OECD forecasts: a weak 2011, awaiting a better 2012

In itsWorld Economic Outlook for November, the Organization for Economic Cooperation and Development (OECD) downgraded its forecasts for 2011. Growth in 2011 will be 4.2%thanks to the strength of emerging economies but recovery is uneven, with greater weakness in rich economies.

The OECD believesmore balanced growth is required, with smaller trade imbalances and a private sector taking over fromgovernment stimuli.With regard to trade imbalances, which are not expected to ease significantly over the next two years, the OECD states that coordinated policies are needed within the G-20 to avoid currency wars and prevent the emergence of protectionism.

As regards replacing public stimuli, the OECD particularly stresses the establishment of credible fiscal consolidation plans to restore economic players’ confidence in public accounts and tomake debt sustainable. All this would result in greater growth in the mediumterm. However, the OECD acknowledges that, in the short term, the effectsmight be restrictive but of limited intensity.

The international organization expects that 2011 will bemore difficult than 2010 with growth that, for OECD countries as a whole, will drop from2.8%to 2.3%, picking up again in 2012. Compared with July’s report, the forecasts have particularly been lowered for the United States, with expected growth of 2.7% for 2010 and 2.2%for 2011, in line with our own forecasts. The OECD is more optimistic about 2012, putting US growth

at 3.1%, which would lead to a fall in unemployment for the period. In contrast, the euro area has improved its prospects for 2010 with 1.7%growth, slightly better than we forecast. This growth, however, won’t improve in 2011, repeating the same figure of 1.7%, also coinciding with our forecasts, while, unlike the American case, there will be no appreciable improvement in 2012.

For Spain, the OECD predicts a slight decline in 2010 followed by 0.9%growth in 2011 and speeding up slightly in 2012 to a rate of 1.8%, slightly above theforecasts of ”la Caixa”.


The United States: growth burdened by employment
We predict the US economy will grow by around 2.2%for the whole of 2011, lower than the 2.8%expected for 2010. The continued weak labour and housing markets, which have amutual effect on each other, as well as household debt, which has reached 118.4%of gross disposable income, limit growth in private consumption while capital goods investment has lost some of its strength fromthe first half of the year and exports are still sluggish. In the coming year, neither fiscal stimuli nor the inventory cycle will contribute asmuch to growth as they did in 2010.

The data for the third quarter continue to point towards amodest recovery, with the economy growing by 0.6% quarter-on-quarter. In spite of the relatively good performance of private consumption, the growth in this period owes a considerable amount to the accumulation of stocks, while capital goods investment and exports continued to slow up compared with the second quarter. Consequently, the risk of anaemic growth, but not of a double-dip recession, exceeds the inflationary risk, with core inflation at record lows, and justifies keeping expansionary fiscal and monetary policies, although it’s still necessary to draw up a credible fiscal consolidation plan for the US economy in themediumterm.

Retail sales are a good example of this underlying resistance that private consumption appears to have found. The component that excludes volatile cars and petrol consumption grew by an appreciable 5.3%year-on-year in October, to which we should add the good performance by automobile sales. We must remember, however, that, discounting the effect of price variations, retail trade is still slightly below the level of December 2007, representative of the situation before the crisis.

This underlying resistance of consumers can also be seen, in a sense, in the business perspective. After five months of falling expectations, the business sentiment index of the Institute for SupplyManagement picked up strongly in October, with the manufacturing index rising to 56.9 points and the services index, which accounts for four fifths of private employment, reaching an even better level of 58.4 points. In both indices we have gone from a situation befitting anaemic growth to another consistent with growth in the economy as a whole of more than 3.0%.

But the main weak factor in the US economy is still the labour market which, in order to recover, needs this robust growth noted in the business sentiment indices to be a reality.Most forecasts for 2011 do not include this optimistic scenario, however, so that, without vigorous demand, the unemployment rate is unlikely to improve substantially and is still anchored at 9.6%in October.

The problem here is that a delay in recovery actually means the situation will get worse because, among other reasons, it pushes up the proportion of long-term unemployed, who are more difficult to relocate. The people
who have been unemployed for more than six months account for more than 44.0%of the total unemployed, doubling the maximum reached in 1982. To all this we must also add the large number of discouraged workers and others who, although they want to work full-time, can only find part-time jobs and who will absorb a considerable portion of any demand for work that might be created over the coming months. It’s therefore difficult to see any substantial improvement in employment before the end of 2011.

This persistent unemployment can be largely blamed on construction slumping again in the third quarter. The real estate problem is closely linked to the weakness in the labour market. In the boom years, construction had grown far above its relative weight in the overall economy, supported by household debt.With the end of easy credit, the sector has lost two million jobs which, given their nature, are difficult to reconvert. This job destruction has had a boomerang effect on the sector as a continually high unemployment rate results in mortgage foreclosures. These, in turn, swell the already excessive supply of housing, practically paralyzing residential investment. Another result of this excess supply is the stagnation in the precarious recovery in house prices and the volume of property sales hasn’t managed to improve consistently after the end of state aid.

Weak demand has left inflation at a record low. Although the general consumer price index (CPI) for October increased by 1.2%year-on-year, the low utilization of production capacity has meant that core inflation grew by just 0.6%year-on-year, the lowest rise since this concept started in 1958.Within a context of extensive leveraging, as in the present, continuously stagnated prices mean that households in debt lose the benefit provided previously by inflation, which reduced the amount of the debt in real terms. Hence the Fed is going to undertake a second round of quantitative easing to push inflation more towards the non-explicit target level of 2%, as well as distancing prices from any hypothetical drop.

For its part, the foreign sector doesn’t look like it’s going to be the catalyst required by the recovery in 2011. Firstly, given the size of the US economy, exports have less relative weight than in other countries. Secondly, it still hasn’t achieved robust growth, in spite of the relatively weak dollar. Although September’s trade balance brought some respite by reducing the trade deficit for goods and services by 5.3%compared with the previous month, this was mainly due to fewer imports, which are still getting back to normal after the sharp increases of the second quarter.

However, exports continue to slow up. Within this context, the dollar will probably remain relatively weak, influenced both by the continued trade deficit and also by the Fed’s expansionary policy.


Japan: weaker than it seems
The Japanese economy will probably have grown by 3.6%in 2010, boosted by exports picking up in the first half of the year and by public stimuli for consumption. But after the end of these temporary factors, growth for 2011 as a whole is unlikely to be higher than 1.5%, with an exit fromdeflation that will have to wait until early 2012. The upswing in GDP growth in the third quarter, up by 1.0%quarter-on-quarter, shows a better situation than is actually the case.

The greatest contribution to growth came this time from private consumption, boosted by temporary factors such as the end of fiscal stimuli for buying durables and due to the effects of a particularly hot summer, leading tomassive purchases of air conditioning and cooling equipment.

But the worst news was confirmation of the slowdown in exports, which have been consistently at the forefront of growth for the last decade. Capital goods investment also seemed more sluggish while, in assets, construction seems to have bottomed out, with a real estatemarket that, in August and September, showed a very timid recovery after the record lows of July.

Weak domestic demand could be seen again in October’s car sales, sliding back now that aid has ended. Looking at these weaknesses, industry, a traditional bastion of Japan’s economy, is still stagnant in the best of cases, with an industrial production index that, in September, accumulated its fourth consecutive drop and is now at 15.4% below the level ofMay 2008, at the start of the crisis.

There was a slight improvement in the labourmarket in the third quarter, with September’s unemployment rate falling to 5.0%. Prices slowed up their fall in October and the CPI was down 0.6% year-on-year but core inflation, the general index without energy or foods, once again lost a substantial 1.5%year-on-year.

In the foreign sector, the trade surplus increased in September but this was duemore to the drop in imports than any improvement in exports. In this respect, although sales to the rest of Asia had been themainmotor of growth in exports in the first half of the year, in September exports to China are still clearly below the maximum level of March.

http://research.lacaixa.com/
Full report: OECD forecasts: a weak 2011, awaiting a better 2012

READ MORE - OECD forecasts: a weak 2011, awaiting a better 2012

Market Outlook 2011

After falling into the hell of the Great Recession of 2008-2009, the year 2010 offered well-grounded hopes of recovery. Unlike the Florentine poet, the world economy did not descend through Dante’s nine circles of hell but rather decisive action by national authorities managed to brake this fall and reverse the direction to the paths of salvation. The year that is now ending has set a firm course to exit the crisis. But as we already warned a year ago, the extent of the fall and the bold remedies implemented mean that we must be cautious. We have definitely left the crisis behind us but are still facing a complicated road ahead.

First of all, the risk of a double-dip recession has been ruled out and recovery is progressing reasonably well. But some developed economies have lost steam and progress is weaker than in previous exits. An environment of sustained growth in production and world trade is fundamental to tackle the first of the three great challenges facing the world’s economy, namely withdrawing fiscal stimuli and reversing the relaxed monetary policy applied but without harming the recovery inactivity.

The good news is that the emerging world, hardly affected by the recession, has reached a cruising speed that seems consolidated and sustainable, and is pulling along the rest. The Organization for Economic Cooperation and Development forecasts more than 4% growth in global production for 2011 and 2012, thanks largely to the emerging economies. However, major doubts are tormenting the world’s leading economy, the United States, whose recovery has stalled in the second half of the year, and it has still not completely digested the effects of its real estate bubble and can’t create enough jobs to face the immediate future with confidence. In any case, we predict that, in 2011, the US economy will grow somewhat more than 2%, a modest rate compared with other episodes of recovery but reinforcing the progress made in 2010.

Wary of the just how solid the recovery might be, the United States’ central bank, the Fed, has launched another round of quantitative easing whose aim is to lower longterm interest rates, boost the stock market and improve consumer confidence. But this new injection of liquidity has led to a fall in the dollar and the revaluation of certain emerging currencies, further complicating a panorama that was already complex and disrupting the second great challenge for next year: the correction of global imbalances. The «currency war» is threatening to turn into an episode of escalating protectionism, which would invariably put paid to the recovery, as might also happen if the extensive balance of payments imbalances continue.

The third great challenge of 2011 will be to push forward with the structural reforms that underpin these two previous challenges and to correctly apply the lessons learned from the crisis. Particularly in the banking system, with the gradual adoption of Basel III, but also in other areas of the economy in order to boost growth potential, improve public sector productivity, remove obstacles to job creation and redirect the
private sector’s heavy borrowing. These reforms will help to restore macroeconomic stability and confidence, thereby ensuring once and for all that we exit the worst recession in decades.


The sovereign debt crisis worsens once again
After a good start to the year, in which recovery seemed to be on the right track, the world economy is taking its leave of the year with a greater risk of a slowdown in growth, although a doubledip recession has been ruled out.

However, all eyes have once again been on the tensions in the euro area’s sovereign debt markets, reappearing after everyone had believed the situation to be under control after the episode before the summer. How economic policy responds will once again be crucial, both in terms of providing another boost to the economy as well as handling the tensions in the government bond market.

The new chapter in the European sovereign debt crisis is being written by Ireland. Unlike the case of Greece, which was caused by serious problems of competitiveness and a lack of transparency in public sector
management, there are fewer doubts concerning the growth potential of the Celtic tiger. Its problem lies in the huge adjustment in its real estate industry and its overlarge banking sector.When the international financial crisis was at its peak, the Irish government promised to guarantee all bank liabilities in order to avoid financial panic in its economy.

But the hole created in its banks by the real estate sector has been larger than expected. In fact, after the summer, the Irish government once again had to inject large amounts of capital into its banking system which made the deficit expected for this year shoot up to no less than 32% of gross domestic product (GDP).

One of the direct consequences has been the closure of wholesale financing markets for the Irish banking system, forcing it to obtain liquidity via the European Central Bank (ECB). Ireland can meet its public debt payments up to mid-2011, but the situation of the Irish banks and the financial effort required to inject
capital on the part of the central government finally convinced the European Union that it was necessary to draw up a bailout plan.

Ultimately, the financial aid offered to Ireland totals 85 billion euros. This is mostly expected to go towards recapitalizing, restructuring and reducing the size of the banking sector.
In exchange, the Irish government has undertaken to apply a draconian adjustment plan that includes cutting 25,000 civil service jobs, big cuts in social expenditure, a drop in pensions and the minimum wage and a rise in value added tax (VAT) to 23% in 2014.

However, the action taken to stabilize the Irish economy has barely eased the tension in the markets. Interest rate spreads for the debt of some of the most exposed countries compared with German debt have widened, there are still fears that one or more countries will go the same way as Greece and Ireland, and it has even not been entirely ruled out that some economies might have to leave the euro. It is to be hoped, however, that the gradual clarification of the economic and financial prospects, as well as the decisions taken by the Eurogroup, will help get markets back to normal, as happened in the episode in the middle of the year.

Portugal is one of the countries under scrutiny due to its slowness in applying adjustment policies, the persistence of its foreign deficit and especially because of the zero progress made in terms of reducing its public deficit. Neither has its domestic political situation helped the most decisive measures to be adopted that
would relieve the high deficit and growing public debt.

Spain has also been affected by tensions in the current European sovereign debt crisis, although the central government’s deficit is falling as planned (down 47% in the first ten months of 2010) and public debt remains below the European average. The risks perceived by the market now lie in the restructuring of its financial
system, the transparency of public accounts in regional governments and the application of structural reforms. The Bank of Spain has therefore announced new measures to increase the information provided by financial institutions regarding real estate exposure. It has also set a target to finalize the mergers of savings banks by the end of the year. For its part, theMinistry of the Treasury has announced new regulations to improve the budget information provided by autonomous communities.Moreover, the Spanish cabinet has approved a calendar of legislative initiatives that, among others, includes pension and collective bargaining reforms
throughout the first quarter of 2011.

In Europe as a whole, the Union’s Finance ministers have reached a draft agreement establishing the broad lines for the new support facility for countries at risk, which will be implemented 2013 when the current European Financial Stability Facility expires. As from the middle of that year, all debt issues by countries in the euro area will include clauses establishing the conditions under which certain aspects can be modified, such as the repayment period, interest rate or even reducing the principal.

Another element that might help to improve market perspectives are the favourable economic results recorded by the euro area. In the third quarter, the growth rate stood at 0.4%, a good figure after the strong growth posted in the second quarter. The driving force behind activity is Germany, with exceptional dynamism that can be seen when we look at, among other indicators, the trend in the IFO index for business activity, which has risen above the maximum reached in 2006. The situation of the different economies that make up the euro area is uneven, with Denmark and Finland at the head, enjoying annual growth of 3.5%-4%, and Greece
and Ireland bringing up the rear, still in recession.

In Spain, year-on-year growth was positive in the third quarter at 0.2%, the first positive rate after seven quarters of falls. However, the third quarter saw GDP stall after a perceptible recovery in the first half of the year. This slowdown can particularly be explained by the effect of the tax hike in July (VAT), the withdrawal of direct aid for buying vehicles and restrictive budgetary measures, such as the cuts in civil service wages. Growth is expected to reappear in the last part of the year and especially throughout 2011, when the recovery is expected to take hold firmly.

In general, in 2011 advanced economies will continue to record sluggish growth while the emerging economies will only slightly lessen the good pace they’ve enjoyed throughout 2010. These differences can also be seen in inflation.

Industrialized countries are therefore very likely to maintain a lax monetary policy, while less developed countries will continue to restrict theirs. The United States’ economy, which has accumulated low production capacity utilization and a moderate inflation rate, is one of the key figures in this disparity.

The third quarter’s figures continue to point towards a modest recovery, with an economy that grew by 0.5% quarteron-quarter, and the latest actions by the Federal Reserve are framed within this complex context. At its meeting on 3 November, the Fed took a far-reaching decision: to extend its bond purchase programme to support the reactivation in growth and sustain price stability while preventing deflation.

The strategy that the institution presided over by Ben Bernanke has decided to follow has supporters and critics. The latter argue that the meagre economic benefit does not offset the high risk of inflation incurred. In this respect, important members of the Fed have countered these criticisms by stating that the institution has the necessary instruments to toughen up monetary conditions without the need to reduce the size of its balance sheet.


Within a scenario where the ECB does not foresee any substantial changes and most liquidity has already been drained off, Euribor interbank rates are unlikely to see any big variation over the coming months. In the medium term, and as the central bank drains of liquidity or clearly indicates that it will start to raise interest
rates, the European interbank rates are likely to rise gently.

For their part, countries such as China, Brazil, South Korea, India and Chile have recorded strong economic growth and a significant upswing in inflationary risk. The response by national central banks has been to raise official interest rates to keep these pressures under control.

Within this complex situation, the main stock markets have performed in a wide range of ways and erratically. In the medium term, the outlook for international mixed equity is still positive, although fluctuations have not been ruled out by analysts.

The greater fall in European stock markets and especially the Spanish stock market has pushed indicators up to attractive levels. Consequently, and in the medium term, as the euro area’s public debt crisis abates, the gap should close between its equity prices those of the United States and the emerging countries, meaning that confidence has been restored and the recent debt crisis has been successfully handled.
http://research.lacaixa.com/
Full report: Market Outlook 2011

READ MORE - Market Outlook 2011

Financial 2011 Outlook

We stick to our marketweight
recommendation for financials,
despite the recent underperformance


In the aftermath of the European bank stress test in July of this year, we changed our
opinion about the state of the European financial system and moved to marketweight
from underweight, while we kept our underweight recommendation for non-financials.
Although our more positive stance regarding financials came under pressure recently,
as financials spreads underperformed non-financials, we stick to our view in respect to
a fundamental stabilization of financial credits. However, although we consider the
systemic fears in respect to the eurozone stability that are currently priced in as
exaggerated, the high spread volatility will persist and the pressure will likely intensify
further in the near term, given that there is no easy short-term solution at hand. Hence,
we refrain from moving to overweight for financials. Nevertheless, we think that the
macro-economic implications from the systemic crisis, which are discounted in
sovereign and financials spreads, are not properly reflected in non-financials. Hence,
we also stick to our underweight recommendation for non-financials.


Uncertainty was a main driver
during the crisis…


The main motivation for our recommendation change to marketweight for financials (in the
aftermath of the European bank stress test) was that we were convinced that the worst for
European banks would lie behind us. Throughout the crisis, one of the major drivers for the
jump-like behavior in spreads was uncertainty.  However, over the last three years of the
crisis, most of the risks and uncertainties that brought the global financial system to the edge
of a collapse in late 2008 / early 2009 are either resolved, in the process of resolution or the
exposures at stake are at least known and therefore do not pose the risk of uncertainty. The
sovereign debt crisis belongs in the last category – unresolved but at least known in respect
to the exposures at stake.


…and uncertainty keeps
declining


During the summer, we saw our hypothesis confirmed, as the spread between financials and
non-financials narrowed further. However, in hindsight, our view missed the crucial remaining
"uncertainty" that drove credit fears over the last couple of weeks: systemic fears regarding
the stability of the eurozone and implications from a potential restructuring of sovereign debt
or bank senior debt. (For more insight into arguments for and against sovereign and bank
debt restructuring, please refer also to our “debating club” section). In the wake of the Irish
crisis, the Armageddon trade – i.e. fears regarding a potential breakup of the eurozone and
the related adverse consequences – resurfaced. The rationale of this Armageddon trade can
be summarized as the “the big elephant in the room” is too big to bail out (to use some of the

recent phrases that circulated in the market) coupled with the crisis experience that debt woes
contain an element of self-fulfilling prophecy. Both parts of the argument – the too-big-to-bail
out and the self-fulfilling aspect– cannot be  easily dismissed. However, while doomsday
aficionados typically leave the discussion here, adding that the provided bailout does not
resolve the underlying source of the trouble and  that the whole system is set to collapse, we
like to dig a little deeper as we think that this view might be wrong because of underestimating
the ability of market economies to change and to adapt to new scenarios.

A politically incorrect excursus on the sovereign debt crisis


Clearly, providing bailout loans
does not resolve the economic
problem, but that’s not the point


Admittedly, it is completely true that providing loans to debt-stricken borrowers does not
resolve the underlying problem, but this argument misses the crucial point. The bailout loans
are not meant to resolve the crisis’ fundamentals. They are just intended to enable the
countries to borrow more to address the underlying problem. A comparison to the drug scene
might help to get more insight: the dispensation of methadone should not be confused with
therapy. It just enables the addict to enter into therapy. Addressing the problems of an addict
is a four-stage process. 1) Convincing the addict that there is a problem, which the person will
deny vehemently (Greece and Ireland already passed this stage).  2) Focusing the addict’s
mind on the resolution of the cause, by taking  him/her off the street and at the same time
avoid going “cold turkey” (i.e. a sudden detoxification with severe medical implications; in the credit
world, this would be called “bankruptcy”). 3) Working on the resolution of the underlying problem,
which is the longest and most painful part of the whole resolution scheme. 4) Find ways to
prevent a relapse. Interestingly, all four stages can be diagnosed during the European
sovereign debt crisis. Starting with the government initially being in a denial mode, but then
surrendering to the inevitable, over the methadone (rescue financing) and the therapy
(austerity measures and structural reforms), until preventing a relapse (Mrs. Merkel’s plan to
enforce the no-bailout clause). At this point, the analogy (hopefully) ends, as in case of drugs
the relapse rate is disappointingly high.

    What can we learn from this excursus? Bailout loans are not a resolution. It is just buying
time. But this is not positive news because it means that, by providing a bailout, the painful
part of the resolution process did not end – it just began. However, whether this strategy can
help to avoid debt restructurings remains to be seen (a risk that will hang over markets for
quite a while). Nevertheless, although even some unorthodox drug therapists would probably
recommend to pursue the “cold turkey” strategy, it remains clear that neither can the “cold turkey”
method replace therapy, nor can a debt restructuring (or leaving the eurozone) avoid addressing the
underlying economic problems. So why opt for the more painful path of immediate debt
restructuring, if the painful economic restructuring cannot be avoided anyway?


Admittedly, moral hazard
is an issue


Moral hazard on the investors’ side might be one answer. The above-mentioned analogy to a
drug addict should not be exaggerated. In particular, it should not imply that there is no moral
issue involved with a bailout. In contrast to the drug case, in which providing methadone does
not bail out the drug dealer, providing rescue loans to enable the borrower to refinance
maturing debt bails out some bondholders (which were part of the problem because they
provided the addictive substance too cheaply, amplifying the problem). Even when the bailout
would just be of a temporary nature and the economic restructuring would be followed by a
subsequent debt restructuring in order to address the legacy problems, some investors (the
ones with shorter-term debt) would be able to escape their share of the burden. This does not
necessarily mean that the bailout comes at the expense of taxpayers who provided the bailout
loans, as bailout loans could be provided under a preferred creditor status (recall that rating
agencies put Greece's rating on watch negative because of one important element of the
revised Franco-German proposal for post-2013 European Stability Mechanism: the preferred
creditor status of government loans). In this case, the bailout of investors in shorter- term debt
would come at the expense of the investors in longer-term debt, as the recovery rate for the
remaining investors would become lower and lower the more pari passu debt will be replaced

by preferred debt from governments. This  fact undermines a troubled country’s ability to
return to bond markets in order to refinance maturing debt by issuing new bonds that are
subordinated to government loans before an anticipated restructuring event.


Risk factors and drivers for financials in 2011 


The European sovereign debt
crisis is the most important
risk factor directly (spread
contagion) and indirectly
(austerity measures can result
in asset quality deterioration)



We have already discussed the most important risk factor for financials above, the European
sovereign debt crisis. Our best guess for the development is that the topic will flare up and die
down every now and then and will therefore result in heavy volatility in spreads. Hence, the
first and foremost implication from this crisis  is ongoing pressure on refinancing costs, which
will influence senior unsecured refinancing activity of banks in 2011 (see below). The second
implication for banks is that austerity measures will result in a soft patch economic
environment in the troubled regions that will weigh on asset quality. This, in turn, could start a
vicious cycle as a deterioration in banks' asset quality may cause more bailout activity for the
respective sovereign, which will weigh on public finances (directly due to required spending or
indirectly due to rising refinancing costs). This could then lead to rising pressure for
governments, and another round of austerity measures, and so forth. This explains why belttightening measures need to be carefully calibrated and should be – in the best case,
designed to foster growth. For Spain and Portugal, the housing market will be in the focus in
this respect. The Spanish house price index rose by almost 45% from 2004 to the peak level
mid-2008, at a 9% annual growth rate. Since  then, house prices declined by 12% in Spain
(5.6% annual rate of losses), which means that the current house prices index is at 2005
levels. In Ireland, the dynamics were faster: from 2000 to the peak in 2006, the housing
market grew at an 11.5% annual growth rate and has been shrinking at the same rate since
then, totaling a loss of 36%. Current house prices are comparable to 2002 levels. The
dynamics in Ireland were similar to the US housing market (measured by the Case-Shiller
index), with a one-year delay, while in Spain the contraction is at a slower pace. However,
some important differences between the European and the US housing crisis are noteworthy.
First of all, loan documentation in Europe experience similar excesses as subprime
documentation in the US. And second, the housing crisis in the US was aggravated by socalled non-recourse loans, where over-indebted borrowers (i.e. the ones with a negative
equity stake in the house) can simply walk away from their loans by handing over the key to
the banks. This created selling pressure as banks tried to get rid of the houses. European
legislation, however, does not allow such non-recourse loans. Another factor that could weigh
on the troubled European housing markets is  the exit of the ECB from its exceptional
measures. The short-term interest rates increased substantially in the second half of 2010,
with the 3M-Euribor rising from a low of 0.65% to a current level above 1%. As many home
buyers in Spain, for example, were using variable rate loans, a surge in the Euribor translates
into higher borrowing costs. This could pose serious problems, in particular for unemployed
borrowers that have only limited income to meet their scheduled payments. While the ECB
has normalized conditions in the money market, with the refi rate being again the decisive
parameter, its bank funding activity is still exceptional. Recently, the full-allotment LTROs
were prolonged again. Nevertheless, any changes on this side will increase the pressure on
banks in the periphery.


The threat of restructuring
remains a Damocles sword


The ultimate risk for investors in bank debt, however, is the threat of restructuring. With the
exposures at stake being very large (aggregated bank debt can easily be a multiple of
domestic GDP), the risk is that governments might choose not to bail out their banking system
in case the resulting default risk for the sovereign would be too high (please refer to our
debating club section for details and arguments). Last but not least, the downturn in European
commercial real estate also poses a risk for financials. The CRE downturn produced negative
headlines with respect to respective mutual funds. So far, mortgage exposure of banks has
not been in the focus. In case of a further deterioration, this might change however.

Supply Forecast


In the following articles, we expand our supply forecast for 2011. Note that we already
published our supply forecast for non-financials and the securitization market in the November
edition of the Euro Credit Pilot. We start with a brief overview of topics for bank senior debt,
which is notoriously difficult to forecast.  We will then discuss the supply for eurozone
government bonds, for sub-sovereigns & agencies and for covered bonds in more detail.


Supply for financials 

Supply forecast for financials
is a notoriously difficult task


A supply forecast for financials, in particular for banks, is a notoriously difficult task, as banks
have many different funding channels. Note that in contrast to non-financials, the liability side
of financials is not necessarily driven by refinancing of the business, but is itself part of the
active business. Hence, typical banks rely on a funding mix involving a vast range of funding
sources. Besides the "capital products" (i.e. subordinated bonds), this can include deposits,
senior unsecured bonds, covered bonds, securitization, private placements and interbank
loans, money market borrowing, commercial paper funding and central bank liquidity
measures, as well as government guaranteed bonds. Banks typically use all refinancing
sources and aim at a funding mix that minimizes funding costs. In addition, the funding
requirements also depend on the changes in  the balance sheet. Hence,  the use of specific
refinancing tools, such as senior unsecured bonds, covered bonds or securitization depends
on several factors, like the structure of the balance sheet  (corporate loans, for example,
cannot be used for cover pools), the cost of funding and the availability of potential alternative
funding sources (i.e. central bank). Nevertheless, one important factor that links non-financials
issuance activity with bank funding requirements is the so-called “Wall of Refinancing”. This
buzzword describes a substantial surge in debt maturities for non-financials in 2013/14. Since
this not only stems from bond maturities but also syndicated and leveraged loans, it will also
impact the banking sector. In particular, the  “Wall of Refinancing” coincides with the new
Basel III rules regarding common equity requirements. According to the new regulations,
banks will have to increase their common equity ratio to RWA from 2% to 4.5% until 2015
(and thereafter they will have to add another 2.5% of common equity due to the so-called
capital conservation buffer). This will force banks to offload some of the loan exposure into the
bond market already in 2011/12; this, in turn, will depend on the absorption capacity for new
corporate bonds, which will probably be skewed towards the sub-investment grade credit
qualities. The higher the volume that can be securitized, the smaller the refinancing needs for
banks, which would otherwise increase, as many loans were refinanced via CLOs, which
have also face a Wall of Refinancing in 2013/14, but won't be available as a funding source.


We expect an increase
in senior unsecured
issuance activity


We expect a higher volume of iBoxx-eligible bonds in 2011 than was the case in 2010. YTD
new issues by financials reached EUR 132bn, in line with our forecast of EUR 125bn. With
new issuance probably remaining subdued for the rest of the year, the 2010 volume will be
above 2007 (EUR 116bn), but below 2008 and 2009 (EUR 162bn and EUR 153bn). For 2011,
we expect EUR 150bn in iBoxx-eligible bonds by banks, insurers, and financial services. Our
estimate is based on the assumption of easing tensions once the sovereign situation is
clarified: either more countries will need support (beneficial for the banking system) or, the
candidates can escape in a way that is accepted by the market (also beneficial). Either way, a
solution will be found in 1Q11, with funding markets resuming stronger activity then.
Redemptions in 2011 (EUR 102bn) will be double those in 2010 (EUR 53bn), while
government-guaranteed bonds  redemptions will be 15% higher (EUR 34bn in 2011). The
higher amount of redemptions, which will be lower for normal funding in 2012 and more than
double for GGBs, has led to fears that banks will not be able to meet their funding
requirements. When this was a problem two years ago, GGBs were designed for those
countries whose banking systems are now in trouble. GGBs might not be a solution anymore.
Still, funding-stretched banks can rely on the ECB. For solid banks, other means of funding,
e.g. covered bonds are available in case senior bail-in discussions spoil the party. Deposits
are also an option, but the market is limited and, in some countries, prices are prohibitive
given the ongoing competition. Overall, one should also bear in mind the ongoing
deleveraging process, which reduces funding requirements.


Sovereign borrowing requirements in 2011 

We expect deficits of EMU countries
to be EUR 128bn lower on
aggregate than this year

Next year, the austerity programs put in place by EMU governments will lead to a
decrease in deficit figures compared to this year. We expect the decrease in the deficit at
the EMU level to be in the EUR 128bn area. Note that we refer to the central government
deficit and not to the general government deficit, as government bonds usually finance the
central government deficit.

Borrowing requirements in 2011 


down by EUR 75bn

While we expect deficits to decline by a sizeable amount, we anticipate borrowing
requirements to decrease less due to higher bond redemptions (domestic and, to a
lesser extent, foreign).


Main trends for 2011
  
We expect gross bond supply to
be in the EUR 825bn area, some
EUR 145bn less than this year

The main trends that emerge from our analysis is that in  2011 borrowing requirements
should decrease due to a projected fall in deficits and despite an increase in bond
redemptions. To recap, we expect gross issuance to be EUR 825bn (EUR 145bn less
than this year) and net issuance of EUR 270bn (EUR 150bn less than this year).


Part of the reduction in gross
supply will be due to some
EMU periphery countries not
issuing next year

Of the EUR 145bn reduction in gross bond issuance, EUR 61bn will be due to the fact
that two countries will not issue next year (Greece and Ireland), while we regard it as
likely that Portugal will also have to ask for financial aid. The reduction in gross supply
would be more moderate if these countries were issuing bonds.

Finally, net supply should
decline next year

After increasing by EUR 50bn from 2009 to 2010, net supply should decrease by EUR 150bn
from 2010 to 2011. EUR 128bn of this decline results from a decrease in the deficit,
while the remaining amount can be attributed to our assumption that Greece, Ireland
and possibly Portugal will be absent from the bond market next year.

Where will demand come
from next year?

An important aspect is how high demand for bonds will be next year. Gross supply has
been quite heavy in the last two years and expansionary monetary policy has driven yields to
record-low levels. With the ECB slowly moving towards exiting liquidity support measures and
supply still abundant, it will be challenging for the EMU countries to refinance in the primary
market. The good news in this respect is that Greece, Ireland and likely Portugal will be absent
from the market, and this may benefit – at least moderately – other peripheral countries.

EMU countries will likely
surface in the foreign
currency market only
in the second half of
next year

EMU countries could look to the foreign currency bond market. Indeed, for Spain and Italy, the
cross currency swap becoming more negative would offer a good window of opportunity to
issue in USD. However, as risk aversion remains high, EMU countries might experience
difficulties in selling their bonds on a foreign currency market. If anything, EMU
countries will wait until some confidence is restored before tapping the foreign currency
market. Hence, this will not be the case until the second half of next year.

Difficult market conditions
should prevent heavy frontloading in the first part of
the year

This year,  EMU countries front-loaded much of their activity into 1Q. Indeed, they
completed 33% of total bond issuance for this year in the first three months. As we regard it
as unlikely that market conditions will improve dramatically in the first quarter of next year, we
do not expect front-loading to be as high as this year.

We estimate that EMU countries might issue EUR 246bn or 30% of total funding in 1Q, EUR 267bn
or 28% of total funding in 2Q, EUR 183bn or 22% of total funding in 3Q and EUR 162bn or
19% of total funding in 4Q.
http://www.unicreditmib.eu/
Full report: Financial 2011 Outlook

READ MORE - Financial 2011 Outlook