Leveraged Loan and High Yield Bond ETF's a Reflection of Credit Activity
Whether banks are lending or hoarding cash is a major concern in today's market. Obviously U.S. banks are cautious given America's past financial crises, which saw it's fifth anniversary this weekend. Now debt markets are tilted in favor of borrowers. To a degree, in fact, that makes one question extent and prudence of borrower accommodation in view of covenant-lite debt.
Two exchange traded funds (ETF's) demonstrate degree of borrower as opposed to lender accommodation. These ETF's are high yield bond and leveraged loan products. Namely, we have SPDR Barclays High Yield Bond ETF (JNK), with an average trade volume of 6M shares. Second, is PowerShares Senior Loan Portfolio (BKLN) trading an average of 3M shares. Both are reflections of lending to business, either through bond issuance or loan syndication. With these kinds of bonds and loans, banks are "also" participants, along with various institutional lenders (pension funds) and hedge funds.
These ETF funds reflect demand for yield associated with leveraged loans and high yield bonds. They also reflect a trend in debt markets of relaxing covenants that otherwise protect lenders. A common argument is that covenant-lite debt prevents bankruptcy. Also arguable is that covenant-lite debt forestalls a bankruptcy or restructuring only for progressing financial deterioration.
High Yield Bond ETF's, Declining Cash Flow and Declining Covenant Quality
JNK, a high yield bond ETF, has witnessed, as with all other fixed income modalities, major retail cash outflows given prospects of Fed tapering. For year to August, an August 22 Forbes report shows high yield bond fund outflow of -$7.3B versus last year's same period in flow of +$21B. Despite outflows, high yield bond demand remains solid with JNK resisting net cash outflow to sustain pricing at its 200 day average. In fact, JNK has dipped twice of recent below its 200 day average and, as of August 20, started an arduous journey returning to and exceeding this level now.
Accounting for JNK price resilience is demand for yield, or income, against a now expected mild Fed tapering and consequent anticipation of leveling interest rates. JNK price resilience goes back to July when reports show bonds rated CCC and lower gained some 7.1% year to date while investment grade bonds declined 5%.
Along with high yield bond price resilience is an equal decline in creditor protection seen in indenture covenants. Moody's reports an index of covenant quality. Ratings range from 1 to 5 with 1 being strongest of debt covenant provisions while 5 is weakest. Debt covenant provisions were very strong following the financial crises and Great Recession, for good reason. However, in July 2012, strength of covenant provisions started a decline. By November 2012, covenant quality reached a new low with high yield covenant-lite packages reaching 30% of issuances versus a 17% historical average according to Reuters. November 2012 showed a covenant quality score of 4.15.
For August, 2013, Moody's showed a covenant quality rating of 4.01 versus July's 3.79. Starting latter 2012 to present, we see a sustained and expanding borrower oriented market for junk bonds.
Leveraged Loans and their Sustained ETF Pricing, but Declining Covenant Quality
Leveraged loans show same dynamic, but without cash outflow for their ETF's. Senior loan funds--sometimes called bank loans or leveraged loans--showed 65 consecutive weeks of cash inflow as of September. Reason for leveraged loan ETF sustained positive cash flow is nature of a loan over a bond. Loans conventionally have credit protection by being senior to even "senior notes" in terms of creditor protection. They also enjoy interest rate protection by being variable. Usually, a bond or note will have fixed interest where loans will be LIBOR plus negotiated basis points.
Also accounting for strength in loan ETF's is underlying loan market strength. Institutional leveraged loan volume for first half 2013 increased 122% at $268B versus same period 2012 at $121B. Institutional firms appear to be lending with confidence, while bank leveraged loan lending is up 3%.
Though loans enjoy superior credit and rate protection over bonds, they remain subject to strengths and weaknesses of their borrower. Like decline in high yield bond covenants, loan covenants have also been in very significant relaxation.
Leveraged loan covenant relaxation is breaking records and exceeding frothy pre-crises levels, substantially. As of August 8, 2013, Forbes reports $162B in covenant-lite loans. Number is 22% above 2012 levels and contrasts with just under $100B in 2007. Leverage ratios have also expanded beyond 2007 levels. Despite this, total debt does appear below 2007.
With leveraged loans and high yield bonds both granting declining creditor protection, environment is certainly borrower friendly. With 56% of loan issuances being refinancing, companies are taking advantage and relieving themselves of creditor oversight, limitations and burdensome performance (or maintenance) covenants.
Performance covenants in loan agreements have traditionally been used to help assure loan repayment. Limiting covenants in bond indentures protect payments to bond holders. Complying with covenants can, however, constrain business decision making and blunt a company's ability to pursue investment and opportunity.
What Covenants get Removed to Form Covenant-Lite Loans and Bonds
High yield covenant-lite indentures generally don't have a limitation on indebtedness provision and/or a limitation on restricted payments provision. Leveraged loan covenant-lite agreements are missing a maintenance covenant.
Covenants are generally divided into maintenance and incurrence covenants. A maintenance covenant requires a company to maintain a certain level of performance and are associated with leveraged loans. For instance, a leverage covenant might require a company to maintain its leverage at no greater than 4x debt/EBITDA. Other common maintenance covenants are cash ratio and interest ratio. Cash ratio monitors cash flow to debt service and interest ratio monitors EBITDA to interest expense.
Incurrence covenants, typically associated with bond indentures, require companies not to incur other obligations that might impair payment to, or credit priority of, bond holders. Common are limitations on indebtedness and restricted payments.
Limitation on indebtedness prevents a company from incurring additional debt that would make its leverage ratio exceed, for instance, 4x debt/EBITDA. Limitation on restricted payments limits a company's cash outflow. This is done by restricting dividend payments, acquisitions and certain investments. Generally, restriction on payments limit a company's external investment.
Covenant-lite Debt Preventing Bankruptcy, or Making Bankruptcy Impractical
When there is an absence of a maintenance covenant in a company's loan, and an absence of limitation on debt and no restricted payments on its bond indenture, no limitation on leverage or cash outflow exists, despite other peoples' money as leverage. Accordingly, the company isn't under a burden to keep earnings in line with debt. The company is free to make decisions, including accumulating more debt, as if it was financing itself on its own cash flow.
While most companies will obviously choose not to financially explode, real issue arises from a capital structure perspective. Notion is that covenant-lite debt prevents bankruptcy by giving a company latitude to develop additional funds.
Or, another way of looking at it, covenant-lite debt allows a company to kick the can down the road accumulating more debt, or issuing more equity, or both. All the while the company has expanding leverage multiples and equity dilution. What a potential nightmare.
Without having restrictive covenants described above, companies with covenant-lite debt don't have objective measures determining when enough is enough. A company could potentially become a debt machine, until an actual default occurs. Meaning the company is actually out of cash, after potentially having entered into lease buybacks, deteriorating available collateral.
Because bond holders generally are junior in creditor priority to loan holders, bonds will probably get nervous first. But, nervousness might not show until there are few assets for distribution among previously expanding creditors.
If companies leverage up due to the latitude given them with covenant-lite debt, deterioration of macro liquidity could impair ability to refinance their leverage, hastening crises, rather than preventing it. After all, most covenant-lite lending is due to refinancing currently, and not leveraged buyouts.
Covenant-lite debt does grant considerable latitude to companies. So long as companies don't use it as an invitation to over leverage, and liquidity conditions allow refinancing of debt. every thing looks good.
Circumstance to really watch is frequency of a triumvirate of all three covenants missing at once.
Tuesday, September 17, 2013
Sunday, September 1, 2013
Asian Cost of Labor, India's Currency Swap Agreements and European Bank Overleverage: Dichotomies All
Dichotomies identify recent market activity. From U.S. GDP to Eurozone GDP, things look better. But add China's policy direction, with emerging market direction, and one can see the point. Coming political battles over U.S. debt ceiling, elections from Australia to looming elections across emerging markets and ultimate monetary policy stance in developed markets give cause for murky water.
Example of dichotomy appears when comparing GM's experience to that of emerging markets' maturing growth. On August 12, reports reveal GM plans to gradually exit South Korea due to rising labor costs and aggressive unionization. Movement like this for GM is significant in that South Korean production is roughly 20% of company's global output. Justification of move appears in South Korea's cost of production per vehicle being 40% above GM's average global cost.
Contrast GM's move away from production in South Korea with Apple's move into consumer markets in China. Apple's proposed deal with China Mobile fits well with growing labor costs and shortages in China. Fundamental for deal making is a rising consumer class prepared to buy smart phones, which is evidenced by generally recognized reporting of China smartphone use exceeding U.S.
Technological compatibility with China's "proprietary" mobile network (Qualcomm's TD-SCDMA compatible chip sets) and carrier subsidization are major issues of discussion. Both are necessary components of any deal making. Consider, however, Apple's loss of technology arising from Samsung production and a droid platform. Apple must be cautious entering a new space of shared technology. But for an estimated $50B benefit, one probably wouldn't care to test the water.
Perhaps palliative and insulating, but not curative, are rounds of currency swap negotiations among emerging markets and their major trading partners. India leads on this proposal. Sometimes called central bank liquidity swaps, these swaps essentially involve native currency deposits in a central bank with U.S. dollar reserves. U.S. dollars are loaned against native currency deposits, with interest rate differentials paid, but currency differential rate previously agreed upon.
India's major currency swap agreement is with Japan at $15B. This agreement was initially written in 2007 at $3B and was part of Japan's other similar agreements with South Korea, Malaysia and Thailand. All products, and extensions, of the "Chiang Mai Initiative", which followed 1997-1998 Asian currency crisis and resulting overtures of "ASEAN plus three" cooperation.
India appears ready to tap such resources, certainly out of need. To leverage resources, India is proposing to sell their obtained U.S. currency to native oil refiners. Thereby, India optimizes and controls flow of foreign currency reserves. Simultaneously, India is looking to support policies reducing petroleum consumption, and other causes of current account deficit.
Where Eurozone GDP flash report on August 14 exceeded expectations with a .3% increase, other influences still weigh. France, Germany, Finland and---Portugal---all saw positive growth. But, through Q3 so far, reports are certainly gaining strength that EU banks are over leveraged and under capitalized. This, despite how many years of struggle.
July 22, thefinanceinsider.blogspot.com reported EU bank assets are 3.5 times EU GDP at 33T euro. Obviously, European governments backstopping a general banking crises under this number are hamstrung. On August 11, ft.com reported EU banks generally must cut assets by 3.2T euro, and major banks specifically must cut 661B euro in assets and raise 47B euro of new capital. All must occur over next 5 years to meet Basel III standards and avoid specters of insolvency. Three banks are of most concern, being Barclays, Deutsche and Credit Agricole.
Supporting EU banking imbalance is July 30's Deutsche Bank's Q2 report showing net profit dropping by 49%, while revenue was up 2%. Net income found itself at 335M euro versus forecasts of 767.6M euro. Hurting profit was increasing provision for legal expenses by 630M euros to 3B euros.
August 29 showed Deutsche issuing stock to raise 2.96B euro at 32.90 per share in European trade. Goal for company was 2.8B euro, and despite dilution, exchange trade increased 6.9% according to Bloomberg. Goal is to increase capital by 5B euro and planned is a 2B euro subordinated debt issuance.
July 30, also saw Barclays' H1 profit down -17% at 3.59B pounds. Decline was due to restructuring costs and 1.35B pound provision for payment protection insurance impropriety and 65M pound provision for interest rate hedging impropriety.
Barclays has been under pressure from U.K.'s Prudential Regulatory Authority to raise capital, having identified a shortfall for the bank of 3B pounds end of 2012. Also on July 30, Barclays announced its plan to raise capital. Issuance of 5.8B pounds of new shares will address capital shortfall, along with issuing 2B pounds of convertible bonds, which appear subject to heavy hair cuts if bank has trouble.
Barclays on August 30 increased per share issuance expectation price from $88.00 to $92.00.
Overall, emerging markets aren't only cycling down, but are in broader transition. Where developed country money moves out of emerging markets, we also see hesitation of direct investment due to rising costs of production, consequent of a rising consumer class. Other hand shows a rising consumer class for sales prospects. Europe looks to be improving, but banks remain over extended, despite a considerable period of deleveraging. Even with years of deleveraging, European bank stock issuance to re-capitalize is being well received. Imbalances seem intuitive.
Example of dichotomy appears when comparing GM's experience to that of emerging markets' maturing growth. On August 12, reports reveal GM plans to gradually exit South Korea due to rising labor costs and aggressive unionization. Movement like this for GM is significant in that South Korean production is roughly 20% of company's global output. Justification of move appears in South Korea's cost of production per vehicle being 40% above GM's average global cost.
Contrast GM's move away from production in South Korea with Apple's move into consumer markets in China. Apple's proposed deal with China Mobile fits well with growing labor costs and shortages in China. Fundamental for deal making is a rising consumer class prepared to buy smart phones, which is evidenced by generally recognized reporting of China smartphone use exceeding U.S.
Technological compatibility with China's "proprietary" mobile network (Qualcomm's TD-SCDMA compatible chip sets) and carrier subsidization are major issues of discussion. Both are necessary components of any deal making. Consider, however, Apple's loss of technology arising from Samsung production and a droid platform. Apple must be cautious entering a new space of shared technology. But for an estimated $50B benefit, one probably wouldn't care to test the water.
Perhaps palliative and insulating, but not curative, are rounds of currency swap negotiations among emerging markets and their major trading partners. India leads on this proposal. Sometimes called central bank liquidity swaps, these swaps essentially involve native currency deposits in a central bank with U.S. dollar reserves. U.S. dollars are loaned against native currency deposits, with interest rate differentials paid, but currency differential rate previously agreed upon.
India's major currency swap agreement is with Japan at $15B. This agreement was initially written in 2007 at $3B and was part of Japan's other similar agreements with South Korea, Malaysia and Thailand. All products, and extensions, of the "Chiang Mai Initiative", which followed 1997-1998 Asian currency crisis and resulting overtures of "ASEAN plus three" cooperation.
India appears ready to tap such resources, certainly out of need. To leverage resources, India is proposing to sell their obtained U.S. currency to native oil refiners. Thereby, India optimizes and controls flow of foreign currency reserves. Simultaneously, India is looking to support policies reducing petroleum consumption, and other causes of current account deficit.
Where Eurozone GDP flash report on August 14 exceeded expectations with a .3% increase, other influences still weigh. France, Germany, Finland and---Portugal---all saw positive growth. But, through Q3 so far, reports are certainly gaining strength that EU banks are over leveraged and under capitalized. This, despite how many years of struggle.
July 22, thefinanceinsider.blogspot.com reported EU bank assets are 3.5 times EU GDP at 33T euro. Obviously, European governments backstopping a general banking crises under this number are hamstrung. On August 11, ft.com reported EU banks generally must cut assets by 3.2T euro, and major banks specifically must cut 661B euro in assets and raise 47B euro of new capital. All must occur over next 5 years to meet Basel III standards and avoid specters of insolvency. Three banks are of most concern, being Barclays, Deutsche and Credit Agricole.
Supporting EU banking imbalance is July 30's Deutsche Bank's Q2 report showing net profit dropping by 49%, while revenue was up 2%. Net income found itself at 335M euro versus forecasts of 767.6M euro. Hurting profit was increasing provision for legal expenses by 630M euros to 3B euros.
August 29 showed Deutsche issuing stock to raise 2.96B euro at 32.90 per share in European trade. Goal for company was 2.8B euro, and despite dilution, exchange trade increased 6.9% according to Bloomberg. Goal is to increase capital by 5B euro and planned is a 2B euro subordinated debt issuance.
July 30, also saw Barclays' H1 profit down -17% at 3.59B pounds. Decline was due to restructuring costs and 1.35B pound provision for payment protection insurance impropriety and 65M pound provision for interest rate hedging impropriety.
Barclays has been under pressure from U.K.'s Prudential Regulatory Authority to raise capital, having identified a shortfall for the bank of 3B pounds end of 2012. Also on July 30, Barclays announced its plan to raise capital. Issuance of 5.8B pounds of new shares will address capital shortfall, along with issuing 2B pounds of convertible bonds, which appear subject to heavy hair cuts if bank has trouble.
Barclays on August 30 increased per share issuance expectation price from $88.00 to $92.00.
Overall, emerging markets aren't only cycling down, but are in broader transition. Where developed country money moves out of emerging markets, we also see hesitation of direct investment due to rising costs of production, consequent of a rising consumer class. Other hand shows a rising consumer class for sales prospects. Europe looks to be improving, but banks remain over extended, despite a considerable period of deleveraging. Even with years of deleveraging, European bank stock issuance to re-capitalize is being well received. Imbalances seem intuitive.
Sunday, August 18, 2013
EMERGING MARKET WEAKNESS: INDONESIA RUPIAH DECLINE AND CURRENT ACCOUNT DEFICIT
South East Asia Focal In Emerging Markets And Indonesian Economic Decline
Emerging market hardship may be expressing a larger influence on global market dynamics than generally reported. Where we see preferred stocks taking a nose dive against common stocks, interest rates continuing to increase and, of course, emerging market currency declines; we also see global equity markets high, but finding more headwinds to push higher.
May, 2013 time frame points to a generally recognized "shift" attributed to comments of Federal Reserve tapering of QE. Other dynamics also appear to be at work, pointing to issues outside of Europe.
South East Asia holds interesting events. Point of interest is Indonesia. It boasts the largest economy in South East Asia at $878B USD GDP in 2012, and eclipses a combined Thailand and Singapore GDP of just under $700B USD. Indonesia's GDP growth rate has been stellar with an annual growth rate of 6.5% coming out of global recession and extending through late 2011. 2012 saw policy propositions that looked protectionist and such appearances frosted investment. GDP has been in decline for last four quarters putting in a Q2 2013 growth rate of 5.81% versus a Q1 rate of 6.03%.
We have witnessed a 70 basis point decline in Indonesian GDP, which previously enjoyed exponential growth. While GDP declines, foreign currency debt, or external debt, have increased. Data shows external debt challenges GDP at $251B USD. External funding of high emerging market growth is not only routine, but contains its own boom and bust cycles.
Indonesia's External Debt, Declining Currency And Rising Bond Yields
External debt is composed of obligations denominated in foreign currency. Resultantly, Indonesia needs reserves of foreign currency to service its external debt. Two problems are developing which raise concerns. First, Indonesia's non-convertible currency, the rupiah, is in depreciation declining 7% this year to lows last observed in 2009, amid the financial crises. Second is an exhausting of Indonesia's foreign currency reserves. Now at $92.7B USD, these reserves have dramatically declined and are also approaching lows witnessed during the financial crises. Reserve declines have followed Bank Indonesia's, Indonesia's central bank, efforts to support rupiah. Now, Bank Indonesia has essentially no choice but to allow market determination of rupiah value.
Feeding problems is a declining GDP amid a July inflation rate of 8.61%, highest rate in four years. Suggestion is that inflation isn't demand driven, or the product of a fast moving economy. Rather, inflation appears to be arising from rupiah weakness. For example, exports are down 4.5% y/y for 15 months of consecutive decline. Retail sales started trending down mid 2012 reaching a y/y low of 8% first part of 2013. While June numbers show a 14.8% growth rate, inflation may drive the number, especially in view of fuel price spikes due to elimination of a fuel subsidy.
Attending inflation is a rise of Indonesia's 10 year government bond yields. Now at 8.13%, Indonesian yields have increased 264 basis points since March 31, 2013 when yields were 5.49%. Contrast this with Thailand's 10 year which is now at 3.99% moving from a March 31 3.42% to increase 57 basis points. Singapore, now at 2.48% rose to this level starting from a March 31 1.367% level to see a rise of 111 basis points.
Just as Indonesian bonds have exceeded peer group bonds in rising yields, they have also exceeded peers in the rate of their widening spread against Bunds and Treasuries. Indicated is an obvious and dramatic increase in Indonesian risk premiums, amid a slowing Indonesian economy.
Indonesia's Balance of Payments Deficit Reveals Macroeconomic Concern
Most troubling for Indonesia is their global balance of payments, pattern of increasing external debt, and abysmally low foreign exchange reserves. For balance of payments, Q1 2013 saw a current account deficit---meaning more imports and therefore domestic expenditure as opposed to income---of -$5.27B. Capital/financial account---which is money invested in Indonesia and therefore income---also saw a deficit of -$1.37B. This resulted in Indonesia using more of its foreign exchange reserves to finance not only a current account deficit, but also a capital/financial account deficit. Consequence was a drain in foreign exchange reserves of $6.62B, yielding the $92.7B in reserves. Down from a 2012 average of just below $115B.
Q2 2013 data released August 16 showed a dramatic current account deficit increase to -$9.85B. Capital/financial account actually showed a surge in foreign investment, but not enough to finance current account deficit. Capital/financial account showed a positive $8.196B. Still foreign exchange reserves made up the difference by declining another $2.477B.
Further rupiah depreciation resulted given balance of payment news with spot prices being at a 2.5% premium against the 1 month non-deliverable rupiah forward contract (NDF) at 10.636/USD and spot at 10.373. Last week, Indonesia's 10 year bond yield increased over 60 basis points.
Indonesian Steps To Solve A Looming Currency/Economic Dilemma
Trouble arises from Indonesia's foreign debt exposure and its cost against a declining rupiah, compounded by declining foreign exchange reserves. Now, accumulation of foreign exchange reserves is becoming much more expensive for Indonesia. Declining rupiah and increasing domestic bond yields are driving inflation, and potentially a liquidity if not solvency problem.
Theoretically, Indonesia could issue more domestic bonds to build foreign currency reserves. Such a proposition confronts already high and increasing costs of borrowing compounded with rupiah now subject to market pricing. Markets aren't fond of rupiah or Indonesian bonds.
Monetary policy solutions by Bank Indonesia look cautious and perhaps dubious by possibly worsening problems. While key interest rate in Indonesia has been raised in response to inflation and in effort to support rupiah, declining growth makes further interest rate increases dangerous to sustaining growth, especially given foreign debt exposure. Last week, Bank Indonesia ordered increases in bank reserves. Indonesia last increased bank reserves in 2010 due to inflation resulting from a hot economy.
Now, Indonesia's economy is cold. But, Indonesian banks must increase their secondary reserves (government bonds and Bank Indonesia certificates) to 4% versus a previous 2.5%. Further, banks must reduce their loan to deposit ratio of 100% to a range of 78% to 92%, depending on risk composition.
Indonesia's Balance Sheet Mismatch of Maturity and Currency
While measures increasing bank reserves look to address inflation and improve bank capital, they are essentially a removal of liquidity in a system that already is demonstrating liquidity risk. Balance sheet mismatching shows two themes that attend emerging market crises: 1) maturity mismatch by using short term lending to fund long term projects; and 2) currency mismatch by using foreign currency denominated loans to fund rupiah generating projects that don't earn foreign exchange.
Indications of mismatches noticed in past experience exist today. Nature of modern banking is to use short term deposits to fund long term loans thereby arbitraging the yield curve. However, Indonesian yield curve can be inclined to flat, hurting banking margins. If Indonesian banks borrow at Indonesian rates, spreads between funds borrowed and lent can be small to flat. Resulting implication is Indonesia's external debt is driven by seeking lower interest funding offshore for domestic loans.
For instance, on August 31, 2012 the spread between Indonesia's 1 year bond versus its 10 year bond was 1.37%. By January 31, 2013 the spread declined to .48%. Spread rose to 1.36% in April but is back in decline showing a current spread of .98%.
Bank Indonesia reports external debt by distinguishing short term and long term debt. Short term is less than one year, while long term debt is greater than one year. According to Bank Indonesia, most external debt is attributed to private sources and is at least one year or more and accordingly characterized as long term. Indonesian loan funding at one year developed country rates against the Indonesian 10 year rate allows Indonesia's banking system and lenders to escape the Indonesian flat yield curve. But, foreign currency risk gets magnified. Then comes a re-weighting of risk for banking assets and reductions in capital asset adequacy ratios for Indonesian banks when global economic weakness shows.
Still, short term external debt held by private sector is at $36.26B according to Bank Indonesia and long term debt at $95.28B. Showing is 38% of Indonesia's external debt is less than one year, versus majority of Indonesia's capital projects of at least 10 years.
Given foreign currency depletion on balance of payment reports, Indonesia has not garnered sufficient industry to raise foreign currencies against loss of domestic currency due to excessive imports. Without creating commerce that accumulates foreign currency, Indonesia's funding of its growth looks very vulnerable to currency risk, maturity risk in down cycles and a longer term condition. A condition of financing growth still reliant on external sources.
Emerging market hardship may be expressing a larger influence on global market dynamics than generally reported. Where we see preferred stocks taking a nose dive against common stocks, interest rates continuing to increase and, of course, emerging market currency declines; we also see global equity markets high, but finding more headwinds to push higher.
May, 2013 time frame points to a generally recognized "shift" attributed to comments of Federal Reserve tapering of QE. Other dynamics also appear to be at work, pointing to issues outside of Europe.
South East Asia holds interesting events. Point of interest is Indonesia. It boasts the largest economy in South East Asia at $878B USD GDP in 2012, and eclipses a combined Thailand and Singapore GDP of just under $700B USD. Indonesia's GDP growth rate has been stellar with an annual growth rate of 6.5% coming out of global recession and extending through late 2011. 2012 saw policy propositions that looked protectionist and such appearances frosted investment. GDP has been in decline for last four quarters putting in a Q2 2013 growth rate of 5.81% versus a Q1 rate of 6.03%.
We have witnessed a 70 basis point decline in Indonesian GDP, which previously enjoyed exponential growth. While GDP declines, foreign currency debt, or external debt, have increased. Data shows external debt challenges GDP at $251B USD. External funding of high emerging market growth is not only routine, but contains its own boom and bust cycles.
Indonesia's External Debt, Declining Currency And Rising Bond Yields
External debt is composed of obligations denominated in foreign currency. Resultantly, Indonesia needs reserves of foreign currency to service its external debt. Two problems are developing which raise concerns. First, Indonesia's non-convertible currency, the rupiah, is in depreciation declining 7% this year to lows last observed in 2009, amid the financial crises. Second is an exhausting of Indonesia's foreign currency reserves. Now at $92.7B USD, these reserves have dramatically declined and are also approaching lows witnessed during the financial crises. Reserve declines have followed Bank Indonesia's, Indonesia's central bank, efforts to support rupiah. Now, Bank Indonesia has essentially no choice but to allow market determination of rupiah value.
Feeding problems is a declining GDP amid a July inflation rate of 8.61%, highest rate in four years. Suggestion is that inflation isn't demand driven, or the product of a fast moving economy. Rather, inflation appears to be arising from rupiah weakness. For example, exports are down 4.5% y/y for 15 months of consecutive decline. Retail sales started trending down mid 2012 reaching a y/y low of 8% first part of 2013. While June numbers show a 14.8% growth rate, inflation may drive the number, especially in view of fuel price spikes due to elimination of a fuel subsidy.
Attending inflation is a rise of Indonesia's 10 year government bond yields. Now at 8.13%, Indonesian yields have increased 264 basis points since March 31, 2013 when yields were 5.49%. Contrast this with Thailand's 10 year which is now at 3.99% moving from a March 31 3.42% to increase 57 basis points. Singapore, now at 2.48% rose to this level starting from a March 31 1.367% level to see a rise of 111 basis points.
Just as Indonesian bonds have exceeded peer group bonds in rising yields, they have also exceeded peers in the rate of their widening spread against Bunds and Treasuries. Indicated is an obvious and dramatic increase in Indonesian risk premiums, amid a slowing Indonesian economy.
Indonesia's Balance of Payments Deficit Reveals Macroeconomic Concern
Most troubling for Indonesia is their global balance of payments, pattern of increasing external debt, and abysmally low foreign exchange reserves. For balance of payments, Q1 2013 saw a current account deficit---meaning more imports and therefore domestic expenditure as opposed to income---of -$5.27B. Capital/financial account---which is money invested in Indonesia and therefore income---also saw a deficit of -$1.37B. This resulted in Indonesia using more of its foreign exchange reserves to finance not only a current account deficit, but also a capital/financial account deficit. Consequence was a drain in foreign exchange reserves of $6.62B, yielding the $92.7B in reserves. Down from a 2012 average of just below $115B.
Q2 2013 data released August 16 showed a dramatic current account deficit increase to -$9.85B. Capital/financial account actually showed a surge in foreign investment, but not enough to finance current account deficit. Capital/financial account showed a positive $8.196B. Still foreign exchange reserves made up the difference by declining another $2.477B.
Further rupiah depreciation resulted given balance of payment news with spot prices being at a 2.5% premium against the 1 month non-deliverable rupiah forward contract (NDF) at 10.636/USD and spot at 10.373. Last week, Indonesia's 10 year bond yield increased over 60 basis points.
Indonesian Steps To Solve A Looming Currency/Economic Dilemma
Trouble arises from Indonesia's foreign debt exposure and its cost against a declining rupiah, compounded by declining foreign exchange reserves. Now, accumulation of foreign exchange reserves is becoming much more expensive for Indonesia. Declining rupiah and increasing domestic bond yields are driving inflation, and potentially a liquidity if not solvency problem.
Theoretically, Indonesia could issue more domestic bonds to build foreign currency reserves. Such a proposition confronts already high and increasing costs of borrowing compounded with rupiah now subject to market pricing. Markets aren't fond of rupiah or Indonesian bonds.
Monetary policy solutions by Bank Indonesia look cautious and perhaps dubious by possibly worsening problems. While key interest rate in Indonesia has been raised in response to inflation and in effort to support rupiah, declining growth makes further interest rate increases dangerous to sustaining growth, especially given foreign debt exposure. Last week, Bank Indonesia ordered increases in bank reserves. Indonesia last increased bank reserves in 2010 due to inflation resulting from a hot economy.
Now, Indonesia's economy is cold. But, Indonesian banks must increase their secondary reserves (government bonds and Bank Indonesia certificates) to 4% versus a previous 2.5%. Further, banks must reduce their loan to deposit ratio of 100% to a range of 78% to 92%, depending on risk composition.
Indonesia's Balance Sheet Mismatch of Maturity and Currency
While measures increasing bank reserves look to address inflation and improve bank capital, they are essentially a removal of liquidity in a system that already is demonstrating liquidity risk. Balance sheet mismatching shows two themes that attend emerging market crises: 1) maturity mismatch by using short term lending to fund long term projects; and 2) currency mismatch by using foreign currency denominated loans to fund rupiah generating projects that don't earn foreign exchange.
Indications of mismatches noticed in past experience exist today. Nature of modern banking is to use short term deposits to fund long term loans thereby arbitraging the yield curve. However, Indonesian yield curve can be inclined to flat, hurting banking margins. If Indonesian banks borrow at Indonesian rates, spreads between funds borrowed and lent can be small to flat. Resulting implication is Indonesia's external debt is driven by seeking lower interest funding offshore for domestic loans.
For instance, on August 31, 2012 the spread between Indonesia's 1 year bond versus its 10 year bond was 1.37%. By January 31, 2013 the spread declined to .48%. Spread rose to 1.36% in April but is back in decline showing a current spread of .98%.
Bank Indonesia reports external debt by distinguishing short term and long term debt. Short term is less than one year, while long term debt is greater than one year. According to Bank Indonesia, most external debt is attributed to private sources and is at least one year or more and accordingly characterized as long term. Indonesian loan funding at one year developed country rates against the Indonesian 10 year rate allows Indonesia's banking system and lenders to escape the Indonesian flat yield curve. But, foreign currency risk gets magnified. Then comes a re-weighting of risk for banking assets and reductions in capital asset adequacy ratios for Indonesian banks when global economic weakness shows.
Still, short term external debt held by private sector is at $36.26B according to Bank Indonesia and long term debt at $95.28B. Showing is 38% of Indonesia's external debt is less than one year, versus majority of Indonesia's capital projects of at least 10 years.
Given foreign currency depletion on balance of payment reports, Indonesia has not garnered sufficient industry to raise foreign currencies against loss of domestic currency due to excessive imports. Without creating commerce that accumulates foreign currency, Indonesia's funding of its growth looks very vulnerable to currency risk, maturity risk in down cycles and a longer term condition. A condition of financing growth still reliant on external sources.
Monday, August 12, 2013
Emerging Market Balance of Payments, Current Account Deficit, And Banks
One can look at drivers of growth and earnings over last couple of years. Where developed country huge GDP's have gone almost up, or flat and into decline, emerging markets have been the investment vehicles for U.S. dollars. These dollars have now come to end.
Yet, we see drivers of money finally finding a last death in a U.S. stock market. Like a Frankenstein monster, this stock market refuses to see comparative pricing levels. Bubbles....who really cares at this point. Entire proposition of a cycle exhausting comes from real time data.
China, a major global driver, is obviously running by a different tune, a different set of monetary policy. China, by the way, has been hesitant in bringing new accommodative monetary measures. They seem very internally focused amid growth rates that now disappoint, if not show "new sprouts of growth". Investors really have to be more astute and see direction, instead of sprouts.
Major emerging markets are now in current account and cash flow deficit, together with falling currency values. This means these falling markets have higher foreign debt exposure, versus their currency values when these foreign loans were garnered to finance past growth. Simple proposition now days is these emerging markets have an overhang of debt, owed in foreign dollars, when their native dollars pay back less of foreign debt every day.
Add to this increases in current account deficits and developing capital/financial account deficits in emerging markets, and these countries are reliant on cashed in U.S dollars. That is, these markets have declining net income, but growing reserve currency values. Sure, these reserve currencies, brought by foreign investments cashing in, can help support their native currency. But, after substantial declines in native currency, these markets will use all of their foreign currency reserves to maintain a balance against foreign debt. One must realize, foreign currency denominated debt in these countries is how financing of investment occurred.
Once foreign currency reserves are exhausted to support foreign debt amid declining native economies and currency values, a currency crises arises. As always, given time, an emerging country shows its interconnection in a system of global finance. 80's Latin America, 90's was Asia. Great Recession?
Developed country banks generally are divergent with European banks, which look weak as cats, where U.S. banks look strong. Europe in general remains in recession, U.S. only avoids recession due to a strategic cash lockup in U.S banks.
Markets currently see money only from a banking perspective....huge earnings growth from financial sector recently. Biggest investment of last four years, being emerging markets, is now convincingly turning against itself.
Major question right now is why oil is high, equating to levels of when emerging markets had positive balance of payment numbers. Emerging markets are now cash flow negative, and oil is currently in speculation....on the wrong side.
With Brent and WTI almost at parity, and no major plays on global delivery, it's unfounded speculation hanging over from reversing a couple pipelines into the Gulf of Mexico.
Yet, we see drivers of money finally finding a last death in a U.S. stock market. Like a Frankenstein monster, this stock market refuses to see comparative pricing levels. Bubbles....who really cares at this point. Entire proposition of a cycle exhausting comes from real time data.
China, a major global driver, is obviously running by a different tune, a different set of monetary policy. China, by the way, has been hesitant in bringing new accommodative monetary measures. They seem very internally focused amid growth rates that now disappoint, if not show "new sprouts of growth". Investors really have to be more astute and see direction, instead of sprouts.
Major emerging markets are now in current account and cash flow deficit, together with falling currency values. This means these falling markets have higher foreign debt exposure, versus their currency values when these foreign loans were garnered to finance past growth. Simple proposition now days is these emerging markets have an overhang of debt, owed in foreign dollars, when their native dollars pay back less of foreign debt every day.
Add to this increases in current account deficits and developing capital/financial account deficits in emerging markets, and these countries are reliant on cashed in U.S dollars. That is, these markets have declining net income, but growing reserve currency values. Sure, these reserve currencies, brought by foreign investments cashing in, can help support their native currency. But, after substantial declines in native currency, these markets will use all of their foreign currency reserves to maintain a balance against foreign debt. One must realize, foreign currency denominated debt in these countries is how financing of investment occurred.
Once foreign currency reserves are exhausted to support foreign debt amid declining native economies and currency values, a currency crises arises. As always, given time, an emerging country shows its interconnection in a system of global finance. 80's Latin America, 90's was Asia. Great Recession?
Developed country banks generally are divergent with European banks, which look weak as cats, where U.S. banks look strong. Europe in general remains in recession, U.S. only avoids recession due to a strategic cash lockup in U.S banks.
Markets currently see money only from a banking perspective....huge earnings growth from financial sector recently. Biggest investment of last four years, being emerging markets, is now convincingly turning against itself.
Major question right now is why oil is high, equating to levels of when emerging markets had positive balance of payment numbers. Emerging markets are now cash flow negative, and oil is currently in speculation....on the wrong side.
With Brent and WTI almost at parity, and no major plays on global delivery, it's unfounded speculation hanging over from reversing a couple pipelines into the Gulf of Mexico.
Sunday, July 21, 2013
Q2 Economic Performance Improved, But Q3 Could See Headwinds
Is The Glass Half Full Or Half Empty
We enter Q2 earnings season in an awkward fashion amid conflicting indications and risks. Second quarter activity saw a boom in interest rates starting in May and only relaxing of late. Associated with this are the record dollars flowing out of bond funds pushing down prices and lifting yields. Then we saw a U.S. dollar gyration spiking down through May, and then spiking up through June. Stocks saw the future of tapered QE in later May and into June, but are making new highs currently in July. Developing country currencies fell against the U.S. dollar while China's economy stepped back.
Some have attributed increasing interest rates to increasing demand driven by growth. Others say interest increases are due to excess liquidity that hasn't spurred demand, but rather increased systemic market risk once the liquidity tap is turned off. It appears both arguments have foundation. But the latter argument has more "real life" support over the other.
Q1 saw lackluster economic performance among indicators. GDP started at a decent 2.4% growth, but inevitably was revised to reflect indicators ending up at 1.8%. For many, this was not surprising given data out of China, Q4 Japan recessionary pressure and of course Europe.
Q2 Started With Weak April Data, Except Housing
April started weaker off of March's minor rally. Dallas Fed Manufacturing Survey, for instance, pulled a positive 7.4 points in March for business activity and a good 9.4 for production. But when April came, the floor fell with business activity at -15.6....real pessimism....and production -.5 points. Construction spending in April fell -1.7% against a March gain of 1.5% with public outlays leading a decline. Retail sales were abysmal and import/export prices showed deflation. April's factory orders data (reflecting March activity) were down -4.8%.
April's other Fed regional indexes also demonstrated disappointment in manufacturing. Of the regional indexes that were positive, they were only hanging on while others remained in contraction. Durable goods orders were all negative and industrial production was teetering to negative.
Only silver lining was the Fed's $40B per month purchases of mortgage backed securities. Contrasting pessimistic data was April's existing home sales, up 10.3% in March and 9.7% in April year over year. Median time for an existing home to stay on the market for sale fell to 42 days from 62 days in March. Banks were obviously producing mortgages to feed the Fed. Pricing advanced 6.2% in March and another 4.8% in April with annual pricing up 11%.
New home sales witnessed similar results with sales up 2.3% in April despite constrained demand. Demand against supply saw new home prices rise 14.9% annually in April. Appears that while mortgage lending was occurring, construction loans to builders remained tight.
Consumer sentiment also elevated in April probably due to more friends of friends buying houses and employment improving. Employment situation report of April exceeded expectations adding 165,000 jobs in April. Market expected 153, 000 jobs to be added while March saw only 138,000 new jobs. Also a factor is the dangerously euphoric equities market. IRA's and 401(k)'s increase giving a feeling of improved retirement security. But euphoric parties come to an end.
Despite other economic indicators, homes and consumer sentiment advanced in April. This dynamic carried through to May and is now seen in June data being revealed today in July. Further, the positives in homes and consumer sentiment are penetrating other indicators positively. Domestic demand has picked up.
May's Housing Data Continued, Other Indicators Improved and Interest Rates Shot Up
Firstly, May saw interest rates start an aggressive increase with spreads between high yield and investment grade widening. U.S. dollar strolled up to the 84.40 level by mid May only to crash into 80.60 by mid June. May 22 saw Fed FOMC minutes that shook equities down, only for deep drops come Bernanke's post FOMC press conference of June 19. That event dramatically dropped equities. All the while, money flowed out of developing currencies, and therefore markets. There interest rates are being cut, while U.S. interest rates increase.
For economic indicators, May saw productivity and cost indicators look better, factory orders (reflecting April) gained 1% against a previous -4.7% loss. Retail sales showed a 4.3% gain year over year with auto sales being important as always with a gain of 1.8% for a second consecutive monthly advance. Industrial production held its own at 0, avoiding more declines. Durable goods orders grew. Interestingly, essentially all Fed regional manufacturing indexes picked up considerably, save for Kansas City, perhaps due to some devastating tornadoes.
Employment advanced with an additional 175,00 jobs versus market expectations of only adding 167,000. But a tenaciously high unemployment rate didn't relent and stayed at 7.6%.
Real source of raising all ships in May is, of course, homes. Existing home sales advanced 12.9% year over year and beat market expectations by 180,000 ending up at 5.18M versus April's 4.97M. This amounted to a highest sales rate since 2009's home purchase stimulus credit. Prices went up 15.4% year over year, perhaps too much, though supply showed a respectable increase over April.
New home sales are similar. Sales of new homes grew in May to 476,000 versus prior month of 466,000 and market expectations of growth at only 460,000. New home supply increased by builders apparently finding additional funding ability to better balance supply with supply going to 4.1 months in May versus 4.0 months in April. Despite a moderate fall of 3.2% in new homes prices in May, perhaps due to elevated pricing, year over year pricing showed a 10.3% gain against April's 14.9%.
Consumer sentiment advanced going from April of 76.4 to May's 83.7, with the market expecting 78.0. Suggestion is increasing home values, people buying homes again and perhaps a more stable jobs market.
Ending Q2, Starting Q3 Data Looks Strong, But Caution Due to Mortgage Rates And Weakened Forward Looking Housing Data
Entering June involved all the dynamics mentioned above, but bolstered by Fed members convincing markets of dovishness. This occurred essentially by June 25, when equities started a climb, after getting spooked on June 19 by Bernanke's remarks . The U.S. dollar started its climb off its bottom on June 19. Meanwhile, between June 17 and 25, the 10 year treasury yield spiked up. Indicated is division in markets and growing weight on dollar and interest rate movements versus a progressively unconvincing rise in equities.
Current economic indicators show optimistic propositions. Employment reveals a gain of 195,000 jobs for the most recent report, demonstrating a three month real advance in numbers. Industrial production is up, along with capacity utilization and manufacturing. Fed regional manufacturing indexes look very good so far with Empire State at a positive 9.46 points and new orders positive though softer than last month at 3.77. Philadelphia Fed Survey is at a strong 19.8 points with new orders a convincing 10.2 positive points.
Threat to what appears to be leading this economic advance is a fall for June, reported in July, of housing starts and permits. Housing starts were an adjusted 928M in May with June coming in lower at 836M, when the market wanted to see an advance of 951M. June's starts to home construction is down 9.9% month over month versus an increase of 8.9% in May. Still, housing starts stay vigorous at a 10.4% increase year over year. Permits for home building also disappointed on July 17th with the report showing June's numbers at 911M versus May's 985M and a market expectation of a high 990M.
Q2's economic rise was Fed money eventually trickling down to real home purchases. All of this was accomplished by banks ensuring strict Basil III reserves while also loaning on mortgages. Consumers became more confident due to rising home values and perhaps stock invested accounts. This dynamic punched through into other indicators of U.S. domestic demand. Result is currently growing strength in domestic demand. This occurs while global demand is weak.
While domestic demand appears to be gaining strength, cause for demand essentially originates out of housing. Unconventional Fed intervention explains advances in housing markets. Increases in demand outside of housing are now only starting and, therefore, do not explain increasing interest rates. A fragile economic environment that hasn't really found broad based support despite Fed intervention probably more so explains rising rates.
Weakness to watch is a fall in housing starts and permits. Caution comes from increasing mortgage rates, bank risk aversion and poor global economic performance. If Q2 trends continue into Q3, hopefully some stable economic growth will take hold.
We enter Q2 earnings season in an awkward fashion amid conflicting indications and risks. Second quarter activity saw a boom in interest rates starting in May and only relaxing of late. Associated with this are the record dollars flowing out of bond funds pushing down prices and lifting yields. Then we saw a U.S. dollar gyration spiking down through May, and then spiking up through June. Stocks saw the future of tapered QE in later May and into June, but are making new highs currently in July. Developing country currencies fell against the U.S. dollar while China's economy stepped back.
Some have attributed increasing interest rates to increasing demand driven by growth. Others say interest increases are due to excess liquidity that hasn't spurred demand, but rather increased systemic market risk once the liquidity tap is turned off. It appears both arguments have foundation. But the latter argument has more "real life" support over the other.
Q1 saw lackluster economic performance among indicators. GDP started at a decent 2.4% growth, but inevitably was revised to reflect indicators ending up at 1.8%. For many, this was not surprising given data out of China, Q4 Japan recessionary pressure and of course Europe.
Q2 Started With Weak April Data, Except Housing
April started weaker off of March's minor rally. Dallas Fed Manufacturing Survey, for instance, pulled a positive 7.4 points in March for business activity and a good 9.4 for production. But when April came, the floor fell with business activity at -15.6....real pessimism....and production -.5 points. Construction spending in April fell -1.7% against a March gain of 1.5% with public outlays leading a decline. Retail sales were abysmal and import/export prices showed deflation. April's factory orders data (reflecting March activity) were down -4.8%.
April's other Fed regional indexes also demonstrated disappointment in manufacturing. Of the regional indexes that were positive, they were only hanging on while others remained in contraction. Durable goods orders were all negative and industrial production was teetering to negative.
Only silver lining was the Fed's $40B per month purchases of mortgage backed securities. Contrasting pessimistic data was April's existing home sales, up 10.3% in March and 9.7% in April year over year. Median time for an existing home to stay on the market for sale fell to 42 days from 62 days in March. Banks were obviously producing mortgages to feed the Fed. Pricing advanced 6.2% in March and another 4.8% in April with annual pricing up 11%.
New home sales witnessed similar results with sales up 2.3% in April despite constrained demand. Demand against supply saw new home prices rise 14.9% annually in April. Appears that while mortgage lending was occurring, construction loans to builders remained tight.
Consumer sentiment also elevated in April probably due to more friends of friends buying houses and employment improving. Employment situation report of April exceeded expectations adding 165,000 jobs in April. Market expected 153, 000 jobs to be added while March saw only 138,000 new jobs. Also a factor is the dangerously euphoric equities market. IRA's and 401(k)'s increase giving a feeling of improved retirement security. But euphoric parties come to an end.
Despite other economic indicators, homes and consumer sentiment advanced in April. This dynamic carried through to May and is now seen in June data being revealed today in July. Further, the positives in homes and consumer sentiment are penetrating other indicators positively. Domestic demand has picked up.
May's Housing Data Continued, Other Indicators Improved and Interest Rates Shot Up
Firstly, May saw interest rates start an aggressive increase with spreads between high yield and investment grade widening. U.S. dollar strolled up to the 84.40 level by mid May only to crash into 80.60 by mid June. May 22 saw Fed FOMC minutes that shook equities down, only for deep drops come Bernanke's post FOMC press conference of June 19. That event dramatically dropped equities. All the while, money flowed out of developing currencies, and therefore markets. There interest rates are being cut, while U.S. interest rates increase.
For economic indicators, May saw productivity and cost indicators look better, factory orders (reflecting April) gained 1% against a previous -4.7% loss. Retail sales showed a 4.3% gain year over year with auto sales being important as always with a gain of 1.8% for a second consecutive monthly advance. Industrial production held its own at 0, avoiding more declines. Durable goods orders grew. Interestingly, essentially all Fed regional manufacturing indexes picked up considerably, save for Kansas City, perhaps due to some devastating tornadoes.
Employment advanced with an additional 175,00 jobs versus market expectations of only adding 167,000. But a tenaciously high unemployment rate didn't relent and stayed at 7.6%.
Real source of raising all ships in May is, of course, homes. Existing home sales advanced 12.9% year over year and beat market expectations by 180,000 ending up at 5.18M versus April's 4.97M. This amounted to a highest sales rate since 2009's home purchase stimulus credit. Prices went up 15.4% year over year, perhaps too much, though supply showed a respectable increase over April.
New home sales are similar. Sales of new homes grew in May to 476,000 versus prior month of 466,000 and market expectations of growth at only 460,000. New home supply increased by builders apparently finding additional funding ability to better balance supply with supply going to 4.1 months in May versus 4.0 months in April. Despite a moderate fall of 3.2% in new homes prices in May, perhaps due to elevated pricing, year over year pricing showed a 10.3% gain against April's 14.9%.
Consumer sentiment advanced going from April of 76.4 to May's 83.7, with the market expecting 78.0. Suggestion is increasing home values, people buying homes again and perhaps a more stable jobs market.
Ending Q2, Starting Q3 Data Looks Strong, But Caution Due to Mortgage Rates And Weakened Forward Looking Housing Data
Entering June involved all the dynamics mentioned above, but bolstered by Fed members convincing markets of dovishness. This occurred essentially by June 25, when equities started a climb, after getting spooked on June 19 by Bernanke's remarks . The U.S. dollar started its climb off its bottom on June 19. Meanwhile, between June 17 and 25, the 10 year treasury yield spiked up. Indicated is division in markets and growing weight on dollar and interest rate movements versus a progressively unconvincing rise in equities.
Current economic indicators show optimistic propositions. Employment reveals a gain of 195,000 jobs for the most recent report, demonstrating a three month real advance in numbers. Industrial production is up, along with capacity utilization and manufacturing. Fed regional manufacturing indexes look very good so far with Empire State at a positive 9.46 points and new orders positive though softer than last month at 3.77. Philadelphia Fed Survey is at a strong 19.8 points with new orders a convincing 10.2 positive points.
Threat to what appears to be leading this economic advance is a fall for June, reported in July, of housing starts and permits. Housing starts were an adjusted 928M in May with June coming in lower at 836M, when the market wanted to see an advance of 951M. June's starts to home construction is down 9.9% month over month versus an increase of 8.9% in May. Still, housing starts stay vigorous at a 10.4% increase year over year. Permits for home building also disappointed on July 17th with the report showing June's numbers at 911M versus May's 985M and a market expectation of a high 990M.
Q2's economic rise was Fed money eventually trickling down to real home purchases. All of this was accomplished by banks ensuring strict Basil III reserves while also loaning on mortgages. Consumers became more confident due to rising home values and perhaps stock invested accounts. This dynamic punched through into other indicators of U.S. domestic demand. Result is currently growing strength in domestic demand. This occurs while global demand is weak.
While domestic demand appears to be gaining strength, cause for demand essentially originates out of housing. Unconventional Fed intervention explains advances in housing markets. Increases in demand outside of housing are now only starting and, therefore, do not explain increasing interest rates. A fragile economic environment that hasn't really found broad based support despite Fed intervention probably more so explains rising rates.
Weakness to watch is a fall in housing starts and permits. Caution comes from increasing mortgage rates, bank risk aversion and poor global economic performance. If Q2 trends continue into Q3, hopefully some stable economic growth will take hold.
Saturday, May 11, 2013
J.P. Morgan Shareholder Vote, Remembering Whale Trades
Given the stockholder proxy now confronting voters, it seems appropriate to recall circumstances for JPM. I wrote this piece at the time, but delayed its publication on this space. Banks have been kicked around like a can on a common street. Still, banks supply funding for basic activities, to more complex endeavors. I've always enjoyed Jamie Dimon's moxie. In the U.S., we have a Wall Street and a Main Street. The two meet often. When they meet, you want a banker on your side with a back-bone...even if it's institutionalized.
Once, J.P. Morgan Senate Hearings Explored a London Whale Tale
U.S. Senate hearing today revealed considerable information into the J.P. Morgan Chase "Whale Trade". A fundamental discovery is that of the $6B loss, much of it consisted of excess deposits at the bank that weren't being used for loans to businesses and individuals. Due to deposit money being used, FDIC insured funds were put at risk.
Information out of the Senate hearing today makes the Whale Trade look like a hedge that became its own position. Appears that this hedge was losing so much money, hedging the hedge became a net loss.
Trouble appears to come from the hedge position being a synthetic credit derivative securing a core position. Most derivatives tend to make market movements at faster rates than the security from which they are born. Simple stock options are a derivative. A synthetic is essentially a derivative on a derivative among counterparties to the underlying or core security.
Once a gain is realized in a derivative of an underlying security, the gain is typically in multiples of the underlying's move. Same applies for losses. Derivatives can typically be characterized as put or call positions against an underlying position. A synthetic position is more like a put or call on an underlying derivative of an underlying security.
Changes In Value At Risk Reduced Real Risk, By Appearances
Real problem for JPM is their Value at Risk model (VaR) and how the limits of this model were exceeded during the Whale Trade. Once exceeded, JPM came up with a new VaR model that reduced the "appearance" of risk exposure by 50%.
This move made their positions on their prodigal synthetic derivative hedge, that refused to come home with its losses, look smaller in terms of overall firm risk. Reality now seems that this model wasn't "sufficiently" back tested against the old VaR model. Without sufficient back testing, the new model could look arbitrary to regulators. Perhaps, hind sight is 20/20.
Adding to issues is an apparently contemporaneous development wherein daily profit & loss statements from JPM to their chief regulator, Office of the Comptroller of the Currency (OCC), were suspended. Despite reports having been routinely delivered previously, these reports were suspended for two weeks at what I'm sure is a peripety of this drama.
Suspending daily profit/loss statements to OCC also appears to include major confusion over the extent of losses. Not only was JPM's VaR changed, but representations of the loss made to OCC put the amount at $550M in Q1, 2012. However, internal memoranda indicated the loss to be around $719M.
What Happened To Risk Management, And How To Capture It Too Late
JPM is a seasoned firm, defined by Securities Exchange Commission rules. Such an incongruity in numbers indicates a break in reporting structures. When reports start to deviate, there is a level of "free lancing", or rogue activity occurring.....somewhere. Corporate structures must then isolate the problem and capture causation. In so doing, corporate must first understand the problem's origin, its nature, then quantify or value the problem, and then control the problem.
Evidently pursuing such a process, it looks like JPM isolated the problem, perhaps apparent in their change in VaR models. This only allowed the problem to grow. By decreasing the value at risk, the huge Whale Trade became smaller. With it being smaller, more money could be committed to correct the hedge, growing it into a frighteningly high risk synthetic derivative core position.
JPM witness statements seem to confirm such a proposition. By April, the firm was indicating an internal loss of $1.2B, despite a previous OCC report of $580M. JPM's chief of CIO at the time stated that she understood OCC was receiving mark to market reports with daily profit and loss statements. All the while, she didn't know of suspending reports for two weeks to OCC.
Passing the buck...At some point, less senior personnel have to know what is going on. If not, more senior personnel will get an "all is well" indication. Next obvious question is the pressure of performance.
Saturday, February 23, 2013
G-20 Greenlight for Currency Depreciation, A Redlight for U.S. Inflation, and Need for QE Decision in March
G-20'S BALANCING ACT BETWEEN PAST AND PRESENT
Last week's G-20 meeting introduced a
new way of acceptably characterizing currency values. Essential
message was currency movements resulting from controlling
inflation/deflation or otherwise executing monetary policy
mandates is acceptable. Not acceptable is currency manipulation
motivated by seeking competitive advantage to only increase
exports.
Such a position statement found balance
between past G-7 member activities that resulted in currency
devaluations such as U.S. and current devaluations such as Japan and Britain. With
this balance also comes the awkward matter of China's almost widening
range in floating its currency against the dollar. Then of course, we
have a Swiss Frank that put a ceiling against the euro.
Past currency appreciations against other currency depreciation sets the stage for what we now see. 2010 through early 2011 saw a remarkable period for currency and equity pricing. May through June in 2010 saw the U.S. dollar start a nose dive in devaluation, from a DXY (dollar against a basket of currencies) value of some 89.00 down to around 73.00 by May 2011. A very significant period of depreciation, for the global reserve currency.
A STAGE FOR TODAY'S CURRENCY DEPRECIATION: PRIOR OTHER COUNTRY APPRECIATION
A STAGE FOR TODAY'S CURRENCY DEPRECIATION: PRIOR OTHER COUNTRY APPRECIATION
Accounting for U.S. dollar depreciation was primarily exceptional monetary policy easing for a second time by the Fed. This QE2 round was well anticipated by markets demonstrated through optimal positioning prior to announcements, with such positioning being signaled by currencies. Namely, where U.S. QE 1 stopped in March 2010 and equities went volatile, U.S. dollar started a considerable appreciation but went into a depreciation about three months before S&P's escalator ride up starting just prior to September 2010. In 2010, Fed spoke of QE2 at their Jackson Hole meeting, explaining the premature market movement.
During the same period, Japanese yen began an export hindering appreciation. This appreciation actually started in 2008 reflecting the yen as a safe haven asset against U.S. near financial collapse. Most noted is the May through June 2010 period. During this period, while a U.S. dollar devalued along with concurrent U.S. quantitative easing, a yen steeply appreciated and sustained its appreciated value until recently. Currently, the yen breaks support routinely, finding lows.
Same dynamic can be seen on charts for British pound. But, while the pound appreciated considerably in 2010 and into 2011, it has from 2011 until recently traded in a range. Now, pound has broke very long term support of around 1.5401 to find itself currently at 1.5230. A move of depreciation perhaps.
Australian dollar is getting impatient, along with its economy for a break down of its currency. But this is also a currency that experienced considerable appreciation in the same time frames as previously described currencies. Still, it hasn't depreciated like a yen or pound. New Zealand fits this role. In fact, just last week, New Zealand's central bank suggested its currency to be over valued.
Understanding all currencies mentioned above provides a basis for G-20 propositions of valuing currencies. That is, rounds of U.S. QE and rounds of other country QE. But what country has the strongest currency influence with commodities, interest rates and risk appetite. These combinations provide major explanations for other currencies now devaluing.
Due to U.S. dollars being the reserve currency and commodities priced in U.S. dollars, should the U.S. dollar dive, commodity prices increase in U.S. dollar terms.
OTHER COUNTRY DILEMMA: COMPARATIVELY CHEAP BUT RISING COMMODITY PRICES AMID MILD TO NO GDP GROWTH, OR FALLING EXPORTS
Reason for sustained to rising commodity prices against a falling dollar is a commodity will remain in demand in a global market against a falling U.S. dollar. Commodity demand results from two major influences: 1) fundamental economic demand coming from consumers and businesses needing the product, especially when dollar denominated commodity imports for countries become comparatively cheaper due to currency translation; and 2) risk appetite for buying up commodity futures, instead of holding the U.S. dollar.
This explains comparative values, or a divergence, against U.S. dollar values and global commodity values. When foreign currencies appreciate against U.S. dollars, their imports of U.S. dollar denominated commodities are cheaper. On the other hand, their exports more expensive.
OTHER COUNTRY DILEMMA: COMPARATIVELY CHEAP BUT RISING COMMODITY PRICES AMID MILD TO NO GDP GROWTH, OR FALLING EXPORTS
Reason for sustained to rising commodity prices against a falling dollar is a commodity will remain in demand in a global market against a falling U.S. dollar. Commodity demand results from two major influences: 1) fundamental economic demand coming from consumers and businesses needing the product, especially when dollar denominated commodity imports for countries become comparatively cheaper due to currency translation; and 2) risk appetite for buying up commodity futures, instead of holding the U.S. dollar.
This explains comparative values, or a divergence, against U.S. dollar values and global commodity values. When foreign currencies appreciate against U.S. dollars, their imports of U.S. dollar denominated commodities are cheaper. On the other hand, their exports more expensive.
For U.S., despite a drop in the U.S. dollar and increases in commodity prices, we didn't see inflationary growth. Appreciation of foreign currencies is perhaps why supply and demand smoothed to prevent U.S. inflation. That is, inventories in commodities didn't increase associated with a global decline in U.S. dollar denominated asset demand. Instead, demand stayed fairly steady until an inflection point was reached in fundamental demand for the commodity. Driven by export declines.
PROPOSITIONS FOR FED DEBATING QE IN MARCH
PROPOSITIONS FOR FED DEBATING QE IN MARCH
That inflection point now appears to be where currency appreciation offsetting increasing commodity prices started to damage other country export potential. That time being second half 2012.
Right now, despite current U.S. QE activity, U.S. dollar isn't declining as with past QE, indicating hesitation for risk. Still, equity and commodity markets are rising consistent with past QE. Raising a warning flag is yen and pound currency depreciation. Yet to be determined is whether a race to the bottom will occur.
Some of the various currency depreciations we see now come from dollar appreciation, despite QE. Balance this with credit spreads wanting to expand, and a consistent 2012 reduction on corporate earnings expectations, and we get what looks today to be a short term pricing conundrum. Perhaps revealed by Fed agenda for its meeting in March
Right now, despite current U.S. QE activity, U.S. dollar isn't declining as with past QE, indicating hesitation for risk. Still, equity and commodity markets are rising consistent with past QE. Raising a warning flag is yen and pound currency depreciation. Yet to be determined is whether a race to the bottom will occur.
Some of the various currency depreciations we see now come from dollar appreciation, despite QE. Balance this with credit spreads wanting to expand, and a consistent 2012 reduction on corporate earnings expectations, and we get what looks today to be a short term pricing conundrum. Perhaps revealed by Fed agenda for its meeting in March
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