The emerging market asset class has been going through difficult times of late. The last month in particular was brutal – thanks to a sell-off in currency, debt and equity markets. This was not the beginning of the travails of emerging markets; emerging market equities have been underperforming vis-a-vis developed market equities since mid-2010. During this period, a performance gap of 55 per cent opened up. This significant performance gap has caught investors by surprise, not least because the economies of the emerging world continue to grow faster than those of the Organisation for Economic Co-operation and Development (OECD). Also, barring a few exceptions, high inflation – the usual destroyer of the bull market in the emerging world – has not materialised.
Growth has not mattered as two-thirds of the outperformance of developed markets over the last 30 months can be explained by multiple expansion. Price-equity multiples in developed markets have gone up to nearly 14 times earnings, while emerging market multiples have remained stagnant at 10 times.
When the global liquidity push began with the first round of quantitative easing, there was a clear belief on the part of most investors that a lot of this so-called hot money would flow into emerging market equities. This, as discussed above, has not really happened. Money did flow into emerging markets, but it went more into debt markets than into equity. This was not just yield chasing, as low total indebtedness in emerging markets (compared to most OECD countries) and far lower fiscal deficits narrowed the default risk premium for fixed income markets in the emerging world. The fundamentals for emerging market debt genuinely improved.>> Read More
Will the bond market vigilantes come to the eurozone and wreak havoc? The strong market reaction to a change in expectations about the monetary policy of the US Federal Reserve suggests that the period of ultra-low market interest rates may be coming to an end sooner or later. The markets recovered at the end of the week hoping that this moment might arrive later. For the eurozone, the implications would neither be immediate, nor direct – but potentially significant.
To see the impact, it is important to understand why bond market conditions have become so propitious since last summer. One reason is that investors firmly believed a pledge from Mario Draghi, president of the European Central Bank, to provide an unlimited backstop to the eurozone’s sovereign debt market. They also attached strong credibility to the notion of a eurozone banking union. This, however, remains work in progress.
If both of those projects were for real, the eurozone crisis would indeed be over since the combination of the two would end all default risk. The ECB would guarantee the solvency of the states. The banking union would guarantee the solvency of the banks. The ECB would guarantee the liquidity of the banks. And the banks would guarantee the liquidity of the states.>> Read More
2012 has been a year in which investors have become much more comfortable with sovereign debt. Below is a snapshot showing credit default swap (CDS) prices for the sovereign debt of 42 countries around the world. As shown, only one country saw its default risk increase in 2012 — Argentina. Six countries saw default risk fall by more than 70%, and they are all European countries. And while the US still has low default risk compared to the rest of the world, it only fell 16% in 2012, which ranks it fourth worst on the list. The Fiscal Cliff looms large.
It’s been awhile since we last posted on sovereign default risk in the form of credit default swaps, so below we take a look at how risk has changed over the past few months for 59 countries around the world. For each country, we highlight the current price (in basis points) of 5-year credit default swaps on its sovereign debt along with the price and date of its 6-month high in default risk. As an example, a country with a 5-year CDS price of 100 means that it costs $100 per year to insure $10,000 worth of that country’s debt for five years.>> Read More
We lower estimates and target prices for banks in our coverage universe, given our expectation of modest profitability led by slowing credit demand and asset quality headwinds. The fiscal deficit slippage and high bond yields are likely to limit near-term valuations. However, in the event of improved macroeconomic conditions, capital infusion and better loan-loss coverage, the sector would merit a re-rating. We change our stance from Overweight to Neutral on the sector and reiterate our preference for banks with high tier-1 capital and high NPA coverage.
Delay in capex investment cycle affecting credit demand. Credit growth is likely to face challenges as capital expenditure (capex) by most large companies has been on hold. Non-mortgage retail credit demand is weaker than in the past, with banks shying away from unsecured retail lending. We estimate FY12 and FY13 credit growth for our coverage universe of large-cap banks at 18.4% and 22.1%, respectively, lower than previous estimates.
Asset quality to drive price performance. India’s slow-growth environment and weakening corporate credit profiles are likely to increase asset quality concerns for loan portfolios. Waning industrial production is expected to lead to higher NPAs, and hence raise credit costs. Perceptions of default risk are likely to be high till macro-economic conditions improve and hence determine the price movements of banking stocks.
Lower earnings and target prices. We lower sector earning estimates by 9.6% and 8.4% for FY12 and FY13, respectively, led by lower loan growth and higher NPA provisions. We also lower our price targets. We prefer banks that are better placed to manage the NPA cycle with: (1) higher tier-1 capital relative to stressed assets and; (2) high NPA-coverage.
It’s official: The European Financial Stability Facility (EFSF) plan announced at the EU summit on October 27th is essentially dead prior to arrival. As a consequence, Angela Merkel and Nicolas Sarkozy appear to be betraying signs of throwing in the towel on the Euro project as it exists today. They appear to be actively contemplating ways to engineer an orderly breakup of the Euro.
As financial market participants gets wind of their intentions – albeit tentative – expect financial markets to accelerate the unfolding of events. The entire Euro edifice could collapse before the New Year. EFSF Chief: The Insurance Plan Is Dead Prior To Arrival When the Chief of the EFSF is pessimistic about the capacity of the EFSF to be leveraged to an extent that is adequate to the task at hand, then you might as well kiss the whole thing goodbye. In a little noted article in Thursday rsquo;s FT, Klaus Regling, head of the EFSF essentially admitted that the plan agreed upon at the EU summit on October summit to use the EFSF as collateral for a first-loss insurance scheme is essentially dead.
As I predicted would occur in an article of mine several weeks ago entitled ldquo;Europe rsquo;s Inane Idea: Fake Brady Bonds, rdquo; the EFSF chief has acknowledged that there is no interest on the part of investors to purchase PIIGS bonds with a first-loss guarantee of only 20%. Regling believes that a first-loss guarantee of 30% may be required to garner any interest. Personally, I have serious doubts that there would be sufficient interest. Any issuance that actually requires a 30% loss guarantee in order to be viable simply has an implicit default risk profile that will be unable to garner sponsorship of sufficient size.
Since there are only about 250 billion euros available for the EFSF first-loss insurance scheme, that means that, even assuming 30% were sufficient, the mechanism would only be adequate to cover about 800 billion euros worth of debt issuance by Italy and Spain – and any other euro area country that needed funding. It has been estimated that roughly two trillion euros of funding are needed to simply merely meet projected roll-over and fresh financing needs through mid 2013. Therefore, the 800 billion projection is totally insufficient to the task at hand. If $800 billion in guarantees are all that Europe can come up with, Europe would probably better off wasting precious resources on this scheme at all.
That is why the EFSF first-loss guarantee proposal seems to be dead on arrival. The plan is totally insufficient, and therefore is unlikely to be implemented at all. I believe that this realization is thoroughly discouraging the Eurocrats that are charged with structuring the EFSF insurance facility and selling it to investors. These Eurocrats are relaying their pessimism back to Merkel and Sarkozy in real time. This in turn, is prompting Merkel and Sarkozy to begin to contemplate ldquo;exit strategies. rdquo; Imminent Fiasco Because Merkel and Sarkozy are unwilling or are unable to support the only viable option available to them that is to fund bond purchases via the ECB, they appear to be engaging in preliminary speculations regarding a possible exit plan.
The European Central Bank needs to act now in order to avert a potential default by a nation like Spain or Italy, Citigroup Inc.’s (C) chief economist told Bloomberg Television on Wednesday.
“Time is running out fast,” Willem Buiter said in an interview. “I think we have maybe a few months–it could be weeks, it could even be days–before there is a material risk of a fundamentally unnecessary default by a country like Spain or Italy, which will be a financial catastrophe dragging down the European banking system and North America with it.”
Other than increasing the size of the European Financial Stability Facility, which would be difficult for political reasons, Buiter added, “the only remaining show is the ECB, and they may have to hold their noses while they do it, and if they don’t do it, it’s the end of the euro zone.”
Well, it is not just the CDS ban, the fact that Greece is now done is also a modest factor, but since nobody can short Greek default risk unhedged, the only option is to short the bonds. As they did today en masse. Greek 1 Year bonds: the most liquid proxy for default in the absence of 1 Year CDS, closed at 183%, after hitting an all time high of 188%, following yesterday’s 173% close. To all those who bought 1 Year Greek bonds when yields hit 100% a month ago because “they just couldn’t possibly drop any more, and you would double your money in one year guaranteed”, condolences for the 50% loss. We are certain that a new batch of bottom callers will emerge, this time calling for doubling your money in six months…. Then three.. Then one and a half… etc… Until finally Zeno’s paradox catches up and you either double your money overnight or you lose it all.
While all eyes this morning are on Chinese CDS (with about an 18 month delay: about par for a centrally planned market), which has finally blown out, the shifting of attention has done nothing to fix the situation in Europe, where CDS is once again wider across the board.
Update: sure enough, here is Ambrose Evans-Pritchard with his own perspective on just this topic, which is oddly comparable to Zero Hedge’s: “Mrs Merkel’s aides say she is facing “war on every front”. The next month will decide her future, Germany’s destiny, and the fate of monetary union.”
Every time we discuss the futility of the nth bailout of [Greece\PIIGS\Europe\the Euro] we make it all too clear (most recently here and here) that the trade off between Germany onboarding ever more peripheral financial risk in one after another all too brief attempt to prevent the implosion of European capital markets and its currency, is not only a relentless creep higher in German default risk (and lower in the German stock market, as August has so violently demonstrated) but increasing political discontent, which after claiming countless political regimes across the world, has finally settled down on one that truly matters: that of German chancellor Angela Merkel. And as Reuters reports, Merkel’s disappointing response to an ever escalating set of crises, both domestic and international, means that the beginning of her end (and by implication of the Eurozone, and of the Euro) may be as soon as September 23, when the vote over the expansion of the latest and greatest European bailout lynchpin, EFSF, will take place.
To wit: “Germany’s Angela Merkel faces the biggest challenge to her leadership since coming to power in 2005, with traditionally loyal conservative allies openly criticizing her approach to the euro zone crisis and her hands-off Libya policy in shambles….it is Merkel’s piecemeal approach to the euro zone’s worsening debt crisis that has come under fire over the past week and now threatens her iron grip on power in Germany.” The biggest problem for Merkel is that she has gone “Japanese” in the opinion of the public: doing neither nothing, nor enough, to halt the European crisis in its tracks: “For some in Germany, she has gone too farby bailing out stricken euro zone members and agreeing to intervention in the bond markets to prop them up. For others at home and abroad, she has not done enough, shirking bold steps that might solve the debt crisis because they would be unpopular at home.” This latest attempt to placate everyone, while achievingprecisely the opposite, will come to a head on September 23 when the vote to expand the EFSF takes place: she is for the time being expected to have a sufficient number of votes to pass the critical for the eurozone proposal. “If it’s not enough, Merkel would be forced to resign. It would lead to a crisis.” And should there be a crisis, it will be the end for the European experiment as well, since with the political situation at the Euro’s biggest financial backer in flux, the free fall in European risk will be one that no one, certainly not the ECB, will be able to arrest. Cue even more improvised bailouts by the central banker oligarchy, yet without Germany, the credibility of any and all such deseprate measures will be nil. This incremental political uncertainty will likely make the life of the FOMC’s Sept 20-21 meeting slightly easier, as an adverse monetary announcement by the Fed, contrary to that priced in, coupled with the risk of a full blown European crisis, will be very frowned upon by the Status QuoTM.
Seen for much of the past six years as a reliable, steady leader whose competence and knack for brokering deals made up for a lack of bold vision, Merkel’s image has taken a beating over the past months and polls show an increasing number of Germans view her government as directionless.>> Read More