Wednesday, 31 July 2013

Chart of the Day - US Stocks: Only private clients remain confident in sustained rally

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong 

We recently took the liberty of plotting not only the rise of the S&P index (blue) versus NYSE Margin debt (red) but we also added S&P EBITDA growth (yellow) as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:

But the Chart of the Day is no doubt Bank of America Merrill Lynch's client cumulative net buys of US stocks since January 2008. So much for the vaunted "great rotation" story...
"Last week, during which the S&P climbed 0.7% to another new all-time high of 1692, BofAML clients were net sellers of US stocks for the second consecutive week. Large, mid and small caps all saw outflows. By client type, net sales were led by institutional clients, who have sold US stocks for the past five weeks. Net sales by this group were the largest since March, and the sixth-largest in our data history (since 2008). And on a four-week week average basis, outflows by institutional clients are the largest in our data history. Hedge funds were also net sellers for the second week in a row, while private clients bought stocks for the eighth consecutive week. 
While private clients’ cumulative net buys of equities year-to-date are entirely due to ETFs, this group has been a net buyer of single stocks in seven of the past eight weeks. The last time this occurred was amid the market correction following the US credit rating downgrade in August 2011. In our view, continued purchases of single stocks by this group would suggest ongoing confidence in the bull market, as this group has largely shunned single stocks over the last four years." - source Bank of America Merrill Lynch.

As fellow blogger Cam Hui aptly concluded in his recent post entitled "Can the US-decouple?" on Humble Student of the Markets:
"My inner investor is far more concerned as these longer term indicators suggest that US equities may be nearing an inflection point. The risk-reward picture is turning negative and he doesn't want to stick around at the party until the very end when the cops raid the place. He reminds my inner trader of that old Wall Street adage, "Bulls make money, bears make money, but hogs get slaughtered.""

Are private clients ready for the "slaughterhouse"? We wonder... 

"I have great faith in fools; self-confidence my friends call it." - Edgar Allan Poe 

Stay tuned!

Tuesday, 30 July 2013

Guest post - Global Financing Gaps and Credit Availability - Rcube Global Macro Research

"Most people spend more time and energy going around problems than in trying to solve them." - Henry Ford 

Courtesy of our friends at Rcube Global Macro, please find enclosed their latest publication where Cyril Castelli and Stéphane Alloiteau look at Global Financing Gaps and Credit Availability:

As our readers know, we closely watch corporates financing gaps. To have a better view than the classical capex minus cash flows, we substract the net equity issuance to the formula, since positive equity issuance adds liquidity, and viceversa for shares buybacks. Whereas this changes significantly the picture in the US, where corporate behavior in their own equity is meaningful, it has less of an impact in the rest of the world. Nevertheless, to homogenize the statistical data we are now following it closely in most G10 markets.

In the US, where the data has been available since the 1970s, we have shown how the non-financial
sector financing needs explained with a lead bank lending behavior and thus corporate credit spreads. In the final years before the subprime fiasco, we showed how exploding financing needs (rising capex, massive shares buybacks combined with weaker cash flows) preceded a U-turn in bank lending behavior, which in the end triggered the bust. Very rapidly afterwards, corporates shut down investments, issued equities, while cash flows started to recover. As a result, financing needs collapsed. Banks, reassured by the improved financial health of companies eased their lending standards.

A similar path is visible in the Eurozone.

Currently, Eurozone non-financial corporations financing needs are quite low. Investment has plunged while gross savings have increased.

As a consequence the EU financing gap (adjusted for net equity issuance) is quite low by historical standards, which should, in the end, translate into easier lending standards.

Contrary to the US where the non-financial private sector deleveraging implies an Equity outperformance, in Europe this is not the case.

It is nevertheless important to take into account the fact that financings gaps as we measure them are flow based. And that places where they have improved most significantly recently are also the countries where the stock of non-financial corporate debt remains the highest. France non-financial sector is in a critical situation with the highest financing gap, weakest corporate margins, weakening leverage ratios (debt/operating surplus).

While credit availability is improving for large companies, we all know that SMEs access to capital is much more difficult in southern Europe. Nevertheless, the credit channel in the Eurozone continues to slowly normalize.

In last week’s ECB Lending survey, this normalization process is visible.

On the household front, the same can be said, with demand for real estate loans rising close to turn positive.

In the UK, the credit channel is strengthening further, with credit availability for both households and corporates recently spiking. Demand is also picking up. The BOE survey is by far both in terms of momentum and levels the strongest of all. 

The IIF has just published its quarterly Emerging Markets bank Lending Conditions Survey.

There, the results are more worrying. Following a sharp deterioration in funding conditions, the overall bank lending conditions index moved back below the 50 mark, meaning net tightening.

The sharpest deterioration happened in Asia, where the overall index reached the lowest level since the survey started in Q2 2011. Asia lending index is the lowest of all regions. AFME is now just above emerging Europe in terms of credit availability.

The survey highlights the recent underperformance of EM assets. The credit channel in emerging markets is tightening again. It was our belief earlier in the year that it would improve on the back of easier international funding conditions, monetary easing and stronger global growth momentum. We were wrong.

We are now waiting for the US Senior Loan Officer Survey to be released, but it is unlikely to add significant news flow. It will probably reveal a very healthy credit channel, which has now been the case for a while.

To conclude, it appears to us that, regarding bank lending behavior, we can look at the world in three segmented zones. The US, UK and Japan, where bank lending behavior is strong and strengthening, the Eurozone where it is healing and moving in the right direction and emerging markets (except AFME and emerging Europe) and Asia in particular where it is now tightening again.

"There are no big problems, there are just a lot of little problems." - Henry Ford 

Stay tuned!

Sunday, 28 July 2013

Credit - Cloud Nine

cloud nine: "A state of happiness, elation or bliss".

Following up from our previous conversation where we made a previous "meteorology" veiled reference in our chosen title, looking at the "improved" European data and markets in conjunction with the European weather, we thought we would continue with this line of referencing in this week's conversation.

For now, in Europe, looks like there is indeed a state of elation or "Cloud Nine", at least in the credit space. There is some form of normalization in spreads, having seen this week the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds, tightening by 5 bps in the cash market to 153 bps, also with High Yield debt issuance surging again, signaling the busiest July on record from an issuance perspective as reported by Bloomberg with the average yield investors demand to hold junk bonds falling 42 basis points so far this month to 5.68 percent, near the lowest in seven weeks, Bank of America Merrill Lynch index data show.

Indeed, the credit markets are back into "Cloud Nine" following the devastation from May and June thanks to the QE tapering bomb, which we previously nicknamed the "Daisy Cutter". 

No doubt the latest PMI releases point to some form of stabilization or respite for the time being in the European space as indicated by the improving PMI data.

US PMI versus Europe PMI from 2008 onwards. Graph - source Bloomberg:
But stabilization, doesn't equate expansion, and while the latest European PMI read has scrapped back just above the 50 line, this near term comfort or "cloud nine" moment, is only a respite given nothing has really materially change in the European space. 

So in this week's conversation we would like to focus our attention again on the elusive credit growth plaguing European economies due to encumbered European banks balance sheet with legacy assets as well as why we think it is in the interest of the US to start normalizing rates, therefore tapering.

The elusive credit growth:
Yes, we hate sounding like a broken record but Europe in our views is still a story of broken credit transmission to the real economy. 

On that point we agree with Bank of America Merrill Lynch's take on the Europe story so far from their note from the 9th of July entitled "European banks: it's tough out there":
"Not enough credit in the system
What Europe is struggling with is a lack of lending. This is in different countries driven by a fear of new regulation; a need to bring funding structures into line with new expectations; provisioning shortfalls; or new business margins being unattractive. Obvious undercapitalisation is rare; indeed, it has almost been driven underground. But there is no point regulators tightening the rules overall if
they are not universally applied. They will not achieve what is sought. The AQR* is an opportunity – already being applied in an unnecessarily leisurely fashion – to finally get ahead.
2013 – or perhaps 2014 as well
With it, 2013 is a lost year for lending. If it is not rigorous enough, 2014 will be lost too. It seems difficult to imagine that the political agenda will last that long." - source Bank of America Merrill Lynch

*AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase. 

Should the AQR indicate a shortfall in capital, then there is potential for bail-in rules to be applied as indicated by Bank of America Merrill Lynch's note:
"Bail-in would be painful but would position Spain for sustained recovery 
Should the AQR indicate a shortfall in capital, we believe it may be that the EU’s proposed bail-in rules would need to be applied. With many Spanish banks having run down subordinated debt through exchanges over recent years and having very limited amounts of senior debt outstanding after years of difficult funding markets, the risk of depositor bail-in could rapidly loom large.
The challenge in potentially bailing in banks that were declared well capitalised by the current authorities would in our view be a political challenge of significant proportion. However, we see it as likely to be necessary if the aim is to build a banking system that will lend to solvent borrowers at reasonable prices. We do not believe that even the major Spanish banks are well positioned to do this at present, with high loan to deposit ratios, or their capital tied up overseas or in equity holdings.
We believe that the price would be worth paying, as a banking system that had truly put all its legacy issues behind it would be best placed to restart lending, which would avoid the creation of new bad debts through weak economic performance and unnecessary company and individual bankruptcies. We discuss recent meetings in Spain and our conclusion that credit withdrawal from the economy is likely to be ongoing later in this report." - source Bank of America Merrill Lynch.

We agree with Bank of America's take, namely that until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending. 

So while credit markets are basking in "cloud nine" as displayed by the recovery in spreads over this week and the re-opening of the issuance market, the latest lending survey data coming out of the ECB point to much different picture as indicated by Jeff Black in Bloomberg on the 25th of July in his article "ECB Says Bank Loans to Private Sector Shrink Most on Record":
"Lending to companies and households in the 17-member euro area fell the most on record in June in a sign the region is still struggling to shake off its longest-ever recession.
Loans to the private sector dropped 1.6 percent from a year earlier, the Frankfurt-based European Central Bank said today. That’s the 14th monthly decline and the biggest since the start of the single currency in 1999.
“The weak economy is still weighing on demand for loans and the ECB needs to figure out how to support that,” said Annalisa Piazza, a fixed-income analyst at Newedge Group in London. “There are still substantial reasons for the ECB to maintain the current accommodative stance.” 
ECB President Mario Draghi pledged last month to keep interest rates low for an extended period of time amid a subdued economic outlook and “weaker and weaker” credit flows. While euro-area banks loosened credit standards for loans to consumers in the three months ended June for the first time since the end of 2007, they continued to tighten them for corporate and home loans, an ECB report showed yesterday.
The rate of growth in M3 money supply, which the ECB uses as an indicator for future inflation, fell to 2.3 percent in June from 2.9 percent in May, according to today’s data. That’s below all 30 estimates in a Bloomberg survey of economists.
M3 grew 2.8 percent in past three months from the same period a year earlier. M3 is the broadest gauge of money supply and includes cash in circulation, some forms of savings and money-market holdings." - source Bloomberg

No loan, no growth, no growth, no reduction of budget deficits.

Is lending going to improve in Europe going forward?

We do not believe it will and so does Bank of America Merrill Lynch in their 9th of July paper on European banks:
"While funding markets are open, high debt costs compared with realisable margins on new business mean that banks have made little use of the term markets. With all the pressures from regulators to fund more conservatively, a lack of term issuance has to be in our view a lead indicator of further balance sheet shrinkage. Without a significant change in new business spreads which remains elusive (Chart 20), we believe that banks will be shrinking across the euro area for some time to come. This will naturally be deflationary for the economy.
Is it going to be possible to get around the banks and provide credit to the economy through other channels? We believe not. - source Bank of America Merrill Lynch.

Last week we made the following point:
While the ECB has recently tweaked its collateral framework as additional policy support, as part of the intent towards re-launching the ABS market to improve SME funding conditions, we think it is too little, too late and that the credit transmission mechanism has been broken in Europe, leading to a surge in bankruptcies as well as unemployment.

The credit transmission mechanism channel is broken as indicated by Bank of America Merrill Lynch graph depicting euro area loans to the private sector adjusted for sales and securitization:
"Schemes to kick-start securitisation of small business loans will in our view struggle to gain traction. Given high levels of non-performing loans in the SME sector, a government-backed or ECB “first loss” piece would likely have to be over 20% of the principal extended, a figure too high for northern European support to be forthcoming." - source Bank of America Merrill Lynch.

Encumbered European banks balance sheet with legacy assets:
Problems on European banks balance sheet, not only have not gone away but in some cases have yet to peak, so while credit markets are enjoying a "cloud nine" respite, the deleveraging of European banks balance sheet has much further to go as displayed by Bank of America Merrill Lynch's graph depicting the list of potentially troubled credit ranging from  13% of loans on banks' books to 40% in Ireland:
"On this basis, all the southern economies have double-digit proportions of their balance sheets in need of close attention. Given ongoing economic weakness in the region, we believe this will tend to create pressure on banks to shrink, in order to conserve capital ratios." - source Bank of America Merrill Lynch.

Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments as per Bank of America Merrill Lynch's graph below:
"Foreign ownership of the debt has stabilised but YTD has risen only marginally. Spanish banks have taken up the majority of the increase in recent months, continuing a trend since 2008 (Chart 28).
In addition, regions and municipalities have taken significant amounts of loans from the banks, as have the various funds set up to pay off arrears accumulated by parts of government. These collectively saw banks’ exposures to government rise by a further €20 billion in 2012; more lies ahead in our view.
Crowding out is likely to continue, for two reasons. First, the pretax margin available in taking government exposure is potentially equivalent to, or above, that of lending because there is almost no marginal cost, credit losses are likely assumed to be zero. Furthermore, a government bond position can be repo funded with a 5% or less haircut even for longer dated exposures. This is a fraction of the discount required to repo fund mortgage or SME exposures, even when such finance is available.
Leverage ratios may bind here too
The trade off between loans and government exposures is also set to be intensified with the introduction of leverage ratios. The zero risk weighting of government bonds made them 'free' from a capital perspective, but a 3% leverage constraint implies an equivalent 30% risk weight based on a target common equity tier. One ratio of 10%. based on the proposed 8% of liabilities bail-in requirement, the effective risk weight would likely be higher."  - source Bank of America Merrill Lynch.

Where we disagree with Bank of America Merrill Lynch's recent note is on their take about the recent improvement in the Macro Data in Europe which according to them could lead to potential increase in credit demand. We do agree though that banks are a leveraged play on recovering economy (so far US banks have outperformed both equity wise and credit wise):
"Macro data in Europe has been, at least, less bad in recent months. Banks are, always and everywhere, leveraged macro plays. This predisposes us to be more positive on the European banking system. Better GDP improves potential credit demand and drives higher asset prices, a key contributor to bad debt charges.
However, better GDP is a necessary but not sufficient condition for a more positive view. There remain several constraints :
- Legacy assets. We believe these are likely to be dominant issues for many banks in Spain and Portugal. The past is not yet behind them
- Non-performing loan generation has been elevated recently in Italy and Spain. While the pace should slow with sustained GDP recovery, provision coverage has lagged new NPL formation, suggesting that more recent problem loans will also need to be addressed
- Returns are not sufficiently high to encourage banks to grow."  - source Bank of America Merrill Lynch.

So far the ECB has limited the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields staying around the 1.60% level at 1.64% and French yields now around 2.25% slightly higher from last week - source Bloomberg:
But how long can the summer lull last?

Probably until the fall, where there is a significant possibility of seeing renewed political risk in conjunction with austerity fatigue. On that note we agree with Nomura's take from the 25th of July from their geopolitics not entitled "Red October":
"- In contrast to 2012, markets have been barely troubled by political risk this year, with the focus very much on the fundamentals and, latterly, the Federal Reserve together with monetary tightening in China.
- However, the autumn (or "fall", as the Americans would have it) may see politics-related risk rising in several geographies, notably the eurozone but also East Asia, the Middle East and the US.
- Although we see a systemic event as a tail risk, we still think that politics has the potential to move markets non-negligibly in the coming weeks, with October currently looking particularly risky." - source Nomura

While the summer lull and "cloud nine" seems to be prevailing, as we argued last week, in conjunction with our friends from Rcube latest call on global weakening earnings momentum, there are significant indicators that are starting to flash warning signs, at least credit wise we think from a European perspective as like anyone else we look at PMIs in Europe but we prefer to focus on credit availability and financing conditions.

First, Europe's largest engineering company Siemens has cuts its profitability forecast amid market slowdown and won't achieve its 2014 margin target of at least 12%, leading for an early exit of its CEO Peter Löscher.

Second, one particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. As indicated in our conversation "The European crisis: The Greatest Show on Earth", :
"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 12th of July points to a deterioration in the Terms of Payments:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?
Delays in "Terms of Payment" as indicated in their July survey have been reporting an increase by corporate treasurers. Overall +27.6% of corporate treasurers reported an increase compared to the previous month, a clear deterioration in the trend. The record in 2008 was 40%.

On top of that French treasurers are clearly indicating in the latest report a deterioration in their operating cash flow position in the latest AFTE report:
The monthly question asked to French Corporate Treasurers is as follows:
How do you assess the current situation of the operating cash flow of your business:
easy, normal or difficult?

A deterioration that does not bode well for France's level of unemployment which should continue to rise given a deterioration of operating cash flows could lead to a rise in the number of bankruptcies in France which continue to rise as per the below graph from Natixis:

So we recommend continuing to monitor closely the French corporate treasurers' survey in the coming months.

Moving on to the subject of why we think it is in the interest of the US to start normalizing rates, therefore tapering, we have long argued that we have more issue with ZIRP policies than QE.

Let us explain.

If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2.

The only way the Fed can start raising interest rate is by first starting its "tapering" dance (following its "twist"...). To do that you need to contract the monetary base first, which is not trivial to say the least.

Looking at the recent bout of volatility with the ML MOVE index jumping from early May from 48 bps to a record 117 bps in a couple of weeks which crushed the fixed income space, it will not be an easy exit for sure - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

On a final note, we recently took the liberty of plotting not only the rise of the S&P index (blue) versus NYSE Margin debt (red) but we also added S&P EBITDA growth (yellow) as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:
The much vaunted stability courtesy of Bernanke's wealth effect looks to us increasingly unstable.

Sometimes when we look at the chosen path taken by our central bankers, thinking they can "print" their way out of trouble and the pernicious destructive effects ZIRP policies have on capitalism (lack of a price for capital therefore it cannot be "efficiently" deployed but only mis-allocated) and labor, we sometimes feel like Zweig must have felt in Petropolis...
Oh well...

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself."  
Stefan Zweig (1881-1942)

Stay tuned!

Sunday, 21 July 2013

Credit - Every Silver Lining has its Cloud

"To penetrate and dissipate these clouds of darkness, the general mind must be strengthened by education." - Thomas Jefferson

Following up on our guest post from Rcube Global Macro Research, where our friends looked at the weakening global earnings momentum (except in Japan), we thought this week, we would take the contrarian approach given equities market seem oblivious to the gathering storm ahead, silver lining being the metaphor for optimism in the common English-language.

The origin of the phrase "Every Cloud has a Silver Lining is traced to John Milton's "Comus" (1634) with the lines:
"Was I deceiv'd, or did a sable cloud
Turn forth her silver lining on the night?"

Indeed, as John Milton's 1634 Comus, it has all to do with deception we think. 

We touched on the subject of cognitive bias in our "Dunning-Kruger effect" conversation. Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content, therefore, we would tend to agree with our friends Rcube latest call on global weakening earnings momemtum.

As humans we posited in our previous conversations that we tend to suffer from optimism bias as indicated by the work of Tali Sharot:
"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events." - Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

Not only do we suffer, from optimism bias, but we suffer as well from "deception" and we also all play "deceit" to some extent. We are all "great pretenders", some way or another. In similar fashion to the 1955 hit by the Platters "The Great Pretender", while the song described a man who deals with his heartbreak by denying it, we seem to be dealing with the "broken economy" (more so in Europe) by "denying" its reality, but we ramble again. For those of you who enjoy human's ability in practicing deception, like ourselves, we recommend the site "" dealing with its various forms.

In this week conversation, we would like to look at the negative trend in Spanish nonperforming loans, indicating Spain is tilting towards the adverse scenario which was used by Oliver Wyman in their Spanish banking stress tests. We will also look at the divergence in Central banks approach and the consequences as well on credit from a "loan" perspective. But first a quick credit and markets overview.

The story last week has clearly been some normalization following the explosion of the "Daisy Cutter", namely bond volatility as displayed by the evolution of the Merrill Lynch MOVE  index, which has been falling  - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Therefore the receding volatility in the fixed income space has led to a significant rebound in High Yield as displayed by the price action in one of the most liquid and active ETFs in the High Yield space, namely HYG. Whereas its investment grade equivalent namely the LQD ETF has not rebounded significantly - graph source Bloomberg:
More interestingly the normalization in the credit space was accompanied by a significant tightening in Itraxx indices credit spreads, thanks to a more dovish tone from Ben Bernanke at the Fed. Therefore, not only credit investors have been enjoying some welcome respite for a fourth consecutive week, which has been the longest streak of gains since before the bond route drove yields to a nine months high in June according to Bloomberg, but, benefited from the re-opening of the new issue markets, with credit investors showing again their strong appetite. For instance Gazprom issued a benchmark bond with an initial price guidance of a 4% coupon 5 year (BBB rating) which attracted 5.5 billion worth of orders in the book from 450 different investors, leading to a lower revised guidance to a more reasonable 3.75% coupon at the launch.

Of course the dovish tones from both the Fed and the ECB have so far limited the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields staying below the 1.60% level and French yields now around 2.16% - source Bloomberg:

As far as summer 2013, the on-going respite is indeed a different experience so far from the summer of 2011 and 2012, which saw a liquidity crisis for the first, followed the following year by a spike in peripheral bond spreads during the summer 2012 which was called-off by the "whatever it takes" stance which kept the "feral bond hogs" at bay for the rest of the year leading to 2012 being a spectacular year for credit returns, following closely the record "reflationary" year of 2009.

But, as we posited last week, and in accordance with this week's chosen title, every silver lining has its cloud, and as far as Europe is concerned, clouds are indeed gathering. Record basking temperatures might indeed lead us to some thundering storm ahead in Europe, looking at the unemployment issues particularly hindering the economic prospects for peripheral countries. One just has to glance at the Spanish "Misery" index to fathom the uphill struggle face by our European politicians - graph source Bloomberg:
The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s.

As far as Spanish banks are concerned, the recent surge in non-performing loans (NPLs) is seriously raising questions again on the adequacy of their level of provisioning. Particularly if ones look at the continuous fall in Spain real estate prices - graph source Bloomberg:
From a starting point of a 100 in September 2007, Spanish prices are now down to 72.64, a fall of more than 28%.
Given that we are now in the middle period considered by the previous Oliver Wyman (OW) stress tests for Spanish banks one can indeed look at the trend for actual nonperforming loans (NPL) and the implication for Spanish banks loss absorption capacity. This exercise is exactly what Nomura has done in their recent note from the 19th of July entitled - "Spanish Banks - On the road for the adverse scenario?":
"Now that we are in the middle of the period considered by the Oliver Wyman (OW) stress tests, we compare actual non-performing loans (NPL) trends with the implied expected probability of default (PD). We estimate an adjusted NPL ratio in May 2013 of 19.5%, representing 55% of total expected 2014 PD in the adverse scenario of 35.2%. On a three-year horizon, the NPL trend is closer to the baseline scenario. However, without a relatively vigorous recovery in 2015, asset quality deterioration could continue beyond the timeframe of the stress test, which would make the current trend closer to the adverse scenario.

Non-recurring income to absorb continued deterioration of asset quality Capital gains from the debt portfolio and other asset disposals should allow the Spanish banks to absorb the continued asset quality deterioration and partially absorb the new provisions needed for restructured loans. We expect net interest income (NII) to reach the bottom this quarter in most cases, although we still see limited upside given the low interest rate environment and ongoing deleveraging.

Support from LatAm – not so much this quarter
Volatile FX and rising bond yields could add some additional headwinds to the earnings contribution from LatAm for BBVA and SAN this quarter (although more so for Brazil vs Mexico). We believe the revenue environment in Brazil remains weak, and given a deteriorating economic outlook, concerns about the outlook for asset quality could return. Although the economic outlook remains positive in Mexico, in our view, this quarter faces some pressure from rising NPLs (particularly from homebuilders).
Relative preferences
We remain negative on the Spanish banking sector. The expected continued asset quality deterioration, the potential impacts of removing mortgages floors, the additional provisions needed for restructured loans or the slowdown in some LatAm economies, are examples of the headwinds facing Spanish bank profitability. In relative terms, we prefer BBVA (Neutral) owing to our bullish medium-term outlook for Mexico and, among the domestic banks, CABK (Neutral) owing to its relative higher returns, and the recent measures announced regarding their international financial stakes, which will allow them to improve the capital position." - source Nomura

As far as nonperforming loans are concerned and in relation to Spain, clearly, the trend is not the Spanish banking friend as indicated by Nomura in their note:
"The OW stress test was made for a three-year period, starting at the end of 2011, so we are now in the middle of the period being considered. In Fig. 4, we compare the 2011 NPL ratio with the 2014 OW expected PD and the actual level of NPLs, adjusted and reported, at a sector level.
The reported ratio includes total sector NPL balances over total credit and loans, reaching 11.2% in May 2013. The adjusted NPL ratio also considers the sectors foreclosed assets, the assets transferred to the SAREB and other EUR 30bn of problematic assets, mainly restructured and substandard loans classified as performing, leaving the May adjusted NPL ratio at 19.5%.
The adjustment of EUR 30bn of problematic assets considers that around 50% of total sector restructured loans are NPLs instead of the 37% reported at the end of 2012. In our recent report, Better today than tomorrow, we showed how total sector restructured loans at the end of 2012 were EUR 208bn, representing 14% of private sector loans, of which EUR 43bn were classified as substandard, other EUR 88bn as performing loans and the remaining EUR 77bn were not performing. The Spanish banks are reviewing these portfolios in order to apply the new and more conservative classification criteria, which will increase the non-performing and substandard restructured loans balances. If we consider as problematic assets all restructured loans, the adjusted NPL ratio will increase from 19.5% to 25.5% for May 2013. Fig. 4 shows that the Spanish financial sector adjusted NPL of 19.5% in May represents 55% of expected 2014 PDs under the OW adverse scenario." - source Nomura

Nomura has also gone further in their report hand have looked at the trend in the on-going deterioration in asset quality:
"The OW stress test assumed a three-year period. However, we believe the economic outlook in 2015 is not clear and a further deterioration in asset quality is possible. In Fig. 6, we show the expected NPL ratios trends if the period was extended to four years instead of the three-year period considered in the OW exercise. In this case, the current adjusted NPL ratio of 19.5% is closer to the adverse scenario than the base one, which theoretically for a four-year period are 21.4% and 17.3%, respectively.
From a macroeconomic perspective, in Fig. 6, we compare the latest available forecasts for the Spanish economy with those considered in the OW stress tests. The IMF published its July World Economic Outlook update on 9 July, downgrading its 2014 GDP and unemployment forecasts for Spain. Its new forecasts now assume that the Spanish economy will not grow until 2015, and it expects a 2014 unemployment rate of 26.5%, which is 50bp above its previous estimate (although this is below the 28% forecast recently published by the OECD).
Although the IMF macroeconomic estimates are still below ours, the downgrades highlight the potential risks for the Spanish economy. We also consider as negative the ongoing political scandals about alleged corruption, which, considering what happened recently in Portugal, could also add more volatility and uncertainty to the country and the banking sector.
We remain negative on the Spanish banking sector. The expected continued asset quality deterioration, the potential impacts of removing mortgages floors, the additional provisions needed for restructured loans or the slowdown of LatAm economies in the case of the two large banks, are some examples of the challenging outlook for the Spanish banking sector and the potential additional negative impacts." - source Nomura

Of course we would have to agree with Nomura, in this case the trend is indeed not your friend and regardless of the "silver lining" of some credit returns, there are indeed some clouds gathering on the horizon. While the ECB has recently tweaked its collateral framework as additional policy support, as part of the intent towards re-launching the ABS market to improve SME funding conditions, we think it is too little, too late and that the credit transmission mechanism has been broken in Europe, leading to a surge in bankruptcies as well as unemployment.

As an illustration of this broken credit transmission mechanism, one can only look at the below graph from Nomura relating to loan growth in Italy to get a clear picture of the damages inflicted to the real economy:
Loan growth? What loan growth?

No wonder the story separating the US economy from the European economy is a credit story. For instance we have been looking on numerous occasions on the price action of the  US Leveraged Loans market versus the European Leveraged Loans market. Comparing market fundamentals between both regions from a credit perspective is paramount in order to gauge the potential growth outcome for the two regions we think. Morgan Stanley in their recent Global Leveraged Insights from the 19th of July and entitled "Game of Loans: US vs Europe" look at these differences:
"Comparing Market Fundamentals: European loans have lower average ratings, higher trailing default rates, and a more challenging loan maturity wall, relative to the US. However, given a much more ‘issuer-friendly’ environment in the US, cov-lite volumes are higher, LBO leverage is greater, and levering transactions are more prevalent.
Technical Strength, but for Different Reasons: The US has been a story of strong demand, thanks to substantial fund inflows and strong CLO issuance. In Europe, positive technicals have been much more a story of low net supply." - source Morgan Stanley

As we posited in May this year in our "Chart of the Day - Too many European banks and why the deleveraging has only just started", the impact of credit growth in Europe is seriously impaired by the on-going deleveraging leading to a vicious deflationary spiral in the European space. It is therefore not a surprise to learn from Morgan Stanley's report the importance in Europe for banks in the loan market:
"Differences in the Investor Base: Banks continue to account for a much larger share of the Europe loan buyer base. As we show in Exhibit 2, banks’ share of the primary market for loans has shrunk over the last decade in both the US and Europe. But banks still account for 50% of the European loan market compared to just 13% in the US." - source Morgan Stanley.

Of course there are as well some quality differences:
"Differences in Credit Quality: The average credit quality of the two markets also differs. Whereas the US loan market is split almost evenly between BBs and Bs, the European loan market is clearly skewed towards Bs (66%), with only 17% BBs. It is notable that this difference in credit quality is almost the exact opposite of what is seen in the US and EU High Yield bond markets, where Europe has a much higher average rating. Investors should keep this quality differential in mind when comparing headline spreads and yields." - source Morgan Stanley

The growth differentiation between the US and Europe is no doubt to us a question of supply in credit:
"Weak Supply Story in Europe, Stronger in the US: In 1H 2013, the US loan market absorbed $267bn in gross institutional issuance, nearly matching levels last seen in the 1st half of 2007. The mix of this issuance, however, is much different today. In 2007, LBOs accounted for 36% of issuance, compared to 10% in 1H13. The majority of gross issuance today is still for refinancing. Subtracting repayments, net issuance for the US loan market was a more manageable $92bn in 1H13, compared to $181bn in 1H07. While stronger 2H growth in the US could lead to more corporate activity, and in turn net issuance, our base case is that supply remains manageable in the US near term.
In Europe, supply has been more muted. From the second half of 2009 through the 1st quarter 2013, LTM leveraged loan net supply was negative, and has only turned positive (just under €1bn) in 2Q13. An important reason for low supply in Europe has been bond-to-loan refinancings. 1H13 EUR high yield bond issuance was €48bn, just slightly below the total for 2012 – the highest year on record. By our estimates, 27% of this issuance has been to refinance bank debt and unlike previous years, concentrated (60%) in single-Bs that tend to dominate the loan market. Naturally, this trend has led to lower issuance of loans and as a result, soft demand has been outpaced by even softer supply. There are, however, tentative signs of revival in the loan market, and we do expect net supply to remain positive in Europe." - source Morgan Stanley

But even for the US, every silver lining has its cloud given the fast pace of credit releveraging and surge in covenant quality trends as highlighted by Morgan Stanley in their note:
"New Issuance Trends – More Worrying in the US
However, not everything looks better in the US from a fundamental perspective. Covenant quality trends in the US have been particularly worrying. Year to date 51% of US loans have been cov-lite — a far higher share than the previous peak in 2007. Although the share of cov-lite issuance is high in Europe by historical standards, it is miles behind that of the US.
Across both markets, new issuance has primarily been used to refinance outstanding debt. US issuance has had a somewhat more shareholder friendly tone, with 15% of proceeds used to fund dividends or share buybacks compared to just 6 percent in Europe. New LBOs also make up a larger share in Europe, although this is predominantly a result of lower overall issuance levels." - source Morgan Stanley

For sure, the buy-back frenzy, has no doubt been more "equity" friendly and definitely more worrying from a credit investor's perspective, making the US market therefore more attractive as of late.

On a final note, "housing bubbles" thanks to cheap credit and hot inflows has no doubt been exported to Emerging Markets when one looks at the cost of housing in Columbia, so much for a post-bubble world... - gaph source Bloomberg:
"Anyone presuming financial markets are in “a post-bubble world” might have a different view after looking at the cost of housing in Colombia, according to Yale University Professor Robert J. Shiller.
The CHART OF THE DAY shows how a home-price index compiled by the South American country’s central bank compares with the Standard & Poor’s/Case-Shiller price gauge for 10 U.S. cities from seven years earlier. Colombia’s index focuses on Bogota, Cali and Medellin, the three largest cities. Both indicators
have been adjusting for inflation. 
“I was not expecting a bubble story when I visited Colombia last month,” Shiller wrote yesterday in a commentary posted on the Project Syndicate website. “People there told me about an ongoing real-estate bubble.” 
Home prices in Colombia have increased 69 percent in real terms since 2004, according to the posting. The gain recalled a 131 percent surge in the 10-city index from its 1997 low to its 2006 peak, he wrote.
Falling inflation and interest rates largely explain the Colombian market’s strength, Shiller wrote. Consumer prices rose in February at the slowest pace since 1955. The central bank cut the overnight lending rate seven times in the past year, and the current 3.25 percent rate is Latin America’s lowest.
Shiller also cited a diminished threat from a Marxist rebel group, the Revolutionary Armed Forces of Colombia, that has been active for half a century. The government has held peace talks with the guerrillas, known as FARC, since October. “That is a good enough story to drive a housing bubble,” the New Haven, Connecticut-based economist wrote." - source Bloomberg

"Every silver lining has a cloud." - Mary Kay Ash

Stay tuned!

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