Bank Of America Spots An €800 Billion Cliff "That Fills Us With Fear"

Ever since the ECB commenced buying tens of billions of sovereign and corporate bonds, it is undeniable that Europe's economic picture brightened substantially, eliminating occasional flash crises such as Greece and Italy which had a contagious event on the rest of the Eurozone, and why not: after all there was a definitive backstop to all the risk - nothing bad was allowed to happen, or as Draghi said, any adverse outcomes would be fixed "whatever it takes."

But in recent months Europe's economic picture has turned decidedly dour, if not so much in the primary data where things are still stable, then certainly in manufacturing surveys, and especially for Europe's economic dynamo, the export economy. As the chart below shows, PMI trends for new export orders have fallen notably in 2018 – and not just for Europe, but also for Japan and the US. This, according to BofA's Barnaby Martin, "may point to less vibrant export activity across the world. For Europe, whether this is really the case, or just a reflection of €-strength earlier in the year, remains to be seen. But for now we think the economic data has not been convincing enough to ignite enough of a rally in European risk assets"

Which brings us to the next logical thought: could Europe be approaching a recession, especially if trade wars with the US cripple Europe's exports which forms that backbone of the German economy, without which Europe is lost. Anecdotally, the following colorful snippet from Martin explains why a US-Europe trade war would really be Europe at war against itself.

If US-EU trade tensions escalate, we would view it as akin to pitting Europe vs. Europe. The US trade deficit with the EU-28 is far from homogenous. Germany exports cars to the US…but France doesn’t, and while Italy is a net exporter to the US, the Netherlands is a net importer. Therefore, growing trade tensions are likely to further fragment the Eurozone, just at a time when ECB QE is drawing to a close.

To be sure, Europe's current growth trajectory remains far from a recession. According to BofA's economist team, which recently took down their 2018 Eurozone growth outlook from 2.4% to 2.1%, partly marking-to-market given the weak Q1 momentum, they acknowledge the downside risks posed by Italy and trade tensions. At the same time, however, they calculate that "a trade war coupled with a confidence shock could push the US economy to the brink of recession."

It's not just trade however that is a defining risk for Europe's highly "connected" economy: a far bigger risk is what happens to the ECB's QE... and what, if anything will replace it?

As Martin explains in a note titled The "next" recession, "we worry that the ECB is ending QE…but nothing else is being instigated to take up the slack. In particular, fiscal stimulus is not on the cards in Europe, despite the positive effects of it being evident now in the US (see Q1 US earnings, for instance)."

This is demonstrated in the next chart which shows just how different the US and Europe are in regard to fiscal generosity vs austerity.

So what happens if the worst case scenario emerges and after several months, not only QE ends but European trade concerns are realized, and a recession becomes unavoidable?

This is where things get complicated, not so much for the economy itself, but for how such a slowdown would impact hundreds of billions of debt that exists largely thanks to the ECB's QE, and which is currently on the cusp between investment grade and junk. Here is Martin:

The idea of the “next” Eurozone recession fills us with a lot of fear however. Not just because many central banks would be relatively constrained in their ability to cut rates after their big post-GFC easing, but more because of how disruptive it could possibly be to the Euro credit market.

As the BofA strategist explains, the disruption would manifest itself first and foremost in how Europe's "QE years" have profoundly altered the structure of the Euro credit market, to wit:

"Not only, on the one side, have they encouraged the more credit-constrained issuers to embrace bond financing, but on the other side the strict eligibility rules of CSPP have motivated high-yield companies to deleverage and return to an IG-status, where possible."

The outcome has been an unprecedented increase in BBB-rated debt to fund Europe's recent growth, debt which however is now also Europe's Achilles heel.

The net result of these two themes in Europe is depicted, starkly, in Chart 4. Since the beginning of 2015 (PSPP  started in March ’15) the size of the BBB-rated non-financial sector has grown from €450bn to €755bn (66%). Conversely, the size of the Euro high-yield market has shrunk from €310bn to €285bn over this period.

As a result, this has left the non-financial BBB-market now 2.5x bigger than the high-yield market in Europe…a ratio not seen since before 2008.

Said otherwise, there is close to €800bn of BBB-rated non-financial bonds, but the HY market is just €285bn in size (as a reminder, the ECB is technically prohibited from purchasing junk bonds in the open market).

Martin then shows what has been behind this dramatic increase in the size of the Euro-denominated BBB market over the last few years: it is demonstrated in the next chart which breaks down the components of market growth: here, around €200bn of growth comes from debut BBB-rated issuers, or said otherwise, "QE drove debt costs so low that many issuers who had previously never raised debt joined the party…"

It is here that the impact of a recession would be most acute: should a Eurozone recession become a more plausible event down the line, then the prospect of negative rating migration would have overwhelming consequences for the credit market in Europe, as the "the potential for such a vast amount of Fallen Angels (BBBs being downgraded to high-yield) at a time when Euro high-yield bonds are shrinking would cause enormous ructions and indigestion in the market."

Even in a best case scenario in which some BBB-rated issuers staved-off a downgrade with rights issues or emergency asset sales, the potential Fallen Angel quantum is still dramatic.

For reference, the largest expansion of ICE BofAML’s European Fallen Angel bond index was from €20bn to €110bn – but this took almost 7yrs to transpire (from September 2008 until April 2015). But in the “next” European recession, rating downgrades would not take 7yrs, in our view.

For the reductionists, there is a far simpler way to describe the above dynamic: the ECB's punchbowl led to an unsustainable credit bubble, especially among investment grade companies that are on the cusp of a downgrade should a recession hit, which would cascade into the capital markets resulting in "enormous ructions and indigestion in the market."

In this light, it is easy to see why BofA is "filled with a lot of fear" from what is coming, and why it's conclusion is that "a Eurozone recession can’t (be allowed to) happen"

However, it is only a matter of time before one does hit, and it will be the fallen angels that are hit first. Which explains why there are already those who, like Oaktree and Horseman Capital, are preparing to capitalize on what we recently called the "$1 Trillion Opportunity In The Coming Bond Crash."


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In reply to by Captain Nemo d…

To Hell In A H… Rothbardian in… Thu, 06/28/2018 - 11:36 Permalink

Economic theory no longer applies in practice. Printing money in theory causes inflation etc. How much as the west printed?  Yes inflation has hidden itself in the housing market, but where else to such a scale? Not precious metals or in energy? I don't know what to believe anymore, regarding how they can keep juggling 30 balls in the air with one hand, but they are.

The event that pushes us over the edge, I simply cannot predict, because according to my previous predictions, I am already 1 year over my own timeline.

In reply to by Rothbardian in…

rex-lacrymarum To Hell In A H… Fri, 06/29/2018 - 16:42 Permalink

I don't think you really understand economic theory. Why would it no longer apply? The validity of economic laws is time and place-invariant and universal. Since you mention "inflation" (i.e., the declining purchasing power of money, or rising prices), it is far more complex than you make it out to be. In other words, just because you have not seen CPI explode after a period of fairly intense money-printing (by post-war standards) definitely does not mean that economic laws have magically stopped operating. 

In reply to by To Hell In A H…

Number 9 Thu, 06/28/2018 - 11:33 Permalink

what is the problem? ONLY 800 bil.. chicken feed..

"Mable, ctrl p 10 trillion"

there, problem solved..


I should run for office and demand moar ctrl p for eveh body..

I am younger and much better looking than berning sanderz

mr1963 Thu, 06/28/2018 - 11:46 Permalink

When you steal your citizens own monies through NIRP, you have to expect consequences through lost value, confidence, and spending power. Bailing out borrowers rarely works, they just borrow more, and fail on that. Eventually, someone has to pay?

hooligan2009 Thu, 06/28/2018 - 12:37 Permalink

"whatever it takes" mans that the ECB would buy down to B/BB "if necessary"- or, as the US did, suspend accounting rules and insitgate their own credit rating agency.

IOW, in a ratings context, "when they go low, we stay higher".

the analogy should be "if you give pacific islanders access to free food and "everything" at zero cost for ten years, do not be surprised that they get fat and lazy - also do not be surprised that if you stop giving out free food and "everything", they will either to revert to exactly the same as before the free "everything" or die. this means you have achieved absolutely no behavioural change whatosever and all the problems are unresolved".

UNresolution is "de rigeur" for the libtard demoNrat socialists within the EU and their drug junkie insane enablers, the ECB.

itstippy Thu, 06/28/2018 - 12:48 Permalink

When you live within your means, stability is comfortable.

When you live above your means by taking on debt, stability is deadly.  You MUST grow or the debt eats you.

QUESTION: With every single major nation's government mired in excessive debt, the vast majority of major corporations drowning in debt, the world's financial institutions leveraged to obscene levels, and the majority of the Western world's people buried under a crushing load of private debt, who are the creditors?


snblitz Thu, 06/28/2018 - 14:22 Permalink

If I read this right, two quarters of negative GDP prints  means many bond ratings are downgraded and the world ends.

Thus the article points out that GDP must not be allowed to be negative.  This seems simple enough.

Also one can see that the government / central banks could also fix the problem by stopping the downgrades.

Should not an article making the above assertions include how the government / central banks might respond to stop the negative GDP prints or otherwise explain why the government / central bank would not be able to do this?

arrowrod Thu, 06/28/2018 - 14:50 Permalink

Is there any good news?  The economy is roaring in the U.S.  The Commerce Department reports a downturn.  How many Democrat government workers are there?

What does the Commerce Department do?

gdpetti Thu, 06/28/2018 - 15:38 Permalink

Well, allowing all those immigrants in helps with the regime change... 'out with the OWO, in with the NWO'... and given Mother Nature's arrival in the next few years, it's just part of the prepping... the culling of the herd.... here's another look at what's in store, the signs are everywhere these days... just look at the Hawaii situation... off the charts... heading to the West Coast.

But as for the northern EU:

Let it Go Thu, 06/28/2018 - 18:16 Permalink

The Euro-zone has entered a rough patch which in many ways is the result of years of inaction. Its banks are weak and concerns over the toll millions of newly arrived refugees will take on society are reaching a breaking point.

This has created what Bloomberg describes as "an escalating crisis that threatens to unravel the bloc’s passport-free travel area and dissolve Germany’s governing coalition." Even trade is playing into this. More on the Euro-zones woes that continue to linger in the article below.

 http://The Euro-zone Has Few Good Options As It Enters A Rough Patch.html