Calamatta Cuschieri Weekly Commentaries-19 November 2012

Eurozone

During last week’s Eurogroup meeting, no major decision on Greece was reached, with the finance ministers agreeing to give Greece two more years to meet its fiscal targets. However, a final decision on the country’s rescue programme will only be taken when the Troika finalises its review of Greek debt sustainability. Although a preliminary version of the report was available to ministers, showing that Greece may need €32.6bn of additional financing through to 2016, the final version is yet to be issued. On the issue of debt sustainability, the European Commission and the IMF continue to disagree on where Greece’s debt-to-GDP ratio will be by 2020 and whether the current debt target should be relaxed. The eurozone member states favour extending the target for two more years to 2022, while the IMF views 120% by 2020 as an appropriate target. The IMF’s position suggests that without a haircut on official loans to Greece, Greece’s debt will prove unsustainable. This, however, is still not being considered as an option by the Eurozone member states, as politicians are likely to find it very difficult to go back to their parliaments to ask for more money for Greece. Instead, alternative options are likely to be considered, such as a reduction in the interest rate Greece pays on its loans from the eurozone and allowing Greece to issue more T-bills. Against this backdrop, the Eurogroup will hold an extraordinary meeting on 20 November to try to bridge the differences with the Troika and find a solution to Greece’s additional funding needs and debt sustainability issues to this effect, Eurogroup President Jean-Claude Juncker has called the meeting to give a “definite decision” on releasing the next €31.5bn tranche of the loan. Market analysts expect a compromise solution for Greece will eventually be reached, but adverse scenarios cannot be ruled out. With debt sustainability at the core of the IMF continuing to fund Greece, the issue will be to find a solution to the country’s unsustainable debt dynamics amid the disagreements between the IMF and European Commission.

Meanwhile, as had been widely anticipated, Eurozone GDP decreased by 0.1% q-o-q in Q3, after -0.2% q-o-q in Q2 and Q1. While this was in line with expectations, it was a little disappointing given the upside surprise in German and French GDP growth (both +0.2% q-o-q) and the less-than-expected decline in Italian GDP of 0.2% q-o-q. On the other hand, Portuguese GDP slumped by 0.8% q-o-q. To date, not all countries have released GDP data but it is evident that the Eurozone crisis has spread to core Europe; Austria (-0.1% q-o-q) and the Netherlands (-1.1% q-o-q).

The negative impact of austerity measures has continued to drag on consumer spending in Spain and the tightening of bank lending standards should have weighed on investment in both France and Spain. Given the scale of the sovereign crisis, the downturn in the global industrial cycle and a further tightening of financial conditions in Q3 12, the Eurozone has once again officially entered into a recession. The German and French quarterly expansion and the less-than-expected decline in Italian and Spanish GDP were not enough to prevent this. The latest sentiment indicators and industrial orders continue to point to an export-led contraction in GDP in Q4, which is likely to drag down French and German GDP.

The Outright Monetary Transactions are not able to prevent the eurozone crisis adversely affecting France and Germany, and the European Council meeting to discuss the roadmap for future integration, scheduled for 13-14 December, is still some weeks away. The confidence shock will therefore continue to hinder investment and hiring decisions while the austerity measures and new tightening of financial conditions in eurozone in Q3 12 continue to point to a further deterioration.

US

The resolution of US fiscal issues of the coming months will not only have a major impact on dollar spreads but also on euro area spreads in 2013 as analysts expect the extension of the debt ceiling in the next few weeks. This is expected to set a risk-off background, though it will not be a decisive mover. Rather, the nature of the agreement reached is what will determine the outlook for H2. Market talk is that there will be a multi-year agreement on lowering the pace of fiscal expansion in the US, helping stabilise the risk outlook. The alternative, which is no agreement and multiple US downgrades, would likely prove even more risk-off for the euro area peripherals than the impact on riskier US assets.

Meanwhile, earlier on this week, hurricane Sandy drove the number of people seeking unemployment benefits up to a seasonally adjusted 439,000 last week, the highest level in 18 months, as the Labour Department said that weekly applications increased by 78,000 mostly because a large number of applications were filed in states damaged by the storm. The storm has affected the claims data for the past two weeks and may distort reports for another two weeks.

As expected, the corporate bond market’s focus has shifted quickly from the U.S. Presidential election to the fiscal cliff. Credit spreads continue to widen, not so much on significant selling, but rather just a lack of buying as a status quo election likely means a status quo economy which means we are looking at the U.S. economy muddling through a GDP expansion of roughly 2% in 2013. The risk remains if the White House and Congress cannot work together, driving the economy into a “self-inflicted” recession in 2013. Clearly the equity market performance since the election has reflected that concern as well. In addition, to the fiscal cliff issue looming over the markets, Europe is still wrestling with its own issues and according to a recent IMF study, a disorderly break-up of the euro would likely reduce U.S. GDP by at least 2% over a 12-month period.

Forex

The US is out-performing Europe more and more each day. Since the single biggest drivers of movements in developed economy currencies are shifts in relative interest rates, and very few central banks are going to do much with monetary policy other than keep it as accommodative as possible, big moves are unlikely in the first half of 2013. However, of the G3 currencies, the US dollar is now looking by far the most attractive when compared against the euro and the yen heading into 2013. There is a strong risk, given that the prospect of ECB buying can support the Spanish bond market for some time and the ECB and Fed are on hold, that EUR/USD is now range-bound before falling in 2013 H3. Likewise, there is a clear risk that USD/JPY has risen too far, too fast this week but can go further between now and next month’s election.

At the moment, US talk is about the fiscal cliff. The worst fear is that no agreement can be reached to avoid spending cuts being imposed automatically and tax cuts coming to an end. Economic data in the US continues to surprise to the upside, as Q3 GDP data show a gap between US and eurozone annual growth that is wider than at any point since the birth of the euro in 1999. US growth has not mattered much to the dollar or even to financial markets in general. Slow growth accompanied by loose monetary policy by the Fed has been a recipe for asset inflation as excess liquidity goes off in search of yield. The dollar has been in fierce competition with other zero-rate currencies as money flows out and away to more interesting countries.

However, the US economy is not growing fast but the risk of recession is fading. The cliff needs to disappear, the debt ceiling lifted and the uncertainty removed. It is only then that the US economy can get back to the steady restoration of the real estate industry, steady growth of the share of the US in global export markets and steady growth of bank lending that so contrasts the US with Europe.

Corporate Credit

Markets remained two-sided this week as participants continued to absorb the various macro overhangs. Notably, the risks have been emanating not only from Europe, but the US as well with concerns about the “fiscal cliff” and mixed macro data. As has been the case for quite some time, the negatives of a weak growth picture and broader macro overhangs have continued to be offset by positioning. Furthermore, the technical picture is supportive for high-quality credit; investors should watch recent high yield flow trends carefully most notably the reported heavy ETF-related outflows over the past week. Despite that risk, seasonality is on investors’ side as well as we have tended to see strong performance from risky assets into year-end, with December typically being a strong performance month, hence a substantial macro or fundamental catalyst would be required to see a meaningful sell-off in the near term.

This week saw the effective end of the European Q3 earnings season, and the re-opening of primary markets. While issuance has lagged the brisk activity seen in early September, volumes have risen; nonfinancial issuance picked up following several quieter weeks during the earnings period. Deals have been heavily over-subscribed and generally priced towards the tighter end of guidance, indicative that investor appetite remains strong. This week, Bank of Ireland priced the first non-guaranteed, public debt market deal from an Irish bank in three years.

Earnings releases for the week was somewhat mixed, with underlying growth generally weak. Despite this, only around 10% of European companies managed to miss on both revenues and EBITDA; the large majority of earnings were in line on one or other of those metrics. Nevertheless, the strong demand backdrop for European credit continues to create a difficult tension for investors given weak growth prospects and lack of progress on the structural issues facing Europe.

Earlier on this week, Barclays issued a $3bn 7.625% 10-year Contingent Capital Note (CCN) with a host LT2 instrument. These instruments are with no interest deferral and loss absorption, i.e. 100% write-off, via an automatic transfer of the bonds to Barclays plc if the Core tier-1 ratio becomes less than 7%.

Bond Picks of the Week

? € 6.375% Commerzbank AG 22/03/2019 (BBB rated) @ 103.25 (Subordinated, Tier 2 Capital)

? € 6.00% Macquarie Bank Ltd 24/09/2020 (BBB rated) @ 106.75 Subordinated, Tier 2 Capital)

? €8.50% Labco SAS 15/01/2018 (B+ rated) @ 102.00 (Senior Secured)