All posts by Daniel Lacalle

About Daniel Lacalle

Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Author of bestsellers "Life In The Financial Markets" and "The Energy World Is Flat" as well as "Escape From the Central Bank Trap". Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Frequent collaborator with CNBC, Bloomberg, CNN, Hedgeye, Epoch Times, Mises Institute, BBN Times, Wall Street Journal, El Español, A3 Media and 13TV. Holds the CIIA (Certified International Investment Analyst) and masters in Economic Investigation and IESE.

Are You Prepared For The End Of The Bond Bubble?

Global Economy, On the cover, Sin categoría

The biggest bubble in financial history is about to end.

With rate hikes, a stronger dollar and the return of inflation, bond inflows are normalizing, sell-off in negative yield fixed income continues, and real rates increase despite central planners’ financial repression. High-yield bond funds saw their biggest outflows since December 2014 last week, as investors withdrew $5.7bn, according to EPFR Global.

Meanwhile, the total value of negative-yielding sovereign bonds fell to $8.6 trillion as of March 1 from $9.1 trillion at the end of 2016.

Three factors are helping the burst of the bond bubble:

  1. The price of oil falling to three-month lows on the evidence of the ineffectiveness of OPEC cuts, a record increase in inventories and a stronger dollar is helping to reduce the thirst for high-yield.
  2. A strong “America First” policy needs a stronger US dollar. The US economy benefits from a strong dollar and rising rates, not the other way around. Believing that the US needs to weaken its currency is a fallacy repeated by mainstream economists. The US exports are relatively small, about 13% of its GDP, and its citizens have 80% of their wealth in deposits. The new administration knows it. They are their voters. The only ones that benefit from a weak dollar and low rates are bubbles, indebted and inefficient sectors. If a rise in rates of 0.25% negatively impacts a part of the economy, after more than 600 rate cuts, it means that such part of the economy is unsustainable. Increasing rates is essential to limit the exponential growth of bubbles and excesses.
  3. The European Central Bank. The placebo effect of ECB policy has already passed. With more than € 1.3 trillion in excess liquidity and a dangerous environment where economic agents have become “used” to unsustainable rates to perpetuate low productivity sectors, it is inevitable that the central bank will begin to unwind its Monetary laughing gas sooner rather than later.

That dollar strength and US rate hikes, reinforced by the Trump administration’s capital repatriation policy, is exactly what the country needs if it really wants to “make America great again.” If you destroy the middle class with financial repression, you will not only lose its political support, but the policy will not work either.

Strong dollar, normalized rates and repatriation of capital create the vacuum effect. Higher demand for dollars is triggered and the attractiveness of low yield bonds outside the US is reduced.

… In Europe, we are not prepared for the bond bubble to deflate.

The vacuum effect can mean a loss of up to a $100 billion just from repatriations. If the top five technology companies repatriated half of their cash back to the US, it would mean more than $240 billion leaving the rest of the world and returning to the US.

But, moreover, rate hikes make it less attractive for investors to buy bonds from European and emerging countries.

At the moment, growth prospects in the Eurozone, and the US-European inflation differential keep the flow of investment in the European Union because in real terms it still offers a decent mix of risk and profitability. But the Eurozone has a problem when governments have to refinance more than a trillion euros and have become used to spending elsewhere the “savings” in interest expenses achieved due to artificially low rates.

 

Are You Prepared For The End Of The Bond Bubble? - z uno

 

Those savings have already been spent, and when rates rise, and it will happen, many countries do not seem to be sufficiently prepared. Same with many companies. The rise in inflation and rates, which has given some breathing air to banks, holds another side of the coin. Non-performing loans have not been adequately cleaned, and remain above 900 billion euro in the European financial system. Banks do not have enough capital cushion to undertake the deep provisions that would entail cleaning up such a hole and have relied on the recovery to try to sell these loans. The improvement in NIM (net income margin) coming from inflation and a rate increase does not compensate for the increase in NPLs and their provisions. A rate hike of 0.25% means an increase in NIMs of 17% for Eurozone banks, but the clean-up of NPLs would completely wipe out that benefit.

The European Central Bank should analyze the risk of fragility. Because it has not been reduced.

Europe continues to suffer from three factors: Industrial overcapacity, high indebtedness and excessive weight in the economy of low productivity sectors.

These sectors -industrial conglomerates, construction- have absorbed most of the new credit. The ECB and governments were too obsessed with increasing credit to the economy to worry about where that credit was going to. When Eurozone economies and companies are afraid of the impact of a hike of just 0.25%, it means we have a problem – really big.

Do you have a business? Are you prepared to pay 1-2% more for your financing in the next five years? Yes? Congratulations. You have nothing to worry about.

Do you have a variable rate mortgage? Are you prepared to pay a few hundred euros more per year in the next few years? Yes? You have no problem.

Do you have a country where net financing needs are going to continue to fall as rates rise? Yes? Congratulations, you are fine.

Do you think that the ECB will have to keep or lower rates because everyone is so entrapped that it needs to be more dovish? I wish you luck.

The big mistake of central banks has been to create bubbles, then deny them, and afterward try to perpetuate them with the same policy that created the initial problem. Lowering rates and increasing liquidity has been the only policy.

Now central banks face a new US administration that sees currency wars and beggar-thy-neighbor policies as what they are, assaults on the middle class. Financial repression did not work in the past, and failing to adapt economies to normalized rates is dangerous.

Investors should really pay attention because real and nominal losses are more than evident in bond portfolios.

EDITOR’S NOTE

This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the forthcoming Escape from the Central Bank Trap.

Courtesy @Hedgeye

Op-Ed at CNBC: “Cut and dried? Oil prices are entering a bearish trend despite supply deal”

Energy, Global Economy, On the cover, Sin categoría

Oil prices have entered a bearish trend despite short-term bounces, supply cuts and improved demand estimates.

The lateral range of $50-$55 a barrel was recently broken, with the new long-term support level for Brent edging closer to $45-$47 rather than $50 a barrel. With money managers’ net length exposure to crude prices at the highest level in months, the risks for oil prices seem tilted to the downside.

There are various reasons for this trend.

The supply cut deal struck between members of the oil-producing cartel OPEC and non-members is ineffective and under question. We read everywhere that compliance is 90 percent, but Saudi Arabia is, in reality, the only member that is reducing output by a lot more than agreed according to OPEC figures (130,000 barrels per day cut above its agreed production), while Russia is at almost at a third (118,000 b/d versus the agreed 300,000 b/d).

Meanwhile Emirates, Kuwait, Venezuela, Algeria and others are between 50 percent and 60 percent compliance on the agreed cuts. Only Angola is cutting more than announced. This reliance on Saudi Arabia doing all the work is dangerous. Saudi Arabia has already announced it will increase output above 10 million barrels per day in February.

 

Iran keeps pumping out oil at record levels and Iraq is increasing its output to multiyear highs. Oil exports from Iran in February reached 3 million b/d, a level not seen since 1979. According to the International Energy Agency, Iraq will increase its output to 5.4 million b/d by 2022. Similarly, Iran is expected to boost production to reach 4.15 million b/d in 2022. These barrels are of high quality and abundant, as reserves have been underdeveloped for years.

Additionally, U.S. production is rising faster than expected. U.S. oil production has increased by 400,000 b/d from the lows, according to the IEA, surprising consensus that thought that shale would not recover before Brent reached $65 a barrel. Shale breakeven is now at the high $30s-low $40 a barrel level, and OPEC has underestimated the strengthening balance sheets and improvement of efficiency seen in U.S. companies. The U.S. is on track to deliver a 1 million barrels per day increase in production from December 2016 to December 2017, according to IEA estimates. This is before any tax cuts from the new administration, which would lower the breakeven price even further.

Despite cuts, inventories remain elevated. At 66 days of supply, OECD inventories are at a six-year high compared to 55 days in January 2011, and 287 million barrels above the five-year average. U.S. crude inventories are close to record highs as well, as shown in the Energy Information Administration (EIA) data.

The main element that analysts skip is that the so-called “lack of investment” is just the burst of a bubble. While many point to capex cuts as the driver of a new super-cycle, few seem to understand that the increase seen in oil and gas investments from 2004 to 2013 was created by the bubble of low interest rates and perception of ever-rising oil prices, not by demand. Capex multiplied in real terms to more than $1 trillion per annum in a decade of excess, creating a structural overcapacity.

While demand growth has been healthy year-to-date, consensus estimates seem too optimistic. International agencies get used to correlations of growth and oil demand that simply do not work and have been broken for years. Efficiency, technology and substitution continue to improve exponentially. This technology and substitution did not stop due to low oil prices, as OPEC expected. Solar, wind, electric vehicles and other alternatives continue to thrive despite lower fossil fuel prices.

Let us also remember that a stronger U.S. dollar and the Trump administration’s “America First” policy destroy the geopolitical premium attached to the oil price. The U.S. can become fully energy independent by 2019, and a monetary policy that finally normalizes rates and supports a strong dollar has an impact on the price of a barrel, which trades U.S. dollars.

The fact that oil prices remain in a bearish trend despite the largest cut in history and money managers’ net long exposure to crude at 10-month highs, shows us that the market is not only very well supplied. It remains oversupplied. Bulls maintain that the market will be balanced in six months. They said the same six months ago.

OPEC and oil producers should focus on being a competitive, flexible and reliable suppliers. Further cuts will only weaken their position.

Daniel Lacalle is a PhD, economist and fund manager, author of “Life In the Financial Markets” and (with D Parilla) “The Energy World Is Flat”. You can follow Daniel on Twitter @dlacalle_IA

Video Interview: Secrets of a Fund Manager, Economist and Author

Global Economy, Interviews, Media, On the cover, Sin categoría

In this interview we explore my views on the economy, technology, Bitcoin, my forthcoming book “Escape from the Central Bank Trap” and many other things. I hope you like it.

Thanks for watching!

 

Daniel Lacalle. PhD in Economics and author of “Life in the Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.

Image courtesy Google

 

Deutsche Bank and the last opportunity

Sin categoría

Deutsche Bank has a new strategy. Unwind the old one.  And it might be the correct decision, as well as its last opportunity to overcome its challenges.

Now Deutsche Bank will make its third capital increase since 2013, a move it wanted desperately to avoid… But it was inevitable.

Details: €8bn capital increase, €2bn disposals and list a minority stake in its Asset Management business.

Based on 687.5 million shares issued, the dilution is 50% and the new shares are issued at a 40% discount to Friday’s close. This capital increase should bring the CET1 capital ratio to 13.4% before disposals. Disposals and other impacts would bring 2018 CET1 capital to 11.8% in 2018 according to consensus.

The question is: Will it be the last one?

The German bank’s shares have recovered dramatically in the past months thanks to the expectation of a new strategy and the improvement in inflation and growth in the EU. The main issue, when it comes to understanding risk, is to understand why the shares fell so heavily before – along with the rest of the European banking system -, even when we were told that banks were “very cheap”.

A few problems that the market identifies in Deutsche Bank, and that we have seen in Italian and Portuguese banks, are:

Capital deficits. An estimated capital requirement of €5.5 billion is expected to exceed €10 billion including the costs of recent fines and the harsh reality that the sale of some non-core assets is likely to be at a price below the book value. Divestments have been delayed and capital requirements became more relevant as the business base deteriorated with negative real interest rates – which depressed the bank margins -, and weak global macro outlooks.

Lower revenues. Deutsche Bank generates almost 50% of its revenues from NII (net interest income on loans). With real rates falling worldwide and more than 25% of the world’s GDP in negative yield territory, the risk to the bank’s income outlook was very relevant.

Costs rise. Even with the cost reduction plans carried out and the efficiency programmes, costs skyrocketed (45% from 2011 to 2015) and revenues did not grow (1% over the same period). The cost-to-revenue ratio remains very worrying. It has soared from 72% in the second quarter of 2014 to 79% in 2015 and is estimated to be 80% in 2017.

Low profitability. A problem for the whole European banking system. But with a core capital requirement of 13%, consensus estimates that Deutsche Bank may not generate profitability above its cost of capital at least until 2018. By 2017, a ROTE (return on tangible assets) of less than 5 % and a return on total assets (ROA) close to 0%.

DEUTSCHE IS NOT LEHMAN

Scaremongers try to call this a “Lehman” moment. But there are many elements that differentiate Deutsche Bank from Lehman Brothers, for example:

  • Non-Performing Loans are not at a worrying level (1.9%, less than 3% in the worst of consensus estimates), and well below the Italian or Portuguese banks, for example.
  • The exposure to derivatives, which is constantly discussed in the media, is enormous – nine times its tangible assets – but it has been that way for many years, it has been falling and we must remember that the risk in derivatives is generated when these are very concentrated in an asset that collapses. Deutsche’s derivatives exposure is very diversified and well managed.
  • Deutsche Bank does not deny its imbalances, and has been increasing core capital and reinforcing its balance sheet for several years. This is a big difference with Lehman. Also, Deutsche has none of the massive exposure to a single risk that the failed US investment bank had.

… But all these problems were already known – or at least feared. What changed last year?

Welcome to the CoCos (Contingent Convertible Bonds). These were very popular bonds issued during the years of Draghi’s “whatever it takes” bubble. These are bonds issued by banks which rating agencies give up to 50% consideration as capital because the coupon can be eliminated if the capital requirements of the issuing bank demand it. These CoCos paid an attractive interest and many investors started to buy it as a “bargain” in the hunt for yield. They were so popular that yields fell from 7% to 4% in very little time. For many investors, buying these contingent convertible bonds had “no risk” and they received a 4-6% coupon because the risk of eliminating the coupon was perceived as very low.

In 2016, the risk that Deutsche Bank would not pay some of the maturities on these bonds generated a domino effect: the stock collapsed, the CDS soared and the alarms went off. It did not happen, and maturities were paid, but the elephant in the room -capital risk- became evident.

The idea that you can stop paying a bond without having an impact on the stock and the bank is – as it always has been – a ridiculous one, and we are seeing a second wave of risk, if confidence continues to deteriorate. Therefore, a real capital increase was inevitable.

This contingent convertible bond solution was a fake and dangerous way to deny the need for aggressive capital increases. It highlighted the balance sheet fragility while putting at risk the entire market cap of the bank due to loss of confidence.

Will Deutsche Bank fall? It is very unlikely. This urgent recapitalization comes as the right answer to a problem that cannot be disguised with empty words and apparently intelligent financial engineering ideas.

But the problems of the European banks remain.

Total banking assets in Europe exceed 300% of the Eurozone’s GDP. At the peak of the crisis, in the US, they did not reach 80%.

Non-Performing Loans in the Eurozone remain above €900 billion.

An erroneous policy of kicking the can further via ultra low rates and high liquidity has made it difficult for banks to recover and strengthen their balance sheet, and monetary policy has made the efforts almost a race to stand still. All divestments and increases in share count were offset by weakening profitability and poor credit demand.

The policy of financial repression in the European Union, has weakened banks, rather than allowing them to strengthen. Despite huge provisions and capital increases, the recovery of the financial sector has been much slower than desirable.

If the ECB persists in denying the problem, it is only going to perpetuate it. It is urgent to put recapitalization mechanisms that do not generate systemic risk, instead of bubble patches like the CoCo bonds.

The mistake of this period is twofold: to compareDeutsche Bank with Lehman, while denying the devastating effects of financial repression in the sector. Laughing at the first undeniable exaggeration, policy makers have ignored the urgent measures needed to solve the second reality.

Today’s capital increase is a step in the right direction. But it needs much more. Put profitability back on the map, really reduce costs and make a detailed roadmap of objectives for investors to rebuild their trust.

Deutsche Bank has a unique opportunity to solve its problems for once and for all. It will require much more than a capital increase. Or it will not be the last one.

Daniel Lacalle. PhD in Economics and author of “Life in the Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.

Image courtesy Google.