July 1 – July 7, 2016 – the janus observer

The bad debt in Italian banks is looking like a BIG problem. The world has become more reliant on Middle Eastern oil. Not looking so rosy for hedge fund reinsurers.

Headlines

Bloomberg – Spain Runs Out of Workers With Almost 5 Million Unemployed 6/30. “The unemployment rate is too high. Yet we’re seeing some tension in the labor market because unemployed people don’t have the skills employers demand.”
FT – US oil reserves surpass those of Saudi Arabia and Russia 7/4. According to Rystad Energy, recoverable oil in the US (264bn barrels) just surpassed Saudi Arabia’s (212bn) and Russia’s (256bn) tally for the first time ever – but it’s still cheaper to pump in the Middle East.
WSJ – Japan’s 20-Year Government Bond Yield Goes Negative for First Time 7/6. On Wednesday the yield on Japanese 20-year government bonds went negative for the first time (a low of minus 0.005% but recovered to positive territory at the end of the day).
WSJ – Larger Than Life: China’s Risky Unlisted Insurers 7/6. A calamity waiting to happen.

Briefs

Justin Lahart of the Wall Street Journal pointed out US Corporates have a golden opportunity to raise CHEAP debt.

As yields the world over drop “the effective yield on 7-to-10 year investment-grade corporates was 3.19%, according to Bank of America Merrill Lynch.” But relative to everything else, that’s really quite attractive.
“Indeed, in the universe of investment-grade debt, U.S. corporate bonds are close to the only game in town for investors looking for any yield. BofA Merrill Lynch credit strategist Hans Mikkelsen calculates that U.S. corporate bonds account for around 12% of all investment-grade debt outstanding world-wide yet they now represent about 33% of investment-grade yield income. Put otherwise, U.S. corporate bonds generate one out of every three dollars paid out by the entire universe of investment-grade debt.“

Anjani Trivedi of the Wall Street Journal wrote about how the Bank of Japan has put itself in a tough corner with all this negative rate business.

“Almost 87% of Japanese government bond yields are now below zero.”
“Unlike other major central banks, the BOJ is a buyer at almost any price and mainly purchases government bonds, which represent almost two-thirds of negative-yielding global sovereign debt globally.”
“Further buying will only push yields lower. Cutting back, while helpful in the short- to medium-term, means that the BOJ has to find other Japanese securities. But, unlike Europe or the U.S., asset-backed securities and corporate bonds are hardly an option because of their relatively small market sizes.”
For reference, “the BOJ now holds almost 30% of its government’s bonds.”

Rich Miller and Steve Matthews of Bloomberg called attention to the challenge that Janet Yellen faces in regard to setting rates when the US economy is running short of labor.
- “Seven years into the economic expansion, the U.S. is showing signs it’s running short of job seekers qualified to fill openings. The shortfall, which has been evident for some time for highly skilled workers, is spreading to workers with less education as unemployment falls further.”
- “We are now close to eliminating the slack that has weighed on the labor market since the recession.” – Janet Yellen, Federal Reserve Chair on June 6
- “At 4.7% in May, the jobless rate is around the level that most Fed policymakers consider to be full employment.”
Central Banks are putting a squeeze on the bond market according to Min Zeng and Christopher Whittall of the Wall Street Journal.
- “A buying spree by central banks is reducing the availability of government debt for other buyers and intensifying the bidding wars that break out when investors get jittery, driving prices higher and yields lower.”
- “Central banks themselves are having trouble finding all the bonds they need. The ECB, for example, can’t buy bonds with a yield lower than its deposit rate of minus -0.4%. As of July 1, 58% of German bonds eligible for ECB purchases traded below that level, according to Frederik Ducrozet, a senior economist at Pictet Wealth Management.”

Special Reports

FT – What next for markets this year: profit or peril? 7/1

Graphics

FT – Government bond yields fall to fresh record lows led by UK Gilts 7/1

WSJ – Debt for Cheap: U.S. Companies Can Profit from Sinking Rates – Justin Lahart 7/1

The Big Picture – China spends more on economic infrastructure annually than North America and Western Europe combined 7/4

FT – Bad-debt warnings triggers fresh fears for Italian banks 7/4

Visual Capitalist – This Map Shows the Average Income of the Top 1% by Location 7/6

WSJ – Central Bank Buying Puts Squeeze on Bond Market – 7/6

Featured

*Note: bold emphasis is mine, italic sections are from the articles.

Bad Debt Piled in Italian Banks Looms as Next Crisis. Giovanni Legorano. Wall Street Journal. 4 Jul. 2016.

“In Italy, 17% of banks’ loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans.”

“Although Italy has only one bank classified as globally significant under international banking regulations – UniCredit – some analysts say bank stresses worsened by Brexit could threaten Italy’s stability and, potentially, even that of the EU.”

According to Lorenzo Codogno, former director general at the Italian Treasury, “Brexit could lead to a full-blown banking crisis in Italy. The risk of a eurozone meltdown is clearly there if Brexit concerns are not immediately addressed.”

“The profitability of Italian banks has long been among the worst in Europe, weighed down by bloated staffs and too many branches, leaving the banks with little extra capital to cover loans that go bad. Today’s low interest rates have hit Italian banks especially hard because of their heavy focus on plain-vanilla lending activities, with relatively little in fee-generating activities such as asset management and investment banking.”

“…impaired loans at Italian banks now exceed €360 billion – quadruple the 2008 level – and they continue to rise.”

“Banks’ attempts to unload some of the bad loans have largely flopped, with the banks and potential investors far apart on valuations. Banks have written down nonperforming loans to about 44% of their face value, but investors believe the true value is closer to 20% or 25% – implying an additional €40 billion in write-downs.”

“One reason for the low valuations is the enormous difficulty in unwinding a bad loan in Italy. Italy’s sclerotic courts take eight years, on average, to clear insolvency procedures. A quarter of cases take 12 years.”

“There is an epidemic, and Italy is the patient that is sickest… if we don’t stop the epidemic, it will become everybody’s problem… The shock of Brexit has created a sense of urgency.” – Pierpaolo Baretta, an undersecretary at the Italian Economy Ministry

However, European officials are loath to let the Italians use the Brexit as an impetus to gain permission to bend the rules of the banking regime that were only just established at great pains. The Italians though are concerned “about the €187 billion of bank bonds in the hands of retail investors that would be wiped out by a bank resolution under the EU banking rules.”

IEA warns of ever-growing reliance on Middle Eastern oil supplies. Anjli Raval and David Sheppard. Financial Times. 6 Jul. 2016.

“The world risks becoming ever more reliant on Middle Eastern oil as lower prices derail efforts by governments to curb demand, the west’s leading energy body has warned.”

“Middle Eastern producers, such as Saudi Arabia and Iraq, now have the biggest share of world oil markets since the Arab fuel embargo of the 1970s.”

“Demand for their crude has surged amid a collapse in oil prices over the past two years that has cut output from higher-cost producers such as the US, Canada and Brazil.”

“Middle Eastern producers now make up 34% of global output, pumping 31m barrels a day, according to IEA data. This is the highest proportion since 1975 when it hit 36%. In 1985, when North Sea production accelerated, their share fell to as little as 19%.”

Further, the adoption of more fuel efficient vehicles has slowed since the cost of gas has come down significantly. “In the US, more than two-and-a-half times as many sport utility vehicles were being bought compared with standard cars.” – Fatih Birol, executive director of the International Energy Agency.

“Even more concerning for policymakers is China, where more than four times as many SUVs were bought, suggesting the country’s rapidly growing car culture has adopted America’s taste for larger more fuel-hungry cars.”

“Lower oil prices are proving to be bad news for efficiency improvements.” – Fatih Birol

Bottom line, “‘the Middle East is reminding us that they are the largest source of low-cost oil,’ said Mr. Birol. He said the region was expected to meet three-quarters of demand growth over the next two decades.”

“Mr. Birol said policymakers needed to impose stricter fuel efficiency targets to reduce demand, arguing it was not feasible in a world market to completely sever reliance on Middle Eastern oil.”

“US oil production will increase, but it is still an oil importer and will be for some time.” – Birol

S&P sounds alarm on hedge fund reinsurers. Alistair Gray and Miles Johnson. Financial Times. 6 Jul. 2016.

“So-called hedge fund reinsurers (HFRs) have failed to make a profit from providing reinsurance cover for more than four years, according to Standard & Poor’s.”

“S&P found that HFRs had performed considerably worse than traditional reinsurers, which have complained that the entry of new money into their sector has driven profitability down for all.”

“Conventional reinsurers tend to invest their income in conservative assets such as corporate bonds, since they do not know in advance how much they will need to pay out in claims.”

“In contrast, HFRs pursue what S&P described as ‘meaningfully risker’ investment strategies. Their assets are managed by their affiliated hedge funds. Allocations vary but include exposure to speculative-grade leveraged loans, private equity and short positions.”

“So-called combined ratio for the HFRs – claims paid and expenses incurred as a proportion of premium income 0 has been above 100 in every year since 2012, meaning a loss from underwriting.”

“Last year the ratio came in at 110.2%, compared with a profitmaking 88.6% for their conventional reinsurance peers.”

“S&P said the HFRs’ investment performance had also been ‘rough’. Overall net investment income dropped 63% from 2014 to $247m last year.”

Other Interesting Articles

Bloomberg Businessweek

The Economist