Wednesday, 29 August 2012

France - Playing the nonchalance - OAT / Bund Yield Spread Widener

"Common sense is not so common." - Voltaire

"nonchalance - the trait of remaining calm and seeming not to care; a casual lack of concern." - Collins Thesaurus of the English Language

Following on our April conversation "France's Grand Illusion", where we pointed with the help of our friends at Rcube Global Macro Research that France was at some point going to face a "rude awakening", due to its structural issues, this time around, we would like to focus our attention to French 10 year government spread versus German 10 year government courtesy of our friends from Rcube Global Macro Research.

In our conversation "A Deficit Target Too Far" from the 18th of April, 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").

OAT / Bund Yield Spread Widener - Guest post - Rcube Global Macro Research:

"We have been waiting for the right time to sell French OATs for a while. We believe that we are getting close to absolute and relative levels that offer such an opportunity.
Indeed, we consider that the massive rally in French bonds has been mostly due to technical factors rather than fundamental ones.
French financial firms have been repatriating assets from PIIGS countries and buying OATs in the process, which has given the impression that French debt was again considered as a safe haven, just like Bunds.
Additionally, the liquidity associated with French sovereign bonds (due to their fungibility), has made them more attractive for global investors.
Moreover, the French debt is still rated AAA by two major rating agencies (Moody’s and Fitch). While this has also certainly helped OATs on a relative basis so far, we are doubtful that it will keep the highest rating going forward.
This tailwind should slowly fade away.
While it is hard to know if these technical factors have now run their course, we believe that at current levels, French bond spreads vs. Bunds are misaligned with their underlying fundamentals:

An additional issue specific to France is the size of its private sector financing gap, which is among the highest.

According to the INSEE, the debt to value added ratio of French non‐financial corporate business has spiked since 2008 from 110% to 135%. The combined effect of a weaker activity and rigid labor laws forces French corporates to borrow to cover their operating expenses. In this context, it’s difficult to see a robust corporate investment, which implies a weaker growth potential for France ahead.
On a more structural basis, France has always been somewhere between Southern and Northern Europe (between olive oil and butter, wine and beer, the Mediterranean and the Northern sea etc.). To illustrate this, we can notice that the concepts of “PIIGS” and the newly coined “FANG”(Finland, Austria, Netherlands, Germany) now classify Europe in two opposite groups, and that France isn’t part of either group (nor is Belgium, another hybrid country).
Therefore, the perception of France is fluctuating between Germany and Mediterranean countries, as shown in the following graph:

Right before the presidential elections, we kept hearing scenarios (especially from French observers) according to which France would surely join the PIIGS in case of a socialist victory.
Now, 100 days after Hollande’s election (which marked a local top for French spreads), this skepticism has all but disappeared. However, we are comfortable with the idea that the perception of France will continue to fluctuate.
Hollande didn’t make extravagant promises during the campaign (not being Sarkozy was enough to win the elections). However, he will now have to face tough choices: according to the the “Cour des Comptes”, the French government will have to find savings and new taxes totaling €33 Billion
in 2013 to reduce its deficits to 3% of GDP.
Further pressuring the few remaining rich will obviously not be enough to reach this goal, and we are doubtful that socialists were given a mandate to make deep budget cuts during the last elections.
We therefore believe that there could also be disappointment ahead for the French fiscal balance.

Although we believe in the medium term widening of the OAT/Bund yield spread, we currently lack a clear catalyst for entering the trade now."
Rcube's target level for entering the trade via OAT and Bund Futures, is 52 bps on the difference between Bloomberg generic indices GFRN10 Index and GDBR10 Index.

"In general, the art of government consists of taking as much money as possible from one class of citizens to give to another" - Voltaire

Stay tuned!

Sunday, 26 August 2012

Credit - Banker's algorithm

"An algorithm must be seen to be believed." - Donald Knuth, Professor Emeritus at Stanford University.

"The Banker's algorithm is a resource allocation and deadlock avoidance algorithm developed by Edsger Dijkstra that tests for safety by simulating the allocation of predetermined maximum possible amounts of all resources, and then makes a "s-state" check to test for possible deadlock conditions for all other pending activities, before deciding whether allocation should be allowed to continue" - source Wikipedia

"The Banker's algorithm is run by the operating system whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state (one where deadlock could occur). When a new process enters a system, it must declare the maximum number of instances of each resource type that may not exceed the total number of resources in the system. Also, when a process gets all its requested resources it must return them in a finite amount of time" - source Wikipedia

Given the on-going discussions relating to Greece negotiating with its creditors and trying to buy some additional time, as well as the much anticipated Spanish official rescue request, with the ECB waiting on the fateful 12th of September German Constitutional court ruling, we thought this time around we would venture towards computational analogies in our title. In similar fashion to our "Banker's algorithm" analogy, it remains to be seen if our European algorithm will avoid deadlock by denying or postponing the Spanish request if it determines that accepting the request could put the European system in an unsafe state.

In similar fashion to our banker's algorithm analogy, the coming months will indeed be decision time given Europe will have to decide at some point whether "allocation" should be allowed to continue.

In reference to Spain, the recent decision by the Spanish State to "allocate" an urgent transfer of 6 billion euros to its bank rescue fund FROB, which controls stakes in Spanish lenders such as Bankia group, will indeed appear in central government budget data once the payment is made:
"Spain is about to boost the capital of the rescue fund after writing down investments in lenders including Bankia group, according to the fund’s annual report dated July 26. The fund posted a net loss of 10.56 billion euros in 2011, sparking a negative equity of 1.86 billion euros." - source Bloomberg, Angeline Benoit and Estaban Duarte, 24th of August 2012 -

We think our analogy this week is once again appropriate. In our computational reference, namely the Banker's algorithm, in similar fashion to the upcoming Spanish rescue request, in our Banker's algorithm:
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood.
1. Can the request be granted? If not, the request is impossible and must either be denied or put on a waiting list
2. Assume that the request is granted
3. Is the new state safe?
-If so grant the request
-If not, either deny the request or put it on a waiting list.
Whether the system denies or postpones an impossible or unsafe request is a decision specific to the operating system."

On the 31st of August, the Spanish government will detail the rules for the Spanish lenders to access funds from the European bailout of as much as 100 billion euros earmarked in June to support the Spanish financial system. Spain must create a "bad bank" as a condition for accessing the loan from the 16 other European countries. The European Commission has asked Spain to delay by another week the plans to create this very "bad bank" so that its experts in Brussels can review the project. We might be speculating again but maybe the European Commission is as well using the "Banker's algorithm".

The Spanish government is introducing new rules to restructure and, if needed, dismantle non-viable financial institutions according to Bloomberg. One can therefore posit that Spanish FROB could indeed use as well the Banker's algorithm in its allocation process...but here is the catch:
 "Like other algorithms, the Banker's algorithm has some limitations when implemented. Specifically, it needs to know how much of each resource a process could possibly request. In most systems, this information is unavailable, making it impossible to implement the Banker's algorithm." - source Wikipedia
Oh well...

CreditSights in their note from the 9th of August entitled - Spanish Government - We Need to Talk about Cutting made the following points:
"The Spanish government has negotiated with Eurozone partners a budget-deficit target for 2012 of 6.3% of GDP. The plan is then to reduce the deficit to below the 3% Maastricht Criterion by 2014. But this year’s target has already been revised up twice from the original 4.4% illustrating how difficult cutting government spending and raising taxes is when the economy is deep in recession.
Following Spain’s 1990s recession, the budget deficit exceeded the 3% Maastricht Criterion in all but two quarters in the eight years between 1991 and 1998. Since the 2007 recession, budget deficits have been larger, but have so far only exceeded the 3% Maastricht Criterion for three-and-a-half years.
Yet, the problems facing the Spanish economy are this time around much larger than they were in the early 1990s. The private-sector debt position at the start of the 2007 recession was equivalent to 215% of GDP. At the start of the 1992 recession, household and business debt was 65% of GDP.
And in the 1990s, Spain’s exit from the ERM allowed the currency to depreciate and the current account to move into surplus. In this recession, Spain’s membership of euro means there is no ability to recover competitiveness via currency depreciation;
The result is that the Spanish government will need to run budget deficits that are far larger than the targets it has negotiated with its Eurozone partners. But it is impossible to see the market continuing to buy the bonds to fund such deficits, Spain is all but certain to need a full government funding programme from the EFSF/ESM."
The process whereby lenders to Spain are paid back thanks to an implicit loan from the Eurosystem to the Spanish government won’t be allowed to persist indefinitely. And when it stops, the money to repay those Spanish government bonds won’t be available.
Absent the Spanish people tolerating a wrenching reduction in their incomes within an unrealistically short timeframe in, they believe a government request for EFSF / ESM funding is all but inevitable."

We would have to agree to the above key points from CreditSights, both Italy and Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index beats Greece as crisis bites as indicated by Bloomberg:
"Record unemployment is cementing Spain’s position as Europe’s most miserable nation, widening the gap over twice-bailed-out Greece, as the debt crisis deepens.
The CHART OF THE DAY shows a composite gauge of Spanish jobless and inflation rates, known as the misery index, is rising quicker than those of other European economies, and as Greece’s retreats from a 2012 high. Globally, only South Africa is faring worse, according to data compiled by Bloomberg News. Spain’s misery index is 26.83 percent, comprising a jobless rate of 24.63 percent and inflation at 2.2 percent. Greece’s score is 23.9 percent and that of the euro region is 13.6
percent. South Africa, which has an inflation rate of 5.5 percent and 23.2 percent unemployment, has a misery reading of 28.7 percent, according to data compiled by Bloomberg News.
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."
 - source Bloomberg.

In our credit conversation we would like to focus on the changing corporate bond environment and focus once again on the structural change in market liquidity as well as default risk, in the credit space. But first our credit overview!

The Itraxx CDS indices picture, ending the week on a weaker note in the credit derivatives space - source Bloomberg:
Credit indices were overall wider on Friday, ahead of the long week-end in the United Kingdom. Overall quality cash credit from investment grade core issuers has been the clear outperformer during the summer. While last week Itraxx Crossover 5 year index (High Yield risk gauge based on 50 European entities) came closer last week to its lowest level since March, it widened back by the end of the week towards 600 bps, on the back of weaker economic data (European PMI).

Both the Eurostoxx and German 10 year Government yields seems to be moving are still moving in synch. It seems the short burst of "Risk-On" is marking a pause, with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week  - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

In relation to the European bond picture, Spanish 10 year yields remain elevated at 6.43, slightly below 7% whereas Italian 10 year yields are below 6% around 5.76% and German government yields fell towards 1.33% - source Bloomberg:

Severing the Sovereign risk / Financial risk link has been the main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index. The recent rise of Itraxx Financial Senior CDS 5 year above the Itraxx SOVx Western Europe 5 year index is only indicative of the respite provided to Sovereign CDS spreads for Italy and Spain provided by the recent discussions surrounding ECB intervention. - source Bloomberg:
The widening of Italy and Spain in the sovereign CDS markets has been increasing by the end of the week (Spain back above 500 bps and Italy at 461 bps on 5 year markets) during which both also touched their lowest level since April 2012 - source Bloomberg:
The spread difference since March between both countries has been relatively stable as indicated in the lower graph.

Our "Flight to quality" picture marking a pause in "Risk-On" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps after having touched a low point as well during the week - source Bloomberg:

Credit wise, while in our last conversation "Desperado" on the 21st of August  we touched on Santander 2 year senior unsecured 2 billion euro new issue, which had been the first Spanish bank to issue since mid-march, we were taken aback by the latest "liability management" exercise which Santander followed immediately after its new issuer with. Banco Santander and Santander Financial Exchanges (each an Offeror and jointly the Offerors) inviting holders of certain Tier 1, Upper Tier 2 and Lower Tier 2 securities to tender such securities for purchase for cash at prices to be determined pursuant to an Unmodified Dutch Auction Procedure (as such term is defined in this Tender Offer Memorandum). The maximum aggregate principal amount of Securities that the Offerors intend to accept for purchase jointly pursuant to the Offers, will be an amount equivalent to €2,000,000,000. The impact of the announcement triggered a rally in some of the securities being proposed for the "liability management" exercise:

As we argued recently (Peripheral Banks, Kneecap Recap), "losses will have to be taken, it is all going Dutch, Dutch auction that is". The moment for losses to be taken has arrived at least for preference shares holders given Spain will impose losses of as much as 80% on owners of preference shares of banks that have received state aid and may be liquidated courtesy of an operation "Banker's algorithm" but we ramble again...In relation to Bankia, being clearly in the crosshair of such "exercise", back in June (Agree to Disagree - 16th of June 2012) we indicated:
"Spain has yet to apply the full extent of the Irish recipe which we discussed in "The road to hell is paved with good intentions":"Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain. One has to wonder if Spanish retail investors will be inflicted additional pain..."
The pain is definitely about to be inflicted.

This latest move reminded us of some of the comments our good credit friend had relating to Spanish banking woes back in April in our conversation "Mutiny on the Euro Bounty":
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

In it is not the first time we have been surprised by Santander, back in April we also indicated:
Moving on to the subject of the Spanish banking sector, quite frankly we have been baffled by Santander CEO Alfredo Saenz deriding Spain defaults surge: "“Mortgages get paid in good times and in bad”. He also added: "“Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid. (We discussed Spanish issues at length in our conversation "Spanish Denial")."

When it comes to Spanish woes and the difficulties in tackling Spain's economic woes, one might wonder how it can be achieved given when Rajoy came to power he split the finance ministry and decided not to give the title of deputy premier for economy to either Montoro or De Guindos, which is creating additional headaches for wary investors as indicated by Ben Sills in his Bloomberg article from the 23rd of March - Montoro Outburst Highlights Rajoy Paralysis as Cabinet Splits:
"The divisions at the heart of Rajoy’s government have hobbled Spain’s ability to operate on a European level. While De Guindos, who represents the government at European meetings, inspires confidence in the bloc’s other finance ministers, they question his ability to deliver on his promises
because he is often contradicted by Montoro, according to an official who takes part in finance ministers’ meetings. In January, De Guindos’s efforts to persuade investors and officials that Spain was fixed on its budget targets was undermined by Montoro’s calls for more flexibility on the pace of deficit reduction."

Moving on to the subject of the changing corporate bond environment and the structural change in market liquidity, we wanted to tackle again this issue of dwindling liquidity and its implication on the credit markets (which we discussed in our conversation "Yield Famine") given yields on corporate bonds worldwide fell to a record low on the 23rd of August as indicated by Bloomberg in their article -
Global Corporate Bond Yields Decline to Record After Fed Minutes:
"Borrowing costs for the most creditworthy to the riskiest companies fell to an unprecedented 3.76 percent yesterday, from 3.8 percent on Aug. 21, according to Bank of America Merrill Lynch index data. Yields on global investment-grade debt dropped to a record 2.97 percent. The extra yield investors demand to own global corporate bonds of all ratings rather than government debt narrowed to 261 basis points Aug. 21, the lowest level since August 2011, Bank of America Merrill Lynch index data show. The gauge widened 1basis point to 2.62 percentage points on the 23rd of August."

Liquidity risk is a concern we share with Thames River Credit fund which indicated the following in their July 2012 letter:
"A structural decline in liquidity has been taking place in the corporate bond market, which has serious repercussions for credit investors. The term liquidity may sound like an obscure, even technical, word but it reflects the ease with which a security can be bought and sold. The most efficient markets are those that benefit from deep pools of willing buyers and sellers, facilitating the transfer of risk. Unlike the equity market, the majority of trading in the corporate bond market is not transacted through centralised securities (also known as market-making).
One of the reasons why corporate securities have traded off-exchange is their greater complexity compared to asset classes such as equity. Features such as duration, maturity, credit risk and subordination can differ even amongst the debt of a single issuer making credit a highly heterogeneous asset class. The trade-off for the greater customisation of corporate securities is diminished liquidity. Of the US$ 8 trillion US corporate bond market only a small proportion of issues will trade with relative frequency. This highlights the important role banks have played in the corporate bond market. A changed regulatory environment, however, is putting increased strain on banks’ ability to make markets in corporate securities."

Thames River conclude their July letter with the following important point in relation to the issue of liquidity for benchmarked credit funds:
"Regulation and bank deleveraging is forcing change on credit markets. This is most notable in the area of liquidity. Without the lubrication of market-making activity, long-only corporate bond mutual funds stand exposed to the risk of a significant sell-off in credit markets. When combined with weakness in the rates market,such an outcome could create a perfect storm for benchmarked corporate bond funds. This is why the decline in corporate bond liquidity matters."

We could not agree more, the risk is real. We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit":
"That Which is Seen, and That Which is Not Seen"

The Bond Bubble:
"In 5 out of the past 7 years, inflows to bond funds have exceeded 5% of AUM. Inflows to bond funds are running at an annualized $259bn (versus prior 2010 alltime high of $183bn). Inflows to Investment Grade & High Yield bonds funds thus far in 2012 account for a staggering 63% of total fund flows to all equity, bond & commodities." source Bank of America Merrill Lynch:
"Investor preference for Bonds over other classes is clear to see. Since 2007 there has been $650 billion into Fixed Income. Over the same period, Equities including ETFs saw outflows of $52bn." - source BofA Merrill Lynch.

When it comes to our final subject of default risk, in the credit space, CreditSights in their High Yield Market Trends published on the 20th of August indicated the following:
"The current relationship with HY (High Yield) and HG (High Grade) is more in line with what is seen in high default rate periods in the US such as 2002 and 2009. That still holds true today in both the US and Europe. The 127% quarter-to-date average (113% in 1H12) comes against the current default rate of 3.3% and is dramatically above the 76% long term average. The current HY incremental yield % versus HG is more in line with 2H02 levels of 127% when the trailing default rate declined from 10% to 8%. During the 1H2009 crisis, the 129% average came against a backdrop of 11.5% default rates. In 4Q07, when default rates ran at 1.7% the premium was 50%. Obviously that did not price in a jump in the default rates to over 14% by the end of 2009. There certainly has been a legitimate discussion that the HY market remain cheap by any of these comparisons unless you see a massive spike in defaults ahead.
With respect to the European data, they would add a caveat that the relative lack of depth in the crossover and middle tiers of the corporate universe and the relative absence of industry breadth (i.e. beyond TMT) in the “early years” of the European HY market impairs the usefulness of these metrics in Europe. In terms of framing the very low default rate levels in Europe today with what we saw in late 2007 in HY markets globally, there is an eerie similarity in that systemic is what drove the spike after the subprime mortgage crisis took out Lehman Brothers and the structured finance market while sending banks into a counterparty-driven interbank meltdown. The mere discussion of such risks in the Eurozone could make the risk of a bank system liquidity event more of a threat to the Euro HY market than the US HY market. While all HY markets (and equities) would sell off dramatically in such an event, the fact that actual default rates would more likely spike in Europe (and for a protracted period) would increase the risk of forced realization of such losses. That in theory would be when the price gap between US HY index and Euro HY index would widen more notably and losses would be “crystallized”. While that is a fat tail, they often highlight that still could end more just as a tall tale. The reaction of the HY and equity markets in Europe are voting “tall tail” at this point.
At the end of the analytical process used to frame the relative value of HY assets, it is defaults that matter most, and a material differential in actual defaults will be required to generate a more notable decoupling of returns in the rolling returns over longer time horizons across the US and Euro HY markets. As they look out towards mid-2013, it will take a systemic crisis and more than economic contraction to drive that in their view. To this point the roll-up of individuals credits still shows very manageable defaults in both the US and Euro HY markets."

On a final note, in relation to liquidity and volumes, as far as our equities friends are concerned, Christmas came early volume wise, it came in August as indicated by Bloomberg Chart of the day:
"The CHART OF THE DAY tracks the number of shares changing hands on the benchmark Stoxx Europe 600 Index since 2002, based on weekly data. About 9.34 billion shares were transacted last
week, according to data compiled by Bloomberg. That’s the fewest since 2002 except for during the traditionally slow periods at the end of the year, when business across the continent all but grinds to a halt.
Investors are staying on the sidelines as European politicians and central bankers wrestle with the region’s debt crisis, which has spread to Italy and Spain as it enters its third year, said Graham Bishop, a strategist at Exane BNP Paribas in London. European Central Bank President Mario Draghi said Aug. 2 that the lender would consider buying distressed countries’ bonds to help lower borrowing costs. “Christmas has come early,” said Exane’s Bishop. “We are now in sight of replicating Christmas in August with investors in wait-and-see mode until the ECB does what they said they will do. There’s a combination of policy uncertainty and the normal summer lull.”
- source Bloomberg.

"Complacency is a state of mind that exists only in retrospective: it has to be shattered before being ascertained." - Vladimir Nabokov

Stay tuned!

Tuesday, 21 August 2012

Credit - Desperado

"It's not enough to succeed. Others must fail." - Gore Vidal

"In chess, a desperado piece is a piece that seems determined to give itself up, typically either (1) to sell itself as dearly as possible in a situation where both sides have hanging pieces or (2) to bring about stalemate if it is captured (or in some instances, to force a draw by threefold repetition if it is not captured) (Hooper & Whyld 1992:106–7). Andrew Soltis describes the former type of desperado as "a tactical resource in which you use your doomed piece to eat as much material as possible before it dies." - source Wikipedia.

In continuation of our chess title analogy which we made in our conversation "The Game of the Century", and looking at the recent headline evolution, with Merkel hinting towards concessions for Greece before Greek Prime Minister Antonis Samaras visit, as well as speculation around yield targeting by the ECB being a possible game changer with implicit German approval, we thought we would use this time around yet another reference to the game of chess, in the light of how politically driven markets' behavior have become. Indeed, it appears to us that Angela Merkel has craftily played in our European on-going chess game (like a chess Grand-Master) and successfully applied operant conditioning!:
"By targeting the short end of peripheral yield curves. It will permit the ECB to study behavior conditioning (training) by teaching Italy and Spain to perform certain structural reforms in response to specific stimuli/bond purchases. Truth is cognitive–behavioral therapy has demonstrable utility in treating certain pathologies such as "motivating a 5 years old child" or a European politician (but we ramble again...)." - Macronomics - "Sting like a bee - The European fight of the Century"

Early August in our conversation "Sting like a bee - The European fight of the Century" we indicated the following:
"To summarize, a rate cut is in the cards, bond buying is in the cards if Spain ask for it (tap out in true MMA fashion), and unsterilized outright open interventions are a possibility:
“You shouldn’t assume that we will not sterilize or sterilize” - Mario Draghi.
The markets were too optimistic and do not seem to understand the European decision process, hence the importance, we think of focusing on the process and not the content in true behavioral therapist fashion. Investors should know by now that it takes some time for the ECB to change its policy as its main contributor, namely the Bundesbank, has a different concept of what a sound monetary policy is compared to other central banks.
But more importantly, one must understand that Central Banks ammunitions are scarce and precious, and that their ability to fight a balance sheet recession is limited, and that important decisions are in the hand of the politicians."

In chess games, sometimes it is possible for the inferior side to sacrifice two or three pieces in rapid succession to achieve a stalemate but, we ramble again.

Back in our 4th of August conversation we clearly indicated that you needed to focus on the process and become a behavioral therapist in relation to the on-going European crisis:
"Many pundits have been arguing that by focusing on the short end of the peripheral countries curves, the ECB via Mario Draghi, is in fact steepening the curve for both Italy and Spain which is apparently the opposite effect one needs to help these economies. We think these pundits are focusing too much on the content in their analysis and should be focusing on the process which is the basis for good understanding of Behaviorism. Basically in true MMA grappling/submission analogy, we think that implicitly, the Bundesbank (Weidmann with the support of Merkel) has conceded to bond purchases by the ECB, in order to keep a tight leash on both Italian and Spanish politicians to keep up with the pace of structural reforms. It seems to us, that Germany has learn from the Greek "experiment" in the sense that buying indiscriminately bonds on the whole term structure not only put the ECB's balance sheet under great risk, but, it also alleviates significantly the pressure from politicians to make good on their commitments which they made in order to garner financial support. In fact we think the ECB has set up the stage for an operant conditioning chamber (also known as the Skinner box):"When the subject correctly performs the behavior, the chamber mechanism delivers food or another reward. In some cases, the mechanism delivers a punishment for incorrect or missing responses. With this apparatus, experimenters perform studies in conditioning and training through reward/punishment mechanisms." - source Wikipedia"

In this credit conversation we would like to focus on the following points, the growing disconnect between fundamentals and markets indicating somewhat a reduction in tail risk and the on-going performance of risky assets in the short term. But first our credit overview!

The Itraxx CDS indices picture, a much tighter week with spreads moving towards there March lows in the credit derivatives space - source Bloomberg:
The Itraxx 5 year Crossover Index (European High Yield risk gauge based on 50 entities) was tighter today by around 10 bps closing to the lowest levels of March while the Itraxx SOVx 5 year index (indicative of Sovereign CDS risk, 15 Western European countries including Cyprus) moved towards its lowest level around 228 bps since the latest series started trading back in March where Cyprus replaced Greece in the index (the Itraxx indices are rebalanced every 6 months).

The Itraxx Crossover 5 year index and European volatility, moving back towards March levels with room for some further tightening - source Bloomberg:

Yet, severing the Sovereign risk / Financial risk link remain to be seen as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index which remains broadly flat - source Bloomberg:

Our "Flight to quality" picture displaying so far "Risk-On" with Germany's 10 year Government bond yields rising again towards 1.60% and the 5 year CDS spread for Germany well below 100 bps in the process, both converging - graph below, source Bloomberg:

Our European bond picture with German government yields rose back towards higher levels around 1.60%, whereas both Spanish and Italian 10 year bond yields have fallen significantly on market expectations of further bond buying on the short end of the curve by the ECB  - source Bloomberg:

Although Spanish government bond yields have recently receded from their record levels, overall Euro Zone leverage continues to rise in line with prior crisis according to Bloomberg:
"The significant growth in public debt that invariably follows a banking crisis is a product of lower revenues, bailout costs and associated stimulus packages. Euro zone aggregate government debt grew 37% between FY07 and FY11, with Ireland's debt up more than threefold and Spain's up 92%, key impediments to a swift euro zone recovery." source Bloomberg.

And so did Euro Zone bank sovereign holdings which grew 30% from 2007 levels according to Bloomberg undermining in effect the efforts in severing sovereign risk from financial risk:
"As government debt swelled across Europe from 2007, total euro zone bank holdings of sovereign debt grew more than 370 billion euros, aligning the fates of banks more closely with their sovereign nation. Spanish, Italian and Portuguese banks represent 95% of this growth, with a 73 billion euro drop in French bank exposures offsetting a similar increase for Germany" - source Bloomberg.

Although European authorities are determined in severing the link between financial institutions and sovereign risk, Spanish banks stopping recently their bond purchases has had circular effect and led to decoupling!:
"Spanish bank sovereign debt holdings rose 50% between November and March, as ECB cash was put to work supporting yields. April and May data show a fall in these holdings, with recent auctions suggesting that domestic banks have stopped this practice. As a result sovereign yields and CDS rose, driving bank funding costs higher and forcing share prices lower." - source Bloomberg.

Spanish bank funding costs have clearly been driven higher as clearly indicated by today Santander 2 year Senior unsecured new issue that came to the market, becoming the first Spanish bank to issue in the unsecured markets since mid-march (it was the last one too). Santander had announced it was issuing 500 million euros at mid-swap +390 bps (coupon 4.375% - 2 year Spain+100 bps) but quickly raised the size of the issue to the billion mark when seeing the interest (3 billion plus in the book), clearly seizing the window of opportunity in this on-going "Risk-On environment.

Truth is non-performing loans in Spain reached 9.42% and are still inching higher pointing towards additional headwinds for the Spanish banking sector as a whole - source Bloomberg:

If Irish banking woes can be used as a proxy for future Spanish banking woes, Bank of Ireland and Allied Irish results clearly indicated they continued to struggle during the first half of 2012 not only because of large loans impairments, but legacy problems, high funding costs and other headwinds meant that both banks were even loss-making on a pre-impairment basis according to CreditSights latest report - Irish Banking Mortgage Mayhem from the 19th of August:
"The foreign banks with large Irish operations also suffered similar losses, although their Irish loan portfolios are relatively small proportion of group credit risk.
The main concern has switched from losses on commercial property lending to a rapid and substantial deterioration in residential mortgage portfolios. A 50% fall in house prices from their peak, combined with a significant increase in unemployment and economic austerity measures, mean that banks’ losses on mortgage lending are at an unprecedented level.
Loans 90 days or more are 14% of total mortgage loans, and around two thirds of mortgages have a loan-to-value ratio of more than 100%. Loan impairments look set to remain high for some time and will possibly be inflated further by new personal insolvency legislation, but they will not be on the same scale as the banks’s losses on commercial real estate." -
source CreditSights

In that context, Irish banks are pressuring the government for easing the seizure for homes bought as investments in order to recoup some of their losses on renting out these properties given the severity of the defaults, as indicated by Joe Brennan in his Bloomberg article - Irish Bailout Masters Press for Rental Home Seizures:
"The Irish government’s effort to overcome legal and cultural obstacles to foreclosures is growing more urgent as delinquencies on rental properties grow, making it harder for banks to increase lending, and slowing the recovery. At Allied Irish Banks Plc, the biggest mortgage lender, more than a third of its loan book for so-called buy-to-let properties is in trouble after home prices halved and unemployment tripled since 2007 amid the worst recession in the country’s modern history. A well-functioning repossession framework is important to maintain debt service discipline and to underpin the willingness of banks to lend, which is crucial for Ireland’s economic recovery,” Craig Beaumont, the IMF mission chief for Ireland, said in an e-mail response to questions. Before December 2009, lenders used a 1964 law as the basis to repossess homes. This was repealed and replaced in 2009, which due to a drafting oversight, applied only to loans taken out after Dec. 1 2009."

"Desperado" Irish Financial system which clearly implies upcoming headaches for the weaker players in the Spanish financial system. From the same  Bloomberg article:
"In all, the state has injected or pledged about 64 billion euros to banks, and five of the six largest domestic lenders are now in government hands. State-owned Allied Irish, the country’s largest mortgage lender, said last month that payments on 37 percent of its Irish buy-to-let mortgage holdings are at least three months behind, compared with about 13 percent for its owner-occupier loans."

Given the uncertainties relating to the Spanish banking bailout and the potential full bailout application for Spain, it is no surprise to see therefore Banking giant Santander taking advantage of the window of opportunity in securing much needed funding alas at much higher cost than previously secured. Spanish banks reliance on ECB is continuing to rise as indicated by Bloomberg:
"Spain's net borrowings from the ECB rose in July to hit a record high of 375.5 billion euros, and gross drawings now represent one-third of the ECB's total gross bank lending. Final details of up the banking bailout and the potential for a full sovereign bailout application are uncertainties that may continue to pressure availability of bank liquidity." - source Bloomberg.

As far as our "European operant conditioning chamber" set up by Angela Merkel is concerned we do agree with Jacques Cailloux from Nomura's recent arguments relating to unconditional yield targets being discussed:
"1. The ECB is attached to conditionality as a guiding principle for any future intervention.
2. The ECB has already restricted its remit in terms of bond buying.
3. Spreads versus yield targets.
4. Same spread for everyone unconditionally?
Overall, we do not believe the ECB is about to embark upon unconditional yield targets across all euro area countries. The only feasible option in the short term, in our view, would be to specify its intervention modus operandi for countries requesting help such as Italy and Spain. We believe this is very likely to take place at the September meeting (as hinted at by Asmussen’s interview in Frankfurter Rundschau this morning)."

One can therefore ponder in our European chess game if Spain is indeed a "desperado piece" that seems determined to give itself up. Oh well...

Moving on to the subject of the growing disconnect between fundamentals and markets indicating somewhat a reduction in tail risk and the on-going performance of risky assets in the short term, we agree with Suki Mann from Société Générale in his 21st of August 2012 in the sense that credit could experience some additional tightening in the short term:
"Fundamentals to take over, but when? Surely, they've got to come more into consideration, otherwise we're doing away with the concept of relative value within IG cash corporate credit. For instance, there's already a long list of casualties where normally we'd see price action reflect the broken limbs. Not anymore. Some of the more recent actions have seen ArcelorMittal being junked, while Banque PSA will be; Telekom Austria's and KPN's operating performances leave much to be desired while the latter's asset sales have been postponed pressuring its creditworthiness; and Heineken is besieged by M&A risk. None of that is putting anyone off. All the bond valuations of the aforementioned entities are flat at worst, but mostly better than when the action/event occurred. That's because technicals are smothering everything. In addition, it is probably convenient also to take the investment stance that the aforementioned credits - national champions and well-known blue chips - are unlikely to default over the next few years. There are some rating transmission risks, but that's manageable. There's an emerging comfort factor that it is relatively safe to park money in these assets, which clipping the yield govvies, for example, do not provide. Few are contemplating a reversal in spreads anytime soon with any volatility in macro taken through the iTraxx indices as the credit markets risk proxy (just as it was in H1). So we could easily get more tightening in fact, we will. That's what we are seeing now, and if we do not get the heavy supply currently being anticipated (unlikely), then the August tightening could pale into insignificance in comparison with what could occur in September."

In addition to the on-going technical support to credit as highlighted by Société Générale, Corporate pension plans shift towards bonds which has occurred in the past five years will sustain the "Yield Famine" and appetite for credit, hence our positive stance towards credit in this deleveraging environment.
"The CHART OF THE DAY displays the year-end percentages of pension-plan assets invested in equities and fixed income since 2003 for companies in the Standard & Poor’s 500 Index. The data were compiled by S&P’s Capital IQ Compustat unit and cited by David Bianco, Deutsche Bank AG’s chief U.S. equity strategist in a report on the 14th of August. Stocks amounted to 46 percent of S&P 500 plan assets at the end of last year. The allocation was 12 percentage points lower than in 2007, during a housing-driven bull market. Bonds were 42 percent of assets, a 10-point increase over the same period. Real estate and other assets accounted for the balance. “It is unlikely that the trend of diminishing equity allocations reverses,” Bianco wrote. He cited two reasons for the conclusion: the closing of many plans to new workers, which limits the amount of time plans have to invest, and accounting changes that make funding gaps easier to track.
S&P 500 pension plans have a $325 billion total deficit, according to Bianco, based in New York. Although this gap has narrowed from $355 billion at the end of last year, lower bond yields are hurting returns, the report said. The yield on the Barclays Capital U.S. Aggregate Bond Index has been as low as 1.71 percent in 2012, down from 2.24 percent when 2011 ended.
Companies outside the S&P 500 may be even less committed to stocks than those in the index. Only 32 percent of pension assets in the U.S. were invested in equities when last year ended, according to the Federal Reserve. Forty percent was allocated to bonds."
- source Bloomberg

As we indicated back in our conversation "Yield Famine":
"Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. In that context of falling yields and falling volatility, we do agree with the recent comments our good cross asset-friend made in our recent post "European Credit versus volatility looks increasingly appealing":
"Long 1 year atm (At the Money) volatility on Equity Indexes versus long credit via short CDS Indexes positions looks increasingly appealing on current levels. "

In our conversation "St Elmo's fire", we pointed out we had been tracking with much interest the on-going relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
Given the Standard and Poor's 500 is trading close to a multi-year high and that the US data picture appears to be somewhat improving, and looking at the on-going turmoil which has plagued the European markets, we have long argued that the difference in the behavior of financial conditions between Europe and the US had been credit conditions. We discussed at length this point in our conversation "Growth divergence between US and Europe? It's the credit conditions stupid...". Looking at Nomura's recent note entitled "Does Europe Matter?" from the 21st of August, it looks to us that our call has indeed been validated:
"One explanation why the effects of the Euro-crisis have been more localized can be found in the behavior of financial conditions. In the 2009 slowdown, a key feature was a general tightening of financial conditions globally, as banks delevered indiscriminately.
In the context of the Euro-crisis, tightening financial conditions have been much more concentrated in the eurozone, while, remarkably, US financial conditions have been little affected. Figure below illustrates this basic observation: During the global financial crisis, the shock to financial systems was synchronized and hit the US and the eurozone with very similar intensity. During the recent European turmoil, financial conditions have deteriorated much more in the eurozone than in the US, especially in the second half of 2011, which is likely affecting growth dynamics throughout 2012."

Nomura also makes the following important points in their recent note:
"Does Europe Matter: Strategy vs. Economics
European tensions have been a major driver of global financial market volatility since 2010. Lately, however, there has been evidence that global markets have become more resilient to eurozone specific market tension.
This is ironic, given that the Euro-crisis has yet to find a clear resolution. But it can be rationalized by a combination of various factors.
First, the economic spill-over effects from the Euro-crisis have been much more localized compared to what we saw in the global financial crisis in 2008-2009. With a key part of the explanation being that a global credit crunch and a global tightening of financial conditions has been avoided.
Second, various ECB interventions (actual and verbal) have reduced the tail risks for eurozone banks and for sovereign finance. This matters greatly for global risk assets, which are most sensitive to the most extreme forms of tensions, which are now seen as smaller tail risks. Moreover, reduced peripheral exposure in private sector portfolios globally imply that portfolio contagion effects eurozone asset price weakness have been reduced.
This leaves us with a weird new equilibrium, where global risk assets may be able to trade somewhat more independently from eurozone tensions, at least until we see a renewed increase in eurozone risk exposure (which seems a long way off given ongoing changes in benchmarks) or a dramatic escalation of eurozone crisis dynamics in its own right.
The Euro-crisis is obviously not the only risk, which may impact global risk assets. Tension around the so-called fiscal cliff in the US and/or a more pronounced slowing of global growth momentum is a key factor to watch. From a short-term trading perspective, we would argue that those risks are embedded in asset prices. But this could change over time, as the weak growth in Europe will remain a drag on the global cycle until policies which can support growth have been implemented. In addition, a further compression in global risk premia would leave global risk assets more vulnerable to downside growth surprises.
Europe is more globally significant in the long-term than in the short term. From a trading perspective, Europe is likely to be a less dominant driver. However from an economics perspective it is still a drag on global growth and trade. It will certainly matter longer term, especially if the Euro-crisis continues to escalate over time."

"In all instances, we saw peripheral CDS (measured by the average of Spain and Italy's 5-year CDS) widen more than 100bp. To facilitate comparison between the different periods, we have scaled the impacts to measure the impact per 100bp of peripheral CDS widening (Figure below)." - source Nomura

And Nomura to conclude:
"From a strategy point of view, our conclusion is that the current positive performance for global assets could have further to run in coming months. Moreover, we believe global risk assets could remain fairly resilient even in the face of moderate renewed deterioration in the eurozone."

On a final note we leave you with Bloomberg Chart of The Day showing that Italy 150 years ago presaged Euro bond risk:
"Italy’s unification 150 years ago sent bond yields of its strongest state surging more than 100
basis points in an indication of the penalty Germany might endure if the euro region issues common debt, according to Stephanie Collet, a Universite Libre de Bruxelles researcher. The CHART OF THE DAY shows how yields on bonds of the Naples-led Kingdom of the Two Sicilies rose to align with those of the Kingdom of Piedmont-Sardinia in the year before unification in 1861, according to data collected by Collet. Italy at the time was divided into seven states, each with its own currency and bonds. Naples, the biggest economy with the lowest debt, suffered the largest increase in financing costs. “Naples had a really good standing at that time and as investors began to perceive it as part of a unified Italy, it started to pay a high risk premium,” Collet said in an interview. “Based on the Italian unification example, joint euro bonds wouldn’t solve anything. Germany would be the one that would suffer the most, unless a true fiscal union is put in place.”
- source Bloomberg.

"The four most beautiful words in our common language: I told you so." - Gore Vidal

Stay tuned!

Wednesday, 15 August 2012

The link between consumer spending, housing, credit and shipping.

"Confidence is contagious. So is lack of confidence." - Vince Lombardi

Back in March in our conversation "Shipping is leading deflationary indicator", we argued that shipping was in fact an important credit and growth indicator, but most importantly a clear deflationary indicator. We also indicated that consolidation, defaults and restructuring were going to happen, no matter what in the shipping industry. We discussed at the time the restructuring process involving one of the biggest container shipping companies of the world CMA CGM. We followed up on this shipping discussion in April in our conversation "Shipping is a leading credit indicator", where we indicated that the deterioration of credit would accelerate the demise of some shipping companies due to many banking institutions paring back drastically funding or pulling-off completely from structured finance operations such as shipping : "For us the Baltic Dry Index is another indicator in the deterioration of credit as well as an indicator in deteriorating credit conditions leading to a surge in Non-performing loans on Banks' Balance Sheets."

It was therefore not a surprise to read on the 13th of August 2012, Ambrose Evans-Pritchard's column in the Telegraph entitled - World shipping crisis threatens German dominance as Greeks win long game where he indicates the following:
"Germany’s shipping industry faces a wave of bankruptcies over coming months as funding dries up and deepening economic woes across the world cause a sharp contraction in container trade."

We foresaw credit contraction would indeed trigger waves of bankruptcies and restructuring in the shipping industry, indicative of the deflationary forces at play in global growth which Ambrose Evans-Pritchard indicated in his article:
"Container volumes arriving at European ports plunged in June, dashing expectations of a summer rebound. Imports fell 7.5pc from North America and 9pc from Asia. Flows into the Mediterranean region crashed by 16pc, reflecting the violence of the recession in Greece, Italy, Spain, and Portugal."

We also warned in our previous conversations that credit contraction would accelerate the demise of the weaker players in this game of survival of the fittest, because major banking institutions are indeed pulling the plug from shipping structured finance, confirmed yet again by Ambrose Evans-Pritchard in his recent article:
"Commerzbank – the world’s second-biggest provider of ship finance, and reluctant owner of a flotilla of foreclosed ships – said it is shutting down its €20bn (£15.7bn) ship funding operations entirely to “minimise risk and capital lock-up” under tougher EU banking rules."

The latest results from German bank Commerzbank validate our  April call in relation to rising non-performing loans and the fact that banks such as Crédit Agricole, Danske Bank and Commerzbank were retreating from structured finance operations such as shipping as clearly indicated by the serious drop in syndicated lending in Europe in the first quarter of 2012 (see our April conversation on that point):
"Commerzbank said its asset-based finance unit, which comprises its commercial real estate and lending to shipping companies, will drive a “significant” increase in the funds the firm needs to set aside for risky loans in the second half. The bank’s second-quarter loan-loss provisions rose to 404 million euros from 278 million euros, while the ABF unit set aside 300 million euros in the period compared with 233 million euros a year earlier." - source Bloomberg - Commerzbank Forecasts Second-Half Net Below First Half - 9th of August 2012.

As a reminder from our April conversation:
"Commerzbank’s 2008 takeover of Dresdner Bank AG increased its stake in shipping lender Deutsche Schiffsbank to 92 percent, doubling the size of its maritime-loan portfolio, just before the industry entered its biggest crisis since World War II." - source Bloomberg.
In this specific conversation, we would like to look at the shipping industry and the long term trends identifying in the process the most likely survivors in this deflationary play, as well, as indicating the very important impact consumer confidence and consumer spending have on shipping and the importance of housing for shipping given the recent "green shoots" witnessed in the US housing markets.

Back in April we indicated the following relationship with the housing bubble: "The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fuelling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008 at 11,440; with the index touching a low point of 680 in January 2012" - source Bloomberg:
 Today, the recent deterioration of the Baltic Dry Index is yet another sign of the deterioration in the world growth outlook with the index falling back again towards the lows of March 2012. - source Bloomberg:
"The Baltic Dry Index, a gauge of rates to transport dry-bulk commodities including grains and coal by sea, is down 55 percent this year and on course for a fourth annual slide in five, data compiled by Bloomberg show." - source Bloomberg.

Dry bulk cargo represents the largest part of the $350 billion shipping industry:
"The marine shipping industry is roughly $380 billion, according to the United Nations. Publicly traded carriers account for some 67% of the market. About 8.6 billion tons of cargo were shipped via seaborne trade in 2011. Dry bulk cargo accounted for about 43%, followed by tankers (40%), and containerized traffic (12%), according to IHS Global." - source Bloomberg.

The recent demise of the world's oldest shipping company Stephenson Clarke founded in 1730 is symptomatic of a global surplus of vessels and overcapacity (which is as well plaguing the European car industry as a side note).

As far as the shipping industry is concerned, and in terms of our theme of survival of the fittest, size matters:
"The shipping industry is aiming to utilize larger ships in order to generate bigger economies of scale. The containership industry has evolved to include ships with capacity reaching 15,500 twenty-foot equivalent units (TEUs). The only barrier to container capacity increasing to 20,000 TEU-vessels is port loading and unloading infrastructure." - source Bloomberg.

Size matters and so do Bunker fuel prices for shipping company margins:
"Bunker fuel prices have increased 11% after reaching a 17-month low of $560.20 per ton in June. Prices are still 15% lower than the March high of $735.30 per ton. Higher prices can squeeze margins for shipping companies due to the lag effect. NYK Group expects its bunker fuel prices to be mostly unchanged for the year ending March 2013." - source Bloomberg.

Bunker fuel prices affect profitability of shipping companies because they constitute the bulk of expenses:
"Bunker fuel is fuel oil used in ship engines, stored at or near major ocean ports and primarily sold and delivered under contract to shipping companies. Prices vary widely from port to port. Bunker fuel constitutes the bulk of voyage expenses for shipping companies. Higher bunker fuel prices can adversely affect earnings and vice versa." - source Bloomberg.

Falling margins for shipping company are also affected by the fall in Dry Bulk rates which have continued to fall from Mid-July led by Capesize according to Bloomberg:
"Dry bulk spot rates for supramax and handysize ships have fallen 21% from their June-July highs, yet are still 70% and 51% higher respectively from their February lows. Panamax rates have fallen 21% from mid-July and are 41% above February lows. Capesize rates are down 45% since July 9, yet 29% above June lows and 87% lower than the December 2011 high." - source Bloomberg.

Vessel prices declined courtesy of the credit binge which led to overcapacity in similar fashion the housing bubble was led by cheap credit:
"Prices of seaborne vessels have been steadily declining since peaking in 4Q08 as excess capacity slowed the new build backlog, along with cheaper builds in China and tight credit markets. Chinese shipbuilders have been using price in attempt to win share. Price pressure has come on less sophisticated dry-bulk ships relative to LNG tankers." - source Bloomberg.

In similar fashion to housing in the US and Spain, the shipping "overhang" is leading to a rise in ship scrapping:
"Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by 584% since June 2005. This is creating a more efficient fleet as older ships are replaced by newer models. Triple-E ships consume about 35% less fuel per container and are able to carry 16% more containers, according to Maersk." - source Bloomberg.

The excess capacity is leading to strongest player such as Maersk to add new efficient ships to their fleet as indicated by Kyunghee Park in his article - Maersk to Add Prius of the Seas With Fuel-Saving Ships:
"A.P. Maersk-Moeller A/S’s planned fleet of the world’s largest container vessels will be as
groundbreaking for their shape as their size.
The 20 ships will be the first cargo-box carriers with rounded hulls rather than streamlined V-shaped ones, according to Daewoo Shipbuilding & Marine Engineering Co., which is developing the 18,000-container vessels. The change reflects a shift by operators away from designing ships to go as fast as
possible to instead emphasizing fuel economy
. “These vessels will be the Prius of the seas,” said Lee
Jae Won, an analyst at Tongyang Securities Inc. in Seoul, referring to Toyota Motor Corp.’s distinctively-shaped hybrid car. “They’re fuel efficient and environmentally friendly.”
The fatter hulls will let Copenhagen-based Maersk install a fuel-efficient two-engine setup that’s too wide for current ships. It will also recover cargo capacity that is lost with tapered hulls, letting the ships carry 16 percent more boxes than vessels only a few meters smaller. Combined with other technologies, the ships will use about 35 percent less fuel per box than vessels now used on Asia-Europe routes and produce around 50 percent less carbon emissions, according to Maersk."

There you go, survival of the fittest and creative destruction "à la" Schumpeter impacted by the rise of Bunker fuel prices leading for a reduction in speed as indicated by the same article:
"The higher costs have already prompted shipping lines to slow vessels 18 percent over the past three years to an average speed of about 10.4 knots. That has cut fuel bills and eased global overcapacity that caused industry wide losses last year.
Reducing the speed of container ships by 10 percent can pare fuel consumption by as much as 30 percent, according to ship assessor Det Norske Veritas. A 25 percent reduction can cut carbon emissions by more than 350 tons a day per ship, the Transpacific Stabilization Agreement, a shipping group, said in 2010."
- source Bloomberg.
Given the container shipping industry market is already dominated by the top 10 carriers, A.P. Maersk-Moeller A/S appears to us as the strongest contender in winning this deflationary contest:
"The top-ten container liners have about 60% of the market, according to data from Alphaliner. Supply and demand dynamics drive financial performance. Consensus forecasts call for containership demand to increase in the range of 4% to 6% in 2012. North-South trading routes are expected to outperform, while Asia-Europe routes are anticipated to slow." - source Bloomberg.

"A.P. Moeller-Maersk A/S said its container line, the world’s largest, returned to profit in the second quarter after freight rates jumped. Net income for the container unit was $227 million in the three months ending June 30 compared with a loss of $95 million in the same period a year earlier, the Copenhagen-based company said on the 14th of August in a statement." - source Bloomberg:

If you want to pick winners in this survival of the fittest contest, you have A.P. Moeller-Maersk A/S investing in fast and fuel efficient vessels (Maersk vessels are designed to operate efficiently at both high and low speeds),  and so is Evergreen Group, owner of Asia's second biggest container line is as well adding more fuel efficient vessels to its fleet as well as Neptune Orient Lines Ltd:
"The Maersk vessels, which will also feature a waste-heat recovery system, will still be able to go as fast as 23 knots. That compares with a top speed of 25 knots for the Emma Maersk, the largest container ship afloat. The new vessels will be 59 meters wide and 400 meters long.
That’s about 3 meters wider and 4 meters longer than the Emma, which holds 2,500 fewer boxes. The limited size increase means major European ports will be able to handle the ships without having to buy new cranes and other equipment. U.S. ports aren’t big enough for such vessels."
- source  Kyunghee Park, Bloomberg - Maersk to Add Prius of the Seas With Fuel-Saving Ships

Moving on to the relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending:
"Consumer demand drives Asia-originated containerized traffic and freight flows to Europe and North America. Auto parts, furniture, apparel and textiles, and appliances and kitchenware are some of top containerized product types imported into the U.S. and Europe. Any changes in consumer spending will directly impact global containerized traffic volumes." - source Bloomberg.

While many pundits are discussing the on-going "green shoots" in US housing, the impact on the Containership industry led by consumer spending and consumer confidence is very significant:
"Containerized traffic is dominated by the shipment of consumer products. A resurgence in international container volumes will be dependent on the housing markets improving. Furniture and appliances are some of the top freight categories imported into the U.S. and euro zone from Asia in containers. Furniture demand collapsed with the housing market." - source Bloomberg.

Unfortunately for container shipping the recent US drought is very bad news for their earnings as well as for world growth as indicated by Bloomberg in their article - Grain Cargoes Seen Slowing Most in 19 Years on Drought
"The worst U.S. drought in more than a half century and dry weather from Europe to Australia will mean the biggest contraction in grain cargoes for 19 years and unprofitable rates for owners of Supramax commodity carriers. Global trade in grains will drop 4.9 percent in the 2012-13 marketing year, according to the U.S. Department of Agriculture. Forward freight agreements, handled by brokers and used to bet on future costs, anticipate a fourth-quarter rate of $9,117 a day, 17 percent less than now, Baltic Exchange data show. Shares of Eagle Bulk Shipping Inc., the largest U.S. operator of the vessels, will slump 30 percent in the next 12 months, according to the average of six analyst estimates compiled by Bloomberg. Corn and soybean prices rose to records this month as U.S. farmers plowed under ruined fields and heat waves across Europe wilted crops from Italy to Russia. The fourth quarter is usually the most important for Supramaxes hauling grain as it coincides with the Northern Hemisphere’s harvests. The period generated the best average returns in four of the past six years."

Although population and diet trends bode well for Dry-Carrier demand, given the US is the largest net exporter of major agricultural products such as wheat, corn and oats, the recent US drought represent additional headaches for the already struggling container shipping industry:
"The U.S. is the largest net global exporter of major agricultural products such as wheat, corn and oats. The net amount of imported products appears to be growing for many emerging economies due to changing diets. The demand for animal feed increases with the demand for protein, which should help drive dry-bulk service demand." - source Bloomberg.

Could Jim Rogers be right after all, that on the long term farmers will be the ones driving Lamborghinis, not bankers? We wonder.
"If the world gets better, I know I'm going to make money on commodity demand. If it doesn't get better I'm going to make money on commodities because they're going to print money. In the seventies, most stocks did badly, the only stocks that did well were commodity stocks. That's going to happen again. The farmers are going to be driving the Lamborghinis." - Jim Rogers

"Beware of little lending. A small leak will sink a great European ship." - Martin T. - Macronomics

Stay tuned!
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