Category Archives: On the cover

On the cover

The Eurozone Banks’ Trillion Timebomb

Eurozone banks have fallen dramatically in the stock market despite the results of the stress tests carried out by the ECB, and the EU Banks Index is down 25% on the year despite year-long bullish recommendations from almost every broker. This should not surprise anyone because we have seen in the past that these tests are only a theoretical exercise. Moreover, stress tests’ results are widely challenged, and rightly so, because the exercise starts with the most ridiculous premise in economics: Ceteris Paribus, or “all else remaining equal”, which never happens. Every asset manager knows that risk builds slowly and happens fast.

 

Disappointing earnings, rising risk in the eurozone as well as in their diversification markets such as emerging economies, weak net income margins and low return on tangible equity are factors that have contributed to the weak performance of European banks. Investors are rightly suspicious about consensus estimates for 2019 with expectations of double-digit EPS growth rates. Those growth rates look impossible in the current macroeconomic scenario.

Eurozone banks have done a good job of strengthening their capital structure, reaching almost a one per cent per annum increase in Tier 1 core capital. The question is whether this improvement is enough.

Two factors weigh on sentiment.

. More than EUR104 billion of risky “hybrid bonds” (CoCos) are included in the calculation of core capital.

. The total volume of Non-Performing Loans across the European Union is still at around EUR 900 billion, well above pre-crisis levels, with a provision ratio of only 50.7%, according to the European Commission.  Although the ratio has declined to 4.4%, down by roughly 1 percentage point year-on-year, the absolute figure remains elevated and the provision ratio is too small.

This is what I call the “one trillion eurozone timebomb”. One trillion euro risk when the MSCI Europe Bank index has a total market capitalization of around EUR790 billion.

(Source: Bloomberg, Bologna, Miglietta, Segura)

Let us focus on the CoCos, because it is a less commented issue.

The EUR104 billion of CoCos can be a double-edged sword. On one side, they have been one of the favourite instruments to improve core capital rapidly. It was a very popular instrument in recent years to reinforce capital and diversify funding sources. On the other hand, it is a highly risky asset that can create a domino effect on the equity and the other bonds of the entity. Let us face it, the idea that a CoCo can default with no contagion risk to the rest of the capital structure is simply ludicrous.

These CoCos are hybrid bonds. Rating agencies assign them up to a 50% of ‘equity’ component because the investor can lose the entire coupon, as well as part or all the principal if the issuer’s capital ratio falls below 7% or 5%.

These high-risk bonds have been issued widely and with great success in a world in which investors were hungry for some yield in the face of falling interest rates when many assumed the rising strength of banks. It was almost a “no brainer”. Core capital was rising, banks were stronger than ever, and the yields of these Co-Cos ranged between 4 and 7%. Except the risk was much higher.

In 2011, European banks issued 10 billion euros in these products with returns that reached 10%. It seemed a safe business with almost no risk of default.

The policy of central banks and financial repression, once again, led investors to take more risk for lower yields.

By 2017, Eurozone banks had issued more than 70 billion euros with yields that fell to 4%.

From 10% to 4% yield as risks were gradually building, bank stocks were falling and economic data began to disappoint.

These products were extremely popular because few investors thought that the banks would have no problem meeting the required 10% Tier 1 core capital figure. The risk of breaching the core capital threshold seemed impossible.

“Impossible” and “no risk” are very dangerous words in any asset class. In hybrid bonds, it is reckless to believe in no risk.

A recent paper (Contagion in the European CoCos market) by professors Pierluigi Bologna, Arianna Miglietta and Anatoli Segura, concludes: “The recapitalisation of the banks as a going concern provided by CoCos cannot be detrimental for the stability of the rest of the market. Should the operational features of CoCos keep on proving destabilising in future stress situations, rethinking their role as bank regulatory capital tools would be necessary”.

Unsurprisingly, CoCos have fallen sharply and created a domino effect that impacts equities as well.

The idea that a bond can default with no threat to the equity or solvency of the issuing bank could have only occurred to central planners with no clue of risk and contagion.

Eurozone banks bounced in late August while forward earnings estimates were falling (see above).

Risks in CoCos are evident. In NPLs, concerns are mounting:

  • Weaker earnings from the borrowers due to the slowdown. According to the BIS, the percentage of large zombie companies (those that cannot pay interest expenses with operating profits) has soared to 9% of quoted names.
  • The need to accelerate recapitalization to avoid the next crisis will make it less easy to refinance NPLs.
  • The impact of the global slowdown in banks that had opted to grow in emerging markets, commodities and public infrastructure financing.

Anyone who believes these two problems will be solved by extending quantitative easing and low rates has learnt nothing from the past years.

What these risks show is that eurozone banks need to implement a much more aggressive recapitalization plan. Capital increases and eliminating cash dividends will likely have to return. Managers do not want to do it because shares are too low according to them. However, waiting for a bounce has proven to be a big mistake. 2018 was the year of the perfect combination to drive banks shares higher: Confidence in the eurozone, the likelihood of rate hikes, improvement of fundamentals and earnings growth. None of it happened. Waiting for things to get better for asset classes is not enough.

Eurozone banks are better than three years ago. They are nowhere close to having solved their challenges.

Brexit. A Deal That Pleases No One

The agreement announced between the British government and the European Union has been received in the United Kingdom with criticism from all sides. The defenders of staying in the European Union consider it very negative, of course. However, and this is the most important part, it is unlikely that the conservative party itself will support this agreement in parliament. Jacob Rees-Mogg has called the agreement “a failure of the negotiators and a failure to deliver Brexit.” Boris Johnson has said that it turns the United Kingdom into a “vassal state” and Nigel Farage has described it as “the worst agreement in history”.

Including the entire United Kingdom in the customs union and maintaining the payment of 10 billion pounds a year to give the European Union veto rights to the most important decisions is something that most conservative members of parliament will reject and that does not satisfy the Labor Party – which is also not pro-EU, let’s be clear – nor the liberal-democrats.

That is the great problem facing the government of Theresa May. That not even the government as a whole supports this agreement. The resignations that have been registered prove it. Even if the rest of the government decides to accept this agreement as a lesser evil, it is very difficult for the parliament to approve it.

At the centre of the controversy is a negotiating process that the European Union has left as a United Kingdom issue. But by letting the United Kingdom deal with its own divisions and problems, the EU also lost the perfect opportunity to offer British citizens and the rest of Europe a refreshing, leading and exciting project. And that is the big problem. That Brexit has been seen in many circles in Brussels as an opportunity to advance in the political and interventionist project, instead of moving towards a union in freedom for global, economic and political leadership.

The problem of the UK government is that it is led by a person, Theresa May, who must present a proposal to leave the EU when she has always been an advocate of remaining (Theresa May initially campaigned for the “Remain”). Thus, it is not surprising that the parliament arithmetics in favor of this agreement is not at all clear.

The British Parliament has more members in favor of Brexit than against, but it cannot be THIS Brexit.

Boris Johnson and the pro-Brexit hardliners may see an opportunity to weaken Theresa May and force a change of leadership that will bring a new leader more committed to a better deal.

Moderate Labour, who have been terrified for months with the radical drift of the Corbyn team, may also see an opportunity to weaken the leader who tries to take Labour to the far left.

My perception is that if there were a second referendum the result would probably be the same. In the United Kingdom there are no voices with political weight and real popular support to defend the European Union project. In the United Kingdom, the debate is either seeing the European Union as an annoying partner or as an impossible danger to solve.

Citizens in Europe see Brexit with sadness, logically. In the United Kingdom, news arriving from the European Union do not encourage a remain stance. High unemployment, unresolved immigration problems, lack of global leadership, high taxes, the specter of a new debt crisis in Italy and other risks. Pro-Europe UK leaders offer no other argument to citizens than the so-called Project Fear, a massive economic risk. However, British citizens see UK unemployment at 75-year lows, while in Europe they see the slowdown of the eurozone and the budget crisis of other countries, and do not find an unquestionable reason to stay in the club.

The UK citizen who votes for Brexit does not seem convinced that the only solution is to belong to a union that demands more control but offers less growth and employment.

The reactions to the agreement have not been very euphoric in any case. It seems something that was presented to fail. The pound and stock market did not react as the EU negotiators would think once the deal was seen as unlikely to pass parliament. In the bond market, Gilts strengthened as UK bond spreads fell while eurozone peripheral yields soared. The opposite of what would be seen as an EU victory.

Reaching an agreement that benefits everyone is difficult, but not impossible

The problem in the United Kingdom is that the agreement that would satisfy the pro-Brexit is impossible, and that the agreement that would please the pro-EU is impractical. That the message of economic ruin is not bought by Brexiters and not even the Remainers see the marvels of the EU membership.

Economically, it has been a mistake to present British citizens with the idea of “either the EU or the chaos”, because it does not work when there is not a clear, exciting and global leadership project.

The United Kingdom, one of the voices that defended economic freedom and open markets in an increasingly bureaucratic European Union is an essential partner to advance in Europe. Reaching an agreement that benefits everyone is difficult, but not impossible.

I have never bought the “EU or chaos” argument. I believe that both parts can benefit from a mutually beneficial deal. I am convinced that, even if this agreement is not approved, the British government will reconsider and present a solid plan for its citizens.

 

 

Oil oversupply a ‘double-edged sword’ for OPEC (CNBC)

Oil oversupply a ‘double-edged sword’ for OPEC, analyst says from CNBC.

If OPEC remains fixated in inflating oil prices, they will simply hurt their customers in a weakening global growth environment.

What oil prices are showing is simply that we were living a mirage of bullish estimates and artificial inflation of prices, and it lasted very little.

If you want to be bullish oil from here you need to believe in three things:

. OPEC greed (probable)

. Global demand growth rising (improbable)

. Rates falling and leveraged bets increasing (unlikely)

The reflation trade never existed. It was simply part of the fallacy of synchronized growth, and it is dissipating alongside the central-planned myth of GDP growth by design.

 

Oil Price Roundtrip, A Headache For OPEC

Oil prices surged into the third quarter due to a combination of factors:

  • Artificial supply manipulation, as OPEC maintained production cuts despite healthy demand and better inventories. We discussed it here.
  • Strong leveraged buying based on reflation expectations. As the graph below shows, net length in crude oil rose significantly, only to fall abruptly as rates rise.
  • Excessively optimistic demand growth estimates. In the past three months, we have seen demand estimates slashed by brokers who, at the same time, kept bullish estimates of oil prices into 2019.

Now we are seeing an obvious “hangover” effect, similar to what we saw in 2008.

If you remember, in 2008 we saw oil prices rise dramatically despite global growth estimates coming down and evidence of rising risks to the global economy. We might not be in a similar situation to 2008, but we are seeing a clear evidence of a slowdown.

Moody’s has slashed its estimates of global growth for 2019 by 10% in the past three months, to 3%. Meanwhile, crude inventories are likely to rise in the next months as the main importers start to show the reality of lower growth.

The US has reached an all-time record in oil production, 11.6 million barrels per day, and expected to reach 12 million barrels per day in the next two years, surpassing Russia and Saudi Arabia as the world’s largest producer.

As such, oil prices have roundtripped despite OPEC keeping the tight grip on supply, and also despite concerns on Venezuela and Iran output.

Not only short-term prices are down on the year, but the entire long-term curve has shifted down.

We are talking an entire $5 move down in the forward curve, and oil is now in contango, after spending a few months in backwardation.

Inventories, which fell between April and September, are back at high levels.

The move in oil is simply another piece of evidence of the global slowdown that had been reflected in the price of copper and other commodities. More disinflationary risk as Chinese data becomes more concerning and the eurozone, as well as emerging markets, publish weaker-than-expected figures.

We cannot blame the US dollar, because oil prices have been falling without any rise in the DXY (dollar index).

OPEC has kept its supply cuts, so there is very little else they can do. More importantly, if they decide to artificially manipulate supply again, the response from consumers will be more diversification and it will be -again- only to the advantage of the US producers.

Furthermore, if OPEC remains fixated in inflating oil prices, they will simply hurt their customers in a weakening global growth environment.

What oil prices are showing is simply that we were living a mirage of bullish estimates and artificial inflation of prices, and it lasted very little.

If you want to be bullish oil from here you need to believe in three things:

. OPEC greed (probable)

. Global demand growth rising (improbable)

. Rates falling and leveraged bets increasing (unlikely)

The reflation trade never existed. It was simply part of the fallacy of synchronized growth, and it is dissipating alongside the central-planned myth of GDP growth by design.