Stock rally – The real One?

After a disastrous start to the year, stock markets recovered sharply last week to end up above the lows reached in 1997 and 2002 on Wall Street, thanks to a strong performance of the banking sector (S&P 500 banks + 46% last week closing at 72.51 Friday, still 80% down from the high of February 2007).

With follow through today at time of writing (5.00 pm GMT), could the bounce mark the bottom of the current stock market cycle?

Whilst encouraging, I do not believe that we are witnessing more than a bear market rally that could however be substantial:

· Valuations are down but not crying fool as yet

· CDS for European sovereigns are still at close to their highs meaning that we are not out of the wood with Eastern Europe indebtness and possible default

· The real estate market has not yet stabilized as showed by the Case-Shiller index or the level of foreclosure despite all means deployed

(http://www.bloomberg.com/apps/news?pid=20601087&sid=aqtJdtiZTJtk&refer=home)

· TED and OIS have stopped deceasing since February and stand above 1%

· The spread of 10 year BBB banks over 10 year Treasuries is reaching new highs at above 7% vs 1.5% historical average

· The G20 meeting this weekend has showed a consensus of disunity, but for the elimination of the banking secrecy in tax efficient scapegoats

BNP Paribas takeover of Fortis: is it a good deal for Luxembourg?

All articles are focusing on the value of the deal from the standpoint of BNP Paris, the Belgian state or shareholders of Fortis Holding, the quoted entity. But what about Luxembourg?

1. Let’s start from the rescue of Fortis on 28th September 2008

• The Luxembourg state brought €2.7 billion in exchange for a 49.9% stake in Fortis Luxembourg (now BGL) via a convertible bond, valuing the company at € 5.4 billion.
• BGL had a Cooke ratio of 11%.
• BGL had no exposure to toxic assets.
• With Luxembourg funds, the Cooke ratio stands at around 20% and should pass any stress test (I am assuming that, since the rescue, no toxic assets had been transferred by the Belgians into the Luxembourg subsidiary or no assets were withdrawn by the parent company).

2. What is Luxembourg getting with BNP Paribas deal?

• 1.4% in BNP Paris (vs 1.1% in the previous deal).
• Dilution to 34% of BGL (same as before).

3. Is it a good deal for Luxembourg?

• The implicit value of BGL is €6.9 billion on a BNP Paribas share price of €27, i.e. €1.5 billion more than the previous deal.
• On 2006 and 2007 bottom line (record years) this represents a PER of 11, way too excessive.
• I do not see what changes have occurred to justify a better valuation today than in September. If anything, the environment has substantially deteriorated, the DJ Eurobanks index losing 60% since.
• On September valuation, Luxembourg would have a paper loss of between €500 million (BGL has the same value as in September) and €1 billion (BGL value decreased by 30% i.e. 50% of the DJ Eurobanks index fall since).
• Luxembourg loses control of one of the major banks and employer in Luxembourg to a French Bank at a time where (French and other) are trying to widen the meaning of so called tax havens, and target Luxembourg among others. It is providing to the French a powerful political tool to pressure Luxembourg bearing in mind that arm-twisting is going to be the rule.
• Luxembourg loses the opportunity to take control of BGL and use it as a tool to develop Luxembourg financial center and to promote Luxembourg independence.

As a whole, and according to publicly available information, I rate this as a bad deal for Luxembourg.

03 March 2009 Eastern Europe

Whilst the sub-prime  crisis has been generously shared by Americans with their European counterparts, the fast deteriorating situation in Eastern Europe is a problem quasi-exclusively European.

Where are We?

Eastern European economies have widely used external debt to finance their growth, estimated by Morgan Stanley at $1,700 billion including, $400 due in 2009 or approximately 1/4 of their GNP. Most of this debt is held by Western European banks, and a large portion is denominated in Swiss franc and euro. Borrowers have taken advantage of the “necessary” stability of their currency in order to join the euro to borrow at lower rates in Swiss franc and euro; for example in Poland 60% of mortgages are in Swiss franc when the zloty has lost 50% of its value in 6 month, doubling the borrowing cost, unsustainable beyond the short term. This mechanism can be replicated throughout Eastern Europe.

According to the EBRD , 10% (up to 20%) of credits in Eastern Europe are or will de defaulting, i.e. $170-$340 billion. Without any help from the IMF (whose resources are becoming stretched) or the European Union, many countries risk entering a severe depression. The situation is so more urgent that their current accounts deficits are widening and therefore their currencies falling vs the euro and the swiss franc.

Erik Berglof, the EBRD Economist, anticipates that the region needs €400 billion to cover their debt and stimulate their credit system when some Western European government are pushing their bank to reduce their exposure to the East.

In this context, Austrian banks are at the forefront with €230 billion lent to the region, i.e. 70% of its GDP… Belgium, Sweden, Holland and Italy are following with 30%, 23%, 16 and 10%. Beyond, Spanish banks are busy with Latin America, Dutch and UK banks with Asia. I do not talked about the Irish banks that are already insolvent.

The insolvency risk of Western European banks expose to Eastern Europe is going to increase, having already to bear the cost of the sub-prime debacle. And I do not talk about all the loans  made to emerging markets as a whole that would represent $4,900 billion, including 74% made by European banks with a leverage 50% higher than American and Japanese banks according to the IMF.

The World Bank, The EIB and The EBRD announced Friday a €24.5 billion package to strengthen banks and support lending to the real economy in Eastern Europe. Whilst a step in the right direction, it will be far from enough if we get a real mess in the East.

Markets are clearly and rightly unconvinced with the rhetoric following the Brussels meeting Sunday 3 March.

02 March 2009 Daily comment

Another day, another flop.

• The Dow and S&P decisively went through their technical support of 2002 and  November 2009 in a follow-through of Friday, led by banking, energy and resources stocks; we are back to 1997. What’s next? Since market participants are expecting a disastrous nonfarm payrolls number, the market should rebound short term by the end of the week. Today’s ISM manufacturing better than expected number had no effect on the markets (Bloomberg).
• Commodities took a bath today, the CRB index down over 5% and at its short term support at 200.
• Energy sharply down at 10%  with the WTI flirting with $ 40 a barrel on the April 09 futures.
• Precious metals not a safe-haven these days with gold down $22.50 (-2.3%) at $926.5, silver and platinum more resilient at $12.93 and $ 1,058 (-1.4%). Gold is nearly oversold short term.
• OIS and TED spread steady at 1%. Yields in Europe and the US tightening along the yield curve.
• And again… $30 billion provided by the US government Monday to plug a record Q4 2008 $ 61.7 billion loss. Well, now we are at $ 180 billion of State money for AIG alone.

01 March 2009 Weekend wrap-up

• Barak Obama announced that the US budget deficit will quadruple to $1,750 billion in 2009 or 12.3% of GDP (the highest since WWII). You bet the deficit will be larger when stimulus plan n°2 will be announced later during the year together with a downward revision of GDP.

• Saturday, Ireland announced that the €18 billion hole in public finances (the national debt will reach 45% of GNP – no so bad compared to many other European countries…) will be addressed via tax increases.  This is the first country to announce it; many will follow in the years to come to plug fast growing deficits which, before the crisis, were already too large in many countries (add social security and other public deficits and you get the picture) . Watch prices of Government bonds, the next bubble to deflate.

• Wall street at the lowest for 12 years, just over 50% down from its peak in October 2007. There are $3.000 billion sitting in money market funds and, despite the zero or near-zero return, there no sign that some will find their way to the equity markets. True technical indicators are pointing to an oversold market, but S&P earning downgrades (we are at -40%, Goldman Sachs forecasts -56% for this recession vs -79% during the great depression) is not abating and in this environment sentiment is king.

• Citigroup gets $52.5 billion capital from the US Government and GSIC (Government of Singapore Investment Corp) conversion of preferred shares into common stock, the US ending up with 36% of the share capital. Will this be enough? One may doubt with mounting non-performing loans (and what is the value of all these so-called toxic assets?) and no quick economic recovery in view.  Even more if, as it seems the case, the US authorities are going to closely look at the TCE (Tangible Core Equity = common stock) instead of Tier 1 (that counts preferred shares – shares you said? no, low ranking debt). According to Bloomberg banks have so far written down $1,100 billion and raised $1,000 billion, i.e. $100 billion equity capital shortfall (prior to the Citigroup preferred shares conversion). We have not seen the end of it.

• HSBC plans to shore up its capital reserves by cutting its dividend and raising £12.6 billion via a right issue on Monday (the largest ever in the UK) despite a £15 billion profits expected for 2008 (-11% compared to 2007) according to analysts at Keefe, Bruyette and Woods. HSBC either is expecting substantial more losses coming from toxic assets in their US operation and additional losses stemming from a weakening economy, including in Asia, or/and the need to compare favourably to banks that have received and continue to receive funds from Governments that might lead to competitive distortions. This leads to questions concerning the way banks are helped with loans, preferred shares, convertibles, you name it, and no direct equity but for a few exceptions (Citicorp seems to open the way to more direct governments’ involvement at the TCE level)

• Eastern Europe? No bail-out! decided the European leaders during an emergency summit meeting on Sunday 1 March in an other display of strong unity and well coordinated economic policy during this crisis. The joint declaration is offering nothing new beyond rhetoric (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/misc/106390.pdf). If the crisis in Eastern Europe is as deep as some analysts are forecasting,  hiding behind rhetoric (“getting the real economy back on track by making the maximum possible use of the single market, which is the engine for recovery.”) and waiting that things gets much worse to act reminds me of the inaction of Governments between August 2007 and September 2008. I will discuss the subject of Eastern Europe crisis in a forthcoming article.

• Next week: watch the Initial Jobless Claims and the ISM Manufacturing numbers in the US where the consensus is 33.5 (35.6 prior) and -640,000 (-598,000 prior).