Hence our title. But reading through Hyman Minsky's 1982 paper "Can "It" Happen Again? A reprise (H/T Zero Hedge), the roots of instability according to Hyman Minsky are: "...velocity-increasing and liquidity-decreasing money-market innovations will take place. As a result, the decrease in liquidity is compounded. In time these compounded changes will result in an inherently unstable money market so that a slight reversal of prosperity can trigger a financial crisis".
The proceeds of the new issues raised by Siemens will be used to buy-back up to 3 billion euros worth of shares. This is a negative development from a credit perspective indicative of this growing structural instability we think. In our previous "Hooke's law" ending remarks we argued:
As indicated by John Glover and Andrew Reierson in their Bloomberg article - Europe Trounces U.S. as Corporate Gains Reach 9%":
"Corporate bonds in Europe last outperformed U.S. debt in 2008, when they lost 3.3 percent, less than the 6.8 percent drop in value of American company debt. Last year, Europe gained 1.99%, while the U.S. soared 7.51%."
Reserve Chairman Ben S. Bernanke to signal added monetary stimulus this week, according to Credit Suisse Group AG. The CHART OF THE DAY shows the Bloomberg U.S. Financial Conditions Index moved above zero on July 27, a threshold that signals receding market risk. It was below negative 1 last year when Bernanke spoke at the Kansas City Fed’s annual economic symposium in Jackson Hole, Wyoming. The bottom panel shows the spread between the rate to exchange floating for fixed-interest payments and Treasury yields for two years, a gauge of investors’ perceived risk in the banking sector, fell yesterday to the lowest since May 2011. Bernanke speaks at this year’s Jackson Hole conference on Aug. 31." - source Bloomberg.
But, this false sense of "stability" is increasingly indicative of growing signs of "instability". Back in our July conversation "Hooke's law we argued: "The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%)."
Our equities friends would be well advised to remain cautious September wise and take a few chips off the gambling table, September being statistically volatile (September: The Worst of Months - Cullen Roche - Pragmatic Capitalism). The lower earnings estimates will be the biggest risk to come in coming months as indicated by Bloomberg Chart of the day:
according to Barry Knapp, head of U.S. equity strategy at Barclays Plc’s securities unit.
As the CHART OF THE DAY shows, analysts lowered profit projections for companies in the Standard & Poor’s 500 Index more often than they raised them in the months of September and
October since 2000. The figures were compiled by Barclays and exclude periods in which the U.S. economy was in recession. October was the worst month for earnings revisions in the past 12 years, according to Barclays data. Based on the number of changes made by analysts, estimate cuts surpassed increases by 5.2 percentage points. September tied for the second-worst month with December. The gap between lower and higher estimates was 3.2 points on average. January was the only other month of the year in which reductions predominated." - source Bloomberg.
Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."
The Itraxx CDS indices picture, ending this month on a weaker note in the credit derivatives space - source Bloomberg:
"We are downgrading our stance on corporate credit, moving to underweight in Europe and to neutral in the US. The prevailing lack of confidence among agents amounts to an uncertainty shock, one that is taking its toll on economic growth and appears unlikely to abate soon. Recent data points on the macro (Europe, China PMIs) and micro (guidance from Cisco, Caterpillar, Hewlett Packard) fronts suggest growth, particularly in Europe, is running at stall speed.
Risks to the outlook are skewed to the downside, in our opinion. A confluence of factors constrains the outlook for economic growth and corporate profitability, particularly in Europe. They include: the Eurozone crisis, the US fiscal cliff and election uncertainty, political instability in Greece and Italy, doubts over the vitality of the Chinese recovery and rising geopolitical tensions in the Middle East.
In the meantime, the susceptibility of markets to a downside shock is high in an environment of weak growth.
On the other hand, the prospects for policy upside appear constrained versus expectations. In Europe, we expect clarification on the tenor and timeline for bond purchases. However, additional details would run into two major obstacles. First, the Eurozone is a heterogeneous bloc; peripheral countries have disparate problems which require different solutions in terms of aid and conditions, making a “one size fits all” programme an ineffective remedy. Second, there is a moral hazard issue associated with a fully transparent programme; if the terms are too generous, the incentives to reform swiftly would vanish. In the US, we expect Chairman Bernanke to explain the mechanisms the Fed would use to ease further at Jackson Hole, but avoid promising easing is forthcoming. Our economists peg the odds of QE in September at roughly 50/50.
Credit valuations look extended, particularly in higher beta European corporates. Our regression models using economic indicators (Europe composite PMIs, global manufacturing PMIs) suggest iTraxx Xover spreads are c100bp rich to fair value (Chart 1). Given substantial, albeit well flagged, event risks in September, we recommend investors set shorts in higher-beta European credit and take some profits in credit globally."
The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
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. While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability."
Both the Eurostoxx and German 10 year Government yields are still moving in synch but most likely towards "Risk-Off" in the coming weeks 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:
Our "Flight to quality" picture marking pointing towards "Risk-Off" 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 - source Bloomberg:
As far as the EUR/USD is concerned we told you in our conversation "Sting like a bee - The European fight of the Century" to watch out for political "sucker punches" during this summer "lull" because they do sting like a bee! Friday's "sucker punch" on EUR/USD as displayed by the significant intraday move - source Bloomberg:
In relation to the European bond picture, Spanish 10 year yields climbing towards 6.70, slightly below 7% whereas Italian 10 year yields are still below 6% around 5.80% and German government yields fell towards 1.36% - source Bloomberg:
The regions were responsible in 2011 for most of Spain's overspending, 8.9% of GDP (unchanged from 2010) while the debt level of the regions as a percentage of GDP are still rising as indicated by Bloomberg:
In addition to the rapidly debt picture, for the three Spanish regions asking for a rescue, unemployment has been rising as well in all three:
In addition to Regional woes, Spain has been busy as well with its banking sector woes this week, given Bankia Group announced 4.45 billion euros of losses for 1H2012 versus a 205 million profit in 2011 (year of its nicely priced IPO...). Bankia had 6.63 billion euros of provisions for 1H impairments costs, and its group clients funds fell 37.6 billion euros from December to 173.8 billion euros. Consequences for Bankia was that its banking rescue FROB has had to immediately inject capital given Bankia group's BIS II Core Capital ratio fell to 6.3% and its bad loans ratio jumped to 11% from 6.3% in 1H 2012.
During the same week, we had the secretary of state for the economy, Fernando Jiménez Latorre, telling us that there was no significant drop in Spain bank deposits. Reading the following comment from HSBC made us wonder about the delusional state of some members of the Spanish government:
"ECB deposit data out and the usual health warnings apply, for anyone of a remotely nervous disposition. This latest set of data show an alarming increase in the pace of deposit flight from Spain - see the graph below. After what appeared to be something of a moderation in June, with 'only' EUR8.6bn disappearing vs EUR30bn+ in both April and May, last month saw EUR74bn leave the Spanish financial system. This brings the YoY pace of decline to a rather Greek 12%. Deputy Finance Minister Latorre is on the tape this morning saying that there's no significant drop in deposits, which one would have to assume refers to this month, as the July data is alarming."
Since Draghi's verbal Chuck Norris intervention and subsequent spread tightening, however, one would imagine that the pace of deposit flight would moderate, so August's data should mellow. Yet the MoM flow in domestic govt bonds held by Spanish banks has been declining again, consistent with the trend this year since the LTRO induced peak. Makes you wonder who is there in the background buying these assets given the headlines and risks, as the domestic bank bid has been so supportive over the last few years.
Were the Spanish financial system capable of shedding assets at the same rate, or ideally, faster, all would be well. But look at the loans to deposits graph below and note that the Spanish system LDR is still climbing. It's not as large a funding gap as you might see elsewhere in Europe (currently 117% LDR, vs e.g. Finland on 143%, Ireland on 129%, Italy on 122%, or the Netherlands on 120%), but more the trend that's concerning, as Spain belong to the unfortunate minority of countries where the funding gap is widening - Greece, Cyprus, and more recently, Portugal. No wonder there's a sense of urgency at the ECB these days." - source HSBC
Back in our conversation "Agree to Disagree" in June we wrote:
"If our European politicians had studied carefully what had happened in Argentina before their default in 2002, they would not be pressing for a "Banking Union" but should rather be more concerned about a deposit guarantee scheme if they are "really serious" about keeping Greece in the Euro. Back in March we argued the following in our conversation "Modicum of Relief":
"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.
Unless our European politicians rapidly introduce European laws guaranteeing depositors money ("insurance for depositors against the risk of euro exit" is qualitatively different from "deposit insurance"), capital flight might start in Spain as it has already in Greece."
As far as Spain is concerned, deposit outflows have been confirming our June call:
"The dangers of deposit outflows. While complacency is prevailing so far in relation to Spanish deposits, it cannot be taken for granted, as shown by the situation in Argentina which quickly spiraled out of control and led to its default in 2002:
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested." - CreditSights, 31st of July 2001 paper "Defining the Default Path".
We might be rambling again in our longer than usual conversation but we have long argued the impact the LTRO has had on the Spanish banking system. amounted to "Money for Nothing":
We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (All Quiet on the Western Front - April 2012):
"In August 2011 we wrote in our conversation "It's the liquidity stupid...and why it matters again...":
"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians.
As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011
One can easily conclude that not only will the regional bail-out fund will need to be recapitalized but FROB as well given the Bankia group will certainly need additional capital injunctions as the economic outlook deteriorates further in Spain because no loan growth means no earnings, rising non-performing loans and rising deposit-outflows mean rising loan-to-deposits level. Capital injections mean additional strain on the budget with weaker tax receipts.
Back in our conversation "Modicum of Relief" we indicated the following:
"On the subject of systemic risk diagnosis, wholesale bank deposits flights and tracking the loan-to-deposit ratio of banks can be used as a simple gauge of risk profile. It is as well a good indicator of banks 'capacity in supporting lending in their respective economy. Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process (as per our "car" analogy used in our previous conversation)."
As far as similarities between Spain and Argentina and in relation to capital flight:
"the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point." - CreditSights 31st of July 2001 paper "Defining the Default Path"
Moving on to the subject of the relationship between credit and equities correlation, the significant outperformance of U.S. equities indices versus their European peers, is interesting given the outperformance of European credit versus U.S. credit.
We have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
We have on various occasions discussed the relationship between credit and equities. Back in January 2011, in our credit conversation "A tale of two markets - Credit versus Equities", we indicated the following in relation to credit and the relationship with equity volatility:
"In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.
In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money) equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study."
We would like to go further given the R2 (coefficient of determination of a linear regression) between Credit/Spot equities and Credit/Equities Volatilities (ATM for At The Money) in both Europe and the U.S. tell a different story courtesy of our good cross-asset friend. An elevated R2 level indicates a significant relation. One can see in the below table the higher correlation between European Itraxx Credit indices (Itraxx Main Europe being the investment grade risk gauge and Itraxx Crossover being the European High Yield risk gauge) and the Eurostoxx 50 equity index. In the U.S. in the table below you can see the relationship between CDX IG (Investment Grade) and CDX HY (High Yield) with the Standard and Poor's 500 (SPX) and the Russell index.
The correlations between Credit Indices in Europe versus Spot equities remain very significant in Europe and in Japan but less so in the U.S. At current levels the relationship between the Standard and Poor's and Credit is weak, whereas the Russell Index is more positively correlated to Credit in the U.S. The fact that the Standard and Poor's volatility is strongly correlated to Credit is counterintuitive.
The overall underperformance of Japanese credit spreads which continue to weaken is at present the only notable disconnect between credit spreads and spot equities:
According to our good cross asset-friend, this weak Japanese relationship warrants monitoring and could be played by selling CDS and buying Nikkei Put Options, which benefit from absolute low volatility levels. Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since March 2010 until the 21st of August 2012 - source Bloomberg:
Monitoring levels of correlation in the short-term is fundamental if you are looking at adding relative value positions or if you would like using historical signals to position yourself on either credit or equities.
"If you want stability, prepare for instability" - Martin T - Macronomics.