SOVx Western Europe - And Then There Were 14...

"Ten little Indian boys went out to dine; One choked his little self, and then there were nine. Nine Little Indian boys sat up very late; One overslept himself and then there were eight. Eight little Indian boys traveling in Devon; One said he'd stay there and then there were seven. Seven little Indian boys chopping up sticks; One chopped himself in halves then there were six. Six Indian boys playing with a hive; A bumble-bee stung one then there were five. Five Indian boys going in for law; One got in Chancery then there were four. Four Indian boys going out to sea; A red herring swallowed one then there were three. Three Indian boys walking in the zoo; A big bear hugged one then there were two. Two Indian boys sitting in the sun; One got all frizzled up then there was one. One Indian boy left all alone; He went and hanged himself and then there were none."
- Agatha Christie, And Then There Were None, Ch. 2

Following the "selected default" of Greece and the "voluntary" restructuring, given the auction is taking place on the 19th of March, followed on the 20th of March by the roll of credit indices (every 6 months for indices, every three months for single names), the Current SOVx series 16, is now made up of 14 names instead of 15.

The SOVx cliff drop with the Greek exit from the 5 year index - source Bloomberg:

So courtesy of school drop out Greece, Itraxx SOVx 5 year index is trading closely to Itraxx Financial Senior 5 year index for now until roll day on the 20th of March(25 European banks and insurance single names CDS) - source Bloomberg:

20 bps apart between both credit indices as of the 13th of March.

The remaining members of the Itraxx SOVx 5 year index series 16, as of 13th of March - source Bloomberg:

Given the current Portuguese financial rescue package of May 2011 of 78 billion euros for 2011-2014 is most likely not sufficient, there may be trouble ahead, hence our reference to Agatha Christie's masterpiece, yet another rambling of ours. Risks are as follows:
-further overshooting of deficits
-funding shortfalls for Portugal.

Troika is planning for Portugal to access market funds in late 2013. Maybe it is time for the Troika to pay a close attention to what the CDS market is telling them: Portugal's 5 year CDS is still hovering above 1250 bps (5 year implied probability of default of 64.75% according to CDS data provider CMA as of the 14th of March 2012).

As indicated by Amundi Asset Management in their recent Cross Asset Strategy Monthly report:
"The European Commission recently handed down its verdict, and there are no fewer than twelve countries that are subject to risk: Belgium, Bulgaria, Denmark, Spain, France, Italy, Cyprus, Hungary, Slovenia, Finland, Sweden and the United Kingdom. Add to these countries those that are already receiving special assistance (Greece, Ireland, Portugal and Romania), and nearly two-thirds of European Union countries are receiving special attention. As you can see, these are not isolated cases, but indeed the vast majority of the Union."

In relation to lucky number 13, namely Portugal (BB- at rating agency S&P), Amundi also indicated the following in relation to the insufficient financial rescue package:

"The gross financing requirement for 2011-2014 as estimated by the IMF was already higher in December 2011 than in May:

In December 2011, according to the IMF, Portugal’s gross borrowing needs over the programme period of 2011-2014 were larger than foreseen in May 2011 (EUR163bn vs EUR152bn) partly due to slower than forecast GDP growth over 2012-2014. The IMF bridged this gap in its December 2011 report on Portugal via larger privatization receipts(EUR5.6 vs EUR5bn, despite undershooting in 2011) and much larger market access via short-term borrowing. Also, according to the June report, the general government debt was expected to peak at 115.3% of GDP in 2013 while the December report modified this to peak at 118.1% in 2013.

Since the publication of the IMF December report, the 2011 fiscal deficit has overshot.

General government debt % GDP Portugal’s fiscal deficit in 2011 initially targeted at 5.9% of GDP was higher -- at 7.5% if GDP -- if we exclude EUR5.6bn or 3.3% of GDP of oneoff revenues from the seizure of pension fund assets from three banks. And this despite the fact that the contraction in GDP in 2011 was less than initially expected (-1.5% versus -2.2%). The deficit number for 2011, after the pension maneuver, was 4% of GDP. However, this means that the 2012 deficit target is likely to be overshot since it would be very hard to bring down the deficit from 7.5% in 2011 (excluding one off) of GDP to 4.5% in 2012."

Oh dear...

And Amundi to conclude:
"While 2012 represents a relatively safe window in terms of default risk for holding Portuguese debt maturing over the next twelve months, we see trouble ahead in terms of funding shortfalls due to overshooting of deficits. However, the situation is by no means comparable to the gravity of the Greek problem because of a different political context and slightly more favourable debt burden. A reminder: Greek debt to GDP is currently(before PSI) over 160% versus 107% for Portugal.
We expect that further shortfalls may induce the IMF to put in place a second package before the current one expires in 2014, especially since for the time being the IMF seems to be satisfied with the progress being mage by Portugal. Moreover, the Troika will surely be unwilling to confront another PSI unless absolutely necessary. Until then, the ground will remain wobbly..."

Most interesting points made by Amundi Asset Management in their recent report in relation to our European Flutter's "issues list" are as follows:
"It is very interesting to see that a good number of sensitive issues from the 1990s have resurfaced over the past three years – more specifically:
• The lack of budget and tax harmonisation, which made the European Monetary Zone an incomplete monetary union;
• The lack of a federal budget, which prevented automatic transfers from growth areas that were in good financial health to disadvantaged areas;
• Unwillingness to build true federalism, because of the desire to conserve a measure of autonomy and sovereignty, an indispensable element in the absence of a central government;
• The ECB's inflexibility, and specifically the unified target and mission (the currency's internal value, i.e. inflation);
• Convergence criteria based essentially on public finance criteria (public deficit and debt). Making this a virtually exclusive factor in the health of an economy relegated essential criteria such as the job market, competitiveness, and account balances to the background.
• The logic of the Stability Pact appeared inappropriate. More than that, it enshrined budgetary rigour as the only means of correction and promoted pro-cyclicality for certain economic policy instruments whose effectiveness, indeed, lies in their anticyclical nature."

"Self-preservation's a man's first duty. And natives don't mind dying, you know. They don't feel about it as Europeans do."
- Agatha Christie, And Then There Were None, Ch. 4

Stay tuned!

Shipping is a leading deflationary indicator

"All things are subject to decay and when fate summons, monarchs must obey."
John Dryden

In our recent post "Money for Nothing", we argued the following:
"Many pundits have been arguing about the importance of the Baltic Dry Index as a leading indicator. For us, it is just another indicator in the deterioration of credit and for tracking NPLs for the Danish banking sector given, as indicated by Bloomberg:
"Nordea highlighted the weak economic environment in Denmark and decreasing collateral values in the shipping industry as key drivers of the 134% increase in loan losses since 3Q. These trends will likely hurt peers Danske Bank (27% share of total Danish lending) and DNB Bank (11% share in syndicated shipping loans)."

In this conversation, we would like to go further. Shipping is in fact an important credit and growth indicator, but, more importantly a clear deflationary indicator.

As a reminder:

Danish Bankruptcies rising:

As indicated by Deutsche Bank in their shipping survey from the 13th of February:
"Modern tanker values have now firmly trended below the lows of 2008/2009 as the rate slump pressure owners' financing".

Looking at the historical 5 year Old Dry Bulk Ship Prices since 2006, one can clearly see the weak trend of the economic recovery and the deflationary forces at play - source Deutsche Bank:

Given big player Maersk is expecting its container line, the world's largest,  to lose money again in 2012, as rates drop, as indicated by Bloomberg on the 27th of February by Christian Wienberg (Maersk Says Container Line to Lose Money Again as Rates Drop), it spells trouble ahead for the exposed Danish banking sector:
"Maersk’s container division had a net loss of 2.88 billion kroner ($521 million) last year compared with a profit of 14.9 kroner a year earlier, the Copenhagen-based company said today in a statement. That exceeded an estimated loss of 2.28 billion kroner in a survey by SME Direkt. The container result for 2012 will be “negative” as overcapacity will continue to hurt the market, Maersk said today.
Global rates have dropped because the container shipping industry has added too many ships in anticipation of an economic recovery, causing overcapacity. Container demand growth will slow to as little as 4 percent this year compared with 7 percent in 2011 and expansion on Maersk’s most important trade lane, Asia to Europe, will be lower than the global average, the company said today. Maersk also predicted that earnings from its oil division will decline."


LTRO 1 and LTRO 2 will not enable Europe to escape a slower growth, credit crunch and a recession. Maersk is in fact shifting its business away from Europe as indicated by Christian Wienberg in Bloomberg in his article - Maersk Bets Against European Recovery as Recession Kills Trade:
“We think there will be negative growth in Europe this year and that is affecting our view of Asia-Europe trade,” Trond O. Westlie, chief financial officer of A.P. Moeller-Maersk A/S, the owner of Maersk Line, said yesterday in an interview in Copenhagen. “The solution that Europe is trying to take is different from the solution that the U.S. is taking. We believe that general growth will be higher in the U.S.”

We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities of the ECB will have to depreciate."
The law of unintended consequences - 25th of January 2012.

Also in the same Bloomberg article:
"Maersk, which is also struggling to adjust to over-capacity, has responded to Europe’s turmoil by deploying fewer ships for the route. The company said Feb. 17 it will cut capacity on Asia-to-Europe trade by 9 percent in an effort to avoid further losses. In contrast, Maersk has no immediate plans to cut vessels to the U.S. or high-growth markets, Westlie said.
“The question as to when we’ll see demand picking up depends on when euro zone leaders will come together and resolve their issues -- and there are quite a few issues,” he said.
Euro area leaders have yet to agree on how to bolster their rescue fund as U.S. policy makers including Treasury Secretary Timothy F. Geithner have urged Europe to make crisis-fighting efforts “credible.”

Not only Maersk will reduce its capacity on Asia-to-Europe trade, they indicated on the 17th of February, they would as well increase freight rates on the route. As indicated by Bloomberg Chart of the Day on the 8th of March, this price effort might be futile - source Bloomberg:

"The CHART OF THE DAY shows fee increases announced by A.P.Moeller Maersk A/S since 2010, and the actual change in spot rates on the planned implementation day and two weeks later, based on figures compiled by Alphaliner, a Paris-based data provider. Maersk, the world’s biggest container line, intends to raise rates by $400 per 20-foot box starting April 1. Other lines have announced similar plans (CMA CGM SA, Orient Overseas International Ltd.).
The additions, if implemented, may be quickly rolled back or trimmed, if history is any guide. Vessels on the Asia-Europe route are operating at less than 90 percent full and that will probably decline further next month because of new ships entering service, said Tan Hua Joo, an analyst in Singapore for Alphaliner. Overcapacity, price wars and rising fuel costs caused the industry to lose about $5.1 billion worldwide last year, according to Drewry Shipping Consultants Ltd."

Baltic Dry Index on Course for Lowest Monthly Average Since 1986 - source Bloomberg:
"The Baltic Dry Index (BDIY), a measure of commodity shipping costs, is on course for its lowest monthly average in more than 25 years as an oversupply of vessels keeps hire costs below break-even levels."

It is still a game of survival of the fittest.

Consolidation, defaults and restructuring are going to happen no matter what we commented recently:
"Standard and Poor's Ratings has lowered its long-term corporate credit rating on the world's third largest containership operator, France's CMA CGM S.A., to 'B-' from 'B+'. The ratings agency also lowered its issue ratings on CMA CGM's debt to 'CCC' from 'B-' and placed all issuer and issue ratings on CreditWatch with negative implications. The recovery rating on the debt remains '6,' indicating S and P's expectation of negligible (0%-10%) recovery in the event of a payment default."

CMA CGM in debt moves - Financial Times - 7th of March 2012:
"France’s CMA CGM plans asset sales to raise cash and has asked its banks to reschedule debt payments for this year and next, demonstrating how slumping container ship earnings have undermined the finances of the world’s third-biggest line.
Rodolphe Saadé, the Marseilles-based company’s executive director, told the Financial Times the company had outlined the request for a debt restructuring to its bankers at a meeting on Tuesday where it had given details of its 2011 performance."

Of course it was expected, that's what the bond and CDS markets had been telling us for a while:
Zero Freight Rates Fueling CMA CGM Default Risk to 90%: Corporate Finance - source Bloomberg, 5th of September 2011:
"Bonds and derivatives tied to CMA CGM SA, the third-largest container line, are signaling that the company has a nine in 10 chance of defaulting as the slowing global recovery pushes freight rates to about zero."

"He who rejects change is the architect of decay. The only human institution which rejects progress is the cemetery."
Harold Wilson

"He who rejects restructuring is the architect of default." - Macronomics.

Stay tuned!

Markets update - Credit - Ecce Creditor

"ecce creditor venit ut tollat duos filios meos ad serviendum sibi."
"behold, the creditor has come to take away my two sons to serve him" - Holy Bible, The Second Book of the Kings, Chapter 4.

Given everyone has been waiting for the white smoke of the ISDA determinations committee relating to CDS trigger in true "Vatican papal conclave style" (see below), following the Greek PSI outcome, and the ultimate enaction of Collective Action Clause; we thought a religious analogy was more than an appropriate rambling thanks to the "voluntary" leap of faith Greek creditors have been coerced to take.

Voting of the papal conclave:
"On the afternoon of the first day, one ballot may be held. If a ballot takes place on the afternoon of the first day and no-one is elected, or no ballot had taken place, four ballots are held on each successive day: two in each morning and two in each afternoon. Before voting in the morning and again before voting in the afternoon, the electors take an oath to obey the rules of the conclave. If no result is obtained after three vote days of balloting, the process is suspended for a maximum of one day for prayer and an address by the senior Cardinal Deacon. After seven further ballots, the process may again be similarly suspended, with the address now being delivered by the senior Cardinal Priest. If, after another seven ballots, no result is achieved, voting is suspended once more, the address being delivered by the senior Cardinal Bishop. After a further seven ballots, there shall be a day of prayer, reflection and dialogue. In the following ballots, only the two Cardinals who received the most votes in the last ballot shall be eligible, and a two-thirds majority of the votes shall not be required. However, the two Cardinals who are being voted on shall not themselves have the right to vote." source Wikipedia

As far as our economics beliefs are concerned, and if economics was a religion, we would be polytheists. But yet again, we divagate, and it is time for our credit market overview, looking at the effect of the second round of LTRO, and what's next for Europe following the Greek PSI and more.

The Credit Indices Itraxx overview - Source Bloomberg:

Following the much awaited results of the Greek PSI, according to a market maker, today's price action was in the sovereign space, with some renewed buying on Italy and Spain. Indeed, there is a flurry of government bonds issuance next week in Europe: Italy issuing next Wednesday 2 year, 3 year and 15 year bonds (6.5 billion euro), and Spain issuing on Thursday 3 year, 4 year and 6 year bonds (4.5 billion euro), France as well issuing on Thursday, 2 year and 5 year BTAN bonds (8.5 billion euro).

Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level finally moving clearly above Italy, 27 bps, a trend we have been monitoring for a while - source Bloomberg:

The spread between the Itraxx Financial 5 year CDS index versus the SOVx Western Europe is still at record level (139 bps) indicating the ongoing divergence of support courtesy of LTRO 2 - source Bloomberg:

In addition to the ongoing disconnect between the Itraxx Financial Senior 5 year CDS index and the Sovereign CDS SOVx index Western Europe, there is an interesting decorrelation between the SOVx index and the Eurostoxx Volatility (6 month implied volatility at 100% Moneyness Default Model) - source Bloomberg:

This indicates that the stress on Sovereign CDS remains elevated.

Meanwhile, the Eurostoxx index continues to rise while Sovereign Risk remains a concern for caution:

No surprise therefore to see no change in our "Flight to quality" picture. Germany's 10 year Government bond yields continue to remain well below 2% yield and 5 year CDS spread for Germany has fallen as well: Demand for precautionary assets remains elevated and the widening for the 10 year German benchmark bond remain somewhat capped - Source Bloomberg:

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

As we argued previously in our conversation "Modicum of relief":
"We think the "modicum of relief" of LTRO 2 will be relatively neutral to risky assets compared to LTRO 1."

The current European bond picture with Italy and Spain 10 year government yields accelerating their fall in yields, courtesy of the LTRO 2 - source Bloomberg:

In our previous credit conversation we also indicated the following:

"While yields are falling, support for peripheral debt is coming from peripheral banks which are in effect encouraged by the LTRO in purchasing their domestic debt, other European banks are not participating to the party."

This trend has indeed been confirmed by Barclays in their European Banks note published on the 9th of March:

"In addition, we believe that buying of peripheral sovereign bonds by domestic institutions in the January and February auctions and buying of bank bonds by Italian banks that used the first LTRO played a role in the recent tightening of bank credit spreads. As shown below, Spanish and Italian banks increased their purchases of government bonds in December and January. This contributed to a substantial tightening of secondary sovereign curves since the beginning of the year and lowered the perceived level of systemic risk. Bank holdings in financial institutions increased by €80bn in December and January. This was largely a result of retained government-guaranteed issues by Italian and Spanish banks, but also included additional purchases in the primary and secondary markets, in our opinion."

Every cloud has a silver lining, and Italy and Spain can indeed thanks their respective domestic financial system for the ongoing support.

But,  courtesy of LTRO 2, our ECB "Ecce creditor" faces significant risks going forward:
Guilt, Bad Conscience:
"Guilt has its origin in `debts', in the contractual relations between creditor and debtor, in which the latter pledged that if he should fail to repay, he would substitute his debt by something else that he possessed (body, limbs, wife, freedom)." - Michael Mahon, "Foucault's Nietzschean genealogy: truth, power, and the subject".

 As indicated by Barclays in their latest note:
"Let us not ignore the downside
As we extol the success of the 3y LTROs, we must also reiterate the risks, ECB funding has become an integral part of bank funding and, at €1.1trn, it now accounts for approximately 5% of liabilities.
Although the LTRO may have helped avert a funding shortfall and credit crunch, it also increased balance sheet encumbrance and added refinancing risk for 2013-15. After the February LTRO, we estimate that approximately €5.0trn of European bank assets are now encumbered to support covered bonds or ECB borrowings. This reduces the potential recovery pool for unsecured creditors in the event of default. Once depositor preference and bail-ins are factored in, the recovery rate on senior unsecured bonds is likely to be close to zero. In addition, the large LTRO usage heightens refinancing risks for banks during 2013-15, despite the flexible repayment schedule, with banks holding the option to begin repayment in one year."

As a reminder from our last credit conversation:
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios."

Going forward, we think you should be focusing on the ECB's monthly lending surveys, loan-to-deposit levels, deposits flights from peripheral countries as well as the rise in nonperforming loans (see our post "The European Opprobrium") as indicated by Barclays:

"As shown above, the average non-performing loan ratio rose 6bp to 5.6% in Q4 11, after rising only 2bp in Q3. Uncovered NPLs rose 3.2%, the largest quarterly increase since Q2 10. In some countries, asset quality pressures are more acute. In Spain, the banking system’s nonperforming loan ratio rose 45bp in the last three months of 2011, to stand at 7.6% at the end of December. Our economists forecast that euro area GDP will contract between Q3 11 and Q2 12, and will only return to growth in the fourth quarter of the year. We expect this to result in an acceleration of the pace of quarterly nonperforming loan increases and higher loan loss charges." - Source Barclays.

We indicated previously that Spanish banks ratio of non-performing loans to total loans came in at 7.61% in 2011 which is the highest percentage since 1994, hence our current negative stance on Spain.

So, what's next for Europe given credit markets have now been stabilised courtesy of liquidity injections via "LTRO Alkaloid" 1 and "LTRO Alkaloid" 2?
We thought Cheuvreux analyst Jolyon-Charles Montague made some interesting points in his note "Atlas shrugged" on the 7th of March:
"With credit markets stabilised in core Europe and the endgame for eurobonds on the horizon, investors will increasingly focus on the bigger challenge of structural reform. A deft touch will be required to implement fiscal austerity yet avoid recession. In any case, growth will be at best anaemic as debt brakes are applied. But, to quote the catchphrase of Japan’s longest serving post bubble Prime Minister, Junichiro Koizumi, there can be “no growth without reform”.

Lessons from Japan: failure to reform
Japan provides two important lessons for European investors: first, a case study of the perils of failing to achieve structural reform; second, how to invest in and trade a 20-year bear market. We conclude that for the current rally to continue beyond 2012 structural reform must be implemented, deflation averted and regulatory forbearance reversed: no small feat. It is often underappreciated that in 1989 Japan's net public debt to GDP was just 14.4% and the major driver for its explosion was a lack of tax revenue not fiscal largesse. Europe arguably is in a worse position than Japan as it has little room to raise taxes. Furthermore, Japan's government spending excluding social security and interest payments is among the lowest in the world. Given an aging population, Europe is on the verge of experiencing the same surge in social security spending.

A history of Japan's banking crisis
Based on the insights from Japan, most rallies will last around 12 months before topping out. The major warning sign will be any form of central bank tightening, including shrinking its balance sheet. The longest rally was from 2003 to 2006, when hopes of inflation returning and reform proved a heady mix, and banks rallied 308%. It ended with the reform agenda dying and central bank tightening, all before the global financial crisis began.

How to trade a 20-year bear market?
In every rally brokers outperformed but not banks. Commodity-driven trading companies also always outperformed. Autos and precision equipment companies mostly outperformed the rallies. These two sectors were the best along with pharma since the 1989 peak. However, pharma and food and beverage always underperformed the rallies as did airlines, utilities and construction companies. Just picking the right sectors is not enough. Toyota and Honda were among the market's best performers since 1989 rallying 56% and 240% respectively whereas Mazda fell 87% and Mitsubishi Motors 91%."

It appears to us that Europe could end up "lost in translation/deflation" and could face indeed a similar Japanese fate with the central bank tightening sooner rather than later and the reform agenda dying, which is in fact a similar view taken by Nomura in their note from the 8th of March - ECB: Still in a wait-and-see mode, but now with a hawkish bias:
"We think the longer inflation stays above 2%, the greater the risk of a pre-emptive ECB rate hike. We are not there yet, but risks have increased that market expectations will start to price in rate hikes sooner rather than later."

On a final note, please find Bloomberg Chart of the Day, indicating that Price swings in the Standard &Poor’s 500 Index have become more muted this year, making investors complacent about the outlook for stocks, according to Canadian brokerage firm Brockhouse and Cooper Inc:

"The CHART OF THE DAY shows closing percentage moves in the S&P 500. There have been no daily swings of 2 percent or more in either direction this year, compared with more than 25 occurrences in the second half of 2011, when Europe’s sovereign-debt crisis triggered a drop in equities. The lower chart panel tracks the Chicago Board Options Exchange Volatility Index, or VIX, known as the market’s “fear gauge.”
“Volatility tends to come with negative surprises, and it’s been quiet since December,” said Pierre Lapointe, a strategist at the Montreal-based brokerage. “But quiet periods usually don’t last. There is a risk of complacency. This is a low volatility environment and investors shouldn’t think this is the new norm.”

"It is easier to find men who will volunteer to die, than to find those who are willing to endure pain with patience."
Julius Caesar

Stay tuned!