Sunday, 11 November 2012

Credit - Froth on the Daydream

"Do you think when two representatives holding diametrically opposing views get together and shake hands, the contradictions between our systems will simply melt away? What kind of a daydream is that?" - Nikita Khrushchev

Definition of froth:
noun - A mass of bubbles in or on a liquid; foam 
verb - to produce or cause to produce froth
source - Collins English dictionary.

Our reference in this week title is of two-fold. A froth being a mass of bubbles in a liquid form, looking at the quantity of liquidities injected in the system courtesy of central banks (see our post "QE - To infinity...and beyond"), and given the incredible rally in the credit space with more and more players looking at "stealing third base" (to use a baseball analogy), one can argue that many investors are really getting outside their "comfort" zone and investing once again in the riskiest part of the capital structure (Leveraged loans, High Yield, PIKs bonds, etc.), hence our froth reference. Yes, arguably once more, central banks are indeed "frothing".

But, our title is as well a reference to 1947 novel by French author Boris Vian, one of our favorite books of all time. It tells the story of a man who marries a woman, who develops an illness that can only be treated by surrounding her with flowers. We think the current global economic situation tells a similar story, namely that economies developed an illness (credit bubbles) that can only be treated by surrounding them with liquidities.
Credit Booms and Financial - Crisis - IMF
"The majority of the largest financial crises over the past three decades followed significant private credit expansion. While credit booms need not be followed by a period of bust (the IMF calculates that one third of booms sampled were followed by a banking crisis) it notes that many more were followed by sub-trend growth for the subsequent six years." - source Bloomberg

In Boris Vian's great poetic novel, the hero Colin marries Chloé, but Chloé falls ill upon her honeymoon with a water lily in the lung, a painful and rare condition that can only be treated by surrounding her with flowers. One can as well argue that a BSR (Balance Sheet Recession) is a rare condition that can only be treated by surrounding it with liquidities but if credit is not flowing to the real economy which is definitely the case in the Eurozone; a similar fate looms for the European economy as for Chloé in the novel. In the novel at some point, the flower expenses become prohibitive and Colin soon exhausts his funds. 
"The CHART OF THE DAY shows that the ECB’s assets have climbed to 33 percent of the gross domestic product of the nations that use the euro, exceeding levels for the U.S. and Japan. It also shows Draghi’s proposal could drive the central bank’s holdings to exceed 43 percent if policy makers bought all 1.01 trillion euros ($1.27 trillion) of Italian and Spanish bonds due by end-2015 and failed to sterilize purchases. Draghi will propose unlimited buying of government debt, while refraining from a public cap on yields, according to two central bank officials briefed on the plan before the ECB meets today. Sterilization involves draining money from other parts of the financial system to offset the new funds being added." - source Bloomberg.

We are very fond of Boris Vian's novel, and we can find many more analogies in this week credit rambling's title with his masterpiece. 
For instance, as Chloé becomes even sicker, the house they live in starts to shrink and becomes darker and gloomier on a daily basis although the little grey mouse that lives in the house does all its best to clean the windows in order to let the light in. When one looks at the future for Greece, it looks increasingly likely that Greece will become the euro's poorest nation in two years as indicated by Bloomberg:
"The CHART OF THE DAY shows Greek output per person adjusted for relative price levels is set to fall to 71.3 percent of the European Union average in 2014 from 79.8 percent last year, according to the commission’s Ameco database. Slovakia, the second-poorest euro nation, will surpass Greece as early as this year, while Estonia, the zone’s most impoverished state, will top Greece at the end of 2014. Greece is struggling to meet debt-reduction targets imposed by international lenders more than two years after receiving its first bailout. The need for more austerity measures is pushing the economy deeper into recession and more than one-fifth of output will have been erased by 2014, when growth is set to resume after six years of recession." - source Bloomberg

In Boris Vian's book, Colin struggles to provide flowers (credit) for Chloé to no avail and his grief at her ultimate death is so strong his pet mouse commits suicide to escape the gloom. Looking at how the ECB (Colin) is struggling at providing real flowers (credit) to the Spanish real economy (we have long argued that the LTROs provided by Mario Draghi amounted to "Money for Nothing"), we can only wonder about the accuracy of our reference when looking at the deflationary bust unfolding in Spain before our very own eyes - graph source Bloomberg:
"The CHART OF THE DAY shows that the 30 percent expansion of the ECB’s balance sheet since Draghi’s first meeting as President in November 2011 has reduced the Euribor-OIS spread, a measure of European banks’ reluctance to make unsecured loans to one another, to a five-year low. In that time, Spain’s 10-year borrowing cost has risen, even after Draghi channelled 1 trillion euros ($1.3 trillion) to banks via two rounds of Longer-Term Refinancing Operations in December and February. Draghi has also cut interest rates to 0.75 percent in three 25 basis-point reductions, and reinforced his July 26 pledge to do “whatever it takes” to defend the euro by announcing an unlimited bond-purchase program. Spain is yet to request aid, a precondition of central bank bond purchases. The ECB left interest rates unchanged on thursday's meeting." - source Bloomberg

"Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process." - Macronomics, Modicum of relief - March 2012

Euro Area Bank Lending Survey - source Thomson Reuters Datastream / Fathom Consulting:

When ones looks at the amount of consumer gearing in Europe versus the USA, no wonder that the amount of "frothing" or flowers from the ECB has been staggering. As indicated by Bloomberg in the below graph, the Credit Penetration has been falling from the 2009 highs, courtesy of the BSR and the deleveraging needed but the gearing of private households as fallen in the US whereas it has risen in Portugal for instance!
"Globally, domestic credit to GDP has fallen seven percentage points from 2009's all-time high, as banks deleverage and consumers pay down debt. While Portugal and the U.S. have the same 193% ratio, the Portuguese credit boom drove consumer gearing to 193% from 135% in 2005-09, unlike the U.S., where the ratio has dropped over the same period." - source Bloomberg

Looking at the recent surge of the Bloomberg US Consumer confidence Index from -34.7 to -34.4 in the period ending November 4, the best reading since April, we remain more positive on the US economy than the European economy. As we indicated last week in our conversation "The year of the empty hand", the divergence of growth between the US economy and the European economy is still reflected in credit prices such as the US leveraged loan cash price index versus its European peer - source Bloomberg:

In our previous conversation "The link between consumer spending, housing, credit and shipping", we indicated that Shipping is an important credit and growth indicator:
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".

The below Bloomberg graph displays such a link between economic growth and shipping as well as housing:
"The Baltic Dry Index is a barometer of the health of the shipping industry and broader global economic activity. The daily index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina. It also gauges dry-bulk supply-and-demand dynamics." - source Bloomberg

Consumer Confidence is as well a barometer of economic conditions. When one looks at the Consumer Confidence evolution in the Eurozone, one can see the growing headwind for growth to resume which would alleviate the concerns in regards to solvency issues for some European countries:
Source Thomson Reuters Datastream / Fathom Consulting.

In similar fashion, we already touched at the link between European Consumer Confidence and Consumption in our June conversation "Yogurts, European Consumer Confidence and Consumption" where we argued: 
"Yogurts matter as an indicator? One has to wonder...As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit."

Yogurt giant Danone share price versus European Consumer Confidence since 2006 - source Bloomberg:
"Mind the Gap..."

Economic Sentiment is a well a leading indicator we think, when it comes to predicting GDP growth as in the below Bloomberg Graph plotting the evolution of both in Europe since 1998:
Another, "Mind the Gap".

No wonder GDP growth in Europe is indeed turning South for all:
Source Thomson Reuters Datastream / Fathom Consulting.

In relation to France, 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").

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

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

What was that Standard and Poor's April note indicating with which we completely disagreed with in our April conversation relating to France - "France's Grand Illusion"? As a reminder:
"Apr 04 - Although the current recession in Europe will probably extend into the third quarter, we believe the economy may pick up modestly late this year and in 2013, said Standard and Poor's today in announcing the publication of its report "No Fast Lane Out Of Europe's Recession."

We did not share the same beliefs as Standard and Poors and we still do not share them.

France Fiscal Position - source Thomson Reuters Datastream / Fathom Consulting:

As far as France sovereign CDS is concerned, it trades at the same level as Belgium with Belgium being in a better fiscal position - source Bloomberg:
Back in our conversation "Spanish Denial", we indicated:
"When it comes to Net Financial Wealth of Households as a percentage of GDP, 2000 and 2007, as indicated by Eurostat, Italy is indeed a much richer country than expected, even compared to France and Spain. We could even go further in our analysis and compare Belgium to Italy, given their similar high debt to GDP levels (98.5% for Belgium, 119.6% for Italy), but very low household debt (around 53% for Belgium), very high savings rate (around 17% in 2011 in Belgium) as well as very high level of savings and a mostly domestically held government debt. Both countries enjoy massive private sector wealth, therefore foreign debt is negligible"

The current CDS level reflects our position that Belgium is a better risk than France having not only a much better Fiscal position but a much lower household debt and a very high saving rate:
"A wealthy private sector is significant when it comes to debt dynamics given that by broadening the tax base and introducing bigger transfers from the private sector to the public sector means the demand for government bonds in the primary market can provide a stable base as indicated by last year's report published by Danske Bank - Euro area: Why Italy is not Greece:
"The deficit in the peripherals, apart from Italy, increased sharply in 2008 and 2009. In Italy, however, it never exceeded 6% of GDP, and in 2010 the deficit of 4.6% was half that of Spain and Portugal and much better than Greece and Ireland."

On a final note in relation to France, BNP Paribas latest quarterly earnings has revealed the extent of credit contractions in France as indicated by Bloomberg:
"The appetite for loans in France is diminishing on stagnant growth. BNP said decelerating demand in its domestic retail network had edged loans down in 3Q, with consensus calling for GDP growth of just 0.1% in 2012. Net interest income at French lenders could be under pressure from waning demand and persistent low rates. French business lending contracted 0.5% yoy in September (ECB)." - source Bloomberg

"high expectations + strong consensus = danger."

"Both expectations and memories are more than mere images founded on previous experience."  - Samuel Alexander, Australian philosopher.

Stay tuned!

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