Blood Moons, Animal Spirits and Hunting Knives

Investor trepidation towards Europe in today’s markets is understandable.  Regional macro data remain anemic.  Europe continues to produce weak data, Euro-Area economic sentiment saw its worst losing streak in a decade and low interest rates are set to continue throughout the medium term.  Meanwhile, the Fed has raised rates nine times since December 2015, taking the US dollar index with it.  The transatlantic valuation gap is pronounced; the Stoxx Europe 600 trades at an average ~14x 12-month forward earnings vs. S&P 500 which trades at 17x.

There is also a changing of the guard to come over the next several months.  Draghi, who ushered stability into Europe during his 8-year term, leaves the ECB this October followed by Carney, who steps down as Bank of England Governor three months later.  Draghi helped to stabilize Europe during the sovereign debt and global financial crises while Carney will be remembered for navigating the UK through Brexit.  New heads for the European Commission and European Council start this November after Jean-Claude Junker and Donald Tusk steps down later this year.

Despite the turmoil, some positive news has come out this year.  Take the UK for example. Stockpiling helped Q1 GDP growth although this is likely to be a one-off.  Job creation and consumer confidence picked up despite Brexit woes. Unemployment has fallen below 4%, its lowest since the ‘70s, while wages increased 3% YoY outpacing inflation at 2%.  Finally, the UK deficit is at its lowest in 17 years falling from ~10% of GDP to <2% of GDP.  This compares to the US deficit, which has increased from $385BN to $779BN in fiscal 2019 or ~4% of GDP.

Political Update

France:  Marie le Pen’s National Rally (RN) succeeded in May’s European Parliamentary elections winning 24% of France’s votes.  President Macron’s party took 21% of the votes which, given his past challenges, is not a bad outcome.  Recent measures (eg. scaling back pension tax, appeasing yellow jackets) helped to sway voters back to his camp.  Le Pen’s win does however pose a problem for Macron who continues to push for full European integration.  He is currently advocating for de Villeroy to head the ECB when Draghi steps down.

Germany: The SPD/CSU/CDU union is reeling from Andrea Nahles’ resignation from SPD in June following poor results in Parliamentary elections.  Complicating matters, the CDU leadership seems undecided.  Merkel, who is set to formally exit as Chancellor in 2021, was meant to take a backseat to CDU heiress apparent, Annegret Kramp-Karrenbauer (“AKK”), but the handover seems to be in doubt.  AKK has mishandled a few occasions since taking up the role last year.  Amidst the political confusion, a near brush with a recession and the ongoing differences on tariffs, Iran, natural gas pipelines and NATO, Germany’s economic prospects remain negative in the near term.

Greece: Tsipras won another confidence vote in May, bringing his total victories to 5 since taking office. Yes, five.  Tsipras’ painful austerity measures have brought Greece back from the brink of collapse but have also created enemies for him in the process.  Investors in Greece may take solace in the fact that should Tsipras ever falter, the main political party waiting in opposition is a market-friendly Kyriakos Mitsotakis.  Greece still has the highest debt / GDP ratio in the Eurozone (181% in 2018 YE) but the €2.5BN 10yr bond issued in March, Greece’s first 10-year offering in nine years, was priced at a ~4% yield and had an oversubscribed order book of ~€12BN.  Despite coalition problems and uncertain election prospects this October, markets are rewarding Greece for its efforts.   Benchmark ASE is up 29% YTD.

Italy: Deputy PM Salvini’s efforts paid off at the European parliamentary level where his anti-immigration party La Liga won 34% of Italy’s vote.  Coalition partner Five Star Movement performed poorly, losing ~6MM votes leaving Deputy PM di Maio to face a confidence vote at home.  Salvini has taken this opportunity to consolidate leadership over the coalition by pushing for specific demands to be met including tax breaks, increased public works, and stricter immigration laws.  Prime Minister Conte has threatened to step down if the infighting between La Liga and 5 Star continues. The quarreling has done little to help Italy’s economy which slipped into recession in H2 2018 and increased its debt / GDP ratio to 132% last year.

Spain:  Spanish socialists have had a strong H1 in 2019.  Current PM Sanchez and his socialist party PSOE won the April 28th Spanish general elections taking ~33% of the 350 seats but falling short of the majority.  Since then, coalition talks have been underway among PSOE (Centre Left), Podemos (Left) and as of recent, Cuidadanos (Centre Right).  PSOE also won 33% of Spain’s votes in European Parliamentary elections effectively handing Spain and Sanchez the task of pushing Europe’s original socialist agenda forward.  The wins are positive news for Sanchez who still faces a confidence vote in July.

UK:  We referenced a potential Conservative party meltdown or Brexit delay in January. Both have transpired.  Theresa May failed to pass her withdrawal agreement 3 times before finally stepping down in June.  The inability of the UK government to reach an agreement has left the Brexit process in shambles.  Europe has again agreed to extend Brexit deadline to Oct. 31. In the interim, the Conservative party will elect a new PM.  Leading candidates include Boris Johnson, who is in favor of a No Deal Brexit if something hasn’t been agreed by the new deadline, and Jeremy Hunt, who seems more inclined to avoid a No Deal Brexit.

“Trade wars are good and easy to win.”  – Tweet. Donald Trump

Aside from a tumultuous political scene, Europe’s recovery has been sidelined by deflation, a fragile banking sector, Brexit and the “on-again-off-again” trade wars contributing to the global slowdown.  A small sample from last year skirmishes include:

• 08 March: the US announces a 25% tariff on steel and a 10% tariff on aluminum. Australia, Argentina, Brazil and South Korea win exemptions.  Canada and Mexico exempted later May 2019;
• 22 March: US announces tariff on $50BN of Chinese goods citing theft of US Intellectual Property;
• 02 April: Chinese announce 15% – 25% tariff on 128 US products worth $3BN;
• 03 April: the US lists 1,300 Chinese products to tax worth $50BN;
• 04 April: China lists 106 US items worth $50BN of products including soybeans to tax at a 25% tax rate;
• 05 April: Trump announces $100BN in Chinese tariffs;
• 09 May: China cancels all US soybean orders (13MM metric tons);
• 05 June: Mexico retaliates to the March US steel/aluminum tariffs with 15% – 25% tariffs over apples, bourbon, cheese, pork and potatoes worth $3BN worth of US imports. Lifted in May 2019;
• 01 June: US steel and aluminum tariffs come into effect;
• 15 June: 25% tariff on $34BN of Chinese imports come into effect;
• 22 June: EU retaliates with tariffs over 180 products worth $7.5BN including aluminum and agriculture;
• 01 July: Canada responds with tariffs over ~$17BN goods covering ~300 products. Lifted in May 2019.

… you get the picture.  In total, the US has applied tariffs on $250BN of Chinese goods while China has retaliated with tariffs on $110BN of US imports.  The US is proposing tariffs on an additional $325BN more of Chinese imports.

As of June 2019, US/China discussions have stalled while the US/European talks seem to be unraveling.  The EU has not been exempted from the US Steel/Aluminum tariffs and punitive auto tariffs loom in the background.  Auto-related trade accounts for ~10% of total transatlantic trade. More importantly, the United States is the top destination for EU-built cars, accounting for ~30% of total EU exports or ~25% of US car imports by value.  This is an acute problem for Germany; U.S. tariffs could reduce German car exports by about ~€19BN ($21BN), according to a study by the Munich-based Ifo economic research institute.  Daimler AG and Volkswagen shares have suffered as a result.

The European Commission received approval from the European Council to start formal trade negotiations with the US in Jan 2019.  However, there are suggestions that the US is waiting for results from an ongoing WTO trade arbitration decision on unfair EU subsidies to Airbus.  A favorable WTO might sway the US to implement further EU tariffs for compensatory damages. Should the ruling come through, reports suggest new US tariffs would be announced sometime over the 2019 summer and would cover products ranging from wines, cheeses to resinoids and hunting knives. The EU has its own complaint against US subsidies to Boeing currently progressing with the WTO, however, this will not be concluded before 2020.   WTO-sanctioned tariffs for the US while the EU waits for a ruling on Boeing gives the US significant leverage over EU/US trade discussions going into H2 2019.  The US has not been shy about its desire to access EU agricultural market, and if the Airbus ruling goes in its favor, expect to see automobile tariffs come into effect at least until agricultural markets come up for renegotiation.

The Animal Spirits in the Yield Curve

Trade fears are one of the factors pushing market participants into sovereigns dropping their yields further into negative territory. Debt with negative yields increased ~50% in H1 2019 surpassing $10 trillion for the third time in a decade.  In the UK, Brexit has pushed 10-year Gilt yields to their lowest since 2017 flattening the spread between 10YR – 2YR to ~30bps.  Monetary policies appear locked into negative territory as well.  In March, ECB confirmed that negative rates would continue throughout 2019. Switzerland is another country which has employed negative rates but is worth mentioning separately.

In April, Switzerland’s National Bank reaffirmed its commitment to its -0.75% deposit rate cementing its status as the country with the lowest key rate of any major western nation.  Negative rates have been the main tool Chairman Jordan has used to mitigate against investors seeking a “safe-haven” currency since Switzerland ditched its peg to the Euro in 2015.  This has come with counterproductive consequences which have particularly been acute within Switzerland’s housing sector.

Local pension funds and banks in search of yield have allocated heavily into real estate leading to overdevelopment in certain regions. The number of single-family homes and residential investment property developments has doubled since 2005 while vacancy rates are approaching 1990 levels when Switzerland experienced its last real estate crisis.  The over-capacity may become an issue for insurers such as Swiss Re, Axa Winterthur, Zurich and banks such as St. Galler Kantonalbank, Raiffeisen who are active in the sector.

European Banks

Low yields have been a problem for European banks since the global financial crisis.  The ECB’s attempts to move away from a decade of expansionary monetary policy continues to prove challenging.  Instead of raising rates as Draghi had previously insinuated, the ECB reversed course in March by leaving key ECB interest rates unchanged and announcing new stimulus measures to help prop up the Eurozone. The third TLTRO series is set to start in September 2019, one month before Draghi steps down. It will be the ECB’s third go at offering cheap multi-year loans on the regions’ banks in hopes that the institutions will provide credit to the real economy.

Round three of TLTRO offers little prospect of addressing some of the structural issues plaguing the European banking sector.  The new round of stimulus into the economy will undoubtedly place further pressure on sector performance.  ROE for the sector remains low in the 6% – 7% range while the cost of equity hovers somewhere between 8% – 10%.  Low-interest rates are expected to hold until at least mid-2020 particularly while inflation prospects remain below the ECB’s target of “below but close to 2%” (Eurozone 5YR5YR Inflation swap rate is currently at 1.3%).

Both Italy, which arguably poses the biggest systemic threat to the EU and feasibly stands to gain the most from TLTRO-III, and Spain were sidelined by measures the ECB announced in June limiting their ability to access the newly issued cheap funds.  Italy’s banks sit on €1.5 trillion of debt while foreign lenders currently hold ~€425BN of Italian credit.  Banca Carige (€24BN in assets) is one ongoing saga in the growing list of Italian bank bailouts (Banca Popolare di Vicenza, Veneto Banca, Monte dei Paschi di Siena are some of the Italian banks bailed out in recent years).

Add in idiosyncratic mishaps like UK Metro Bank’s accounting error, Santander’s refusal to redeem their 6 ¼ AT1 CoCos, the ongoing Troika Laundromat scandals hitting the Nordic banks (eg. Danske Bank, Swedbank, Nordea), and the overall poor performance of the sector (Stoxx Europe 600 Banks ETF is down ~20% over the last 12 months) and it’s understandable why some might avoid the sector.

These factors make European banking a sector worth focusing on for value or contrarian strategies.  It exhibits many of the characteristics classic distressed investors look for:  A) The sector is currently cheap: The sector trades at ~0.7x P/B or about half of the value at which US banks trade,  B) Risk has come down: 10 YR CDS rates for investment grade financials have mostly declined over the past year (including DB, Mediobanca, Commerzbank, Santander, Societe General, etc. see chart below) C) The sector is unloved: The herd has either vacated the space or is short the sector unconvinced of a potential turnaround.  Additionally, the EU regulatory framework is complex and stifles those who are unwilling or unable to navigate its peculiarities, D) Catalysts to unlock value: The big one here is an interest rate hike which, arguably, does not appear to be on the cards anytime soon.  However, two of the main candidates for ECB’s next presidency have been critical of Draghi’s dovish policies (Weidmann and Knot) while Villeroy and Rehn, both main contenders for the position, have questioned the ECB’s use of negative interest rates and inflation targeting respectively.

Last Blood Moon for a While

People from the ancient Incan civilization believed a blood moon during a total lunar eclipse to be an omen.  January presented the last total lunar eclipse we will see until at least 2021.  Anyone who saw this eclipse witnessed the moon turn an apocalyptic blood red perhaps foreshadowing what to expect in the coming months.  It brought to mind the famous Rothschild axiom, “the time to buy is when there is blood on the streets”.  Some other thoughts as we head into the 2^nd half of 2019.

Alternative investment firms held $2.1 trillion in dry powder as of June 2018, up from $1.8 trillion as of Dec. 31, 2017.  Increasing asset prices and loose lending terms are direct results.  Default rates have remained subdued, no doubt due to the borrower-friendly environment. US levered loans default rates are at a 7 year low of 1%.  Meanwhile, in Europe, the trailing 12-month speculative-grade default rate in Q1 ‘19 was 0.9%.

The IACPM average corporate default outlook index improved substantially Q1 2019; ~50% of credit portfolio managers surveyed expect defaults to rise vs. 73% of portfolio managers when the survey was conducted this past December.  Despite the improvement, IACPM’s 12-month corporate credit default outlook remains negative; it’s fair to say that most PMs are not bullish on economic prospects in the coming months.

The discrepancy in actual defaults and what PMs believe to be the next crisis highlight the difficulties for value and distressed investors.  But aside from the usual suspects (brick and mortar retailers), other interesting themes worth considering:

• Single name CDS are making a comeback – deep fundamental analysis required to pick up interesting stories
• Nordic airlines struggling: Norwegian Air (Norway) grounded 10 Boeing 737 Max aircraft after the Boeing accidents. Wow Air (Iceland), Primera Air (Denmark) have gone under while Scandinavian Airlines is facing strikes. To top it off, the Swedish Krona is the worst currency this year.
• Real Estate Lows: Dublin home prices are falling again as stricter mortgages are limiting consumers’ ability to borrow.  Irish homebuilders such as Cairn Homes Plc and Glenveagh Properties could come under pressure.  Across the Irish sea, London housing prices have sunk to their lowest since 2015 bringing the U.K. property price index to a 7 year low.

Anthony Ugorji
CEO