarnik effect" as the "doom loop" aka the nexus between the sovereign and the banks is yet to be meaningfully addressed. 

In our previous conversation we pointed out to the more pronounced slowdown affecting Europe including France as well. With French Services PMI at 47.5 in January, at the lowest level in the last 4 years versus 49 in December it doesn't bode well for French GDP going forward:

- graph source Bloomberg

This is what we had to say about France in our last conversation about France:

"The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average)." - source Macronomics January 2019

Sure there is global weaker tone when it comes to macro data, but it is no doubt more pronounced in some places and in Europe in particular hence our concerns and the use of the dreaded "R" word, "R" for recession when it comes to Europe, with Germany coming close to it recently.

But, the latest dovish tone from the Fed is very supportive for high beta, bearish US dollar, bullish Emerging Markets equities, bullish gold and gold stocks as well.

With global "easing" on its way back, following investors fears of a policy mistakes and with a Fed more S&P 500 dependent thanks to the wealth effect, credit could see a return of "goldilocks" thanks to low rates volatility. 

The "R" word has been rising as of late thanks to the global deceleration in global trade on top of a flattening yield curve, but when it comes to credit markets in general and US credit markets in particular, it seems that the "D" word, "D" for deleveraging is staging a comeback as indicated by Bank of America Merrill Lynch in their Situation Room note from the 29th of January entitled "The (soft) floor on credit fundamentals":

"The (soft) floor on credit fundamentals

Our view is that large capital structures in the corporate bond market will go to great length to defend their IG ratings as it could become prohibitively expensive to operate in high yield. That (soft) floor on fundamentals remains one of the reasons we are overweight BBB-rated names. We make a couple of timely observations. First, although the situation remains evolving, we note that General Electric – the 6th largest BBB-rated issuer - is now again trading like the BBB-rated name it currently is, which is a remarkable turnaround after trading in line with BB-rated names during its weakest period last October/November (Figure 1).

Second, when Verizon – the second largest BBB - reported earnings this morning they managed to disappoint and the stock declined more than 3%. However with the company’s emphasis on deleveraging credit investors where not disappointed as spreads tightened about 2bps. AT&T – the largest BBB – was downgraded to BBB-flat in June last year. We would argue that for very large issuers BBB-flat is effectively the floor on ratings, as with further downgrades Fallen Angel risk would be too high for many investors. Since June 30, 2018 – when AT&T became BBB-flat rated in the indices – credit spreads in the Telecom sector, which is dominated by Verizon and AT&T, have tightened 12bps even as the overall IG market widened 10bps (Figure 2).

While we appreciate the longer term challenges to the Telecom industry from technological change, for the next several years we are comforted by relatively stable cash flows and the financial flexibility to support BBB ratings afforded by high dividend yields in the 4.5%-6.6% range. Hence our overweight stance on the Telecom sector." - source Bank of America Merrill Lynch

If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think.

In addition to a potential "D" for deleveraging story playing out for the US, Europe as well could also see a more defensive balance sheet stance coming from CFOs given the weakening growth outlook more pronounced on European shores. On that very subject we read some interesting additional points made by Bank of America Merrill Lynch in their note mentioned above:

"Credit Strategy/Equity Strategy: Who are the refi “losers”?

From the era of hubris… to the reality check

Between 2012 and 2017, European corporates basked in ever-declining debt costs, thanks to unprecedented support from the ECB. The result was a steady boost to Earnings Per Share estimates. Buoyant credit markets thus led equity markets higher. But now the tables have turned, and the equity market should be prepared for a reversal of this symbiotic relationship. European credit spreads have doubled over the last year and companies are finding that they must now pay large concessions on bond deals to attract the requisite demand. Moreover, bond refinancing is a pressing need for a number of companies that failed to term-out their debt maturities during the good times. We think that credit markets now signal that EPS downgrades lie ahead.

A walk into the future - who are the refinancing "losers"?

Table 1 screens for European issuers that could see the greatest EPS downgrades from refinancing their 1-5yr debt. Based on today's credit landscape, we calculate EPS hits of up to 4%. Which names tend to be captured by our screen? Those with plenty of frontend debt still, and those where credit markets have already priced-in steep credit curves.

While Table 1 highlights a variety of names, reflecting these mix of themes, (peripheral) utilities, autos, industrials and telecoms feature prominently. And while there may be mitigants to EPS hits for utilities (regulatory regimes) and autos (financial debt), if debt costs continue to rise in Europe, these sectors would be impacted in other ways.

The canary in the credit mine for stocks

At the height of ECB QE, interest costs for European companies had dropped to 20yr lows. However, interest expenses returning to pre-QE levels will likely become a reality, and will be a further headwind to an already slowing profit cycle. EPS Revision Ratios have been trending down since 2017, when credit spreads turned, and our top-down profit cycle model is predicting 0% EPS growth this year. While operational leverage is undoubtedly the key profitability driver, a 100bps rise in interest costs could lead to a ~2% hit to European EPS. Our strategic view on equity styles and sectors is to focus on quality companies with higher profitability and lower leverage - names that we think will be less vulnerable to rising interest cost and widening credit spreads.

Defend the debt…not the dividend

Companies manage to shareholders, not bondholders. That is the unspoken rule. But we believe that this narrative may no longer hold in today's world of tougher debt rollovers. Equity investors should be prepared for companies to "defend" their debt more than their dividend going forward. Equity investors should therefore be mindful of companies with a high quantum of front-end bonds, and with high dividend payout ratios.

Who are the refi "winners" still?

The silver lining for equity investors is that while debt costs are rising everywhere, some companies have been relatively slow to refinance their bonds over the last few years, and are thus paying higher-than-market coupons on their existing debt. When refinancing time comes, we believe these companies (Table 2) will likely see a small EPS boost.

- source Bank of America Merrill Lynch.

Whereas 2018 was not a good vintage for European stocks, then indeed there might be more additional pain for some equities holders should CFOs in Europe as well embrace a more defensive balance sheet stance, though, leverage in Europe has been creeping up at a much slower pace with the exception of France, being the outlier when it comes to corporate credit leverage overall.

We pointed out in our previous conversations that corporate treasurers in France were becoming more cautious given the deterioration they were seeing in their operating cash flows and slowdown in activity. We could therefore see more dividend cuts coming from French local players, if indeed CFOs adopt a more credit friendly approach when it comes to their balance sheet. The French "leverage" is highlighted in the below Barclays chart from their European Equity and Credit Strategy report from the 30th of January entitled "How worried should we be about Credit?":

- source Barclays

In relation to the European situation we read with interest Bank of America Merrill Lynch's Credit/Equity Strategy note from the 29th of January entitled "Who are the refi losers":

"Canary in the credit mine for stocks

The end of all-time lows on interest charges, as QE ends Since the inception of ECB QE in 2015, corporate borrowing costs have been falling up until 2017, when we saw the Euro cost of debt drop to all-time lows (Chart 5).

With ECB QE coming to an end, we have seen widening corporate credit spreads amid a widespread economic downturn and trade tensions. In periods of declining macro conditions, although safe-haven government bond yields tend to fall amid expectations of looser monetary policy, corporate credit spreads tend to widen due to the perception of rising default risks.

Interest expenses returning to pre-QE levels becomes especially important when EPS Revision Ratios in Europe have been trending down since May ’17 (chart 6) and our topdown earnings model predicts 0% EPS growth in Europe over the next 12 months (chart 7).

Unsurprisingly, investors are increasingly demanding that companies preserve cash to pay down debt rather than spend it on dividends or capex (chart 8).

We prefer more defensive High Quality names with lower relative quantities of frontend debt (or flatter credit curves). These are names that are less likely to see a hit to EPS from future debt refinancing, we think. Also similar to the list, we are strategically overweight the Food & Beverages equity sector in Europe.

European stocks dropped 18% last year, peak-to-trough, but have recovered the majority of December’s losses this year. Recent Fed action has clearly brought short-term relief, but so far has failed to generate large inflows back into Euro corporate credit. The key question is whether we can see a repeat of 2016, when the Fed took a long pause – and helped credit markets. However, in Europe, we think the ECB are unlikely to be able to offer new big stimulus, given the political constraints of QE.

We would note that equities have 88% correlation with credit spreads. But credit markets can also serve as useful leading indicators for equity investors. Large declines in EUR HY credit spreads have reliably signaled major troughs in equities in the past. With global growth in question, central banks are the only game in town (chart 9).

The credit market-equity market nexus

Note as well, that our analysis shows that a rise in European high-yield spreads of 100bp leads to an approximate 2% hit to market EPS in Europe (from the current levels). Given that our top-down model for European earnings suggests 0% EPS growth in 2019, we think that this is quite a meaningful number." - source Bank of America Merrill Lynch

If indeed the Fed's dovish pattern has been more positive for US equity holders including the high beta space, we do agree with Bank of America Merrill Lynch that, in Europe, the story might play out differently, with equities benefiting less from the ECB than credit markets overall. With slowing growth we continue to dislike European banks equities. From a credit perspective, it is more on a case by case basis we think but we would rather own selected credit from European banks than their stocks as far as we are concerned regardless of the high beta/cheap valuation put forward by some pundits or "confidence men" out there. 

So does it mean a return for "goldilocks" for credit? Sure they are many external factors such as Brexit and other geopolitical factors that come into play but, given the Fed has been in the driving seat in the most recent "risk-on" mood, there is a potential for a continuation of the rebound but probably not as significant as the one we saw during the second part of 2016 thanks to the rally in oil prices. We have touched this subject before on numerous occasions but when it come to a sustained rally for US High Yield, oil prices do matter a lot given the exposure to the Energy sector. 

With a notable slowdown in global growth on the back of rising angst surrounding the outcome of the trade war between the United States and China, with central banks coming to the rescue there is indeed a potential for credit to continue to perform on the back of the stabilization of fund flows in the asset class. In relation to US corporate credit's potential for pushing the United States into recession, as we stated before, earnings will be essential in 2019. On this subject we read with interest UBS's take from their Global Macro Strategy note from the 28th of January entitled "Credit Perspectives - US Corporate Credit - What we worry about and what we don't":

"While US growth is coming lower, rest of the world growth is still falling even quicker. Much as we think that at the aggregate level there are mitigating factors that imply US corporate debt won't itself lead to a US recession, there seems to be little doubt higher leverage means the US economy is more vulnerable to a profits slowdown, even one that has its origin abroad. The lack of willingness and ability from China to give a major stimulus this time has compromised growth both in Asia and Europe. Given that Asia has been a big driver of the demand for both tech and energy, key sectors for the US LL and HY markets, a slowdown here could have a big impact on US spreads. Energy issuers are still amongst the most vulnerable, even if the breakeven price for shale has fallen to USD 40-50 per barrel on WTI (Figure 24).

At those levels HY energy spreads could rise to 800-1000bps, we estimate. For the IG space, the big risk is European financials, to which US financials display a very tight correlation (Figure 25), and which have widened but less than would have been expected in the face of a sharp growth slowdown in Europe.

However, the decline in credit market liquidity means a sign of relative calm should not be read as a signal of health. Things could change dramatically with a few downgrades, or an uptick in NPLs." - source UBS

Given the significant rally in European credit since the inception of QE in Europe and with the ECB purchasing directly corporate credit, should a new TLTRO materialize in the coming months to continue to support the European financial sector, we do not think the upside will be as significant as seen before. We do have to agree with UBS namely that the "Zeigarnik effect" of our "generous gamblers" will probably be less potent than previously in engineering a significant rebound in credit markets à la 2016.

Moving back to the subject of earnings and risk-on/Goldilocks, we think there is limited upside in 2019 and we did warn in 2018, that when it came to earnings estimates, analysts were being overly optimistic in their outlook. December has clearly set the tone for vicious EPS revisions and cuts in many instances. If indeed CFOs become much more defensive of their balance sheet, then we could see more dividend cuts in 2019, which would be more credit positive, no wonder we suggested to seek higher quality in US Investment Grade versus high beta credit, performance wise, it has been more supportive to play quality (ratings) over quantity (high beta/yield) as highlighted in the below charts from Bank of America Merrill Lynch from their Credit Market Strategist note from the 25th of January entitled "High grades to IG":

"High grades to IG

While equities and high yield ended this week roughly flat (Figure 1) the strong rally in investment grade continued with credit spreads tightening at a roughly 5bps weekly pace (Figure 2).

This makes sense as the key economic data release this week – Jobless Claims – at the best level since the 1960s (Figure 3) confirms recession risk remains remote. Moreover, the Fed remains clearly on hold for an extended period of time (Figure 4) on the negative GDP impacts of tighter financial conditions and uncertainties surrounding trade war and the government shutdown.

For IG, the material decline in rate hiking risks in reaction to just some tenths cuts to economic growth is a good tradeoff. Being relatively more sensitive to economic growth for high yield and equities the tradeoff is a bit different.

The most likely scenario for how this year plays out, in our view, is continued improvement in the macro – US government reopens, Brexit resolves, US–China relations de-escalate and the US economy continues to grow above trend. As financial conditions ease this environment eventually puts the Fed in a position to resume its rate hiking cycle – probably sometime in the middle part of the year – which is going to be a more formidable challenge for IG. For now, we expect tighter credit spreads – although obviously the first big step has already been taken – but over time IG outperformance fades and turns to underperformance. We remain overweight IG corporate bonds." - source Bank of America Merrill Lynch

So yes, clearly, there is room for slightly more tightening with the Fed's dovish tilt and lack of interest rates volatility with falling inflation expectations. In terms of upside, it is a question of not having "great expectations" and being very selective hence the return of global macro and active management at this stage of the cycle with continued rising dispersion. 

Our final charts below clearly highlight the importance of central banks and in particular the Fed in driving asset prices, with its balance sheet policy reduction being the most important factor at play when it comes to the "Zeigarnik effect".

• Final charts - Central banks to markets: let's be friends again...

With the most recent dovish tilt coming out of the US Federal Reserve, no surprise "risk-on" lives on. It is all about after all a question of "growth sensitive assets" as indicated in our final charts from Bank of America Merrill Lynch The Inquirer note from the 30th of January entitled "Wanted: Monetary easing, not Verbal flexibility":

All indicators point to weak global growth, and suggest EASING monetary policy

1) Only 5 out of 38 economies are seeing rising OECD leading economic indicators (LEI). The net proportion of countries with rising LEI is in the bottom decile of its history since 1988. 2) The world's monetary base shrunk 1.7% YoY in November, only the sixth time since 1980. All prior five occurrences of a shrinking monetary base were associated with recessions in Asia/emerging markets, and ALL were eventually associated with global monetary easing. The Fed's plan to "watch paint dry" and shrink its balance sheet by USD50bn/month this year, is likely to shrink the global real monetary base by 5% YoY by end-2019. Global central banks are implying a massive rise in the money multiplier to counteract this, and/or a rise in monetary velocity to keep nominal GDP growth humming. We think these assumptions are heroic. 3) The global 1m earnings revisions at 0.5 (i.e. for every upward revision there are two downward revisions) is in its bottom decile. 4) Asset prices that have an opinion on global growth (Dr Copper, Dr Sotheby's, Dr. Halliburton etc.) are in their lowest decile. Again, prior instances of such analyst pessimism and weak asset prices were followed by monetary easing. Policymakers seem to be flexible, and the markets like this flexibility if data weakens. Next stop easing?" - source Bank of America Merrill Lynch

Given the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks, it seems that markets are more than happy to remember an incomplete balance sheet reduction from the Fed at this stage but, we ramble again...

"An educated person is one who has learned that information almost always turns out to be at best incomplete and very often false, misleading, fictitious, mendacious - just dead wrong." - Russell Baker, American journalist.

Stay tuned!

Credit - In the doldrums

"There are many countries in the world that when they reached the middle-income stage, they witnessed serious structural problems such as growth stagnation, a widening wealth gap and increasing social unrest." - Li Keqiang 

Looking at France's recent PMI print for manufacturing coming at 48.5 but most importantly services coming at 48.8 which in the French economy represent around 80% of the GDP versus 76% for the rest of the European union and given it has been a while since we have not used our beloved maritime analogies, we thought it would be nice to re-acquainted ourselves in our chosen title this week:

"The doldrums is a colloquial expression derived from historical maritime usage, in which it refers to those parts of the Atlantic Ocean and the Pacific Ocean affected by the Intertropical Convergence Zone, a low-pressure area around the equator where the prevailing winds are calm. The low pressure is caused by the heat at the equator, which makes the air rise and travel north and south high in the atmosphere, until it subsides again in the horse latitudes. Some of that air returns to the doldrums through the trade winds. This process can lead to light or variable winds and more severe weather, in the form of squalls, thunderstorms and hurricanes." - source Wikipedia

Colloquially, the "doldrums" are a state of inactivity, mild depression, listlessness or stagnation which we think clearly characterizes for us the French situation in particular and the European situation in general. 

Therefore this week we will focus our attention on France and ask ourselves an interesting question, can you have a credit-less recovery in Europe?

In relation to France, if the Services PMI contracts at such a rapid pace, it still doesn't bode well for France's unemployment levels with president Hollande hoping to overturn the trend by year end. In that specific case the trend is definitely not the friend of French president Hollande as services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

We were not surprised either to see Germany's Flash Composite Output Index jumping to a 10-month high of 54.3 from 53.2 in October. The services index also climbed to a 9-month high of 54.5 from 52.9, the manufacturing PMI climbed to a 29-month high of 52.5 from 54.5, and the manufacturing output index increased to a 3-month high of 54.0.

The reason for Germany's racing ahead have all been explained not only in the title of a previous post of ours "Winner-take-all" in February 2013 but also in the contents should you want to dig further on the subject:

"In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down" 

We have updated the graph displaying Manufacturing PMI for both Germany and France - graph source Bloomberg:

As a reminder, in our first credit post of the year, namely the "Fabian Strategy", we sounded the alarm in relation to France being clearly in the crosshair in 2013:

The story for 2013 in Europe we think, will be France:
In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April 2012, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

Back in November 2012 in our credit conversation "Froth on the Daydream" we argued:

"Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far")."

We also indicated in  our February 2013 conversation "Winner-take-all" the following:

"While the French government has decided to revise its growth outlook for the year, the overly ambitious fiscal deficit in France of 3% will not be met and even the revised growth outlook of 0.2% to 0.3% will not be reached."

To that effect we justified our negative stance using a definitely scary graph displaying, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) which we thought was telling the story on its own at the time and still is, we think - source Bloomberg:

Of course the divergence story between Germany versus France, is not only a growth divergence story, it is also an unemployment divergence story - source Bloomberg:

We concluded our February note with this statement at the time:

"After all the "Japonification" of Europe is a story of a broken monetary policy transmission channel, leading to liquidity constraints to the private sector with and therefore no impact whatsoever to the real economy, so no potential for economic growth to resume in France in particular and Europe in general."

In relation to Europe's PMI data from November, France we think is the worrying outlier, as indicated as well by Nomura from their recent note from the 21st of November 2013 entitled "Modest recovery ongoing as trend stabilises":

"In France the PMI data for November were disappointing, suggesting the economy is losing momentum. The composite output PMI was 48.9 (from 50.5 previously), the lowest reading in five months and consistent with the three-month moving average declining marginally to 49.8 from 49.9 in October. While almost negligible in size, the fall in the three-month moving average of the French composite index is the first in eight months and it points to some possible downside risks to our French GDP forecast of 0.2% q-o-q for Q4. 

The weakness in the French data was evident in the manufacturing and services sectors. The manufacturing PMI dropped to its six-month low of 47.8 in November from 49.1 previously (consensus: 49.5). There was no bright spot in the detailed report. In particular, manufacturing new orders fell by more than 2 points to 46.1, signalling little chance of revival in the sector in the near term. Moreover, new export orders dropped by 3.6 points to 48.5 and the employment index slipped to its five-month low at 48.2.

In the services sector, the headline index declined by 2 points to 48.8 (consensus: 51). One element of concern was the sharp 4 point fall in the employment service index to 46.7, which underpins the subdued nature of the recovery in France. The new business sub-index is the only bright spot in the services report, which rose to 49.3 from 48.5. However, it remained below 50, thus not sufficient to bring the sector out of contraction in the near term." - source Nomura

and Nomura to conclude their report:

"The data also show a greater divergence in economic performance between Germany and France, with the data for France confirming the services sector remains the laggard as we have highlighted in the latest edition of our business cycle positioning tool Galileo" - source Nomura

If indeed the services sector remains the laggard, then at some point the French president will have to stop being delusional about the probability of reversing the unemployment trend before year end. It will not happen.

Moving on to the subject of the possibility of a credit-less recovery in Europe, Bruno Cavalier from French broker Oddo, came-up with an interesting report on the 20th of November. We have long argued that no credit, meant no loan growth and no loan growth meant no economic growth and no reduction of budget deficits. In his note Bruno Cavalier argues that the argument relating to the possibility of having a recovery without bank lending is incorrect in his note. He indicates that the credit ratio to GDP has fallen from 55% since 2009 to 46%. Obviously this credit ratio varies tremendously from one European country to another. For instance, since the peak figure of 1st quarter 2009, it is down by 50% in Ireland, 30% in Spain and 20% in Greece.

EMU: Loans to the private sector - graph source Thomson Reuters, ECB, Oddo Securities:

EMU: Loans to the non-financial corporations - graph source Thomson Reuters, ECB, Oddo Securities:

Bruno Cavalier quotes a report that shows that out of 388 economic recoveries identified in 50 countries on several decade from researchers of the IMF (Abiad, Dell’Ariccia & Li (2011), “Creditless recoveries”, IMF working paper 11/58). They have established that one out of five recoveries is credit-less. He indicates that often, these credit-less recoveries have been preceded by financial crisis. The work of Abiad and Dell'Ariccia, shows that although credit might be constrained, a recovery is possible. Another study by the BIS, quoted by Bruno Cavalier (Takats & Upper (2013), “Credit and growth after financial crises”, BIS working paper 416), shows that in recoveries following a financial crisis, correlation between credit and growth are non-existent for the two first years following the crisis and turn slightly positive (but weak) in the consequent two years.

The on-going financial fragmentation in Europe can be seen in the differences in loan rates between core countries and peripheral countries - graph source Thomson Reuters, ECB, Oddo Securities:

Where we agree with Bruno Cavalier from Oddo Securities is the importance of tracking Bank Lending Survey which are done on a quarterly basis by the ECB. 

EMU: Credit conditions (z-score, supply & demand mixed) - graph source Thomson Reuters, ECB, Oddo Securities:

We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions.

The divergence between US and European PMI indexes is all about credit conditions. This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will use it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg:

The widest level reached since 2008, between both PMI indexes was 8.90. Whereas investor sentiment combined with an excess of demand over supply pushed the average price of S&P/LSTA Index loans up a quarter-point to a fresh post-credit-crunch high of 98.88 cents on the dollar in 2013.

Another survey we have been using specifically on France to track financial conditions has been a monthly survey in French published by the AFTE (Association of French Corporate Treasurers). In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

In order to comprehend the opinion of French corporate treasurers on the evolution of banks' margins, the AFTE calculates a difference between the average interest rate applied to new corporate loans and the 3 months Euribor rate. The series below stopped in October and continue to indicate some stability in banks' margin on new corporate loans below one year. New credits above a one year maturity provided  to French corporate treasurers remains at elevated levels:

What has been improving though for French corporate treasurers according to the latest November survey is access to financing. There is a slight improvement in the latest survey, but conditions remain tough for French companies:

While the rebound from the lows of the end of 2011 (which was due to the acute liquidity crisis faced by the European financial system), the LTROs have somewhat improved financial conditions for French corporate treasurers, nevertheless conditions remain tough at -6.2% of negative opinions still.

The latest AFTE survey ties up with Bruno Cavalier's note indicating the difference of opinion between bankers and small to medium size enterprises (SMEs) treasurers. Bankers indicate a lack of demand, while corporate treasurers indicate that financial conditions are still too restrictive, too tight.

SMEs which cannot get or accept a bank loan because cost was too high - graph ECB, Oddo Securities:

Share of SMEs which only get part of the loan they ask for - graph ECB, Oddo Securities:

Bruno Cavalier in his note concludes that given the on-going fragmentation in Europe and the credit rationing that follows, it reflects three parameters, risk aversion, difficulties of refinancing for banks and the balance between their risks and recapitalization needs. While the ECB will remain accommodative and the upcoming Asset Quality Review (AQR) in 2014, he thinks we cannot expect a strong rebound for credit availability in the coming months or quarters, but as balance sheets get cleaned up, the following credit cycle that will follow should comfort the economic recovery.

Touching again on the subject of credit-less recovery, another paper from the World Bank published in May 2013 by Naotaka Sugawara and Juan Zalduendo entitled "Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge" made some interesting points:

"Private sector credit plays a crucial role in helping a country to recover from an economic recession. For instance, credit provided by commercial banks can re-energize the investment expenditure of enterprises and is an important option in handling household finances. While a recovery without private sector credit is possible, the empirical evidence suggests that such recoveries occur at a much slower pace. Indeed, a credit-less recovery, defined as a recovery from recession without a pick-up in real bank credit to the private sector, is not an unusual event but has been observed both among advanced and emerging economies.1 Even with different samples, the literature tends to find that the share of credit-less recoveries is around 20 to 25 percent of all recoveries." - Naotaka Sugawara and Juan Zalduendo, Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge

Growth Performance, eight quarters before and after trough - source Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge:

"In both country groups, though especially in the group of advanced economies, growth rates two years (or, eight quarters) before a trough, t-8, are similar between credit-less and credit-with events. However, the growth gap gets wider and becomes quite noticeable at least a year (i.e., four quarters) prior to the trough t. In the year the recovery occurs, credit-less episodes experience slow growth rates; however, this gap narrows after a year from the trough. By eight quarters after the trough, growth in credit-less recoveries is 1.5 percentage point lower than that in credit-with recoveries in developed countries. For emerging markets, the growth gap is even wider four and five quarters after the trough, but it also narrows during the rest of the second year following the trough. As a result, the growth differential in the group of emerging markets ends up at broadly the same level as in advanced economies." - Naotaka Sugawara and Juan Zalduendo, Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge

They concluded their paper with these points:

"Credit-less recoveries are neither rare nor insurmountable challenges. The empirical evidence suggests that such recoveries occur at a much slower pace and are only somewhat more common among emerging markets. But recoveries do eventually occur. In fact, economic performance is in large measure correlated with the depth of the correction triggered during the economic adjustment that precedes the trough; specifically, the size of the downturn and the extent of external adjustment that typically accompany a recession (from the current account adjustment to developments in exchange rates). Also, openness has a dual role. Trade openness decreases the likelihood of a credit-less recovery as trade is a more stable source of financing. Conversely, capital account openness might have a large impact by the deleveraging process that typically follows a recession. But one must also be careful as to what this implies for countries going forward as the pre-recession period might have also meant large benefits in terms of growth.

As to policies during the recession, policymakers must be aware that excessive fiscal loosening might end up exacerbating the likelihood of a credit-less recovery, though more research would be needed to understand better their medium- to long-term implications. In contrast, monetary policy seems to play a more beneficial role by not increasing the likelihood of a credit-less event, especially in advanced economies. Finally, the country choice to avail itself of an IMF-supported program is negatively correlated with the likelihood of a credit-less recovery. Seeking an IMF program tends to help countries recover with an increase in private sector credit. The relationship becomes statistically meaningful when the economic conditions at the trough are controlled for. 

And what can be concluded from the estimation about the likelihood of credit-less events in ECA? Here the model seems to suggest that indeed many countries in the ECA (Europe and Central Asia) region were likely to experience a credit-less recovery—and they indeed did. But one must also draw hope from the fact that investment—and presumably eventually growth—typically recovers 8 quarters after a trough. This would suggest that a credit-less recovery is not a reason for extreme concern. More worrisome is that the region is now facing a renewed negative external shock."

But when it comes to Europe, the situation is more complex due to the single currency than warrants the World Bank and Oddo Securities. In a Bruegel Policy Contribution of February 2013, the author Zsolt Darvas in his note entitled "Can Europe Recover Without Credit?" argues the following:

"Data from 135 countries covering five decades suggests that creditless recoveries, in which the stock of real credit does not return to the pre-crisis level for three years after the GDP trough, are not rare and are characterised by remarkable real GDP growth rates: 4.7 percent per year in middle-income countries and 3.2 percent per year in high-income countries.

• However, the implications of these historical episodes for the current European situation are limited, for two main reasons:

• First, creditless recoveries are much less common in high-income countries, than in low-income countries which are financially undeveloped. European economies heavily depend on bank loans and research suggests that loan supply played a major role in the recent weak credit performance of Europe. There are reasons to believe that, despite various efforts, normal lending has not yet been restored. Limited loan supply could be disruptive for the European economic recovery and there has been only a minor substitution of bank loans with debt securities."

• Second, creditless recoveries were associated with significant real exchange rate depreciation, which has hardly occurred so far in most of Europe. This stylised fact suggests that it might be difficult to re-establish economic growth in the absence of sizeable real exchange rate depreciation, if credit growth does not return." - Zsolt Darvas - Bruegel Policy Contribution.

One of the most important point which has sustained credit markets in Europe, has been the strong issuance levels in the bond markets and the arrival of new issuers due to the on-going deleveraging process of European Banks and the acceleration of "dis-intermediation" as large corporates become more reliable on bonds for financing rather than on bank loans which are generally more difficult to get due and service due to covenants. 

Zsolt Darvas made this very important points in his paper:

"Using US firm-level data, Becker and Ivashina (2011) interpret switching by firms from loans to

bonds as a contraction in credit supply, conditional on the issuance of new debt. They find strong evidence of substitution of loans by bonds during periods characterised by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. They also find that this substitution behaviour has predictive power for bank borrowing and investment of small (out-ofsample) firms, which are not able to issue bonds.

In a related paper, Adrian, Colla and Shin (2012) also document the shift from loans to bonds in the composition of credit in the US, and argue that the impact on real activity comes from the spike in risk premiums, rather than contraction in the total quantity of credit. Gertler (2012) adds, by sketching a simple conceptual framework, that credit spreads are a more useful indicator of credit supply disruptions than credit quantities. Gertler (2012) cites Gilchrist and Zakrajsek (2012), who conclude that the increase in spreads during the recent financial crisis was likely symptomatic of unusual financial distress, and not just the reflection of the increased default risk faced by borrowers.

Certainly, the above-mentioned studies analysed data that was available at the time of writing and therefore their sample periods end between 2009 and 2011. Since then, a number of attempts were made by European governments and the European Central Bank to help restoring normal lending and therefore the finding that credit supply was limited up to 2009 or 2011 may not

necessarily imply that such limitations exit now as well. However, European banks still suffer from a large, €400 billion, capital shortfall according to the OECD (2013); the share of non-performing loans continues to be high; bank share prices are low even after the recent increases; and banks need to meet tight capital, liquidity and leverage requirements, even though some of the Basel III requirements were relaxed in January 2013 (Basel Committee, 2013). These factors suggest that credit supply may remain constrained in the EU." - Zsolt Darvas - Bruegel Policy Contribution.

We also agree with the author's final conclusion:

"If credit growth does not return, economic recovery may prove to be difficult in the absence of sizeable real exchange rate depreciation." - Zsolt Darvas - Bruegel Policy Contribution.

For illustrative purposes, we looked at Spain's non-financial loans versus GDP growth to illustrate the case of a the credit-less recovery discussed - graph source Bloomberg:

But Spain being in the colloquial "doldrums", namely a state of inactivity, mild depression, listlessness or stagnation, some of that air returns to the doldrums through the trade winds, could lead to light or variable winds and more severe weather, in the form of squalls, thunderstorms and hurricanes ahead in Europe, when one looks at the unemployment issues particularly hindering the economic prospects for peripheral countries.

One just has to glance casually at the Spanish "Misery" index to fathom the uphill struggle face by our European politicians - graph source Bloomberg:

The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s.

So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:

"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."
 

On a final note, we think the outlook for the US could be further boosted by fall in Oil imports, making the exit strategy for the Fed as difficult as it was for the team of Apollo 13 and the heroin of visually stunning movie Gravity to land back to earth - graph source Bloomberg:

"U.S. oil imports are close to a 22-year low, a trend that is expected to continue through 2014 from increased domestic shale drilling. About 10.5 million barrels a day were imported in 2005, with about 8.5 million barrels coming from seaborne trade. That number has decreased to 5 million barrels, according to Teekay Tankers. Crude tanker ton-miles will decline, though product tankers should benefit from an increase in U.S. refined exports." - source Bloomberg.

"Happiness, to some, elation; Is, to others, mere stagnation." - Amy Lowell, American poet.

Stay tuned!

Today's French industrial production is indicative of recession looming

"The only relevant test of the validity of a hypothesis is comparison of prediction with experience." - Milton Friedman 

Back in November in our conversation "Froth on the Daydream" we discussed specifically on France our concerns:

"As far as our new barometer of Euro Risk is concerned, all is not well. The 3% deficit target in 2013 is highly unlikely to be reached when one looks at a very simple economic indicator, namely France's industrial production and GDP growth since 2001. French recession will happen. Industrial production slumped to -2.5% the lowest level since 2009 and the biggest drop since January 2009. More than the 1% decline forecast by economists in a Bloomberg news survey. Not only industrial production is cratering but sentiment among manufacturers executives was unchanged at 92 in October.

Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far")."

Today's Industrial Production tumbled, which is indicative of a looming recession for France, as the output for factories, mines utilities and the construction industry fell 1.2% in the month from December when market expected only a 0.2% drop.

Overall on a YoY basis, France's Industrial production came at -3.5%, well below market expectations at -2.7% - source Bloomberg:

French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) - source Bloomberg.

In our first credit post of the year, namely the "Fabian Strategy", we sounded the alarm in relation to France being clearly in the crosshair in 2013:

The story for 2013 in Europe we think, will be France

More recently in our February conversation "Winner-take-all" we indicated:

"A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 42.7 for Services PMI is the lowest since February 2009. Overall French composite PMI is at 42.3, the lowest level since April 2009. "

After shrinking 0.2% in the final quarter of 2012, GDP will shrink by 0.1% in the current quarter according to the median forecasts of 13 gathered by Bloomberg.

That would amount to France triple dipping into recession. The current 2013 budget is based on 0.8% GDP growth, and that target is clearly out of reach we think.

"The groundhog is like most other prophets; it delivers its prediction and then disappears." 

- Bill Vaughan, American journalist. 

Stay tuned!