stefan_isaacs_100

Ten reasons to like US high yield today

Global growth concerns, fears of a less accommodative Fed, and limited high yield market liquidity coupled with complacent and crowded investor positioning has served to reprice the US high yield market over the past few months. Following on from the worst quarterly performance in Q3 2014 for some three years, the US high yield market arguably now offers a significantly more attractive entry point. Whilst acknowledging that the market has moved faster over the past few days than I was able to write this blog, here are ten reasons why US high yield could be considered a buy at these levels:

  1. Spreads have moved back to levels not witnessed since October 2013. In June this year, spreads had only been tighter for around 17% of the time (since our data began in the mid-1990s). The recent correction left this number peaking at around 40%.
    US high yield spreads have moved back to 2013 levels
  2. The yield on the BofA Merrill Lynch US High Yield Index recently reached 6.4%, having traded as low as 4.85% in June, and is currently around 6%, a level likely to appeal to institutional buyers.
  3. Whilst the absolute level of yields may look low by historic standards, valuations relative to cash and government bonds still look compelling.
    US high yield looks attractive versus cash
  4. Given the relatively high level of income the asset class generates, and a benign outlook for defaults, the asset class can suffer considerable spread widening before underperforming cash and government bonds. Assuming a 2% default rate and no change in government bond yields,  high yield spreads would need to widen by approximately 100bps from current levels to underperform a similar duration US Treasury bond. This would see spreads back at levels not witnessed since 2012.
  5. Other fixed income assets have significantly outperformed high yield so far this year. According to BofA Merrill Lynch indices, US Treasuries have returned 5.5% and investment grade corporates have returned 7.7% year-to-date, while US  high yield has gained 4.5%. As the chart below shows, BB rated bonds (the highest rated category of the high yield market) have cheapened up considerably vs BBB corporates.
    US BB rated credit has cheapened up versus BBBs
  6. Technicals are in a much better place than they were a few months ago, with the asset class having witnessed some $21 billion of outflows in 2014 (according to BofA Merrill Lynch). New issue supply has slowly abated and the market is becoming more discerning about taking risk.
  7. US high yield company fundamentals, although having worsened slightly over the past couple of years, still look in reasonable shape, with leverage and interest cover both at 3.9x at an index level.
  8. The backdrop for defaults remains benign. Re-financing risk is one of the major obstacles for leveraged companies, but this risk appears limited over the next couple of years as many companies have taken advantage of abundant liquidity to term out their debt, as illustrated in the chart below.
    Refinancing does not pose a near-term threat
  9. When the Fed eventually raises rates, it is likely to err on the side of caution and tighten policy slowly. The carry trade is unlikely to come to an abrupt end in the near future.
  10. Tighter policy is likely to be accompanied by an improving economic backdrop. Whilst the corporate profit share of GDP is already relatively high, it is likely that this would be sustainable in a stronger economy.
stefan_isaacs_100

Exceptional measures: Eurozone yields to stay low for quite some time

Richard recently wrote about the exceptional times in bond markets. Despite bond yields at multi-century lows and central banks across the developed world undertaking massive balance sheet expansions the global recovery remains uneven.

Whilst the macro data in the US and UK continues to point to a decent if unspectacular recovery, the same cannot be said for the Eurozone. Indeed finding data to be overly optimistic about is no easy task. Both consumer and business confidence indicators continue to point to a subdued recovery; parts of Europe are technically back in recession and inflation readings continues to disappoint to the downside. The most recent CPI reading came in at a mere 0.4%, German breakevens currently price five year inflation at 0.6% and longer term expectations have shown signs of questioning the ECB’s ability to deliver on the inflation mandate.

Recognising the sheer size of the Eurozone banking system remains key to understanding the challenge Eurozone policymakers face. With a banking system over three times larger than the US (relative to GDP); significantly higher non-performing loans and massive pressure to deleverage as shown in the first chart below, it is unsurprising that the so called transmission mechanism appears damaged. The failure to pump credit into the Eurozone economy, especially into the periphery, continues to weigh on funding costs for SMEs & promote exceptionally high levels of unemployment. These are only now beginning to stabilise at elevated levels as shown in the second chart below.

Banks have started the deleveraging process

Peripheral Europe

With previous demands for austerity in Europe preventing economies from running counter-cyclical fiscal policies and uneven progress in structural reform, the onus continues to fall on monetary policy and the ECB. And yet for a variety of reasons the response has fallen considerably short of that from the FED, BoE & BoJ, who have been happy to expand their balance sheets considerably.

Balance Sheets

The result has been, an overvalued Euro, imported disinflation and a lack of investment. Having offered re-financing cuts, forward guidance, massive liquidity in the form of the LTRO & TLTRO, the ECB will ultimately be forced to follow other central banks in undertaking broad asset purchases.

Whilst these broad asset purchases or QE are unlikely to be unveiled today, they are the only likely means in the near term, of ensuring that the banking system in Europe is able to extend significantly more credit to the real economy. This in turn should help to raise inflation expectations, boost potential growth and allow the ECB to fulfil its mandate.

In Europe exceptional times call for exceptional measures. The ECB isn’t done, even if certain members will have to be dragged kicking and screaming to the QE party. I expect European bond yields to stay low for quite some time.

stefan_isaacs_100

Is Europe (still) turning Japanese? A lesson from the 90’s

Seven years since the start of the financial crisis and it’s ever harder to dismiss the notion that Europe is turning Japanese.

Now this is far from a new comparison, and the suggestions made by many since 2008 that the developed world was on course to repeat Japan’s experience now appear wide of the mark (we’ve discussed our own view of the topic previously here and here). The substantial pick-up in growth in many developed economies, notably the US and UK, instead indicates that many are escaping their liquidity traps and finding their own paths, rather than blindly following Japan’s road to oblivion. Super-expansionary policy measures, it can be argued, have largely been successful.

Not so, though, in Europe, where Japan’s lesson doesn’t yet seem to have been taken on board. And here, the bond market is certainly taking the notion seriously. 10 year bund yields have collapsed from just shy of 2% at the turn of the year and the inflation market is pricing in a mere 1.4% inflation for the next 10 years; significantly below the ECB’s quantitative definition of price stability.

So just how reasonable is the comparison with Japan and what could fixed income investors expect if history repeats itself?

The prelude to the recent European experience wasn’t all that different to that of Japan in the late 1980s. Overly loose financial conditions resulted in a property boom, elevated stock markets and the usual fall from grace that typically follows. As is the case today in Europe, Japan was left with an over-sized and weakened banking system, and an over-indebted and aging population. Both Japan and Europe were either unable or unwilling to run countercyclical policies and found that the monetary transmission mechanism became impaired. Both also laboured under periods of strong currency appreciation – though the Japanese experience was the more extreme – and the constant reality of household and banking sector deleveraging. The failure to deal swiftly and decisively with its banking sector woes – unlike the example of the US – continues to limit lending to the wider Eurozone economy, much as was the case in Japan during the 1990s and beyond. And despite the fact that Japanese demographics may look much worse than Europe’s do today, back in the 1990s they were far more comparable to those in Europe currently.

Probably the most glaring difference in the two experiences is centred around the labour market response. Whereas Eurozone unemployment has risen substantially post crisis, the Japanese experience involved greater downward pressure on wages with relatively fewer job losses and a more significant downward impact on prices.

With such obvious similarities between the two positions, and whilst acknowledging some notable differences, it’s surely worthwhile looking at the Japanese bond market response.

As you would expect from an economy mired in deflation, Japan’s experience over two decades has been characterised by extremely low bond yields (chart 1). Low government bond yields likely encouraged investors to chase yield and invest in corporate bonds, pushing spreads down (chart 2) and creating a virtuous circle that ensured low default rates and low bond yields – a situation that remains true some 23 years later.

Japan and Germany 10 year government bond yields

Japan and Germany corporate bond yields

As an aside, Japanese default rates have remained exceptionally low, despite the country’s two decades of stagnation. Low interest rates, high levels of liquidity, and the refusal to allow any issuers to default or restructure created a country overrun by zombie banks and companies. This has resulted in lower productivity and so lower long-term growth potential – far from ideal, but not a bad thing in the short-to-medium term for a corporate bond investor. With this in mind, European credit spreads approaching historically tight levels, as seen today, can be easily justified.

Can European defaults stay as low as for the past 30 years

Europe currently finds itself in a similar position to that of Japan several years into its crisis. Outright deflation may seem some way off, although the risk of inflation expectations becoming unanchored clearly exists and has been much alluded to of late. Japan’s biggest mistake was likely the relative lack of action on the part of the BOJ. It will be interesting to see what, if any response, the ECB sees as appropriate on June 5th and in subsequent months.

BoJ basic discount and ECB main refinancing rates

Though it is probably too early to call for the ‘Japanification’ of Europe, a long-term policy of ECB supported liquidity, low bond yields and tight spreads doesn’t seem too farfetched. The ECB have said they are ready to act. They should be. The warning signs are there for all to see.

stefan_isaacs_100

High yield: bullish or blinkered?

I recently attended JP Morgan’s annual US high yield conference. It’s one of the best conferences around: well attended, and with more than 150 companies, panel discussions and specialist presentations. As such, the topics covered give a good flavour of the market’s latest thinking.

Unsurprisingly, many of the well-rehearsed arguments in favour of high yield resurfaced once again, with presentations focused on the following:

  • The structurally low default rate (see chart below), largely a function of accommodative central bank policy, limited refinancing risk and growing investor maturity, with spreads over-compensating as a result.

Slide1

  • Projections that US high yield will outperform other fixed interest asset classes in 2014, returning 5%-6% (leveraged loans likely to deliver 4.5%).
  • Room for spreads to tighten further given that they remain over 100+ bps back of the lows in 2007. Currently 378bps vs 241bps in May 2007.
  • How refinancing, rather than new borrowing, is driving the majority of issuance in the US. Refinancing accounted for 56% of issuance in 2013, though down from 60% in 2012.
  • The need for income in a low interest rate world is providing a strong technical support, evidenced by $2bn+ of mutual fund inflows into the US high yield market year to date. Significant oversubscription for the vast majority of new issues has also been a notable feature of the market for some time now.
  • The short duration nature of the asset class – particularly attractive in an environment of potentially rising rates. Modified duration for US and European high yield is 3.5 years and 3 years respectively. This compares to 6.5 and 4.5 years for the investment grade equivalents.

Now these are all relevant arguments in favour of the asset class, and indeed I believe that US high yield will likely be one of fixed income’s winners in 2014. What did surprise me, though, was the almost total absence of discussion around some of the headwinds that it faces.

For example, presentations seemed to gloss over the fact that much of the good news, from the perspective of default rates at least, has arguably already been priced in. The market is unlikely to be surprised by another year of sub-2% defaults, rather the risk lies in an outcome that sees a higher default rate than anticipated by the consensus, even if that is difficult to envisage right now.

Other challenges are presented by liquidity (while this has improved since the immediate aftermath of the credit crunch, investment banks are still reluctant to offer liquidity given the high capital charges they face and the low yields currently on offer); by the lack of leverage available to end investors compared to 2006-7, when banks had the ability, strength and desire to lend to those investors on margin; and by the increasing negative convexity the market faces at the moment.

Slide2

With US high yield paper already trading at an average price of 105 and as high as 107 in Europe (see chart above), the threat of bonds being called will act as a cap on further capital appreciation. And, of course, the flip side of these high prices is low all-in yields. With these standing around 3.8% on the European non-financial high yield index and 5.2% on the US high yield index, investors can only question how much lower they can go.

Slide3

Perhaps in this environment, with inflation ticking along comfortably below 2%, investors should accept that a nominal return of 5-6% looks decent. That said, returns this year are likely to be driven by income rather than capital appreciation, and may well look skinny versus previous years. As I said before, I’m still constructive on high yield, but after the stellar returns in the past few years, we must be careful to avoid being blinkered.

This entry was posted in credit and tagged by . Bookmark the permalink.

Please note the content on this website is for Investment Professionals only and should be shared responsibly. No other persons should rely on the information contained within this website.

stefan_isaacs_100

Eurozone inflation surprises to the downside. ECB will grudgingly be forced to cut rates.

Last week saw year-on-year core inflation in the euro area fall from just over 1% in September to a two year low of 0.7% in October (see chart). Such a level is entirely inconsistent with the ECB’s definition of price stability as inflation “below but close to 2%”, and will likely be met with a downward revision to medium term inflation prospects and with it an ECB rate cut later this year.

Slide1

The ECB will no doubt have monitored the recent steady appreciation of the euro (see chart), which has effectively acted as a tightening of policy and will likely have a disproportionately negative effect on the periphery. Coupled with the latest inflation data, the strengthening of the euro will no doubt increase calls from the doves on the Governing Council (who should be acutely aware of the rising risks of a Japanese-style deflationary trap) to run a more stimulative policy.

Slide2

With little evidence of upward pressure on German wages, the internal devaluation required within the eurozone to facilitate a more competitive and balanced economic area has also been dealt a blow. Richard recently noted an improvement in euro area funding costs, and with it a stabilisation of broader economic data. However, this is from a very low base and the challenges that Europe continues to face should not be underestimated. Both unemployment and SME funding costs remain stubbornly high in the periphery and non-performing loans continue to move in the wrong direction (see chart). The ECB understandably wants to maintain pressure on politicians to deliver on structural reforms, and no doubt some harbour fears of leaving fewer policy tools at their disposal once they cut rates towards zero, but the risks of medium term inflation expectations becoming unanchored to the downside should be a wakeup call and a call to action!

Slide3

stefan_isaacs_100

Equity multiple expansion to the rescue. A benefit to high yield ?

The high yield market rightly pays a good deal of attention to leverage trends (the relationship between debt and earnings). The larger the quantum of debt a business carries relative to its earnings, the greater the risk. Other metrics are arguably as important, though it is the leverage metric that consistently garners the lion’s share of attention. With spreads near the post Lehman tights, it is unquestionably concerning to see a trend of rising leverage as earnings plateau and companies generally take on more debt.

Slide1

Slide2

The very same central bank policies that have kept bond yields low and encouraged high yield companies to take on more debt have also helped to support higher equity prices. As money has flooded into the asset class, the market has not surprisingly re-rated upwards. What this has meant for high yield investors is that one measure of the ‘margin of safety’, or an equity cushion has, at least temporarily, been increased. The chart below shows the implied equity cushion by subtracting the average level of US high yield leverage from the S&P Mid Cap trailing 12 month enterprise multiple. The higher the implied cushion the better. So for example with stock markets at the lows in early 2009, the implied equity cushion fell to a mere two turns, but has since recovered to a far more healthy and above average six.

Slide3

Many will no doubt point out that an implied cushion is exactly that- implied. And the argument is clearly a pro- cyclical one that relies on an imperfect comparison. We’d concur with that and emphasise the fact that there can be no substitute for thorough credit analysis. We will always prefer to invest in appropriate financial leverage, strong interest coverage and free cash flow generation over equity implied multiples. The former gives a business flexibility and exposes it less to market vagaries.

Yet there is no getting away from the fact that central bank policy has, and can still yet, come to the rescue of even some of most levered high yield companies. In hindsight, few of us would have predicted the surprisingly low level of defaults we’ve witnessed through this cycle. And whilst IPOs of high yield companies has been a fairly rare thing over the last few years, higher equity multiples, an on-going return of animal spirits and a desire/need to put money to work may yet alter that trend.

Slide4

stefan_isaacs_100

It’s a new dawn, it’s a new day. The ECB takes baby steps towards QE

Just when you thought the Fed had well and truly killed the carry trade, a surprisingly dovish Mario Draghi reminded markets yesterday that Europe remains a very different place from the US. Having previously argued that the ECB never pre commits to forward guidance, yesterday marks something of a volte-face. ‘The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.’ The willingness to offer guidance brings the ECB closer to its UK and US peers, the latter having been in the guidance camp for some time. This firmly reinforces our view that the ECB retains an accommodative stance and an easing bias.

The willingness to offer forward guidance to the market no doubt came after some long and hard introspection within the Governing Council. So why the change ? Firstly, the ECB is worried that it may miss its primary target of maintaining inflation at or close to 2% over the medium term. Secondly, Draghi indicated an increasing concern that the real economy continues to demonstrate ‘broad based’ weakness, and finally, as has been the case for some time, the Council worries that the Eurozone continues to labour with subdued monetary dynamics. This sounds increasingly like Fed talk of recent years.

Draghi also expressed his concern yesterday during his Q&A at the effective tightening of monetary conditions via higher government bond yields (see chart) since the Fed’s tapering discussions. Frankly the last thing the Eurozone needs at this stage in its nascent recovery is higher borrowing costs.

Bond yield have risen

Draghi in communicating that the next likely move will be an easing of policy has attempted to talk bond yields down. European risk assets appear to have taken his comments positively but the bond market remains sceptical. At the time of writing only short to medium dated bonds are trading at lower yields.

In conjunction with revising down its 2013 Italian GDP forecast from -1.5% to -1.8%, the IMF has publicly urged the ECB to embark upon direct asset purchases. Is this a likely near term response ? For now those calls will likely fall on deaf ears especially with German elections later this year. The ECB clearly believes that its next move would be to cut rates further in response to a weaker outlook. Buying time seems to be the current approach.

However, should Eurozone inflation expectations continue to undershoot (the market is currently pricing 1.36% and 1.66% over the next 5 & 10 years, see chart)  and economic performance remain downright lacklustre across Europe, then the ECB will have to think very carefully about what impact it can expect from a ‘traditional’ monetary response. QE may be some way off, and would no doubt see massive objections from Berlin, but in the same way that the ECB never pre commits, maybe just maybe, QE will be on the table sooner than the market is currently anticipating.

Inflation expectations in Europe

stefan_isaacs_100

Heinz: Beans, Buffett and the return of animal spirits

After years of inactivity, the combination of strong corporate balance sheets and cheap funding has sparked demand for takeover deals. The largest and highest profile deal this year has been the acquisition of H.J.Heinz by 3G Capital and Berkshire Hathaway. It is exactly the type of business that Berkshire Hathaway’s Chairman and CEO Warren Buffett typically goes for: profitable growth; a very recognisable brand; and years of emerging market growth forecast in the future.

Berkshire Hathaway and 3G Capital are buying Heinz for $72.50 per share, a 19 percent premium to the company’s previous record high stock price at the time the deal was announced in mid-February. Including debt assumption, the transaction was valued at $28 billion. Berkshire and 3G will each put up $4.4bn in equity for the deal along with $12.2bn in debt financing. Berkshire is also buying $8bn of preferred equity that pays 9%.

Let’s not beat around the bush. It’s a great company. The business has seen thirty one consecutive quarters of organic growth, stable EBITDA margins, owns a number of globally recognised brands and should be well positioned for future emerging market led growth. Despite this, some are questioning whether Buffett is overpaying for Heinz. So is the price of the deal justified?

The answer, at least in part, lies with cost of debt. The pro-forma capital structure (per the offering memorandum) looks like this:

PF Capital Structure Sources ($m) Net Debt/PF EBITDA
Cash -1,250
1st Lien 10,500 3.87 x
2nd Lien 2,100 4.75 x
Rollover Notes 868 5.11 x
Total debt 12,218 5.11 x
Preferred Equity 8,000 8.46 x
Common Equity 8,240
Total 28,458

Current price talk on the first lien debt sits at $ Libor + 2.75% (floored at 1%) with the second lien at 4.5%. If this is finalised, the company will see an approximate blended interest cost of 3.9% on its new debt securities. Prior to the transaction, Heinz was rated as a solid investment grade business attracting a Baa2/BBB+ rating. Assuming the deal goes through, its new second lien notes are expected to be rated B1/BB-, some five notches lower than Heinz’s current rating, reflecting the much higher financial leverage and structural subordination.

It’s worth noting that through last year Heinz’s 6.25% 2030 bonds traded in a range of 4–5%, despite the much higher rating and lower financial leverage at the time; albeit some term premium is warranted given the longer dated nature of the debt. The bonds have since sold off in recognition of the greater risk – as things stand they will remain in place.

HNZ

Now let’s compare the price action of the proposed debt financing to the preferred equity to be owned by Berkshire Hathaway. Whilst the paper is structurally subordinate to all other debt, it still sits ahead of some $8,240bn of common equity and attracts a cash coupon (which can be deferred) of 9% vs the 3.9% weighted average above. It’s also worth bearing in mind that the transaction has been structured to encourage the preferred equity to be retired, at least in part, ahead of both the first and second lien debt, potentially leaving bondholders with significantly less subordination than at day one. I’d argue that this is by far the most attractive (quasi) debt to invest in within the structure, though that is hardly surprising given that unlike Buffett, few of us can write a cheque of this magnitude.

HNZ2

As animal spirits return and the leveraged finance community falls over itself to lend to well known companies, the likely winners in the space will be the private equity community. Whilst we are nowhere near the levels of the great private equity binge of 2004-07, the value of takeovers in 2013 is already running well ahead of 2012. After years of corporate deleveraging, we may now be entering into a period of increased M&A activity. Company managers may find that if they aren’t willing to start leveraging up given the environment of extremely low borrowing costs, then investors like Buffett will do it for them.

The Heinz deal has been another recent shot across the bows of the bond market. Rising leverage has a longer term implication for credit markets, in that it is bad for credit quality. Bigger and bigger companies are clearly in play and this is something we will be keeping a very close eye on.

This entry was posted in credit, ratings and tagged by . Bookmark the permalink.

Please note the content on this website is for Investment Professionals only and should be shared responsibly. No other persons should rely on the information contained within this website.

stefan_isaacs_100

Insane in the brain. Dangerous precedents being set in Cyprus

Depositors in Cypriot banks awoke on Saturday morning to learn a harsh lesson. A guarantee is only as strong as your counterparty. With the Cypriot banking system requiring €10-12 billion of bailout funds – some 60% of GDP – the government has been forced to accept burden sharing with depositors. Depositors who went to bed Friday night believing their savings were safe awoke Saturday to find that it has been proposed that those with deposits below €100k in the bank will be “taxed” at 6.75%; those with deposits above €100k will be “taxed” at 9.9%, contributing approximately €6bn to the bank bailout in total. This is regardless of supposed depositor insurance schemes. Depositors will receive equity in their respective banks by way of compensation and potentially bonds entitling those who leave their money in the banks for 2 years to a share of Cyprus’ future gas revenues. The remaining €4-6 billion will likely come from the Troika.

If press reports are to be believed this was a ‘take it or leave it offer’ from the Troika with German and Finnish finance ministers unwilling to go to their respective parliaments without depositor burden sharing. This highlights the very real current challenges of domestic politics within the European Economic and Monetary Union and raises further issues.

Firstly, there are significant political challenges to be faced. Domestic opposition to this deal is likely to be significant, not least as it will be seen to be disproportionately harsh on domestic savers – who had believed their deposits were protected up to €100k, and favourable to wealthy non-Cypriot depositors who reportedly hold huge sums offshore in the banks. It can be argued that those with over €100k in deposits with the banks should bear the brunt of any proposed bail-in. With a small parliamentary majority, the Cypriot government may struggle to pass the necessary legislation. Approval will also need to be sought from Eurozone member states.

Secondly, alongside the recent expropriation of junior bond holders at SNS Reaal the attitude towards tax funded bailouts appears to be hardening. Whilst this crisis has already witnessed both equity and debt written down, the rubicon of depositor burden sharing has now been crossed. Precedent now exists for this approach over the socialisation of losses across the Eurozone as a whole. Whilst the Troika will endeavour to play its significance down, unintended consequences may still materialise.

Thirdly, the Cypriot situation serves as a reminder of the current fragmented approach of depositor guarantee schemes across Europe. Depositor guarantees are only as strong as the sovereigns providing them. In the case of Cyprus with a banking system seven times the size of its economy, clearly those guarantees were worth very little. With depositor rates currently paying very little across Europe it is unlikely to take much to prompt a change in investor behaviour.

Fourthly, it raises real questions about depositor preference. With only circa €2bn of Cypriot bank debt outstanding, policymakers have judged this too small in and of itself to recapitalise the banking system. That may be true. However by favouring senior debt over depositors it does beg the question whether the individual on the street is in theory better off owning higher yielding bank debt than depositing cash.

Fifthly, the ECB has apparently threatened that if the measures are not agreed, then it would withdraw European Liquidity Assistance (ELA) funding for Laiki Bank, Cyprus’ second largest bank, leaving the Cypriot sovereign with the bill for the entire banking sector and having to pay out on deposit insurance in full. This highlights the extent to which a number of banks in Europe remain reliant on ECB funding, and that if that funding is withdrawn then their collapse is inevitable.

Finally, we have yet another example of a country being forced to face a stark choice between ceding sovereignty to Brussels or facing financial ruin. The Eurozone project continues to ask a great deal of its citizens. Bailouts don’t – and won’t – come cheap.

The Cyprus deal will be in the headlines for the next few days. We can’t help but think that the markets will be listening to Cypress Hill – Insane In The Brain for the next week or so. Maybe the Troika should too.

stefan_isaacs_100

European autos, stuck in reverse

French auto manufacturers Peugeot and Renault report full year 2012 earnings this week. If Peugeot SA’s write down announced on Friday is anything to go by – when it took a €4.7bn non-cash charge – the outlook for the company and indeed other European focussed auto manufacturers continues to be a bleak one. European market conditions have been described by S&P as ‘dire’. Overcapacity and general economic uncertainty have resulted in utilisation rates below break-even profitability for a number of plants. Cash continues to be burnt and unsurprisingly, share prices don’t make for pleasant reading.

Renault, Peugeot stock price

The need for an overhaul of the likes of Peugeot, Fiat and Renault remains acute.  European light vehicle registrations are headed for a fifth consecutive year of declines (see chart below), Italian and Spanish registrations are at nearly half their pre-crisis levels, profit margins on compact vehicles are slim and Peugeot, Fiat and Renault are losing market share to investment grade rated manufacturers like BMW, VW and Daimler.

Eurozone new light commercial vehicles - monthly registrations

Struggling under a mountain of debt, Peugeot, Fiat and Renault find themselves in a non-too dissimilar position to that of the US auto manufacturers back in 2008/2009. Several years ago GM, Ford and Chrysler were able to successfully restructure, both inside and outside of bankruptcy, allowing them to close capacity, reduce over-indebtedness, renegotiate onerous union contracts and subsequently return to profitability even at levels of production significantly below those pre-crisis. That experience remains in stark contrast to European OEMs (Original Equipment Manufacturers) who continue to labour under many of those same pressures whilst facing ongoing weak domestic demand.

Vehicle registrations in US and Eu-15 (in Million units)

Management continues to struggle to right-size their businesses some 5+ years into the financial crisis in the face of strong political pressure and a determination to avoid job losses. Ironically, the very interference that has hampered change in Europe has now led to Peugeot having to rely on French state support. But these choices cannot be put off into perpetuity and unwelcome decisions are inevitable. Until that point in time, losses will continue to mount, cash will be burnt and creditors will likely favour US over European OEM risk.

Credit default swaps - evolution

Page 1 of 912345...Last »