EU-Wide Stress Test Results Adding to Systemic Risk

As professional investors, we have been trained by the markets, the CFA Institute, and business school professors early on to avoid certain kinds of investments. Examples include scams such as Florida swampland (if it is too good to be true, it usually is) and obsolete businesses such as U.S. textile mills (by far Warren Buffett’s worst investment in his storied career) or newspapers & magazines whose revenues are still dependent on print advertising.

As I previously pointed out, Italian banks, along with systemically-important Deutsche Bank, have the distinction of fitting into both categories. Deutsche Bank’s core investment banking & trading businesses are obsolete in the post-crisis, capital-constrained world (think Basel III, Basel IV, Solvency II, and IFRS9), and yet Deutsche’s leadership remains in denial. Meanwhile–as I pointed out in two earlier blog posts (“Strengthening the Global Banking System’s Weakest Link” published on April 12, 2016 & “Italy’s NPLs Still the Global Banking System’s Weakest Link” published on July 7, 2016)–Italian policymakers have for years refused to reform or even acknowledge the growing NPL problem within the Italian banking system. It wasn’t until this year that investors finally forced Italian policymakers and banks to act; more than 7 months into the year, they have yet to provide a stronger or more comprehensive solution that will likely involve a combination of (hugely dilutive) capital raises, offloading NPLs to foreign investors, along with some kind of “bail-in” steps for the Italian bank with the worst balance sheet, i.e. Banca Monte dei Paschi di Seana (BMPS).

The publication of the 2016 EU-Wide Stress Test last Friday was intended to alleviate solvency concerns and to halt the vicious cycle of declining European bank stock prices that began early this year. 51 large European banks holding 70% of all European banking assets were covered. These banks were domiciled in the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Hungary, Ireland, Italy, Netherlands, Norway, Poland, Spain, Sweden, and the UK. Banks in two of the Euro Zone’s most troubled economies, i.e. Greece and Portugal, were not included in the stress test.

Key macroeconomic assumptions/projections of the 2016 stress test (see Figure 1 below) were similar in severity relative to those in the 2014 stress test. E.g. the 2014 stress test assesses a 3-year cumulative real GDP “shock” of -7.0% in the Euro Area, vs. a 3-year cumulative -7.1% shock in the 2016 stress test, as shown in Figure 1 below.

Figure 1: Key Macroeconomic Assumptions/Projections of the 2016 EBA Stress Test
eba2016stresstestassumptions

The 2016 stress test, however, did refine its overall framework by adding two explicit assumptions relative to the 2014 stress test: 1) explicit bottom-up treatment of FX-related trading losses to entities in central and eastern Europe in the event of EM currency depreciation, and 2) cumulative losses of 71 billion euros driven by the concept of “conduct risk,” with 15 of the 51 banks tested having a conduct risk liability of more than one billion euros.

On the surface, the results of the 2016 stress test were relatively benign. The 51 banks in the sample had a weighted average fully loaded CET1 capital ratio of 12.6% as of year-end 2015. This starting point was 150 bps above that for the 2014 and 400 bps over that for the 2011 stress test. Since December 2013, the fully loaded CET1 capital for the 51 banks sampled has increased by 180 billion euros. Under the “adverse scenario,” the 2016 stress test estimates a decline of 340 bps in the weighted average CET1 ratio to 9.2% by the end of 2018, driven mostly by projected credit losses, conduct losses, and losses stemming from counter-party risks. More importantly–out of the 51 banks sampled–only 10 banks finished with a fully loaded CET1 capital ratio of less than 8.0% by year-end 2018 (post any mitigation measures enacted after year-end 2015). They are: BMPS (-2.44%), Allied Irish Banks (4.31%), Raiffeise-Landesbanken-Holding (6.12%), Bank of Ireland (6.15%), UniCredit (7.10%), Barclays (7.30%), Commerzbank (7.42%), SocGen (7.50%), Deutsche Bank (7.80%), and Criteria Caixa (7.81%). Figure 2 below shows the EBA’s projected fully loaded CET1 capital ratios as of year-end 2018 on a bank-by-bank basis:

Figure 2: Fully Loaded CET1 Ratios at Year-End 2018 Under the EBA’s Adverse Scenario
(source: Goldman Sachs, EBA)
CET1 Ratios

Unfortunately, as I have asserted in my weekly global macro newsletters and my last two blog entries on the Italian banking system, what investors are looking for is not a “rubber stamp” approval by bank regulators on the integrity of European banks’ balance sheets or a halfhearted fund-raising effort by BMPS, but a strong, decisive, and system-wide capital-raising effort with government backing, along with a multi-year reform plan to rebuild the sustainability of long-term profits currently being impeded by: 1) prevalence of negative interest rates across much of the Euro-wide yield curve, 2) slow structural growth rates, especially within countries such as Italy, Portugal, and Greece, and 3) obsolete business models where certain business operations (e.g. trading) are being quickly replaced by hedge funds and fintech companies.

Over the last two trading days, European banks’ stock prices (ETF ticker EUFN) have fallen by nearly 3%. In particular, BMPS is down by 13%, UniCredit by 15%, Barclays by 5%, and Deutsche Bank by 7%. Major criticisms of the framework/results of the EBA’s 2016 stress test have been as follows:

  1. Banks in the region’s two most NPL-challenged countries, Greece and Portugal, were not included in the stress test;
  2. Under the BMPS rescue plan conceived last Friday, the bank will securitize its entire bad loan portfolio (face value of 27.7 billion euros) at a price of 33 cents on the euro. A securitization at this price is below investors’ expectations; this means if other Italian banks are forced to take similar haircuts on their NPLs, their capital ratio position would be less than what the 2016 stress test currently implies, thus requiring a more substantial (and dilutive) capital raise on the part of Italian banks;
  3. The stress test did not include the impact of regulations that are likely to be implemented over the next several years. Known collectively as “Basel 4,” KPMG estimates that these would lead to an extra 350 billion euros of capital requirements for the world’s largest 100 banks.

Bottom line: The publication of the EBA’s 2016 stress test results have failed to quell investors’ concerns of a systemic meltdown of the Italian banking system. Moreover, a successful recapitalization of BMPS is far from assured, as its capital raise is contingent on the sale of its 27.7 billion euro NPL portfolio, the latter of which will likely result in a larger-than-expected haircut on the Italian-wide 360 billion euros of NPLs. Continue to underweight European financials, especially Deutsche Bank and Italian banks in general.

Italy’s NPLs Still the Global Banking System’s Weakest Link

I last discussed the vulnerabilities in the Italian banking system in our April 12, 2016 blog post (“Strengthening the Global Banking System’s Weakest Link“), where I asserted that–given its global inter-connectivity  today–the world’s financial system can only be as strong as its weakest link. Typically, a liquidity or solvency issue can linger on indefinitely, simply due to the absence of external shocks or because the overall global economy is doing well. In the case of the current NPL issues with the Italian banking system, an effort in January to encourage sales of NPLs by providing government-backed guarantees unfortunately attracted investors’ attention to Italian banks’ NPL issues. When we last covered this issue three months ago, Italian banking stocks were “only” down 20% YTD; today, they are collectively down by 55% YTD.

The vulnerability of the Italian banking system–and by extension, that of the Western European banking system–has come under increased scrutiny over the last several months, exacerbated by: 1) the unexpected, ongoing deflationary malaise in much of the developed world; the May 2016 Italian inflation reading was -0.3% year-over-year, worse than market expectations of -0.2%. June 2016 Italian inflation is expected to hit -0.4% year-over-year, resulting in six straight months of deflationary readings, 2) the dramatic flattening and downshift of the Western European yield curve; globally, nearly US$12 trillion of government bonds now have negative yields, and 3) an unexpected vote for “Brexit,” equivalent to a negative growth shock within the EU, as well as heightened political and economic uncertainty.

The Italian banking system in particular is saddled with 360 billion euros of NPLs, equivalent to about one-third of all of the Euro Zone’s NPLs. Moreover–as efforts since January have demonstrated–a concerted sales effort in NPLs in Europe is not a simple task. Firstly, EU rules explicitly ban the use of government-backed guarantees to cushion NPL losses. Secondly, the average restructuring period for Italian bad loans is an abnormally long 8 years; a quarter of cases take 12 years. Finally, the European market for NPLs is small and underdeveloped relative to the overall stock of NPLs in the banking system. In other words, the market for selling Italian NPLs is relatively small, and is almost non-existent without government-backed guarantees (e.g. A proposal by Apollo to purchase 3.5 billion euros of NPLs held by Italian bank Carige back in March made no progress). Italy’s NPL issues are especially concerning given the lack of core profitability of the Italian banking system (see Figure 1 below).

Figure 1: Return on Regulatory Capital of European Banks by Country – June 2015 (source: EBA, Goldman Sachs)

returnoncapitalEBA

It is generally agreed upon that an Italian government-led recapitalization of 40 billion euros into some of Italy’s largest banks (Unicredit, BMPS, and Intesa, for example) would be adequate to resolve the Italian NPL issue, as long as Euro area growth re-accelerates; at the very least, the immediate probability of a Euro-wide banking contagion would be reduced by an order of magnitude. There are two real obstacles to this “happy scenario,” however: 1) the EU, backed by Germany, is resistant to any Italian government-led efforts to recapitalize the banks at no cost to Italian bank debt holders, as this directly goes against EU rules. Any attempt to “bail-in” Italian banks would increase contagion risks among all of EU banks as both depositors and debt holders will likely take their capital and flee to either the U.S. or other safe haven asset classes, such as gold, and 2) Italian Prime Minster Matteo Renzi has promised to resign if he loses the constitutional referendum to be held in October. Recent opinion polls suggest Renzi’s campaign will fall short; this will likely lead to significant Italian and EU-wide instability given the surge of the populist Five Star Movement in recent opinion polls. Seen in this light, the fragility of the Italian banking system is an ongoing cause for concern.

Leading Indicators Suggest Further Upside in Global Risk Asset Prices

Note: I know many of you reading this are either overweight cash or net short U.S. equities. Please don’t shoot the messenger: I am not personally biased to the upside – I am merely channeling what my models are telling me, and they are telling me to stay bullish.

In my January 31, 2016 newsletter, I switched from a generally neutral to a bullish position on global risk assets. Specifically:

  • For U.S. equities, I switched from a “slightly bullish” to a “bullish” position (after switching from a “neutral” to a “slightly bullish” stance on the evening of January 7th);
  • For international developed equities, a shift from “neutral” to “bullish”;
  • For emerging market equities, a shift from “neutral” to “slightly bullish”; and
  • For global REITs, a shift from “neutral” to “bullish.”

My bullish tilt on global risk assets at the time was primarily based on the following reasons:

  1. A severely oversold condition in U.S. equities, with several of my technical indicators hitting oversold levels similar to where they were during the September 1981, October 1987, October 1990, and September 1998 bottoms;
  2. Significant support coming from both my primary and secondary domestic liquidity indicators, such as the relative steepness of the U.S. yield curve, the Fed’s renewed easing bias in the aftermath of the December 16, 2015 rate hike, and a sustained +7.5% to +8.0% growth in U.S. commercial bank lending;
  3. Tremendous bearish sentiment among second-tier and retail investors (which is bullish from a contrarian standpoint), including a spike in NYSE short interest, a spike in the AUM of Rydex’s bear funds, and several (second-tier) bank analysts making absurd price level predictions on oil and global risk assets (e.g. Standard Chartered’s call for $10 oil and RBS’ “advice” to clients to “sell everything”).

In a subsequent blog post on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“), I followed up on my bullish January 31st prognostications with one more bullish indicator; i.e. the strengthening readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”) indicator which “suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last two times I discussed the CBGDI in this blog was on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“) and on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“).

To recap, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD-constructed leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. Moreover, the CBGDI has historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%; and has led or correlated with the MSCI All-Country World Index, with an R-squared of over 40% (which is expected as local stock prices is typically a component of the OECD leading indicators).

The latest reading of the CBGDI has continued to improve upon the readings which we discussed several months ago (see Figure 1 below)–just 10 days after we turned bullish on global risk assets. Both the 1st and the 2nd derivatives of the CBGDI have continued to climb and are still in (slight) uptrends, suggesting a stabilization and in some cases, a re-acceleration (e.g. the economies of South Korea, New Zealand, Spain, and India) in global economic activity. So don’t shoot the messenger–but it appears that the rally in global risk assets coming out of the late-January-to-early-February bottom still has more room to run.

CBGDIMay2016

Strengthening the Global Banking System’s Weakest Link

As I discussed in my most recent newsletter (please email me to request a copy) and in my February 19, 2016 Forbes column (“Shares Of Global Banks Are Too Cheap To Ignore“), I remain constructive on shares of U.S. financial companies, despite (or even because of) their recent underperformance. More specifically, I asserted that much of the current fears (e.g. impact of rising energy-related defaults and ongoing litigation costs & financial penalties related to conduct leading up to the 2008-09 global financial crisis) surrounding U.S. and global financial stocks are overblown.

I also asserted that share prices of global financial companies in 2016 will mostly be driven by the Federal Reserve’s monetary policy, as a significant portion of U.S. banks’ revenues is driven by “net interest income,” i.e. the traditional role of banks’ borrowing short and lending long. In Wells Fargo’s case, net interest income makes up more than 50% of the firm’s revenue. If the Fed embarks on a renewed hiking campaign and the U.S. yield curve flattens, then U.S. banks’ margins will be hit, which in turn will depress their share prices.

Fortunately, the U.S. yield curve is still very far away from flattening. E.g. As of this writing, the spread between the 10- and the 1-year Treasury rate stands at 1.27%. Just as important, the CME Fed Watch indicator does not suggest a rate hike until the FOMC’s December 21, 2016 meeting at the earliest. Moreover–despite the recent underperformance of U.S./global financial stocks–credit risk for the global financial sector remains relatively and historically low; in fact, as computed by S&P Global Market Intelligence, the implied credit risk within the global financial sector is actually the lowest out of all ten major S&P global sectors.

As financial history and the experience of the 2008-09 global financial crisis have demonstrated, however, the global financial system is only as strong as its weakest links; and it is these “weakest links” that investors have recently focused on. More specifically, the slow pace of general and banking reforms within the Euro Zone, particularly the relatively high level of nonperforming loans in the Italian banking sector, is raising the specter of counter-party risks and resulting in a flight of capital away from Italian/European financial stocks (e.g. UniCredit is down 37% YTD, Intesa down 26%, and Banco Popolare down 38%), and to a lesser extent, U.S. financial stocks.

Figure 1: Italian Banks Have Relatively High NPL Ratios (as of June 2015)

europenpls

The Italian banking system is saddled with about 360 billion euros of NPLs, making up about one-third of the Euro Zone’s total NPLs (although 50% of it has already been provisioned). With Italian banking stocks down nearly 20% YTD (and down 25% over the last 12 months), Italian policymakers are now being forced to act to shore up the country’s bank balance sheets through sales of NPLs, equity raises, and accelerating the write-off of NPLs. An effort in January to encourage sales of NPLs by providing government-backed guarantees gained little traction (and unfortunately attracted investors’ attention to Italian banks’ NPL problem), as Italian policymakers could not agree on how the plan would be implemented, especially in light of European rules that explicitly ban state aid to failing companies.

So far this week, Italian policymakers–working in conjunction with banks, pension funds, and insurers–have drawn up plans for a 5 billion euro bailout fund (dubbed “Atlante”) to purchase NPLs and/or to inject capital into ailing banks. Investors’ initial responses have ranged from skeptical to condescending, given the relatively small size of the fund and the lack of details surrounding its implementation. Bottom line: Italian/European policymakers, in conjunction with the private sector, will need to work harder to create a more comprehensive and workable solution to reduce NPLs in the Italian banking system. Until this happens, the current rally in U.S./global financial stocks from their early February lows will remain precarious.

U.S. Consumer Spending Yet to Overheat: Fed to Pause

According to the CME Fed Watch, the chance of a Fed rate hike this Wednesday is virtually zero. The reasons for the Fed to “stand pat” have been well recited but here they are again: 1) ongoing, elevated global systemic/slowdown risks due to the recent decline in global financial stocks, a Chinese economic slowdown, and chronically low oil prices resulting in fears of higher corporate defaults, 2) despite a recent pick-up in the U.S. core inflation rate (the 12-month change in the January core CPI is at 2.2%), the Fed’s preferred measure of core inflation, i.e. the 12-month change in the core PCE, remains tolerable at 1.7%, and 3) Since the late 1990s, the world’s developed economies have mostly grappled (unsuccessfully) with the specter of deflation; e.g. over the last 3 years, the Bank of Japan expanded its monetary base by 173%, and yet, the country is still struggling to achieve its target inflation rate of 2% (Japan’s January core CPI was flat year-over-year). As such, the Fed should err on the side of caution and back off from its recent rate hike campaign.

As of today, the CME Fed Watch is suggesting 50/50 odds of a 25 basis point rate hike at the Fed’s June 15 meeting. Historically, the Fed has only hiked when the odds rise to more than 60/40, and I believe this is the case here. Many things could change from now to June 15; however, given: 1) lingering fears over a Chinese slowdown and the loss of Chinese FOREX reserves, and 2) the fact that core PCE readings have not yet registered a +2.0% reading (I need the year-over-year change in the core PCE to sustain a level of over +2.0% for many months before I am convinced that inflation is a problem), I remain of the opinion that the next rate hike will mostly likely occur at the FOMC’s September 21 meeting.

Finally–despite an ongoing rise in U.S. employment levels (see Figure 1 below)–both U.S. wage growth (see Figure 2 below) and consumer spending growth (See Figure 3 below) remain anemic. Note that both U.S. wage growth and consumer spending growth do not “turn on a dime”; this means that–until or unless we witness a sustained rise in both U.S. wage and consumer spending growth–the Fed should err on the side of caution and back off on its rate hike campaign. At the earliest, this will mean a 25 basis point hike at the FOMC’s September 21 meeting.

USemployment

Figure 2: Nominal Wage Growth Remains Below Target Despite Year-end 2015 Push

 

nominalwagegrowth

PCEgrowth

Leading Indicators Suggest a Stabilization in Global Risk Asset Prices

Even as the vast majority of analysts stayed bullish on the global economy and global risk assets early last year, I began to turn bearish for a variety of reasons, including: 1) global liquidity, as measured by the amount of US$ circulating freely in the global financial system, continued to weaken, 2) valuations in U.S. equities were at the 95th percentile of all readings dating back to the late 1970s, as measured on a P/B and P/E basis, 3) U.S. corporate profit margins were already at 50-year highs, while U.S. corporate profits as a percentage of U.S. GDP was at a high not seen since 1929, 4) U.S. corporate earnings growth, ex. energy, were beginning to decelerate, and 5) our proprietary leading indicator, the CB Capital Global Diffusion Index (“CBGDI”) was indicating a global economic slowdown, as well as a pullback in global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s latest readings in many of our weekly newsletters, and last discussed it in this blog on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“). Specifically, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. The CBGDI has also historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators).

In my May 15, 2015 blog entry, I also stated:

Our own studies suggest the global economy has been slowing down significantly since the 2nd half of last year [i.e. 2014]; more importantly, the negative momentum has not abated much … the 2nd derivative of the CBGDI has gotten weaker. It also extended its decline below the 1st derivative, which in the past has led to a slowdown or even a major downturn in the global economy, including a downturn in global asset prices.”

The rest is history, as they say.

Recent readings of the CBGDI, however, paint a much brighter picture. Firstly, both the 1st and 2nd derivatives of the CBGDI have stabilized and are now increasing. Secondly, both global equity prices (i.e. the MSCI All-Country World Index) and oil prices have declined to levels that are indicative of a more severe slowdown than the CBGDI readings imply (see Figure 1 below). To me, the latest readings of the CBGDI suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

CBGDIDecember2015

 

 

Margin Debt Outstanding Remains High but Suggests an Oversold Market

A client said: “U.S. margin debt outstanding remains at a very high level; as such, I expect U.S. stocks to correct further.”

We last discussed the overbought condition in U.S. stocks as measured by U.S. margin debt outstanding in our January 29, 2014 blog entry (“Record Rise in Margin Debt Outstanding = Single-Digit Stock Returns in 2014“). U.S. margin debt outstanding stood at $478.5 billion at the time (measured as of December 31, 2013), after rising by $123 billion over the previous 12 months. The rapid rate of margin debt growth at the time suggests a highly overbought market. For comparison, the 12-month increase in margin debt outstanding leading to the March 2000 peak was $134 billion; for July 2007, an unprecedented $160 billion. At the time, we stated that this rapid accumulation of margin debt would lead to tepid stock returns going forward. The S&P 500 stood at 1,848.56 as of December 31, 2013; as I am typing this, the S&P 500 is trading at just shy of 1,900. After two years, the S&P 500 has gone nowhere; although your portfolio would’ve performed well if you had an overweight in consumer discretionary and tech; less so if you had an overweight in energy or materials.

As of December 31, 2015, U.S. margin debt outstanding stood at $503.4 billion–a tepid $25 billion increase over a period of two years. With the recent sell-off in U.S. stocks, margin debt would likely have declined by at least $20 billion this month. This means U.S. margin debt outstanding as it stands today is likely to have revert to its December 31, 2013 levels. Figure 1 below shows the 3-, 6-, and 12-month absolute change (in $ billions) in U.S. margin debt outstanding from January 1998 to December 2015.

usmargindebt12312015

A margin debt outstanding of around $480 billion is still high by historical standards; however–based on the 3-, 6-, and 12-month rate of change–U.S. margin debt outstanding is actually at an oversold level–reminiscent of similarly oversold levels in late 1998, early 2008, and the 2nd half of 2011. In two of these instances (late 1998 and the 2nd half of 2011), the S&P 500’s subsequent returns were phenomenal (38% and 27%, respectively, over the next 12 months); in the case of early 2008, however, not so much. With that said, March 2008 still represented a tradeable bottom–as long as one got out of U.S. stocks by summer of 2008.

As I discussed with my clients, I do not believe the current liquidation in energy, materials, and EM assets will morph into a globally systemic event. As such, I believe U.S. stock returns will be decent over the next 6-12 months.

Our 2016 Outlook on U.S. Treasuries: 2.5% on the 10-Year

In our June 28 global macro newsletter (please email me for a copy), I upgraded our outlook on U.S. Treasuries when the 10-year Treasury yield closed at 2.49%. We believed the 10-year was too high given the ongoing deflationary pressures stemming from the European sovereign debt crisis, the Chinese economic slowdown, and lower commodity prices. I subsequently downgraded U.S. Treasuries in our August 30 newsletter–when the 10-year Treasury yield closed at 2.19% (after dipping to as low as 2.00% during the August 24 global equity market correction)–as I believed global deflationary pressures were in the process of peaking. At the time, I noted that: 1) Chinese disposable income was still growing at high single-digits, 2) the Chinese CPI for the monthly of July sat at 1.6% year-over-year, and 3) fears over a further, deeper-than-expected devaluation of the Chinese yuan against the US$ was unfounded, as Chinese policymakers still have political incentive to support the country’s currency, along with the firepower to do so (as of today, China’s FOREX reserves stands at $3.43 trillion, while its November 2015 trade surplus is still near a record high at $54 billion). This means any further deflationary pressures from the Chinese economy were dissipating.

Combined with the Greek government’s 11th hour deal with the European Commission (i.e. Germany and France), fears over a more catastrophic financial market dislocation was adverted. This means that U.S. Treasury yields should rise further in the coming months. In our August 30 newsletter, I slapped a target yield of 2.50% for the 10-year Treasury over the next six months.

10yeartreasury

For 2016, I am reiterating our 2.50% yield target for the 10-year Treasury. We model our 10-year Treasury yield expectations with the following “building blocks” model:

10-year Treasury Yield = expected 10-year U.S. inflation + expected U.S. real GDP growth + global central bank purchases (including U.S. QE) + geopolitical premium

While both energy and base metal prices have either broken or are approaching their December 2008-March 2009 lows, I am of the opinion that U.S. inflation will be higher next year as the combination of a tighter U.S. job market, rising U.S. housing prices, and higher healthcare costs overwhelm the deflationary effects of lower commodity prices on the U.S. consumer economy (of which the CPI is based on).

As the markets price in higher U.S. inflation and a more hawkish Fed policy next year, I expect the 10-year Treasury yield to rise to 2.5% sometime in the next several months. For now, I remain bearish on U.S. Treasuries, but may shift to a more bullish stance should: 1) the Chinese economic slowdown runs deeper-than-expected, 2) the U.S. stock market continues to weaken, or 3) the Fed adopts a more dovish-than-expected bias post the December 16 FOMC meeting.

The Re-leveraging of Corporate America – Part II

We last discussed the increasing leverage in U.S. corporate balance sheets in our April 1, 2015 commentary (“The Re-leveraging of Corporate America and the U.S. Stock Market“), when we asserted that the combination of historically high U.S. stock market valuations, extremely high participation in the U.S. stock market by hedge fund managers (from a contrarian standpoint), and near-record high corporate leverage makes the U.S. stock market highly vulnerable to a major correction over the next several months.

At the time, we noted that U.S. corporate debt issuance averaged $650 billion a year during the 2012-2014 time frame, or 40% higher than the 2009-2011 period. Moreover, U.S. corporate debt issuance was on track to hit a record high in 2015, buoyed by the ongoing surge in M&A activity, sponsor-backed IPOs (companies tend to be highly leveraged upon a private equity sponsor exit), along with record share buybacks and the pressure to increase dividends. At the time, we noted that U.S. corporate debt issuance was on track to hit $1 trillion this year.

Since April 1, U.S. corporate debt issuance has continued to increase, although the pace has slowed down since concerns about the Greek debt crisis and the Chinese economic slowdown materialized this summer. Moreover–with energy and metals prices still underperforming–high-yield issuance has slowed down dramatically, although investment-grade issuance has continued to plough ahead. Nonetheless, U.S. corporate issuance has already set a record high this year, with nearly $800 billion of debt issued on a YTD basis (as of last Friday). At the current rate, U.S. corporate debt issuance could still hit $900 billion this year given the still-substantial pipeline of debt issuance driven by the recent frenzy of M&A activity.

Figure 1: U.S. Corporate Debt Issuance at Record Highs ($ billions)

uscorporatedebtissuanceNov2015

Moreover, U.S. net cash levels–that of Apple notwithstanding–have been crumbling under ever-increasing dividend yields, corporate buybacks, and M&A activity. Figure 2 below shows the substantial increase of debt/EBITDA ratios in Goldman’s universe coverage–especially since 2011–while companies with positive net cash levels are down by about one-third in the same time frame.

Figure 2: Rising Corporate Leverage While Cash Levels Continue to Decline

uscorporateleveragevscashDespite the August correction, we believe U.S. stocks remain overvalued. Combined with increasing and near-record high corporate leverage levels, this leaves U.S. stocks in a highly vulnerable position. With the Fed poised to begin a new rate hike cycle at the December 16 FOMC meeting , we believe there is a strong likelihood of a more substantial (15%-20%) correction in the S&P 500 from peak to trough sometime in 2016.

Why China Will Not Cut Rates Any Further This Year

In response to a slowing property market, lower consumer spending growth, and a slowing global economy, the People’s Bank of China (PBOC) has cut its one-year policy rate five times and its reserve requirement ratio three times over the last 12 months. Last November, the PBOC’s one-year policy rate sat at 6.00%–today, it is at 4.60%. Moreover, the PBOC’s cut in its reserve requirement ratio–from 20.0% to 18.0% since February–has released more than $400 billion in additional liquidity/lending capacity for the Chinese financial system.

I believe Chinese policymakers will maintain an easing bias over the next 6-12 months given the following:

  1. As I discussed a couple of years ago, a confluence of factors–including China’s debt build-up since the 2008-09 global financial crisis, slowing population growth, as well as natural limits to an export- and CAPEX-driven growth model–means China’s real GDP growth will slow to the 5%-8% range over the next several years. Consensus suggests that China’s real GDP growth will be lower than the official target of 7% this year. Given China’s significant debt build-up since the 2008-09 global financial crisis, policymakers will need to do more to lower lending costs and to encourage further lending as global economic growth continues to slow;
  2. Most of the debt build-up in China’s economy over the last 7 years has occurred within the country’s corporate sector–with real estate developers incurring much of the leverage. In other words, both real estate prices and investments are the most systemically important components of the Chinese economy. While real estate prices and sales in Tier 1 cities have been strong this year, those of Tier 2 and Tier 3 cities have not yet stabilized. This means policymakers will maintain an easing bias unless Chinese real estate sales and prices recover on a broader basis;
  3. Chinese credit growth in August met expectations, but demand for new loans did not. Real borrowing rates for the Chinese manufacturing sector is actually rising due to overcapacity issues and deteriorating balance sheets (China’s factory activity just hit its lowest level since March 2009). No doubt Chinese policymakers will strive to lower lending costs to the embattled manufacturing sector as the latter accounts for about one-third of the country’s GDP and employs 15% of all workers. This will be accompanied by a concerted effort to ease China’s manufacturing/industrial overcapacity issues through more infrastructure investments both domestically and in China’s neighboring countries (encouraged by loans through the Asian Infrastructure Investment Bank, for example).

I contend, however, that the PBOC is done with cutting its one-year policy rate for this year, as Chinese policymakers are dealing with a more pressing issue: stabilizing the Chinese currency, the yuan, against the US$ in the midst of recent capital outflows (Goldman Sachs estimates that China’s August capital outflows totaled $178 billion). Simply put–by definition–a country cannot prop up its currency exchange rate while easing monetary policy and maintaining a relatively open capital account at the same time. With the PBOC putting all its resources into defending the yuan while capital outflows continue, it will be self-defeating if the PBOC cuts its policy rate at the same time. The PBOC’s current lack of monetary policy flexibility is the main reason why Chinese policymakers are trying to find ways to stem capital outflows.

Rather than easing monetary policy, Chinese policymakers are utilizing other means to directly increase economic growth, such as: 1) Cutting minimum down payment requirements for first-time home buyers from 30% to 25%, 2) Approving new subway projects in Beijing, Tianjin, and Shenzhen worth a total of $73 billion over the next six years, and 3) Cutting sales taxes on automobile purchases from 10% to 5%, effective to the end of 2016. I expect the PBOC to regain its monetary policy flexibility by early next year, as the combination of record-high trade surpluses and still-low external debt should allow China to renew its policy of accumulating FOREX reserves yet again.