Deutsche Bank’s To Raise €8 Billion Capital And Tweaks Strategy

From Moody’s

On Sunday, Deutsche Bank AG announced an €8 billion fully underwritten common equity capital raise and some major course corrections to its 2020 strategic plan. These measures, on top of the firm’s progress in de-risking its balance sheet, are positive for DB bondholders. Most importantly, the capital raise gives DB more time and financial leeway to achieve the revised 2020 plan, although sustainable improvement to the bank’s credit strength and ratings will depend on the success of its ongoing reengineering. With plenty for management still to do, capital and liquidity protection and strong strategic execution will continue to drive DB’s creditworthiness this year.

The fully underwritten €8 billion equity capital raise will increase DB’s fully loaded common equity Tier 1 ratio by about 200 basis points to more than 14% pro forma as of year-end 2016, significantly improving its capital position relative to its closest global investment bank peers, especially considering the reduction in tail risk resulting from a settlement with the US Department of Justice announced in late 2016.

The capital raise is a powerful response to the challenges DB faced in 2016, and will allow the bank to pursue business and revenue growth more assertively following losses in 2016 that hindered efforts to strengthen and stabilize profitability and led to some customer and counterparty attrition. The settlement with the Justice Department has helped alleviate concerns, and momentum has picked up in many businesses this year, aided by improved market conditions.

Along with the capital raise, DB announced five key components to the latest recalibration of its strategic plan. They are the following:

  • Retain, rather than dispose of, Deutsche Postbank AG and merge it with DB’s domestic operations, thereby eliminating the Postbank ring-fencing, which would make retail liquidity more fungible and increase the potential for cost efficiencies
  • An initial public offering of a minority stake in Deutsche Asset Management to provide a new share currency that DB can use for retention and recruitment of investment management talent and for potential expansion
  • Reconfigure the existing Global Markets, Corporate Finance and Transaction Banking businesses into a single Corporate and Investment Banking division to generate additional cost savings and pursue a strategy more focused on cross-selling to real economy corporate clients
  • Some senior management changes, including the creation of two deputy CEO positions
  • Board approval of upcoming Additional Tier 1 coupons and an intention to reinstate the common dividend at a rate of €0.11 per share in May 2017

Management indicated further restructuring costs of approximately €2 billion through 2020 and a plan to establish a legacy portfolio of approximately €46 billion of risk-weighted assets, mostly in the form of legacy rates and credit positions and other non-core assets.

The decision to retain, rather than dispose of, Postbank is a major strategic reversal. If approved by regulators, the plan to integrate Postbank into DB’s existing German private and commercial banking and wealth management businesses may eventually bring bondholder benefits in the form of fungible liquidity across the bank, and a greater contribution of earnings from German retail banking, bringing more balance to the business mix. Streamlining and refocusing these businesses will help DB build leaner, more profitable franchises that more closely match its long-term strategic goal to simplify and de-risk the bank while revitalizing its operating platform and processes.

At this stage, however, we think large cost savings will prove difficult to achieve. In 2016, DB reported an 84% cost-to-income ratio for Postbank and an 83% cost-to-income ratio for the Private, Wealth & Commercial Clients segment, illustrating the formidable execution challenge the bank will face to reach its 65% target. The task is further complicated by the fact that Postbank owns BHW, a savings and loan association whose business model is particularly challenged by the low interest rate environment.

Germany’s Overvalued Real Estate Market Poses Risks for Banks and RMBS

From Moody’s

Last Monday, the Deutsche Bundesbank, Germany’s central bank, reported that residential real estate prices in German cities are overvalued by 15%-30% relative to fundamental measures of value, with the large cities at the upper end of the range (see Exhibit 1). Such overvaluation is credit negative for banks with concentrated retail mortgage books in urban areas, banks with large retail mortgage franchises and residential mortgage-backed securities (RMBS). Overvaluation creates the risk of losses if foreclosed properties backing mortgage loans are sold after a fall in house prices. The credit effect for covered bonds is limited owing to the statutory protection provided by Germany’s covered bond law (Pfandbrief Act).

For banks, the risk lies in their exposure to retail mortgages if a price correction occurs once interest rates rise materially, along with an acceleration in new housing loans originated in the past two years and margins that have shrunk. Although the combination of these factors in and of themselves do not immediately lead to higher defaults owing to the long-term fixed-rate nature of German residential mortgages, a lower recovery value following a price correction in a foreclosure would require the banks to increase cash provisions on defaulted exposures.

Bundesbank data also show that over the past two years, German banks have increased their new lending volumes by 20% versus the average origination volume during 2009-14 (see Exhibit 2). Hence, if residential property prices were to fall following an increase in interest rates or because of supply-demand imbalances, banks would face meaningful loan-loss provisions in case of default. If residential property prices were to retreat to 2010 levels, we would expect the share of loans with loan-to-value ratios (LTV) of more than 100% to increase to more than 40% of all outstanding mortgages.

RMBS would be negatively affected if house prices were to correct because loss severities (the proportion of the loan not covered by the proceeds from selling the property) would rise. German RMBS typically contain loans originated at high LTVs of 90%,6 on average, with some at above 100%. Deleveraging and house price increases in recent years have resulted in current market price LTVs averaging 55%.7 However, this ratio is primarily driven by one transaction (Pure German Lion RMBS 2008). For instance, EMAC-DE transactions and Kingswood Mortgages have LTVs of 80% on average.

The mortgage covered bonds of Sparkasse KoelnBonn and Hamburger Sparkasse (all rated Aaa) are most exposed to a potential correction of urban residential real estate prices. Both programs have a large share of residential and multifamily mortgage loans in the cover pools, and these issuers focus mortgage loan underwriting on urban areas. Nevertheless, German Pfandbrief are well protected against a potential fall in house prices. The 60% loan-to-lending-value threshold prescribed in the Pfandbrief Act ensures that only loan parts equal to the first 60% of a property’s lending value (defined in the act as the long-term sustainable property value excluding any speculative price components) are eligible for cover pools. The Pfandbrief Act also stipulates that property valuations are not adjusted upward after loan origination in case of property price increases, providing a buffer against price declines if borrowers default on their mortgage loans.

Low VIX and Thin Spreads Could Be on Thin Ice

From Moody’s.

The February 1 FOMC meeting minutes noted two interrelated developments. First, the narrowing by “corporate bond spreads for both investment- and speculative-grade firms” to widths that “were near the bottom of their ranges of the past several years.” Secondly, some FOMC members were struck by how “the low level of implied volatility in equity markets appeared inconsistent with the considerable uncertainty attending the outlook for such policy initiatives.”

Thus, some high-ranking Fed officials sense that market participants are excessively confident in the timely implementation of policy changes that boost after-tax profits. And they may be right, according to Treasury Secretary Steven Mnuchin’s recent comment that corporate tax reform legislation may not be passed until August 2017 at the earliest. The ongoing delay at remedying the Affordable Care Act warns of a possibly even longer wait for corporate tax reform and other fiscal stimulus measures.

Treasury bond yields declined in quick response to the increased likelihood of a longer wait for fiscal stimulus. Lower benchmark yields will lessen the equity market’s negative response to any downwardly revised outlook for after-tax profits. Provided that profits avoid a replay of their year-to-year contraction of the five quarters ended Q2-2016 and that interest rates do not jump, a deeper than -5% drop by the market value of US common stock should be avoided.

The importance of interest rates to a richly priced and supremely confident equity market cannot be overstated. In fact, the rationale for an unduly low VIX index found in the FOMC’s latest minutes contained a glaring error of omission. Inexplicably, no mention was made of how expectations of a mild and thus manageable rise by interest rates have helped to reduce the equity market’s perception of downside risk. An unexpectedly severe firming of Fed policy would doubtless send the VIX index higher in a hurry.

Moreover, the FOMC’s latest minutes failed to comment on the close linkage between the now below-trend spreads of corporate bonds and an exceptionally low VIX index. As inferred from long-term statistical relationships, the VIX index now supports the possibility of corporate bond yield spreads that are much narrower than what is suggested by the default outlook. For the purpose of quantifying the latter, an aggregate version of expected default frequencies will be employed.

VIX Index and high-yield EDF metric differ on risk

Though the calculations of both the VIX index and EDF (expected default frequency) metrics are sensitive to asset price volatility, the messages delivered by each measure of risk can differ significantly. The 0.72 correlation between month-long averages of the VIX index and the aggregate EDF metric of US/Canadian high-yield issuers is statistically significant, but it is also far from perfect. For example, despite their relatively strong positive correlation, the VIX index and the high-yield EDF occasionally move in different directions.

Since the January 1996 inception of the average high-yield EDF metric, the medians during business cycle upturns were 3.7% for the high-yield EDF and 17.9 for the VIX index. Recently, the high-yield EDF nearly matched its median of all recovery months since December 1995, while a VIX index of less than 13 was well under its comparably measured median. In other words, the high-yield EDF metric senses a good deal more financial market risk than the VIX index does.

By way of simple regression analysis, the high-yield EDF metric now predicts an 18.3 midpoint for the VIX index, which is far above a recent reading of 12.2. Conversely, the VIX index predicts a 2.7% midpoint for the high-yield EDF metric that is less than the actual EDF of 3.7%.

The two broad measures of risk also now predict two vastly different midpoints for the US high-yield bond spread. Compared to the high-yield spread’s recent 384 bp, the VIX index predicts a midpoint of 365 bp which is much thinner than the 462 bp predicted by the recent high-yield EDF and the EDF’s three-month trend.

Both cannot be right. Nevertheless, the modest outlook for 2017’s profits from current production suggests that the EDF’s predictions for the VIX index and the high-yield spread may prove to be more accurate than the VIX index’s projections for the high-yield EDF metric and spread. However as noted earlier, the realization of modest profits growth may be sufficient for the purpose of warding off a deep slide by share prices provided that the effective fed funds rate finishes 2017 no higher than 1.13%, while the 10-year Treasury yield’s annual average for 2017 is no greater than 2.6%.

Leveraging Will Survive Corporate Tax Reform – Moody’s

Moody’s says analysts from a major bank believe that reducing the top corporate income tax rate from 35% to 20% will slow the average annual increase of US industrial company debt over the next 10 years from nearly 5% without a tax cut to roughly 2% with the tax cut.

However, what happened after the slashing of the top corporate income tax rate from 1986’s 46% to 1987’s 40% and, then, to 1988’s 34% questions whether prospective tax cuts will more than halve the growth of corporate debt over the next 10 years.

Nevertheless, business borrowing is likely to be noticeably lower if business interest expense is no longer tax deductible. Such tax-reform induced reductions in business borrowing will be most prominent among very low grade credits and during episodes of diminished liquidity, extraordinarily wide yield spreads for medium- and low-grade corporates, and exceptionally high benchmark borrowing costs.

The top corporate income tax rate probably will be cut from i 35% to either the 20% proposed by House Republicans or to the 15% offered by Trump’s team. Assuming, for now, the continued tax deductibility of corporate interest expense, a lower corporate income tax rate increases the after-tax cost of corporate debt. However, a reduction by the corporate income tax rate may add enough to after-tax income to more than offset the burden of a higher after-tax cost of debt. In addition, today’s relatively low corporate borrowing costs will mitigate the increase in the after-tax cost of debt stemming from a lowering of the corporate income tax rate.

Corporate debt sped past GDP and revenues despite tax cuts of 1987-1988
Thus, a lowering of the top corporate income tax rate probably will not have much of a discernible effect on corporate borrowing. Despite the lowering of the corporate income tax rate from 1986’s 46% to 34% by 1988, the ratio of debt to the market value of net worth for US non-financial corporations rose from 1986’s 38.6% to a mid-1994 high of 51.1%. Moreover, from year-end 1986 through year-end 1989, non-financial corporate debt advanced by 9.6% annually, on average, which was much faster than the accompanying average annual growth rates of 7.2% for nominal GDP and 7.0% for the gross value added of non-financial corporations.

The supposed de-leveraging effect of corporate income tax cuts was further challenged by how debt outran both the economy and business sales despite still elevated corporate borrowing costs. For example, Moody’s long-term Baa industrial company bond yield barely fell from 1986’s 10.73% average to the still costly 10.55% of 1987-1989, while a composite speculative-grade bond yield actually rose from 1986’s 12.44% to the 13.05% of 1987-1989.

It should be noted that the increase in the after-tax cost of debt was greater following 1987’s corporate income tax cut because of the much higher corporate bond yields of that time and yet corporate debt still grew rapidly. In stark contrast, recent yields of 4.74% for the long-term Baa-grade industrials and 5.96% for speculative-grade bonds are substantially lower, which, in turn, lessens the degree to which corporate income tax cuts discourage balance-sheet leveraging.

Is Overvaluation Risk Real?

From Moody’s.

VIX Is Low, Overvaluation Risk Is Not

Overvaluation does not preclude an even higher market value of common stock relative to current and expected corporate earnings. Moreover, provided that the now extraordinarily low VIX index stays under 11.8, a further narrowing by corporate bond yield spreads is likely. However, an increasingly overvalued equity market favors a higher VIX index.

A convincing explanatory model for the high-yield bond spread employs measures of default risk and business activity, in addition to the VIX index. This model recently predicted a 411 bp midpoint for the high-yield spread, which eclipses its recent actual gap of 394 bp. By the way, the latter is the thinnest high-yield spread since September 2014.

What is now the lowest predicted midpoint since April 2015 owes much to an ultra-low VIX index. After removing the VIX index from the explanatory model, the predicted midpoint for the high-yield spread widens to 456 bp. (Figure 1.)

Record highs for stocks, not so for profits

For the first time ever, the blue-chip Dow Jones Industrial average broke above 20,000. Meanwhile, the market value of all US common stock as measured by the Wilshire Index set a new record high.

Nevertheless a popular measure of core profits, though improving, remains well under its apex. Since the moving yearlong estimate of pretax profits from current production peaked at the end of March 2015, the market value of US common stock has climbed higher by 10%. By contrast, the consensus estimates that for the year-ended March 2017, core pretax profits will still trail March 2015’s zenith by -5%. Moreover, the consensus does not expect yearlong profits to eclipse its record high until 2018’s second quarter.

As inferred from the different directions taken by share prices and profits since March 2015, the US equity market is richly priced, if not significantly overvalued. However, overvaluation does not promise impending doom for share prices.

For example, during 1998-2000’s stock market frenzy, though overvaluation first resembled today’s excesses in 1998’s second quarter, the market value of US common stock continued its ascent until March 2000 despite becoming increasingly overvalued. Amazingly, notwithstanding the accompanying -7% drop by yearlong profits from December 1997’s peak, the market value of US common stock managed to soar by a cumulative 49.5% from 1997’s final quarter through the first quarter of 2000.

Not surprisingly, March 2000’s unprecedented overvaluation of equities set the stage for a cumulative -43% plunge to October 2002’s bottom. Granted that today’s overvaluation falls considerably short of the excesses of late 1998 through early 2000, buying into an overvalued market necessarily entails above-average risk.

Based on the historical record, the current rally may not expire soon. Absent another extended bout of profits deflation, the US equity market is likely to set new records regardless of today’s overvaluation. For now, the consensus expects pretax operating profits to grow through 2018.
Interest rate risk now poses the biggest danger to stocks.

Nevertheless, substantially higher interest rates could temporarily drive the market value of US common stock down by at least -5%. Sharply higher interest rates previously outweighed the positive effect of profits growth and temporarily sank share prices in 1994 and late 1987. In both instances, deep declines by interest rates allowed profits to re-assume its leading role as the primary driver of equity valuation.

Incredibly, 1987’s outsized 19% annual advance by core profits was not enough to prevent a stock market crash of frightening severity. In late 1987, the market value of US common stock plunged by as much as -27% from its then record high largely because of a lift-off by the 10-year Treasury yield from a January 1987 average of 7.08% to the 10.36% of October 17, 1987.

In fact, it was at the morning of October 19, 1987’s infamous -18% daily plummet by the market value of US common stock that the benchmark Treasury yield was last above 10%. Who would have thought back then that 30 years later markets would fret over the possibility of a 3% benchmark Treasury yield?

Regarding 1994’s far less dramatic episode, a climb by the 10-year Treasury yield’s month-long average from October 1993’s 5.3% to April 1994’s 7.0% helped to sink the market value of common stock by -5.3% from its then record high despite an accompanying 19% annual advance by profits.

Do not underestimate the power of sharply higher benchmark interest rates to pummel share prices. The equity market sell-offs of both 1994 and 1987 occurred despite significant narrowings by medium- and low-grade bond yield spreads. Nor did the declining trends of high-yield defaults offset the selling pressure arising from fast rising Treasury yields.

As inferred from what occurred in 1987 and 1994, the 10-year Treasury yield may need to approach 3% for there to be at least a 50% likelihood of a 5% drop by equities amid profits growth. However, the record also makes clear that an especially disruptive ascent by benchmark yields is likely to be reversed. In order to stabilize share prices, the 10-year Treasury yield’s month-long average fell to 8.21% by February 1988 and to 5.65% by January 1996.

VIX Index stays low despite risks surrounding overvalued equities

Overvaluation warns of a painful correction in the event market sentiment worsens considerably. In recognition of ample downside risk, the VIX index has tended to be greater in richly priced equity markets, where above-trend VIX indexes have typically been joined by above-average corporate bond yield spreads. (Figure 2.)

In the current market, however, the VIX index has broken from the norm and remained unexpectedly low amid elevated ratios of equity’s market value to core profits. The market value of US common stock recently approximated 11.2-times the yearlong estimate for pretax profits from current production for the highest such ratio since the 11.5:1 of 2002’s second quarter. It was in 1998’s first quarter that common equity’s market value last climbed up to 11.2-times core profits. At that time, the VIX index averaged 21.3, which was far above its recent 10.8. Similarly, when the ratio of common equity’s market value to profits rose to Q4-2007’s previous cycle high of 10.3:1, the VIX index averaged a well above-trend 22.1. Thus, the longer elevated price-to-earnings ratios persist, the more likely is a climb by the VIX index that ordinarily is accompanied by wider corporate yield spreads.

On January 24, 2007 the VIX index closed at a record low 9.89. Ten years later the VIX index closed at the 10.83 of January 25, 2017. The latter was its lowest finish since the 10.32 of July 3, 2014, or when the high-yield bond spread was an exceptionally thin 322 bp. However, even that gap was wider than the 276 bp of January 24, 2007. Do not be surprised if an ultra-low VIX continues to lead the high-yield bond spread lower.

According to the historical statistical relationship, by itself, the recent VIX index of 10.9 predicts a 326 bp midpoint for the high-yield bond spread, which is much thinner than the recent 394 bp. As shown in Figure 3, exceptionally low readings for the VIX index have tended to prompt narrowings by the high-yield spread throughout the current business cycle upturn. (Figure 3.)


US Deregulation Seen to Spur to Growth, Trim Risk

Moody’s says Washington’s transfer of power is complete. Very high probabilities can now be assigned to lowering the 35% corporate income tax rate, easing federal business regulations, and a major overhaul of the US government’s role in health insurance.

Deregulation will supply stimulus at no immediate cost to the taxpayer. Nevertheless, deregulation reintroduces systemic risks that could prove costly over time.

A relaxation of federal business regulations and changes in government-mandated health care programs may supply an unexpectedly large lift to business activity. Not only will overhead costs decline, but businesses will be able to allocate a greater portion of their scarce resources to an enhancement of their product offerings. Success at the latter will expand attractive job opportunities.

Regarding a possible reformulation of Dodd-Frank, diminished regulatory burden will increase the supply of mortgage credit and business credit. Mortgage yields and business borrowing costs may be lower than otherwise, helping to offset the upward pressure put on private-sector borrowing costs by a higher fed funds rate and higher Treasury bond yields.

In addition, a softening of Dodd-Frank would enhance the ability of banks to make markets in corporate bonds and leveraged loans, where the availability of buyers for riskier debt is of critical importance during episodes of systemic financial stress. Corporate credit spreads have been wider than otherwise because of worry surrounding market depth in a time of stress.

Paradoxically, despite fears that a relaxation of regulations will add to systemic risk, a widely followed measure of business credit risk — the high-yield bond spread — has narrowed considerably from an election day, or November 8, close of 515 bp to a recent 409 bp. Indeed, high-yield bonds have far outperformed higher-quality bonds since Election Day. Unlike the 10-year Treasury yield’s jump from November 8’s 1.86% to a recent 2.43% and the rise by an investment-grade corporate bond yield from 3.00% to 3.34%, a composite speculative-grade bond yield sank from November 8’s 6.53% to a recent 5.96%.

As inferred from the high-yield bond market’s upbeat response to the Republican sweep, the outgoing administration’s efforts to reduce systemic financial risk may have weighed so heavily on business activity and the efficient functioning of financial markets that they increased perceived default risk on a company by company basis. How ironic that an anticipated relaxation of financial and other business regulations has lessened perceived default risk considerably.

Room for growth may still go unfilled

And there is plenty of room to expand business activity without the risk of a potentially destabilizing upturn by price inflation. Rates of resource utilization are now exceptionally low for the seventh year of an economic recovery. If demand materializes, the Trump administration’s goal of 3% to 4% real growth for the US economy may at least be temporarily achievable.

However, given the financially stressed condition of many households both at home and abroad, as well as the diminished spending proclivities of the aging populations of advanced economies, spending may fall short of what is needed to sustain 3% to 4% growth over a yearlong span.

Moreover, real GDP growth of at least 3% may not be a recurring phenomenon. Long-term economic growth may be constrained to a pace closer to 2% if both the labor force and productivity continue to rise at rates that are well below their respective long-term trends.

Consensus outlook for profits requires faster than forecast GDP growth

Early January’s Blue Chip consensus projection of a 5.0% annual increase for 2017’s pre-tax profits from current production may be incompatible with the accompanying forecast of a 4.4% annual increase by 2017’s nominal GDP. Only if employment costs slow from their 4.7% annual climb of the year-ended September 2016 might nominal GDP growth of 4.4% deliver profits growth of 5.0%. However, if the recent 4.7% unemployment rate correctly indicates rising wage pressures, a deceleration by employment costs seems unlikely.

As inferred from the strong 0.87 correlation between the annual yearlong growth rates of corporate gross value added and nominal GDP, the consensus prediction of 4.4% nominal GDP growth favors a 4.1% annual gain for 2017’s corporate gross-value-added, where the latter is a proxy for corporate revenues.

In terms of moving yearlong averages, the percentage point difference between the annual growth rates of gross value added less corporate employment costs generates a strong correlation of 0.86 with the annual growth rate of pretax profits from current production.
Combining 2017’s prospective annual increase of 4.1% for gross value added with 4.7% employment cost growth predicts a 2.5% midpoint for the annual increase of 2017’s pretax operating profits. To the contrary, the equity and high-yield bond markets may be pricing in faster growth rates of 4.9% for gross-value-added and 5% for employment costs, where such assumptions support a predicted midpoint of 5% for core profits growth. However, 4.9% growth by gross-value-added may require faster-than-forecast nominal GDP growth of 5%.

Profits growth is likely if capacity use rises

Fourth-quarter 2016’s comparatively low industrial capacity utilization rate of 75.3% amplifies 2017’s upside potential for earnings growth. After declining from a year earlier in each of the last seven quarters including Q4-2016, the capacity utilization rate is expected to increase annually in each quarter of 2017. If true, the return of profits growth in 2017 is practically assured.

The yearly percent change by pretax profits from current production shows a highly asymmetrical response to the capacity utilization rate’s yearly percentage point change. Since early 1979, 68, or 85%, of the year-to-year increases by the capacity utilization rate have been joined by a year-to-year increase for profits. In stark contrast, only 32, or 46%, of the span’s 70 yearly declines by the capacity utilization rate were accompanied by lower profits.

The fuller use of production capacity also bodes well for corporate credit. In terms of yearly changes, the high-yield bond spread narrowed for 63% of the months since mid-1987 showing an increase by the capacity utilization rate, while the spread widened for 66% of the months showing a decline by capacity utilization.
Still low rates of resource utilization suggest that the current recovery may prove to be a late bloomer in terms of realizing its full potential.

Credit Looks for US to Realise Potential

Moody’s says today’s still underperforming US economy leaves plenty of room for significant improvement in 2017 without the unwanted side effect of significantly faster price inflation. The US economy may be far from realizing its full potential.

January 2017 marks the 91st month of the current economic recovery and yet the US economy’s rates of resource utilization leave considerable room for additional production. In terms of the latest three-month averages, only 75.2% of industrial capacity was in use, while payrolls approximated a relatively low 57.0% of the working-age population. When previous upturns were of similar vintage in October 1998 and June 1990, the industrial capacity utilization rate averaged 82.7% and payrolls averaged 59.9% of the working age population.

Will this be the first economic recovery since the 1930s where the capacity utilization rate’s moving three month average fails to reach the 80% mark, where the latter is typically associated with the sufficient utilization of potential industrial output? Thus far in the current upturn, this version of capacity utilization has risen no higher than the 78.6% of Q4-2014. Figure 1 indicates a good deal of room to grow for industrial capacity utilization and, thus, lends support to the possibility of faster than 3% real GDP growth. By comparison, real GDP has risen by only 1.8% annualized, on average, for the current recovery to date and not since 2005’s 3.3% has growth managed to reach 3% for an entire calendar year. (Figure 1.)

In a similar vein, late 2016’s relatively low ratio of jobs to the working-age population preserves the possibility of a fuller utilization of US labor resources that could supply a noticeably faster rate of economic growth. However, the recent absence of labor productivity growth limits the extent to which faster jobs growth can quicken economic growth. (Figure 2.)

Yes, late 2016’s comparatively low rates of resource utilization hint of considerable upside potential for US business activity. Nevertheless, whether such potential is realized depends on a far from assured quickening of expenditures. For one thing, the recent strengthening of the dollar exchange rate heightens the importance of an acceleration by US household spending, which requires improved prospects for employment income.

The critical role of household expenditures cannot be overemphasized. Regardless of the more favorable tax treatment of capital outlays, businesses are only likely to significantly increase their production capabilities if they are convinced of sufficiently profitable markets for new and existing products.

Thus, businesses are likely to heed the warning of slower household spending growth implicit in the dip by payrolls’ annual increase from Q1-2015’s cycle high of 2.2% to Q4-2016’s 1.6%. The last two times payrolls decelerated in a similar manner, recessions arrived within 18 months.

Jobs outlook suggests spreads are too thin

Corporate credit is now very much priced for faster economic growth that will require the fuller utilization of US productive resources. The correlation between the high-yield bond spread and the moving three-month average of payrolls’ monthly percent change is a strong 0.78. Fourth-quarter 2016’s average monthly increase by payrolls of 0.11% predicts a 531 bp midpoint for the high-yield bond spread.

Accordingly, January 11’s far thinner high-yield bond spread of 405 bp implicitly expects faster jobs growth. However, as inferred from the Blue Chip consensus expectation of a drop by payrolls’ average monthly increase from 2016’s 180,000 jobs to 2017’s 161,000 jobs, the high-yield spread may soon be closer to 500 bp than to 400 bp.

Unemployment rate overstates labor market tightness

As opposed to the unemployment rate, the ratio of payrolls to the working-age population may now be the better estimate of labor market utilization, owing to the current recovery’s large number of labor force dropouts. For example, when the unemployment rate previously first fell to Q4-2106’s 4.7% in March 2006 and November 1997, payrolls averaged 60.2% of the working age population, which was well above Q4-2016’s 57.0%.

As inferred from the unemployment rate’s statistical relationship with the ratio of payrolls to the working-age population since 1988, Q4-2016’s ratio of 57.0% is ordinarily accompanied by a jobless rate of 6.8%. Even after allowing for how an aging workforce exerts a downward bias to the ratio of payrolls to the working-age population, the 4.7% unemployment rate still probably overstates the degree of labor market tightening. (Figure 3.)

In addition to an atypically low labor force participation rate, the 4.7% unemployment rate overstates labor-market tightness because of a relatively high U6 unemployment, or under-employment, rate. When the jobless rate’s moving three-month average previously first fell to 4.7% in March 2006 and November 1997, the U6 under-employment rate averaged 8.4%, considerably lower than Q4-2016’s 9.3%.

Nevertheless, the US labor market is firming up, as seen in the yearly increase of the average hourly wage from the 2.5% of Q4-2015 to Q4-2016’s 2.7%. However, when the unemployment rate’s three-month average last fell to 4.7% in Q1-2006, average hourly earnings posted a comparable increase of 3.4%. During the previous cycle, the yearly increase of the average wage’s moving three-month average peaked at the 3.8% of Q3-2006. By the time the moving three-month averages of the jobless rate and the U6 under-employment rate bottomed simultaneously in May 2007 (at 4.4% and 8.1%, respectively), the average hourly wage’s annual increase had slowed to 3.4%.

Despite an earlier acceleration by the hourly wage’s moving yearlong average from the 2.0% of the span-ended September 2004 to the 3.7% of the span-ended March 2007, the annual rate of growth for the core PCE price index peaked at a relatively modest 2.4%. By comparison, the core PCE price index rose by 1.7% annually during the three-months-ended November 2016. The possibly unfinished strengthening of the dollar exchange rate will limit the upside for US price inflation and just might intensify the price deflation still afflicting a number of internationally traded goods.

Ratio of jobs to the working-age population outshines other possible inflation indicators

The market’s recent obsession with December’s 2.9% yearly jump by average hourly earnings may have been unwarranted. After all, the annual rate of core PCE price index inflation generated a meaningless correlation of 0.04 with the yearly percent change of the average hourly wage.

By contrast, the ratio of payrolls to the working-age population again offers useful insight regarding labor market tightness and inflation risk. Since 1992, the year-to-year percentage point change for the ratio of payrolls to the working-age population shows a correlation of 0.31 with the annual rate of core PCE price index inflation, where this and forthcoming comparisons employ moving three-month averages.

As far as predicting core PCE price index inflation, the ratio of jobs to the working-age population also outperforms both the unemployment and U6 under-employment rates. For example, the jobless rate and its year-to-year percentage point change showed weaker correlations of -0.22 and -0.24 with the annual rate of core PCE price index inflation, while the U6 under-employment rate posted comparably measured correlations of -0.23 and -0.22, respectively. Thus, expectations of a continued mild rise by the ratio of payrolls to the working-age population suggest only a limited upside for core PCE price index inflation.

Consensus views on employment and industrial production favor a continuation of the Great Underutilization. Unless payrolls zoom ahead of recent forecasts, the midpoint for fed funds may finish 2017 no higher than 1.125%, while the 10-year Treasury yield spends most of the year under 2.5%. Only if the demand for US output delivers a big enough upside surprise might a substantially fuller utilization of resources help make America great again.

US Housing Finance Agencies Will Benefit from Cut in FHA Mortgage Insurance Premiums

Moody’s says on Monday, the US Department of Housing and Urban Development (HUD) announced that the Federal Housing Administration (FHA) will reduce by 25 basis points insurance premiums that borrowers pay on single-family mortgages. The premium cut is credit positive for US state Housing Finance Agencies (HFAs) because it will make FHA-insured mortgage loans more affordable to borrowers and increase HFA loan originations. The premium reduction will apply to new loans closing on or after 27 January.

HFAs are charged with providing and increasing the supply of affordable housing in their respective states for first-time homebuyers. The FHA, unlike other mortgage insurance providers, insure loans with loan-to-value ratios of up to 97%, which is key to the HFA lending base, given that first-time homebuyers often have limited funds for down payments.

The 25-basis-point decrease in the FHA’s insurance premium, which we expect will save new homeowners as much as $500 a year, also increases the competitiveness of HFA mortgage products. A lower FHA cost will attract more borrowers and stimulate stronger FHA loan originations at a time when mortgage interest rates are rising. As of 30 June 2016, FHA mortgage insurance provided the biggest share of the insurance on HFA pools, constituting approximately 38% of Moody’s-rated HFA whole-loan mortgages (see Exhibit 1), compared with 17% of mortgages utilizing private mortgage insurance.

HFA portfolio performance will strengthen because more loans will benefit from FHA insurance coverage. FHA insurance offers the deepest level of protection against foreclosure losses relative to other mortgage insurers because they cover nearly 100% of the loan principal balance plus interest and foreclosure costs. Additionally, the FHA provides the strongest claims-paying ability relative to private mortgage insurers. Although private mortgage insurers maintain ratings of Baa1 to Ba1, FHA insurance is backed by the US government.

The reduced FHA premiums will also benefit HFA to-be-announced (TBA) loan sales, which are secondary market sales using the Ginnie Mae TBA market. All loans utilizing Ginnie Mae must have US government insurance, and the FHA provides a substantial share of this insurance. Higher TBA sales will increase in HFA margins given that TBA sales have been a major driver of loan production and volume, contributing to an all-time high 17% margin in fiscal 2015, which ended 30 June 2015 (see Exhibit 2).

Delayed Completion of Basel 3 Reform Is Credit Negative for Banks

According to Moody’s the 3rd January announcement from the Basel Committee on Banking Supervision (BCBS) that the final decision on the completion of the Basel 3 reform (also referred to as Basel 4) has been postponed, is credit negative for Banks. The delay could also dent investors’ confidence in banks’ capital ratios and result in higher cost of funding.

The scheduled January meeting of the Group of Central Bank Governors and Heads of Supervision (GHOS) to agree on final capital regulations was postponed because of the lack of agreement on calibrating parameters for the use of internal capital models. The protracted process is credit negative for banks and signals the supervisors’ difficult reach for a consensus on adopting rules for a common/global capital framework, which is critical to preserve a level playing field.

The delay could also dent investors’ confidence in banks’ capital ratios and result in higher cost of funding.

GHOS’ decision to postpone the meeting is unsurprising given differing views among BCBS members. The BCBS is striving to define a revised framework that fairly reflects risks and does not result in “significant” capital increases. Officials from EU countries including France and Germany and the European Commission are worried about choking off bank lending to economies where loans are the primary form of corporate finance. Although what would constitute a significant capital increase has not been quantified, BCBS Chairman Stefan Ingves last month acknowledged that this objective does not mean avoiding any increase for any bank and it may result in significant increases at some banks.

BCBS members agree on the overarching objective, which is to restore confidence in banks’ calculation of their risk-weighted assets (RWAs). That means achieving greater consistency and reducing variability in the calculation methodology for RWAs. The BCBS seeks to constrain the benefit of modelling techniques: in some cases, supervisors consider that the models too frequently result in low capital requirements and the BCBS is specifically targeting banks that have developed aggressive modelling techniques. However, defining the threshold at which such capital benefits become unacceptable is proving thorny for BCBS.

BCBS has a consensus on the need to get rid of unjustified variability, yet lacks a consensus on the acceptable level of difference between the “standardized” measure of risks and banks’ internal model estimates. Banks will be required to assess their risks under both methods and the general floor, which will be set between 60% and 90% of standardized risk weights, will determine the benefits risk modelling could bring: the lower the floor, the greater banks can benefit from models’ outcomes. Those regulators who place greater trust in banks’ internal models favor a lower floor while others, based on well-documented failures that occurred during the financial crisis, argue the standardized approach should drive the outcome, and therefore prefer a higher floor. The more intensive use of models by EU banks makes them sensitive to the floor.

The final decision on the general floor will attract a lot of attention from investors. If the general floor is set at a high level (close to 90%), the GHOS will have been relatively conservative; even more so if the implementation period is short. Were the floor to be set closer to 60% with a long transition phase, it would indicate a more permissive stance. However there are also many technical parameters that are critical to form a view on the framework’s toughness (or lack thereof); for example, floors could be imposed at the model level (setting a minimum level of probability of default or loss given default).

For now, the absence of an agreement and the BCBS’ difficulties in clinching a deal continue to fuel investors’ lack of confidence in RWAs and hence in capital ratios and skepticism towards the adoption of harmonized rules.

Rating Revisions Dispute Thin Spreads – Moody’s

Interesting piece from Moody’s today which warns:

Do not confuse the stunning rally by high-yield bonds since early 2016 with a commensurate enhancement of the fundamentals governing high-yield credit quality. Be aware of how the same overvaluation that now inflates share prices may also be responsible for an exaggerated narrowing of high-yield spreads.

According to almost every explanation of the high-yield bond spread, a recent composite speculative-grade bond yield of roughly 6% now undercompensates investors for default risk. The accompanying high-yield bond spread of 404 bp was the thinnest since the 396 bp of September 23, 2014. However, September 2014’s 2.2% EDF (average expected default frequency) metric for US/Canadian high-yield issuers was significantly lower than the 3.6% of January 4, 2017. Indeed, the combination of the 3.6% high-yield EDF and its -80 bp drop of the last three months predicts a 450 bp midpoint for the high-yield bond spread that exceeds its recent 404 bp.

Of all the major drivers of the high-yield bond spread, only an exceptionally low VIX index supports the possibility of even less compensation for default risk. More specifically, the recent VIX index of 12.0 predicts a 360 bp for the high-yield bond spread. (Figure 1.)

Market behavior of the past year suggests that the VIX index will continue to give direction to the high-yield bond spread. Nevertheless, high-yield spreads could widen amid a climb by the market value of US common stock if a narrowly focused equity rally is incapable of reversing a worsening outlook for high-yield defaults.

Downgrades jump relative to Q4-2016 rating changes

Fourth-quarter 2016’s widening of the gap between high-yield downgrades and upgrades was very much at odds with a pronounced narrowing by the high-yield bond spread. Downgrades supplied 68% of the number of credit rating changes affecting US high-yield companies in 2016’s final quarter. Previously, after dropping from Q1-2016’s current cycle high of 82% to Q2-2016’s 62%, downgrades’ share of US high-yield credit rating revisions would then sink to Q3-2016’s 54%.

The latest upswing by the relative incidence of high-yield downgrades cannot be ascribed to the oil and gas industry. To the contrary, the relative incidence of high-yield downgrades actually increased after excluding oil and gas related revisions largely because of Q4-2016’s financially-driven, as opposed to fundamentally-based, oil and gas company upgrades. More specifically, downgrades’ share of high-yield credit rating revisions excluding all changes closely linked to oil and gas would soar from Q3-2016’s 48% to Q4-2016’s 70%, where the latter was the highest such ratio since the 72% of Q1-2016.

When comparing the US high-yield rating revisions of 2016’s third- and fourth-quarters, a -48% plunge in the number of upgrades stands out. By contrast, the number of high-yield downgrades barely dipped by -4%.

After excluding revisions that were purely event driven, the number of high-yield upgrades attributed to improved fundamentals sank by -46% from the third to the fourth quarter, while downgrades stemming from worsened fundamentals edged higher by 1%.

Spreads may widen unless net downgrades subside

When the high-yield bond spread averaged 379 bp during the year-ended September 2014, not only were fundamentally driven high-yield downgrades -40% fewer, on average, compared to Q4-2016’s pace, but fundamentally-driven upgrades were +29% more numerous. Moreover, in terms of quarterly averages for all US high-yield credit rating changes, the year-ended September 2014 showed -29% fewer downgrades and +41% more upgrades compared to Q4-2016’s results. And yet the high-yield spread is now the narrowest since September 2014?

Notwithstanding the jump by downgrades’ share of US high-yield credit rating revisions both with and excluding oil and gas related changes, the high-yield bond spread still narrowed considerably from a Q3-2016 average of 551 bp to Q4-2016’s 477 bp. Moreover, as noted earlier, January 4, 2017’s high-yield bond spread of 404 bp was the thinnest since September 2014, where the latter was at the end of the just cited yearlong span of a much lower ratio of downgrades to upgrades.

The record warns of a wider high-yield bond spread unless fourth-quarter 2016’s excess of high-yield downgrades over upgrades narrows substantially. As statistically inferred from the relatively strong correlation of 0.80 between the high-yield bond spread’s quarter-long average and the moving two-quarter ratio of net high-yield downgrades to the number of high-yield issuers, H2-2016’s ratio favors a 536 bp midpoint for the high-yield bond spread. Moreover, if the net high-yield downgrades of 2016’s final quarter persist through the end of September 2017, the projected midpoint for the high-yield spread widens to 560 bp. (Figure 2.)

Equity strength enhances credit quality

The fact that the high-yield spread is now much narrower than what might be inferred from the recent excess of high-yield downgrades over upgrades underscores the critical importance of today’s superb financial market conditions to the current thinness of spreads. The considerable support now supplied to the high-yield bond market by an exceptionally low VIX index of 12.0 cannot be overstated. Once financial market conditions deteriorate, the high-yield bond market’s vulnerabilities will become apparent.

Nevertheless, today’s ample amount of systemic liquidity can facilitate a strengthening of high-yield credit quality. Injections of common equity capital enhance corporate credit quality either by (i) deepening the capital base that shields creditors or (ii) funding the retirement of outstanding debt.

Common equity capital is more likely to be secured at an attractive cost during a broad based equity rally. When the US equity market was flat to lower during the six-months-ended March 2016, only two upgrades were ascribed to injections of common equity capital. However, a subsequent rally by US shares has helped to boost the number of common-equity injection upgrades to the 32 of the final nine months of 2016.
In addition, a well-functioning equity market also boosts the number of upgrades stemming from mergers, acquisitions and divestments. After averaging 23 per quarter during the year ended September 2015, the number of upgrades linked to M&A slumped to 12 per quarter amid the soft equity market of the six-months-ended March 2016. Thereafter, stocks thrived during the final nine months of 2016 and the number of upgrades attributed to M&A rebounded to 24 per quarter, on average. Of special importance to financially-stressed high-yield issuers is how broad stock market rallies often facilitate asset divestitures that fund the retirement of outstanding debt.

Credit quality worsened amid huge equity rally of 1998-2000

The breadth of an equity market rally matters. Despite the 18.5% average annual surge by the market value of US common stock during the two years ended March 2000, the US high-yield default rate climbed up from March 1998’s 2.7% to March 2000’s 6.3%, the moving two-quarter ratio of net high-yield downgrades to the number of high-yield issuers soared higher from Q1-1998’s -2.5% to Q1-2000’s +7.7%, and the high-yield bond spread widened from Q1-1998’s 338 bp to Q1-2000’s 522 bp.

Instead of benefiting from the very strong showing by the market value of US common stock, the high-yield bond market was weighed down by the accompanying -5.9% average annual decline incurred by Value Line’s geometric stock price index, which offers insight regarding the breadth of an equity market rally. Despite the equity market’s outsized gains of the two-years-ended March 2000, the gains were narrowly focused according to the slide by the Value Line index. By contrast, the 17% surge by the Value Line index from Q1-2016 to Q4-2016 was actually greater than the accompanying 14% increase by the market value of US common stock.

As revealed by the statistical record since 1994, the high-yield bond spread’s year-over-year change in basis points shows a stronger inverse correlation of -0.82 with the yearly percent change of the Value Line index relative to its comparably measured correlations of -0.76 with the Russell 2000 stock price index and -0.67 with the market value of US common stock.

Moreover, another possibly revealing aspect of 1998-2000’s equity rally was how it occurred despite a relatively high VIX index. Though the methodology determining the VIX index has since changed, after advancing from a 1993-1996 average of 13.9 to March 1998’s 20.2, the VIX index averaged an even higher 22.7 in March 2000.

In conclusion, an extension of the ongoing high-yield rally may require a further overvaluation of the US’s already richly priced equity market. Until downwardly revised earnings outlooks proliferate, the path of least resistance for share prices may be higher. Thus, high-yield bond spreads may continue to ignore the less than favorable trend of credit rating revisions.