The Greek CDS auction has not yet taken place, nor has one quantified how many Greece-guaranteed orphan bonds with UK-law indentures have to be made whole (at a cost to Greece of course, no matter how much Venizelos protests), and somehow the world is already moving on to bigger and better risk strawmen. Because if one sticks their head in the sand deep enough, it will be easy to ignore that European banks have gradually over the past year or quite suddenly (as in the case of Austrian KA Finanz) taken about €100 billion in now definitive losses on their Greek bonds and CDS exposure. Luckily, just like in the US, there is now over $1.3 trillion in fungible cash sloshing in the system, allowing banks to 'fungibly' fund capital shortfalls and otherwise abuse every trace of proper accounting, when it comes to a post-Greek default world. The problem is that none of this actually solves the fundamental insolvency issues plaguing the 'old world', but what it does do, is force the accelerated depletion of an aging and amortizing asset base. That's fine - as Draghi said the ECB can "always loosen collateral requirements even more." So while we await to hear just who will sue Greece and Europe, and how much cash will have to be paid out to UK-law bondholders (before the Greek default is even remotely put to rest), here is a listing of what Bank of America (recall - BofA is the one bank most desperate to remove any lipstick from the pig due to its need for more QE) believes will be the biggest risks to its outlook going forward. In order of importance: 1) Oil prices (remember when a month ago we said this then ignored issue may soon hit the very top of investors worry lists?), 2) Europe; 3) US Economy; and 4) China. That about covers it. Oh and massive debt issuance supply too as well as the even more epic straw man that is this Thursday's stress test. Remember: stress tests will continue until confidence in the ponzi returns!
From Bank of America
The risks to our outlook
The successful Greek PSI addresses – but does not eliminate – a key contagion risk for US financial markets. Clearly risks are reduced due to the absence of major debt maturities in the coming years as well as the escrow account for interest payments. However, risks remain as the second bailout package for Greece may unravel if the country fails to deliver on its commitments. With continued signs of strength in the US economy – particularly in the labor market, as highlighted by the February employment report – conditions are in place to resume spread tightening in credit – albeit given how far we have come already clearly at a slower pace. Thus our recently revised tighter 2012 spread target in high grade (150-160bps vs. current spreads of about 200bps) still applies (Figure 1). However, given higher valuations we review the top risks to our bullish outlook for credit – oil prices, Europe, US economy, China, supply, CCAR.
Risk #1: Oil prices
At this stage we consider the risk of higher oil prices – due to an escalation of the nuclear stand-off with Iran – as the biggest risk to our outlook between now and the middle of the year. On the one hand President Obama has suggested that a “window of opportunity” remains for a diplomatic solution, and experts in a conference call hosted by our colleagues do not expect military action in 2012 (see pages 12-13 here). On the other hand, the outcome of the geopolitical conflict at hand appears particularly difficult to predict given the high stakes for Israel. Thus we prefer to position defensively by overweighting oil producers and underweighting oil users that are particularly sensitive to higher oil prices. In our sector recommendations, we are market weight the Oil & Gas sector, reflecting the balancing of a bullish view on oil producers and a bearish outlook on Gas producers. Our tactical CDS trade is to short oil sensitive names against the index.
Risk #2: Europe
Until the PSI this was #1. However, clearly important risks remain both in the short and long term. What we as credit strategists are most concerned about is eroding/lacking public support for the fiscal checks and austerity programs that are being implemented across the Euro-zone. We are particularly concerned about the peripheral countries where unemployment rates are very high. Even if governments support unpopular austerity agreements, there is high risk that sitting governments may lose power to oppositions that are less committed.
Some of these political risks will play out in the short term – others in 2H or 2013 and later. First up is the regional election in Andalusia, Spain, on March 25th where the centre-right opposition looks likely to end a socialist regime that has been in power since 1982. Then on April 22nd we have the French election where the socialist opposition candidate, Francois Hollande, is well ahead of President Sarkozy in the polls. This is a risk for our markets as Mr. Hollande has stated that one of his goals is to renegotiate the EU fiscal compact from last December.
Then the Greek election is May 6th or 13th. Again it appears that the opposition (leftist parties) – which has not committed to the austerity programs – is polling well. While the polls have recently shifted to suggest a slim majority to the current government, as our European fx strategist discuss here, even such an outcome would be risky, as there are often defections in important votes. Thus, while Greece now is getting an improved capital structure with lower debt and maturities that are extended far out in the future (Figure 3), as well as an escrow account for interest payments, the second bailout program could still unravel.
Risk #3: US economy
To us, the US economic risk appears more back-loaded toward the last part of the year than of immediate concern. In fact, due to automatic fiscal tightening to the tune of about 4.5% of GDP in 2013, our economists have an out-of-consensus outlook for a slowdown in economic growth to 1% in 4Q, as companies anticipate the tightening. While we are mindful of this risk, we think that our markets are unlikely to be affected by this fiscal tightening before perhaps the fourth quarter – and we think there are mitigating factors. The ultimate impact to our markets will depend on the prevailing level of economic growth – for example, a decline in growth to 1.5% from 2.5% will be much more benign for corporate bonds than a drop to 1.0% from 2.0%. However, clearly the US economy faces significant fiscal policy risks – not to mention another potential debt ceiling debacle toward the end of the year or early 2013.
Risk #4: China
China is a perennial constituent of our list of biggest risks. However, as usual we put this risk toward the end – not because of a small expected impact but because it is less likely to materialize this year. Early this week the markets were spooked by China lowering its official GDP growth target for the year to 7.5% from 8.0%. However, this move was expected by our Chinese economists as they discussed it two weeks prior to the move. Also, notice how actual growth in China almost always exceeds the official target growth – sometimes considerably such as in 2007 where the economy grew by 14% compared with a target of only 8% (Figure 4). Thus the new lower growth target is still consistent with our outlook for a soft landing in China with growth of 8.6% this year.
However, longer term we, as credit strategists, remain concerned that something has to give to ease the imbalances in China, including high real estate prices.
Other risks: Supply, CCAR
There are many other risks to our bullish outlook for US credit including supply overflow. First we highlight supply. This year we have seen heavy supply volumes in high grade – for example this week we saw $42.8bn pricing, the second busiest week on record after the week of Jan 26, 2009 (Figure 5), which saw $44.8bn in supply (but including $21.5bn of government guaranteed financial debt). Not counting government guaranteed issuance, this week was the busiest on record. Clearly heavy supply volumes can weigh on spreads, but rather than this being bearish for credit we would call it instead “less bullish”. This is because the higher than expected supply volumes we have seen this year result directly from very favorable excess demand conditions for corporate bonds. Thus the same technical that helps drive credit spreads tighter creates increased supply volumes.
Next week – most likely on March 15th – we expect the Fed to release results from the bank Comprehensive Capital Analysis and Review (CCAR), including the harsh stress tests. Our bank equity analysts expect this to be largely a non-event as companies have managed expectations. Because bank capital positions have improved significantly (Figure 6), we expect any adverse implications of the CCAR to be concerned with banks’ abilities to return capital to shareholders, more than a lack of capital. This highlights that increased regulation and monitoring is mainly an equity story while working to make credit safer.