Banks
While bank stocks are quick to react positively to any indication that the regulatory burden may eventually be diminished, beneath the surface, there are mounting signs of profit headwinds. The latest Fed Senior Bank Loan Officer Survey revealed that banks are tightening lending standards on most loan categories. Worrisomely, demand for commercial, consumer, mortgage and C&I loans is also waning. In fact, C&I loan growth is now contracting on a 3-month rate of change basis. A cooling in bank balance sheet expansion may expose a heavier cost structure than desired in the coming quarters, given that bank employment has been on the upswing. Absent any renewed steepening in the yield curve, the surprise could be that bank stocks underperform in the coming months after overshooting since the election. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.
Bank stocks have experienced a sentiment-driven surge since the U.S. election, supported by expectations for higher interest rates. However, lost in the exuberance has been a marked deceleration in credit creation. Total bank loan growth has dropped to nil over the last three months, led by the previously booming C&I category. That is a sign that while businesses are expecting an economic improvement, they are not yet positioning for one via increasing working capital requirements. Coupled with increased bank staffing levels, the growth in bank loans-to-employment, a decent productivity proxy, has also dropped to zero. Importantly, the yield curve widening has taken a breather, which may be a catalyst for some profit-taking, especially if upcoming bank earnings results disappoint on the credit growth front. We are underweight this index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.
Highlights The global 6-month credit impulse is now in its longest upcycle in a decade. Given also that bond yields have had their sharpest spike in a decade, we would not bet on the upcycle lasting much longer. Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500. Underweight the IBEX versus the Eurostoxx600. Feature A few days into the New Year, two over-arching economic questions are exercising our minds. Is the relationship between sharply higher bond yields and weaker bank credit creation still valid? And is the relationship between weaker bank credit creation and decelerating economic growth still valid? Chart of the WeekCredit Impulses Heading In Different Directions We suspect the answers are yes and yes. European Investors Must Think Globally, Not Locally Europe is not an investment island. Major European stock market indexes comprise large multinational companies whose sales and profits come from across the world. The upshot is that European stock markets almost always move up and down in tandem with other major world stock markets, such as the S&P500 and Nikkei225 (Chart I-2). Mainstream bond markets might seem to be more parochial, given that they are supposedly under the influence of the local central bank. But investors buy and sell high quality bonds as a global asset class. The upshot is that European bond markets also almost always move up and down in tandem with other major developed bond markets (Chart I-3). Chart I-2Major Equity Markets Move Together Chart I-3Major Bond Markets Move Together Hence, European investors must look first and foremost at global drivers. For us, the most important such driver is the global 6-month credit impulse - which sums the 6-month (dollar) credit impulses in the euro area, the United States and China. Does the global 6-month credit impulse have any predictive power? Yes. Chart I-4 shows that it has consistently led the 6-month cycle in the global government bond yield, which is a good proxy for the global growth cycle. Admittedly, this powerful predictive relationship weakened somewhat through 2013-14 during the most aggressive and distortive phase of worldwide QE. However, in the past couple of years, as QE has waned, the global 6-month credit impulse's predictive power has strongly re-asserted itself (Chart I-5). Chart I-4The Credit Impulse Leads ##br##The Global Growth 'Mini-Cycle' Chart I-5The Credit Impulse's Predictive ##br##Power Has Re-Asserted Itself In effect, the charts illustrate that whatever the structural economic backdrop, the global economy experiences a perpetual 'mini-cycle' lasting about 15-24 months. Higher bond yields (or credit restrictions) weaken the credit impulse; the weaker impulse then depresses growth; the depressed growth lowers bond yields; lower bond yields (or credit easing) strengthen the credit impulse; the stronger impulse then boosts growth; the boosted growth lifts bond yields; and back to the beginning... Remember, the credit impulse measures the growth in the credit flow. The important point to grasp is that the impulse can weaken even if the credit flow numbers themselves seem strong. For example, if the credit flow increased from $100bn to $150bn to $190bn it might appear to be growing very healthily. But actually, the impulse would have weakened from $50bn to $40bn, creating a headwind. Where are we in the perpetual mini-cycle? Today, the euro area credit impulse is losing momentum, while the U.S. impulse is waning. Which leaves China's rising credit impulse as the only component supporting the global credit impulse (Chart of the Week). But for how much longer? To repeat, it would just take the global credit flow to decelerate for the impulse to roll over. Now consider that high-quality bond yields have had their sharpest 6-month spike in a decade. And that the current 10 month upcycle in the global credit impulse already makes it the longest in a decade. Hence, we would not bet on this mini-upcycle lasting much longer. A Few Words On Our Credit Cycle Framework Our credit cycle framework has several features which uniquely define it. First, the framework focusses on bank credit. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody's spending power has to go down. In contrast, when somebody borrows by issuing a bond, it merely reallocates spending power from one person to another person. The borrower sees his bank account and spending power go up, but the lender sees his bank account and spending power go symmetrically down. Spending will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, as already discussed, the framework focusses on the bank credit impulse - which measures the growth in the bank credit flow. This is just to compare apples with apples. Remember that GDP is itself a flow statistic. So the growth in GDP receives a contribution from the growth in the credit flow1 (and not from the flow itself). Third, the framework focusses on the 6-month bank credit impulse. We choose this periodicity because 6 months is about the time that it takes to for credit to be fully spent, thereby yielding the greatest predictive power from the credit impulse to economic activity. Fourth, the framework calculates the credit cycle using bank credit to the non-financial sector2 rather than the more commonly-quoted money supply statistics such as euro area M3. The simple reason is that not all loans generate economic activity. Bank to bank lending may stay trapped in the financial system. The money supply - which is on the liabilities side of the banks' balance sheet - would not pick up this distinction. As M3 captures all bank deposits, it would still be expanding rapidly, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending - which is on the assets side of the banks' balance sheet - and only count lending that is likely to generate economic activity (Chart I-6). This reasoning only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. But unofficial shadow lending must eventually show up in the money supply. Therefore, exceptionally for the China sub-component, our credit cycle framework does prefer to use the money supply (Chart I-7). Chart I-6Our Euro Area Credit Impulse##br## Uses Bank Lending... Chart I-7...But Our China Credit Impulse ##br##Uses Money Supply A Few Words On Our Reductionist Framework We are also strong believers in Investment Reductionism. This philosophy stems from two guiding principles: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle - which says that 80% of effects come from just 20% of causes.3 The important point is that most of the moves in most financial markets result from a very small number of over-arching macro drivers. To reiterate, Europe is not an investment island. Investment Reductionism means that much of asset allocation, sector selection, and regional and country allocation distills down to getting the global growth cycle right. The remaining charts should leave readers in no doubt. Chart I-8 shows that the global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset class selection. Chart I-9 then shows that the direction of bond yields determines sector selection: for example Banks versus Technology. Chart I-8Investment Reductionism Step 1: The Global##br## Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield ##br##Drives Sector Selection Chart I-10 and Chart I-11 then show that the sector selection of Banks versus Technology determines both the regional allocation of Eurostoxx600 versus S&P500, and the country allocation of IBEX versus Eurostoxx600. Chart I-10Step 3: Sector Selection Drives##br## Regional Allocation Chart I-11Step 4: Sector Selection Drives ##br##Country Allocation To sum up, the global 6-month credit impulse is now in its longest up-cycle in a decade, and bond yields have had their sharpest spike in a decade. Hence, we would not chase cyclicality at this juncture. Which means that on a 6-month horizon: Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500.4 Underweight the IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Equivalently, the credit impulse is the growth in the growth (second derivative) of the credit stock. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Often known as the 80-20 rule. 4 BCA Strategists differ on this position. Fractal Trading Model* This week's trade is to express a tactical short in equities via Italy's MIB. An alternative market-neutral trade is to go short Italy's MIB and symmetrically long Hong Kong's Hang Seng. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Chart I-13 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II_2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The valuation discount on Italian banks still seems insufficient for the sector's excess NPLs. We expect a better long-term buying opportunity sometime next year. Stay underweight the MIB and IBEX versus the Eurostoxx600. Stay underweight the Eurostoxx600 versus the S&P500. Long Italian BTPs versus French OATs has quickly achieved its profit target. Now prefer long Spanish Bonos versus French OATs. Feature Assessing The Value In Italian Banks Investment reductionism says that the valuation of a bank distils down to three things: The expected size of the bank's assets. In the standard banking model, the dominant asset is the bank's loan book. The expected profitability of the bank's assets. In the standard banking model, the dominant driver of profitability is the net interest margin (the difference between the interest rate received on loans and the interest rate paid on deposits). The expected amount of equity capital required against the bank's assets. The equity capital must absorb the bank's loan losses but it also receives the profits. Increasing the amount of equity capital dilutes the profits over a larger number of shares, and thereby lowers the bank's share price. Chart of the WeekSpain And France have Raised €100bn Of Bank Equity Capital... Italy Has Not Today, the potential reward of owning Italian banks is that they trade at a large valuation discount. Admittedly, growth in assets and profit margins is likely to be anaemic. But Italian banks trade on a price to forward earnings multiple of less than 10. Not only does this seem cheap in absolute terms, it is a 25% discount to other European banks (Chart I-2). Chart I-2Italian Banks Trade At A Significant Discount Chart I-3Italian Bank NPLs Have Increased Sharply But the risk of owning Italian banks is that they still carry €170bn of un-provisioned non-performing loans (NPLs), which is likely to require a large - and dilutive - increase in equity capital. NPLs have increased much more sharply in Italy than in Spain or France (Chart I-3). But the more significant difference is that Italian banks have not yet raised equity capital as a cushion against their rising NPLs. Since 2009, Spanish banks and French banks have both increased their equity capital by more than €100bn. Over this same period, Italian banks have actually shrunk their equity capital (Chart of the Week). Given that Italian bank equity capital stands at €150bn, today's 25% valuation discount is pricing a dilutive increase in equity capital of around €50bn. Will this be a sufficient cushion? Chart I-4How Much Equity Capital Do Italian Banks Require? Our assessment is that it still might be insufficient. Our prudent benchmark is that the Italian banking sector lifts its equity capital to NPL multiple to the lowest coverage that the Spanish banking sector reached in recent years (Chart I-4). That would require Italy to emulate Spain and France and raise closer to €100bn of fresh bank equity capital. Also beware that if an undercapitalized bank cannot raise sufficient equity capital privately in the markets, there is a danger that its investors could suffer heavy losses. This is because the EU rules on state aid for banks changed at the start of 2016. The EU Bank Recovery and Resolution Directive (BRRD) allows a government to step in with a 'precautionary' capital injection only after a first-loss 'bail-in' of the bank's equity and bond holders. Hence, Italian banks are a potential buy if you believe €50bn of extra equity capital will fully alleviate concerns about the large stock of un-provisioned NPLs... and if you believe that the sector's plan to raise equity capital in the market will avoid any major mishap. Given global banks' strong recent bounce, we expect a better long-term buying opportunity sometime next year. Value Doesn't Help Pick Equity Markets Chart I-5Italy's MIB Looks Cheap The headline cheapness of Italian banks inevitably makes Italy's MIB look relatively cheap too (Chart I-5), especially given the Italian stock market's overweighting to banks. Some people suggest sector-adjusting stock market valuations to neutralize the dominating sector skews, thereby creating a truer picture of relative valuation. Adjusted for these sector skews, is a stock market cheap or expensive? This question may be of interest to academics, but it has very little practical relevance for stock market selection. Compared to France's CAC, Italy's MIB and Spain's IBEX are indeed cheaper mainly because of their large overweight to banks. But this cannot change the inescapable fact that this defining large overweight to banks is precisely what drives MIB and IBEX relative performance. Likewise, compared to the S&P500, the Eurostoxx600 is much cheaper mainly because of its overweight to banks combined with its large underweight to technology. But this cannot change the inescapable fact that this defining overweight to banks combined with large underweight to technology is precisely what drives Eurostoxx600 versus S&P500 relative performance. For the sceptics, the charts on page 5 should leave no doubt that everything else is largely irrelevant. The recent outperformance of banks is just a manifestation of the Trump reflation trade, nothing more, nothing less (Chart I-6). Indeed, most of the moves in financial markets over the past month reduce to the same trade in one guise or another. This reflation trade has gone too far too fast, and we would now lean against it. An underweight to banks necessarily means underweighting the MIB and IBEX (Charts I-7 and I-8). Chart I-6The Trump Reflation Trade Has Lifted Banks Chart I-7Banks Drive The MIB Relative Performance Chart I-8Banks Drive The IBEX Relative Performance An underweight to banks and overweight to technology necessarily means underweighting the Eurostoxx600 versus the S&P500 (Charts I-9 and I-10). Chart I-9Banks Versus Technology... Chart I-10...Drive Eurostoxx600 Versus S&P500 Assessing The Value In French, Spanish And Italian Bonds Turning to bonds, the market has deemed that Italian BTPs and Spanish Bonos are more risky investments than French OATs. Therefore BTPs and Bonos require a yield premium over OATs. But what exactly is this yield premium for? In the unlikely event that a large euro area country like Italy or Spain defaulted on its sovereign euro-denominated debt, the monetary union as it stands would be unable to withstand the losses. The euro would likely break up, causing each country to redenominate its bonds into its own new currency, which would then rise or fall against the other new currencies. Today's yield premium on BTPs and Bonos over OATs is simply the expected value of the (annualised) loss that would be suffered in that eventuality. And this expected loss equals the product of two terms: the annual probability of euro break up and the expected depreciation of a new Italian lira (or new Spanish peseta) versus a new French franc after such a break up In turn, the expected depreciation of the lira or peseta versus the franc would broadly equal the respective economy's accumulated competitiveness shortfall versus France. Which leads to a powerful conclusion. Spain has rapidly eroded its competitiveness shortfall versus France, and is on course for full convergence within a couple of years (Chart I-11). If the second term of the above product becomes zero, so too must the product itself. Meaning the yield premium on Bonos over OATS must converge to zero - irrespective of whether the euro survives or not. Chart I-11Spainish Competitiveness Will Soon Reconverge With French Competitiveness Stay long Spanish Bonos versus French OATs. In the case of Italy, a substantial shortfall in competitiveness versus France (and now Spain) does exist, justifying a structural yield premium in BTPs. But recently, this premium widened further because of a larger first term in the above product - a perceived increase in the annual probability of euro break up after the no vote in Italy's referendum on constitutional reform, and Prime Minister Renzi's subsequent resignation. However, as we argued in Italy: Asking The Wrong Question,1 fears of the political repercussions of a no vote were overdone. As the market has come to realise this, the BTP yield premium has quickly retraced most of its recent widening. Our long Italian BTP versus French OATs bond pair trade has achieved its profit target in just 10 days, and we are now closing it (see section below). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on December 1, 2016 and available at eis.bcaresearch.com Fractal Trading Model* This week's recommended trade is to buy gold. Long Gold * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Long Italian Government Bonds / Short French Government Bonds The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br## - Interest Rate Expectations
The scope of the revaluation in banks stocks on hopes for reduced regulatory constraints and the modest yield curve steepening has surprised us, but it would be dangerous to equate share price strength with the perception that underlying activity has reaccelerated. Indeed, the chart shows that overall bank loan growth is steadily decelerating, led by a cooling in C&I credit creation to its lowest rate since the great recession. While credit growth is far from recessionary levels, it is diverging negatively from what bank stocks might suggest. Importantly, banks have been adding to cost structures in recent months, and our gauge of bank sector productivity (bank loans/bank employment) is receding on a growth rate basis. This suggests that there could be a setback if fourth quarter profits do not validate the share price move. Rather than chase the bank group, our preference to play strength in the financial sector is through the asset manager and consumer finance groups, see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, RF, HBAN, CMA, ZION, PBCT.
Highlights Duration: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. Corporate Bonds: The macro back-drop is turning marginally more positive for corporate spreads. C&I lending standards are no longer tightening and bank stocks have rallied significantly. Corporate Bonds: Spreads are too tight at the moment, even for an improving economic environment. Remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now. We are actively looking to add exposure to corporate credit from more attractive levels. Feature There is no question that the U.S. economy is on a firm footing heading into the New Year. Third quarter real GDP growth came in at a robust 3.2%, and the Atlanta and New York Fed tracking models currently forecast fourth quarter growth of 2.6% and 2.7%, respectively. This represents a marked acceleration from the average growth rate of 1.1% witnessed during the first two quarters of 2016. Forward-looking survey data are also pointing in the right direction. The ISM non-manufacturing survey reached 57.2 in November, its highest level since October 2015, while the expectations component of the University of Michigan Consumer Sentiment survey reached 88.9 in December, its highest level since January 2015 (Chart 1). The question for bond investors is how much of this good news is already reflected in Treasury yields. Higher Treasury yields and a stronger dollar have already led to a material tightening in some broad indexes of financial conditions, enough to exert a meaningful drag on U.S. growth (Chart 2). In fact, according to the Fed's FRB/US model, the recent interest rate and dollar moves could be expected to shave 1% from GDP over the next eight quarters. Chart 1Economic Tailwinds Chart 2Financial Conditions Must Ease The natural conclusion is that while some upside in Treasury yields is justified by an improving economic outlook, the bond selloff has proceeded too quickly and must pause in the near-term to prevent financial conditions from exerting an excessive drag on growth. Sentiment and positioning indicators also confirm that the uptrend in yields appears stretched (Chart 2, bottom two panels). As such, last week we tactically shifted our recommended portfolio duration allocation from 'below benchmark' to 'at benchmark'.1 We expect Treasury yields will grind higher next year, reaching a range of 2.8% to 3% by the end of 2017, but the selloff will proceed more gradually, in line with the acceleration in economic growth. A More Uncertain World The premise that the bond selloff has proceeded too quickly is confirmed by our Global PMI models of the 10-year Treasury yield. We track two versions of our Global PMI model. One is a 2-factor model based only on the Global PMI index and a survey of bullish sentiment toward the U.S. dollar. The intuition behind this model is that improving global growth contributes to a higher fair value Treasury yield. However, for a given level of global growth, increasingly bullish dollar sentiment applies downward pressure to yields. This is because a stronger dollar represents a tightening of monetary conditions, so that all else equal, a stronger dollar means we should expect fewer Fed rate hikes. The current fair value reading from this 2-factor model is 2.26%, meaning that the 10-year Treasury yield at 2.49% appears somewhat cheap (Chart 3). The second version of our Global PMI model is a 3-factor model which adds the Global Economic Policy Uncertainty Index (EPUI) as a third independent variable. All else equal, an increase in uncertainty about the economic outlook should depress the term premium in long-dated Treasury yields. The data appear to back-up this assertion, as the EPUI is negatively correlated with the 10-year Treasury yield over time. With the addition of the EPUI, our 3-factor model explains 84% of the variation in the 10-year Treasury yield since 2010, compared to 80% from our 2-factor model. The EPUI spiked last month, and as such, this version of the model suggests that fair value for the 10-year Treasury yield is only 1.82% (Chart 4). Chart 32-Factor Global PMI Model Chart 43-Factor Global PMI Model There are probably good reasons to overlook last month's spike in policy uncertainty. For one, the EPUI, created by Baker, Bloom and Davis,2 is largely constructed from algorithms that scan newspaper articles for keywords. They do not attempt to distinguish between economic news with bond-bearish or bond-bullish implications. Second, we have found that large spikes in uncertainty that do not coincide with deterioration in economic growth tend to mean-revert fairly quickly. This past summer's Brexit vote being a prime example. As a counterpoint, however, the negative correlation between the EPUI and the 10-year Treasury yield is quite robust (Chart 5), and historically, incidents of spiking policy uncertainty and rising Treasury yields have been few and far between. Since 1991, there have been 42 instances when the monthly increase in the EPUI exceeded one standard deviation. In those 42 months, the 10-year Treasury yield increased only 36% of the time, with last month's 53 basis point rise being by far the largest on record. We tend to view the reading from the 2-factor model as the more reasonable assessment of fair value in the current environment. But the spike in policy uncertainty does underscore why we should view the recent bond selloff skeptically. The recent selloff has, to a large extent, been predicated upon promises of fiscal stimulus that have yet to be delivered, from a President-elect who has shown himself to be highly unpredictable. In this environment, near-term caution is clearly warranted. Of course, this week the market's focus will at least temporarily turn away from fiscal policy and toward the Fed. We expect that the Fed will announce a 25 basis point increase in the fed funds rate tomorrow, but also that participants' interest rate projections will not change meaningfully. The FOMC will likely be much slower to react to promises of fiscal stimulus than the market. With the Fed's projected near-term path for interest rates already mostly discounted by the market (Chart 6), we could see a "dovish hike" from the Fed tomorrow coinciding with the near-term top in Treasury yields. Chart 5Economic Policy Uncertainty & Treasury Yields Chart 6A "Dovish Hike" Is In The Price Bottom Line: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. A More Favorable Environment For Credit We frequently point to three main indicators that we use to assess the current stage of the credit cycle: Our Corporate Health Monitor (CHM) Monetary conditions relative to equilibrium C&I bank lending standards In a report3 published earlier this year we found that the performance of bank stocks relative to the overall market is another useful indicator (Chart 7). While the credit cycle is still very much in its late stages, recently, our indicators have been sending marginally more positive signals. The CHM remains deep in 'deteriorating health' territory and non-financial corporate balance sheets continue to lever-up aggressively. However, the indicator did inch slightly closer to 'improving health' territory in the third quarter due to an improvement in all six of its components (Chart 8). Make no mistake, trends in corporate balance sheet leverage are not supportive for corporate spreads. In fact, as we will explore in a future report, the recent divergence between rising leverage and tightening spreads is nearly unprecedented during the past 40 years. But at the margin, recent trends are less worrisome. Chart 7Credit Cycle Indicators Chart 8Corporate Health Monitor Components Box1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Second, although monetary conditions appear very close to our estimate of equilibrium, the recent steepening of the yield curve suggests that the market is revising its estimate of monetary equilibrium higher, leading to a de-facto easing of monetary conditions. In the long-run, with the Fed in the midst of a hiking cycle, this sort of easing is unlikely to persist. But, as we argued in a recent report,4 the bear steepening curve environment could continue in the first half of next year as the Fed is slow to respond to an improving economy. Third, C&I bank lending standards have fallen back to unchanged after having tightened for four consecutive quarters. This likely reflects less stress in the energy sector now that oil prices have rebounded. Fourth, bank stocks have rallied strongly alongside the steepening yield curve. To the extent that higher bank stock prices reflect lower future commercial loan delinquencies, then this trend should be viewed positively from the perspective of credit investors. To test the idea that bank stock performance might help us trade the corporate bond market, we take a look at the past six credit cycles, going back to 1975 (Chart 9). The bottom panel of Chart 9 shows the percent drawdown in relative bank equity performance from its peak during the most recent credit cycle. We define credit cycles as the periods between when the CHM crosses into 'improving health' territory. For example, we define the most recent credit cycle as beginning when the CHM fell into 'improving health' territory in 2002 and ending when it fell into 'improving health' territory in 2009. Shaded regions in Chart 9 show periods when the CHM is in 'deteriorating health' territory. Chart 9Bank Equity Drawdown & Corporate Bond Performance If we construct a trading strategy using the CHM alone, we can get fairly good results. We find that investment grade corporate bonds underperform duration-equivalent Treasury securities in 3 out of 6 instances, over a 12-month investment horizon, following the time when the CHM first crosses into deteriorating health territory, for an average excess return of -1.2% (Table 1). Table 1Corporate Bond Trading Rules: 12-Month Investment Horizon However, we find that this result can be improved if we also incorporate bank stock price performance. If we were to only reduce corporate bond exposure when the CHM was in deteriorating health territory and after the drawdown in bank equities exceeded 20%, then the position is still profitable in 3 out of 6 instances, but for a more negative average return of -1.9%. Further, if we were to wait for the drawdown in bank equities to surpass 30%, then the hit rate on our position improves to 3 out of 5 and the average return falls to -4.6%. We find similar results if we use a 6-month investment horizon (Table 2). In the current cycle, the drawdown in bank stocks breached 25% in February but has since reversed course, and it has not yet reached the 30% threshold. Our analysis suggests that corporate bond underperformance tends to persist for some time even after the drawdown in bank stocks exceeds 30%. Table 2Corporate Bond Trading Rules: 6-Month Investment Horizon Chart 10Corporate Spreads Are Too Low Bottom Line: The macro back-drop is turning marginally more positive for corporate spreads. We remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now, due to poor starting valuation (Chart 10). But we are looking for an opportunity to upgrade from more attractive spread levels in the next couple of months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Too Far Too Fast, But The Bond Bear Is Still Intact", dated December 6, 2016, available at usbs.bcaresearch.com 2 For further details on the construction of this index please see www.policyuncertainty.com 3 Please see U.S. Bond Strategy Weekly Report, "Lighten Up On Duration", dated February 16, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights ECB QE has pushed the euro area's Target2 banking imbalance to an all-time high. Thereby, QE has raised the cost of euro break-up. The ECB must dial down QE because the Target2 banking imbalance is directly related to the size of asset purchases. Core euro area sovereign bonds offer poor relative value in the government bond universe. Long Italian BTPs / short French OATs is now appropriate as a tactical position. Italian bank investors might have to suffer more pain before Brussels ultimately allows a public rescue. Feature "We've eliminated fragmentation in the euro area." Mario Draghi, speaking on October 20, 2016 Mario Draghi is wrong. QE was meant to reduce economic and financial fragmentation within the euro area. But in one important regard, it has done the exact opposite. In an un-fragmented monetary union, banking system liquidity would be spread evenly across the euro area. Unfortunately, the trillions of euros of QE liquidity created by the ECB has concentrated in four northern European countries: Germany, the Netherlands, Luxembourg and Finland (but interestingly, not France). This extreme fragmentation is captured in the euro area's Target2 banking imbalance (Box I-1), which is now at an all-time high (Chart of the Week). Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability. Target2 balances therefore show the cumulative net payment flows within the euro area. Chart of the WeekQE Has Pushed The Euro Area's Target2 Imbalance To An All-Time High To be absolutely clear, this geographical polarization of bank liquidity is not deposit flight in the strictest sense (Chart I-2). Investors are simply using the ECB's €80bn of monthly bond purchases to offload their Italian, Spanish and Portuguese bonds to the central bank, and hold the received cash in banks in perceived haven countries. Nevertheless, ECB QE has unwittingly facilitated a geographical polarization of bank liquidity more extreme than in the darkest days of 2012 (Chart I-3). Chart I-2No Funding Stresses At The Moment Chart I-3Target2 Imbalances Are The Result Of QE QE Has Exposed Euro Area Banking Fragmentation To understand how this polarization has arisen, it is necessary to grasp how Eurosystem accounting works. The following section is necessarily technical, but stick with it because it is important. The ECB delegates its QE sovereign bond purchases to the respective national central bank (NCB): the Bundesbank buys German bunds, the Bank of France buys OATs, the Bank of Italy buys BTPs, and so on. When the Bank of Italy buys a BTP from, say, an Italian investor, the investor gives up the bond, but simultaneously receives a corresponding asset - cash. If the investor then deposits this cash at an Italian bank, say Unicredit, then Unicredit would have a new liability - the investor deposit. But in line with Eurosystem accounting, Unicredit would simultaneously receive a corresponding credit at its NCB, the Bank of Italy.1 Completing the accounting circle, the Bank of Italy would now have a new liability - the Unicredit claim, but it would also have a corresponding asset - the BTP that it has just bought. Therefore, all three accounts would be in perfect balance (see Figure I-1). Figure I-1Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Unicredit Now consider what happens if the Italian investor deposits the cash not at Unicredit, but at a German bank, say Commerzbank. In this case, it would be the Bundesbank that had a new liability - the Commerzbank claim. However, the Bundesbank would not have a corresponding asset. Conversely, the Bank of Italy would have a new asset - the BTP, but without a corresponding liability. In order to balance these Eurosystem accounts, the Bundesbank would accrue a Target2 asset vis-à-vis the ECB, while the Bank of Italy would accrue an equal and opposite Target2 liability (see Figure I-2). Figure I-2Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Commerzbank Essentially, the Target2 imbalance captures the mismatch between a Bundesbank liability denominated in 'German' euros and a corresponding Bank of Italy asset denominated in 'Italian' euros. Aggregated over the whole euro area, these imbalances now amount to more than €1 trillion. Does any of this Eurosystem accounting gymnastics really matter? No, as long as the monetary union holds together and the 'German' euro equals the 'Italian' euro. But if Germany and Italy started using different currencies, then suddenly the Target2 imbalances would matter enormously. This is because the Bundesbank liability to Commerzbank would be redenominated into Deutschemarks, while the Bank of Italy asset would be redenominated into lira. Hence, the ECB might end up with much larger liabilities than assets. In which case, any shortfall would have to be borne by the ECB's shareholders - essentially, euro area member states pro-rata to GDP. The ECB Must Dial Down QE Unlike in the depths of the euro debt crisis, the current Target2 imbalances do not reflect deposit flight. Rather, they are the direct result of ECB QE. Nonetheless, the indisputable fact is that QE has increased the cost of euro break-up. And another six or more months of QE will just add to this cost. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in this year's polling victories for Brexit and President-elect Trump, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do detailed cost benefit analysis. Although the ECB is unlikely to broadcast the unintended side-effects of its policy, it must be acutely aware that the costs of QE are rising while its benefits are diminishing. Given that the Target2 imbalances are directly related to the size of asset purchases, the ECB needs to indicate its intention to dial down QE purchases. And if it does need to loosen policy again in the future, it might be better off emulating the Bank of Japan - in targeting a yield rather than an asset purchase amount. The 6-9 month investment implication is that core euro area sovereign bonds offer poor relative value in the government bond universe. And within the core euro area, perhaps French OATs offer the least relative value. OATs are priced as haven sovereign bonds, yet interestingly Target2 imbalances suggest that banking liquidity flows do not regard France as a haven in the same way as Germany (Chart I-4 and Chart I-5). Chart I-4French OATs Are Priced ##br##As Haven Bonds... Chart I-5...But Banking Liquidity Flows Do Not ##br##Regard France As A Haven Another implication is that the euro should be stable or stronger against a basket of other developed economy currencies. Indeed, expect euro/pound to lurch up in the first half of next year when the U.K. government triggers Article 50 of the Lisbon Treaty to formally begin Brexit negotiations. Only then will the EU27 reveal its own negotiating strategy, and it is highly unlikely to be a sweet deal for the U.K. Italian Referendum Result: A Postscript The financial markets have shrugged off the Italian public's resounding "no" to constitutional reform, and rightly so. The current constitution, created in the aftermath of the Second World was designed to prevent a repeat of a populist like Benito Mussolini gaining power. Irrespective of whether the next General Election is in 2017 or 2018, the no vote actually reduces political tail-risk. A tactical position that is long Italian BTPs and short French OATs is now appropriate. As we discussed last week in Italy: Asking The Wrong Question the bigger issue is how Italy will unburden its banks of its non-performing loans (NPLs). Monte de Paschi's efforts at raising equity are baby steps in the right direction. But Monte de Paschi's €23 billion of sour loans2 are just the tip of Italy' NPL iceberg, which sizes up at €320 billion in gross terms and €170 billion net of provisions. These numbers, expressed as a share of GDP, show striking parallels with peak NPLs in Spain's banking system (Chart I-6 and Chart I-7). Spain ultimately unburdened its banks with a government bailout. Italy may have to do the same. But this will require Brussels to let Italy bend the EU's new bail-in rules for troubled and failing banks. Chart I-6Spain Unburdened Its Banks ##br##With A Government Bailout... Chart I-7...Italy May Ultimately##br## Do The Same The danger for investors is that Italian bank equity and bond holders might have to suffer more pain before Brussels relents. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Unicredit and all other commercial banks use their accounts at their NCLs to make interbank payments. 2 MPS NPLs amount to €45bn in gross terms and €23bn net of provisions. Fractal Trading Model* Bucking the synchronized sell-off in global bonds, Greek sovereign bonds have actually rallied strongly in the last three months. But this rally could be near exhaustion, warranting a countertrend position. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
The financials sector has cheered President-elect Trump's anticipated policy changes as if they will all be enacted within very short order. While the yield curve has steepened modestly, the widening pales in comparison with the violence of the relative performance rise in financial share prices. We caution against extrapolating recent sector gains. If yields rise much further, they will be in danger of moving ahead of the rate of GDP growth, as the latter is unlikely to benefit from any fiscal stimulus for at least a few quarters. Financials (and the broad market), have trouble when this measure of liquidity tightens. The financial sector is already facing a cooling in the pace of credit creation and a decline in credit quality: financials sector ratings migration is steadily deteriorating. The bottom line is that the upward spike in financials sector relative performance is due for a breather, and only neutral weightings are recommended.