PIIGS

Banks Slash Jobs but Severe Headwinds Remain

As banks all over the world slash jobs, we ask ourselves – will this produce more streamline firms ready to generate significant profits, or a sign of the poor outlook for the sector? Unfortunately, stifling regulation repressive and a false bubble has driven this move and severe headwinds remain through exposure to struggling economies and substantial funding needs.

The 50 largest banks around the world have announced almost 60,000 job cuts. UBS are laying off 5.3% of their workforce, blaming stricter capital requirements and slowdown in client trading activity; Credit Suisse cutting jobs by 4% to save SFr1bn and Lloyds a whopping 14%.

Restrictive regulation make banks more stable but less profitable

Stricter capital requirements were just the type of new regulatory measures the Chief Executive of Standard Chartered feared at Davos back in January, would “stifle growth”. At this time we saw banks such as Credit Suisse missing earnings targets and downgrade their expectations severely going forward (from above 18% return on equity to 15%, which turned out to still be too high).

UBS has seen costs in their investment banking division soar to 77% of income and net profit fall almost 50% from a year earlier. Stricter capital requirements mean banks have to hold a higher amount of capital in order to honour withdrawals if hit with operating losses. Furthermore, restrictions on bonuses led to increases in fixed salaries and an inflexible cost base.

Backtracking on a false bubble

Job cuts should also be set within the context of occurring after a ‘false bubble’. Post the 2008 financial crisis and bank bankruptcies and proprietary trading layoffs, the fixed income, currency and commodity business of the remaining players boomed as competition dropped. Banks began expanding. UBS’s proposed cuts of 3,500 jobs comes after an expansion of 1,700 to the workforce and incomparable to the 18,500 job losses experienced during the crisis.

Exposure to struggling economies is a key threat

Crucially, these cuts do nothing to solve the biggest problem these banks are struggling with. They have substantial exposure to struggling EU economies. In Germany, bank exposure to the PIIGS (Portugal, Italy, Ireland and Spain) amounts to more than 18% of the countries GDP. Just last month Commerzbank suffered a €760m write-down from holding debt that is unlikely to be repaid, which all but wiped out their entire earnings for the second quarter of the year. Further fuelling fear of the spread of the crisis from periphery to core is that French banks are among the largest holders of Greek debt.

Here in the UK we’re by no means immune. Our banks have £100bn connected to the fate of these periphery economies. RBS, 83% owned by the British taxpayer is so heavily exposed to Greek debt that it has written off £733m so far this year.

Severe funding needs and fear of lending exacerbate the problem

90 EU banks need to roll €5.4tn over the next 24 months. This will be funded at higher rates and with disappearing demand as investors become more wary, exacerbating the problem. In addition these banks need to raise an extra $100bn by the end of the year. An inability to borrow to satisfy current obligations, not withstanding any expansive moves, is a serious obstacle to profit generation. 

Moreover, job cuts do nothing to boost confidence to encourage banks to lend. Just two weeks ago, EU banks deposited €107bn with the European Central Bank overnight than lend to each other. If banks are not even lending to each other, losing out on a valuable opportunity to make money, then how encouraged are we as investors to get involved?


Europe – Lacking a Long-Term Solution

Over the last few days we have seen a tremendous amount of volatility in the markets, epitomising the lack of clarity with which many investors have struggled. The contagion continues to spread as we hear rumours of a possible downgrade of French government debt although it is far more likely to occur for Italy first. Fundamentally, there is a lack of a long-term solution and the knee-jerk reaction by some EU countries to ban short selling not only misses the point, it may negatively impact the very stocks it is trying to protect. So as we see movement to safe havens, we also see room for opportunistic buying – as long as you invest with those with strong balance sheets unlikely to be hit in future earnings downgrades and have a long enough time horizon to withstand the volatility.

Italy and France to be downgraded? The Contagion Continues to Spread

The markets are already betting for the ratings agencies to downgrade France’s debt with credit default swap spreads widening to double their level at the beginning of July. A rising expense to insure against default implies the market believes it to be more likely. However, Italy is the more likely downgrade candidate in the short-term. The reasons given behind Portugal’s downgrade a few months back apply equally to Italy – an unsustainable debt burden (Italy has the third largest in the word at €1.8tn) and a low likelihood of being able to repay these obligations (as it dips back into recession). The European Financial Stability Fund is losing its credibility since even its increase to €440bn is not enough to cover future potential bailouts and would need to amount to at least €2tn. The crux of the problem, as I’ve iterated before, is that you can’t solve the problem of debt with debt and austerity does not foster growth. Instead debt burdens are increasing at a faster rate than GDP growth in many western economies so the situation is only getting worse.

Outlook for banks: Headwinds for banks remain

European banks remain highly correlated to the future of the periphery. German banks, for example, have exposure to the PIIGS (Portugal, Ireland, Italy and Spain) amounting to more than 18% of German GDP. Commerzbank revealed that a €760m write-down for Greek debt holdings wiped out their entire Q2 earnings. That’s before we look at France who have an even higher exposure and here in the UK, our banks have nearly £100bn exposed to struggling economies. Furthermore, these banks need to refinance maturing debt (at a rate of €5.4tn over the next 24 months) at higher rates and with demand shrinking.

Will the ban on short-selling help? No, it misses the point

The markets are concerned with government fiscal credibility not its regulatory might. Instead, the ban could increase volatility and negatively impact the very stocks it is trying to protect. ‘Shorting’ was acknowledged by the Committee for European Securities Regulators as beneficial for “price discovery, liquidity and risk management” just last year, so we may well see higher volatility than we would have without. Secondly, it limits fund ability to bet on financials going up. Hedge funds use shorts to remove market risk, buying shares in one bank and borrowing and selling shares in another. If they are forced to close these ‘borrowed’ positions, they will have to sell the other bank shares they have bought outright, causing further selling pressure and price falls. Most interesting was the timing of the implementation, just before an announcement was made that the Greek economy shrank by 7% in Q2 – fuelling fears the ban was needed since there’s more bad news to come.

How to trade these markets: Movement to safe haven offering opportunities

So how can you invest in these markets? A possible support to the stock markets is the ‘search for yield’. Sitting on cash can’t be satisfying for long, with rates as low as they are, and the dividend yield on the Eurostoxx is now double the 10 year German ‘bund’ yield. This means that even if markets go sideways, the return generated from holding European stocks could be more attractive than either if the other options. In addition, valuations are looking reasonable, at a near 8x forward earnings. Therefore we may see flows returning to the markets. However, be warned, we are starting to see earnings downgrades and volatility may remain. Therefore invest in companies with strong balance sheets and maintain a medium to longer-term time horizon.

The Greek Tragedy: Could a ‘Haircut’ Help?

Debate has been raging as to whether the Greek economy can avoid bankruptcy. Just how big is the problem, what are the options and how is this impacting financial markets? 

Background to the Problem

Greece is around €300bn in debt. Putting that into context, its budget deficit is one of the highest in Europe and last year amounted to more than four times the Eurozone limit at 13.6% of GDP. This more than supports the country’s inclusion in the infamous ‘PIIGS’ acronym (Portugal, Ireland, Italy, Greece and Spain) used to refer to the areas of sovereign debt concern.

What’s Going On?

Despite the jobless rate reaching 16% (and a horrific 42.5% for youth), the Greek economy has seen only marginal deleveraging. Instead, people are depending on consumer credit to maintain their levels of expenditure and service their debts (i.e. paying credit card bills with other credit cards). Moreover, whilst many in the UK struggle to obtain loans from banks, the overall banking sector in Greece actually increased their credit availability, with the most significant increase going to the government itself.

Attempted Solutions

Last Thursday, Jean-Claude Trichet, President of the European Central Bank, announced that they would lend Greece €45bn in new loans. However, this alone, they acknowledge, is not enough. The ECB wants to see structural reforms and a good deal of privatization, with the claim that €50bn could be generated over 3 to 5 years to reduce debt/GDP from 160% to 140%.

What are the Complications?

Loans to ‘bailout’ struggling countries are partially funded by taxpayers from different countries within the EU. Therefore, the problem is not an isolated one. Furthermore, even after this loan and the privatization contributions, there will be a financing gap of €170bn between 2012 -14 which will need filling. European banks have to refinance €1.3tn maturing debt by end 2012 and are owed over €200bn already by the PIIGs for refinancing ops.

Could a Good ‘Haircut’ Help?

With so much talk of a ‘restructuring’, i.e. bond holders sharing some of the pain, it is interesting to hear the views of Lorenzo Bini Smaghi, an ECB executive board member on the subject. He maintains that these are not the tools by which Greece can save its economy but could cause a “Depression” and “banking system collapse”. Furthermore, those pointing to a compromise of a voluntary or ‘soft’ restructuring appear to be fooling themselves. According to him, there is “no such thing as an ‘orderly’ or ‘soft’ re-structuring” since ‘haircuts’ (a percentage knocked off the par value of a bond) would have to be forced by governments. Crucially, any type of restructuring would cause a panic in the markets and cause credit events reducing the value of these investment vehicles either way.

Yield on a 10 year Greek Government Bond (Orange), 10 year German Government Bond (white) and the spread between the two (yellow) - showing the higher premium demanded by investors for holding Greek debt, near historical highs - highlighting a heightened risk perceived by the markets.

So, What Are the Options?

As previously mentioned, a default on some of its debts would have dire consequences but the prospects for sustainable financial solvency appear weak with such a substantial deficit and the habits of borrowers and lenders not much improved. Most worrying, from the perspective of European stability is the recent comments from a Greek EU Commissioner that “The scenario of removing Greece from the euro is now on the table”. Therefore, although in stark contrast to statements by Greece’s Prime Minister and with France and Germany still heavily exposed to EU laggards, which together make a break up of the euro unlikely in the short-term, it is a fear weighing on investors minds.

How are the financial Markets Reacting?

Risk aversion is back on the rise. Investors are worried and, understandably, demanding higher premiums to lend to Greece. That’s not all. Other markets are suffering. “All sophisticated indicators of systemic risk, cross correlations of CDS and yield spreads show a high sensitivity to restructuring moves and are at levels higher than in September 2008”.

The Investment Insight: What Can You Do?

This has two consequences. Firstly, investors should be more cautious of an indiscriminate sell-off but secondly, this can be used as an opportunity to pick up high quality assets at a lower price. Be wary but remain opportunistic.

How to Invest in These Markets

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Gemma Godfrey, Chairman of the Investment Committee and Head of Research at Credo Capital, and John Authers of the Financial Times on CNBC’s European Closing Bell. Discussing how you should invest your money.

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EU Differentiation… The Key Points you should know…

“United we stand; divided we fall” Aesop (Ancient Greek Fabulist and Author of a collection of Greek fables. 620 BC-560 BC)

The problem with the “EU” banner is that it links together economies that are quite different from each other. Much press has been dedicated to the fate of the PIIGS – Portugal, Italy, Ireland, Greece and Spain but it is interesting to compare journalistic exposure with economic impact. Greece Ireland and Portugal account for less than 5% of EU GDP. To save you shifting through pages of research – here are the key pertinent points for each economy… The structure follows that of my earlier assessment of the futility of EU bailout mechanisms–

  1. FLAWED LOGIC – what are the real issues?
  2. NOT SOLVING THE PROBLEM – will the economy in question be able to grow enough / will the debt burden be manageable enough so that it will fall as a % of GDP?
  3. UNCERTAINTY – what are the political issues?

Source: "Belgium Joins The PIIGS: And Then They Were Six" - Gavan Nolan, Econotwist The Swapper - learning and understanding the increasingly complex financial world.

Portugal – A Disappointing Deficit, Dipping Back Into Recession

  1. DISAPPOINTING DEFICIT and FOREIGN PRESSURE – Disappointed the market with its deficit reduction plan for this year, amounting to a value for the first 10 months of 2010 which was than for the whole of 2009 and forecasted to exceed the EU limit until at least 2012. Exposed to more foreign pressure with around 70% of its debt is held abroad
  2. LOW GROWTH – estimated to only amount to 1.3% for 2010 for an economy expected to fall into recession next yr
  3. POTENTIAL SOCIAL UNREST – planning to reduce its public workforce

Italy – Saved by its Savings, Economic Exposure but Debt Isolation

  1. TOO BIG TO BAIL OUT – second largest debt burden after Greece (public debt equates to 120% of GDP)
  2. LOW GROWTH

  • HOWEVER: High savings rate, exposure to German and Emerging Market economies, less dependant on foreign creditors and therefore more flexible

Ireland – The Public Prefers a Default

  1. HUGE BAILOUT – amounting to 60% of GDP vs. “only” 47% for Greece
  2. POTENTIAL FOR DEFAULT – 57% of the public believe the country will not be able to support the annual interest payments involved with this debt burden (€5bn over 9 years) and would prefer the government to DEFAULT on its commitments
  3. PROTEST and INTERNATIONAL IMPACT – 50,000 took to streets to protest against the Government’s plan to cut the budget deficit. The UK has £140bn exposure to Irish banks

Greece – Flirting with Insolvency

  1. STRUCTURAL LIMITATIONS“overblown state sector”, “uncompetitive and relatively closed economy”
  2. SOLVENCY – It has been argued that the bailout package will only prevent Greece from insolvency for ~a year
  3. CIVIL UNREST – has been seen in response to social program cutbacks

Spain – Pulling a “Sickie”

  1. UNEMPLOYMENT and a potential for DEFAULT – the highest in the EU at around 20% of the population. A third of private sector debt (€0.6tn) was generated from the housing boom and liable to default.
  2. INTEREST PAYMENTS HAVE JUMPED – Since Oct, yields have jumped from 4% to 5% leading to a larger debt burden as a percentage of GDP
  3. SOCIAL UNREST – Just the other week we saw one of the largest “sickies” thrown by their air traffic workers

Hungary – The Government Can’t Win

Although not within the PIIGS acronym – it is important nonetheless to mention this economy at this point and a great example of the potential impacts to investment. It’s a case that highlights the Government can’t win – if it decides that instead of implementing austerity programs eliciting social unrest, it will instead employ more crowd-pleasing reforms, it will get punished nonetheless….

  • DOWNGRADED – Moody’s has downgraded its debt to the lowest investment grade status. One more downgrade and it changes classification and those restricted to investing in Investment Grade debt only will be forced to sell, regardless of any other factors. Great opportunity to pick up dent at a discount (whilst watching the quality of the issuer!)
  • REASON – Short term (less antagonistic) measures are not sustainable – special taxes and utilising private pension schemes to fill holes! The Government is relying on future growth to afford its pension liability in the future and anyone not transferring to a state pension by end Jan may lose 70% of their pension value.

Contrast with the Core

Just to contast these economies with the one seeming to be driving force behind the union – Germany’s deficit could potentially fall to the 3% EU limit next year

INVESTMENT INSIGHT: When investing in the EU – differentiate between countries!

European “Financial Mechanisms” – Can they solve the EU’s problems? And how can I make money from the concern?

World unity is the wish of the hopeful, the goal of the idealist and the dream of the romantic. Yet it is folly to the realist and a lie to the innocent – Don Williams, Jr  (American , b.1968)

There has been much in the news lately on the outlook for the European Union. In May, Greece was offered €120bn in EU government and IMF loans over 3 years to replace the need for new borrowing at exorbitant market rates – the “first bailout of a Eurozone country and the biggest bailout of any country”.  Just last month Ireland joined the queue and received a €85bn injection plan. The flame of contagion was burning bright as investors worried Spain, Portugal and Italy were to follow suit quickly (The other members of the PIIGS acronym – and we’ve been advised what risks lie in an acronym!). Then just as markets calmed after the ECB staged their largest intervention and purchased mainly Portuguese and Irish bonds on Friday, the rating agency Moody’s announced it was downgrading Hungary’s debt by not one but two notches!  This country isn’t even in the periphery of the EU, it’s outside of it entirely… and so the contagion spreads….

Source: Bloomberg. The premium investors demand for investing in Irish government bonds over German bunds remains elevated (indicating a perceived heightened risk)

Why won’t the EU bailouts solve everything?

1. FLAWED LOGIC: attempting to solve the problem of debt with more debt

2. NOT SOLVING PROBLEM: without growth, the debt burden as a share of GDP will continue to rise. The latest European Financial Mechanism only covers maters until 2013,  if Debt/GDP has not reduced significantly then bond holders start sharing the pain

3. UNCERTAINTY: ministers keep changing their minds! (“no bail out” to “bailout”, “no pain for creditors” to “sharing the burden”) – markets don’t like uncertainty!

The key discrepancy –

What the ECB wants EU countries to do: Be prepared to increase the size of emergency bailouts, consolidate budgets and reform (implement austerity measures and assume national responsibility so the ECB can avoid being a bailout tool)

What EU country economies need: COMPETITIVENESS AND GROWTH

Market Impacts

  • YIELDS may have fallen sharply for some periphery debt but as the chart before shows, they remain at elevated levels.
  • FORCED SELLING – Pension funds, insurance cos and ETFs which are focused on matching the liabilities to their assets may have to sell certain debt when its credit rating is cut

How can you exploit this?

“Europe is difficult to understand for markets. They work in an irrational way sometimes,” Christine Lagarde, French economy minister

  1. Companies located in an EU periphery country, with strong balance sheets and demand insulated from worries about their homeland (i.e. international exposure and demand for their products from the east etc) making it a sound investment choice, may suffer from illogical moves in the markets that punish anything connected to the country regardless. This debt can be picked up cheaply.
  2. In addition, a downgrade in a country’s government debt may trigger a wave of forced sellers (the pension funds etc. mentioned above) that are restricted in holding this level of debt. If this is just an automatic trade, these distressed sellers may be exploited with the purchasing power in your hands