Some expansive credit-related thoughts arrive from Alberto Gallo at RBS, for a quiet May Day when Europe’s capitalists take the day off in honour of its workers.
In short, its the safe stuff that may not be safe anymore as/if/when the continent’s economy expands:
The European recovery is under way and buying risky European debt has become a crowded trade. As investors fly back into periphery, high yield and banks, will demand for safe-haven paper remain high? We think it’s now time to focus on the risks for those parts of the market which have so far been considered insulated from the storm. Some of these areas are starting to look like return-free risk to us. We recommend investors concentrate on the niches of the market where there’s still some value (periphery, high yield, financials), but it is equally important to reduce exposure to areas that give little extra yield (<100bp) and face upcoming risks. These fake havens may suffer from a correction over the coming months:
Fake haven number one is the UK, where the central bank owns 30 per cent of government debt (more than any other), the budget deficit is bigger than Italy’s, and a recovery has been built on a housing boom and consumer releveraging while incomes stagnate.
So far so familiar. Rising rates are going to hit borrowers on variable rate mortgages, severely. But note the treatment of the UK housing market in the Europe wide bank stress tests adverse scenario:
The UK will face a steeper decline in house prices of -29.2% vs -21.2% for the EU average. In addition to the EBA one, the Bank of England will implement harsher stress tests with up to -35% decline in house prices.
Much of that is reflected in spreads already, but Alberto singles out one name
Most UK banks still trade at high risk premia vs the rest of the market, which makes us still positive – with the exception of Barclays, which relies on over half of its revenues from corporate & investment banking activities and being less hit by the crisis, has been later in the creation of a bad bank.
But also keep in mind consumer exposed companies, plus anyone with a strong balance sheet and an inclination towards expansion. Companies have been able to raise debt for ages, but executives seem finally prepared to spend it — if the recent pickup in merger activity or the Deloitte survey of finance directors is anything to go by.
Meanwhile, the UK is not the only well regarded Northern European haven with housing issues:
All Scandinavian countries are AAA-rated, and bank spreads are as low as a few basis points in short-dated senior paper. But they have high household debt, at close to 200% of disposable income in Sweden and Norway and close to 300% in Denmark, according to their central banks. Property markets also appear as much as 40% overvalued in Norway and around 22% in Sweden, according to the IMF. Sweden is also now in deflation, and Denmark is close to it.
In the firing line here, debt of SEB, Handelsbanken, Swedbank, Nordea and Danske Bank.
Indeed, Denmark’s banks may have to change the way they are funded. The European Banking Authority proposes to classify Danish covered bonds as level 2 assets, which means a 15 per cent haircut and 40 per cent cap on the proportion of a bank’s liquidity reserves that can be funded this way. As it happens, Denmark has the world’s largest covered bond market on a per capita basis, worth about $550bn, and its banks rely on the market for about 70 per cent of their liquidity needs, according to RBS (who cite Bloomberg).
But, mindful of housing related instability, watch out for macro-prudential measures to cool off housing in Scandinavia:
Scandinavian banks trade as little as a few basis points in z-spread in 2-year, and 30-40bp in 5-year. This offers little upside in our view and does not compensate for the risks of an overheated property market, deflation, high household debt and more potential stringent capital and liquidity rules
There are plenty more reasons to doubt high quality credits will ever remain thus. German blue chips (Bayer, Siemens) are mooted acquirers. Austrian banks are well placed if everything works out fine between the Ukraine and Russia, less so if it doesn’t or if their economies slow down rapidly.
And finally Australia, whose banks are highly regarded borrowers even though the economy is rather exposed to China:
Lower commodities prices and the end of the investment boom are putting pressure on Australia’s public finances. Today the National Commission of Audit recommended sales of postal and rail assets, among other measures, to help save as much as A$70bn a year within a decade. The Reserve Bank of Australia has cut its benchmark rate 225p since 2011 to prop up the non-mining sector, and this has resulted in a housing boom. The IMF has warned about rising house prices,
“… attention should be paid to the risks posed by a prolonged period of rapid price growth, which could give rise to over-optimism about future price increases, leading to overshooting.”
Australian banks have a large exposure to the expensive housing market, with 64% of their loan book consisting of mortgages. However they are priced to perfection with 5y spreads of roughly 66bp. We remain short Australia to hedge China slowdown risk, and recommend switching out of Australian banks which trade tight and into Lloyds, which is more exposed to the ongoing UK recovery
Which is one way of saying that the safest thing to do now, if you do think a recovery is coming, is to take some risk.