Monday, January 23, 2012

2009 all over again?

I am convinced that the global economy - ever since the financial crisis started in 2007 and put in motion a deleveraging wave - is going through a multi-year cycle which looks in general like this: Weak growth --> low inflation -->  Liquidity glut (emanating from the central banks in the deleveraging economies) --> higher prices for financial assets --> macro-economic stabilisation --> higher commodity prices --> higher inflation -->tighter monetary policy --> lower prices for financial assets --> lower growth --> low inflation.
2010 was the year where financial asset prices imploded and growth/inflation weakened but I think that we are now again in an environment where the liquidity glut intensifies (mainly due to the ECB's 3y LTRO) which leads to a longer-lasting rebound in prices for equities, (risky) bonds as well as commodities.

The financial crisis (especially following the Lehman bankruptcy in 2008) pressured prices for financial and real assets sharply lower and led to a severe global recession. Inflation fell significantly and in turn global central banks coul,d orchestrate a massive easing wave and liquidity injections. This led a rebound in prices for equities, (risky) bonds and commodities which - coupled with significant fiscal easing steps - helped also the economy to recover. But mainly due to higher commodity prices, this also led to higher inflation rates which was mirrored by a wave of central bank tightening in 2010 and 2011 (mainly in emerging market economies but also in the Eurozone). This in turn weakened growth and - also via a tighter liquidity environment in the Eurozone - intensified the Eurozone sovereign and banking crises. However, as growth weakened substantially and prices for equities, (risky) bonds and commodities fell markedly, inflation started to fall back again, allowing a growing number of central banks to start easing monetary policy. Furthermore, as in late 2008/2009, the central banks at the epicentre of the financial crisis (this time the ECB) injected an unprecedented amount of liquidity into the system.
I have mentioned previously that the ECB's 3y LTROs are leading to a liquidity glut in the Eurozone (see: The Eurozone liquidity glut dated  Jan 17) which should put downward pressure on the external value of the Euro and peripheral/credit bond spreads while it strengthens banks' balance sheets. As a sidenote, the ongoing high level of usage of the ECB's deposit facility usage is not a sign of the stress in the banking sector. If the ECB's support measures create excess liquidity then one way or the other it has to find its way back to the ECB (The liquidity does not go away). More important is whether this liquidity is being hoarded by the banks (a sign of stress) or is floating around the system (and drives asset prices higher as this happens). Last year, banks used the ECB's liquidity operations to hoard cash. However, as Draghi has mentioned at the last press conference, now the banks which make heavy usage of the 3y LTRO are not the ones which deposit liquidity at the deposit facility. Hence, the liquidity has started to float around the system and we are in the midst of a liquidity glut environment!
As a result, I am of the opinion that 2012 could well see a (partial) re-run of 2009, the year where financial markets recovered substantially from very depressed levels and growth turned the corner. I expect financial markets to continue pricing out the systemic risk of a Eurozone collapse/wave of sovereign and bank defaults given that the 3y unlimited liquidity provision keeps the banks liquid and increases the incentives to set up carry trades which in turn also keeps the sovereigns liquid. As this happens, the financial sector should outperform (i.e. bank shares should outperform vs. the rest of the market as should bank bonds). In a second phase, the economic prospects should improve (as sentiment data recovers) which should then take cyclicals higher.

In this environment, especially, the valuation of the Eurozone banking sector appears still at too low levels. The chart below shows the price-book ratio of the Stoxx600 Bank index as well as the index itself. The price-book ratio fell to around 0,5 in early 2009 before recovering to approx. 1,2 in late 2009 and trading around 1 until early 2011. Last year it fell again towards 0,5 and is currently around 0,6. In order to justify these levels, the market assumes that banks either have to take significant losses (which lowers the book-equity) or have to raise new equity at values significantly below book-equity. The first appears unlikely in the short term, given that prices for peripheral bonds (where banks hold a significant exposure) have risen substantially over the past weeks. With the liquidity glut significantly reducing the probability of a default wave, it is difficult to see the banks suffering from such big losses which would lower their book equity. Furthermore, the banks had to present how they plan to fulfil the capital requirements as defined by the latest EBA stress tests until last week and further large rounds of external financing - which dilutes existing shareholders - should be limited. Finally, the ECB essentially injects a two-digit billion Euro amount into bank equity over the next three years without diluting existing shareholders. Following the collapse of Lehman Brothers, markets for bank bonds were shut and banks issued bonds with state guarantees. These bonds had a 3-year maturity (and are expiring this year) and carried an average coupon of 3.5%. Adding to that a fee for the state guarantee, the cost of this funding should have amounted to approx. 4%. If we take this 4% as an average funding cost, then a Eur 500bn take-up at the LTRO for 1% would result in a reduction in financing costs (and hence an improvement in the P&L) of EUR45bn over the next 3 years. In turn, I think that the recovery in prices for financial shares (as well as bank bonds) has further to run.
Eurozone banks still appear undervalued

Source: Bloomberg

Tuesday, January 17, 2012

The Eurozone liquidity glut

The ECB is orchestrating a Eurozone liquidity glut on an unprecedented scale via their measures to support bank liquidity. It helps the banks to remain liquid and improve their net-interest margin (which in turn helps profitability). Additionally, it also lowers the pain from the significant amount of bank bond redemptions this year and eases the need for banks to deleverage. Furthermore, it has the effect of driving down the external value of the Euro (thereby helping the Eurozone to gain market share and the weak peripheral economies to regain competitiveness at least vs. the non-Eurozone countries) and depressing short-end yields across the credit spectre (thereby easing the pain for the weak peripheral economies and helping the sovereigns to place their new issues). Finally, the resulting higher prices for peripheral bonds strengthens banks' balance sheets. Overall, I think that the second 3y LTRO at the end of February could see a massive take-up and that the ECB's measures are still underappreciated in the market.

I already mentioned in The ECB's XMas Present dated Dec. 19 that I regard the new 3y LTRO by the ECB as an "extremely positive development" and that I expect a huge take-up in the two announced LTROs. In the meantime, the first LTRO took place which resulted in a take-up of EUR 489bn and a net liquidity injection of a bit more than EUR 200bn. Additionally, judging from last week's press conference, ECB president Draghi seemed relaxed about this result and hence we should not expect the ECB to tighten their stance on the upcoming second LTRO at the end of February. For this liquidity operation, I expect an even larger take-up than in December. The easing of the collateral rules which now allow to pledge bank loans meeting specific criteria were not in effect in December given that the national central banks did not yet produce the necessary paperwork. However, Eurozone banks hold approx. EUR7trn in bank loans out of which probably around a fourth to a third might be eligible. Given the very low interest rate on the LTRO of currently 1%, banks don't seem to be able to get cheaper financing of such rather illiquid assets elsewhere. Hence, it makes a lot of sense to fund as much as possible via the upcoming LTRO in order to a) secure financing b) lower financing costs and c) free higher-quality collateral to be used for other transactions. The direct effects will be that the bank system liquidity is secured and the funding pressures on the Eurozone credit markets will ease.
There are approx. EUR 800bn in bank bonds (senior & covered bonds as well as government guaranteed bank bonds) coming to maturity this year. Out of which almost EUR 200bn are government guaranteed paper which were originally issued following the bankruptcy of Lehman Brothers and carried an average coupon of 3.5%. Hence, the effect on the net-interest-margin of Eurozone banks and thus P&L should be substantial. Assuming a total take-up in both operations of EUR700bn (i.e. assuming a net liquidity injection of EUR500bn at the end-of-February LTRO) and using the government-guaranteed cost of funding of 3,5% (which clearly underestimates the true savings in financing costs) suggests a reduction in financing costs of 2,5% p.a. which would equal EUR17.5bn p.a. or approx. EUR50bn over the life of the 3y LTROs.

For the markets, this should have several effects:
a) The external value of the Euro should continue to fall given the rising Euro-glut. The chart below shows the ECB's balance sheet vs. the EUR-USD exchange rate as well as vs. the trade-weighted Euro. As can be seen, during periods of a rising ECB balance sheet (mainly on the back of the liquidity support measures for the banking system), the Euro was in a downward trend which should remain the case. A weaker Euro would also help the Eurozone export sectors to gain market share.

ECB balance sheet vs. external Euro value
Source: Bloomberg, ResearchAhead

b) Short-end carry products should be in demand. Despite the recent fall in yields, the average yield of 3y Belgium/Italy/Spain government bonds is still around 3.4%, i.e. banks can buy these bonds in the secondary market, finance it via the ECB and earn 2.4% p.a. In turn, this should be seen as the main reason why peripheral spreads have tightened markedly over the past weeks.

2-10y Box spreads: Curve normalisation following announcement of 3y LTRO

Source: Bloomberg

c) The higher valuation of government bonds supports bank balance sheets. Given that Eurozone banks hold a significant amount of government bonds on their balance sheets, the fall in government bond prices has weakened bank balance sheets substantially and hence the sovereign crisis also resulted in a banking crisis. Now, however, as sovereign bond prices are rising (given that banks have come back on the buying side), the banking sector balance sheets appear stronger again.

The ECB is orchestrating an unprecedented Euro glut which supports the banks and sovereigns alike. The demand for funds at the second 3y LTRO at the end of February should be very large and its impact should not be underestimated!