Bank regulation, portfolio insurance and equity financing

Dear Reader,


The resulting news that came from the new Basle III arrangements has over the last two weeks led us to (1) sell perpetuals that trade at more than a years coupon above par and (2) re invest those proceeds into perpetuals that trade below par (which have been rapidly rising to par value due to the volume in this trade of late; case in point is the Prudential 6.5% USD which has risen from mid 80s to mid 90s).

However, the new definitions of core tier 1 capital, which effectively include only retained earnings and equity, are likely to lead banks which do not have sufficient core tier 1 to issue equity. We are wary that a number of rights issues are likely to be announced by a number of banks over the next 6 – 12 months due to this. This is likely to be bad news for the stock prices of these banks (at least temporarily) due to the dilution affect of a rights issue. Though I have not been a holder of bank stocks in my portfolio (I hold only one from early 2010), a number of clients have bought the equity of a number of banks from their home country, due to the strong brand image these enterprises have created in their country of domicile from decades of success and growth. Needless to say, almost all these positions are at a significant loss and I believe there is a strong possibility they will remain so in three years time.

However, this leads us to consider an important point. Your author believes financing cycles switch from being equity to debt based. The 1995 to 2000 asset price increases were fuelled from equity financing. This is most clearly seen by the ever increasing number of IPOs being presented and executed in that period. The asset price increases during 2003 – 2007 was fuelled by debt. We are likely to see the next financing cycle fuelled by equity. This makes good sense when we consider that almost all economic participants are heavily leveraged relative to almost all debt metrics commonly used. I would say the order of highest to lowest leveraged are (1) Financials, (2) Households, (3) Governments, (4) Corporates. So far in the de leveraging process we have seen the most action from financials (examples include the large issuance of bonds, common and preferred shares and the conversion of preferred shares to common shares. The elimination of dividends from common shares and preferred shares and the non calling of similar tier 1 hybrid securities, which were previously assumed to be redeemed on the first call date). It is no accident, they are the most leveraged.

We are likely to see a continuing de leveraging from consumers. This will be most evident from spending decreasing and savings increasing. This is likely to reduce economic growth trends in the next three years compared to what we had prior to the crisis (we have mentioned this point repeatedly over the last 12 months). Consumer credit growth in banks, if the above is true, will also likely be weak. This means an important source of bank income will be weak. Retail banks are therefore likely to generate smaller profits than those generated prior to the crisis. For retail banks, this can only be circumvented if they start lending to consumers in countries where they have lower leverage (i.e. emerging countries. Watch HSBC and Standard Charted).

Government de leveraging is a point currently being discussed with great enthusiasm in the media (i.e. newly described austerity measures). However whether it becomes reality is another issue. Next year we will be in the third year of the US political cycle. Since 1939, this has not been a negative year for equities due to pro election projects that come out of the cupboard. If you believe in history repeating itself...you heard it here first!

This article, however, comes back to a question that often floats around the back of my head: “the economy will not do well until the banks do well”: they are the grease that make the wheels of the economy move. No credit expansion, no economic growth. All indicators I look at do not point to consumer credit increasing: and consumer spending is 70% of the GDP of most developed economies. Wages and asset prices are also not likely to go north (two other pillars your author believes drive consumer spending).

However, one can counter that if financing will be driven by equity, then a lack of credit expansion need not hurt growth. However, equity financing is not generally available to the consumer: it is available to corporates. They may spend in the hope of generating greater profits from increasing market share or investing in developing new products. Equity financing therefore predominantly affects corporate spending. They may affect consumer spending by creating new jobs and increasing wages. However, we are seeing spending increase in emerging markets, where consumers are not leveraged and wages are increasing, as are the number of new middle class consumers. Hence, developed market consumers and workers are not going to be the direct beneficiaries of future corporate spending, should it increase from access to equity financing.

Indeed, should such large corporates remain registered in developed countries, one of the largest beneficiaries will be the government due to growing tax receipts. However, we feel as corporates get larger their power over government increases, and this statement may prove to be frivolous.

Conclusions

1. Regulation is affecting the capital structure of banks, which will affect the pricing of securities in the lower part of that capital structure (common stock and hybrid tier 1 capital). The de leveraging of banks is leading this change

2. We fear the de leveraging of the consumer will be negative for consumer spending and retail bank credit growth. Coupled with a weak labour market, this is also negative for the property market. Sufficiently attractive pricing can always help reverse this trend in an open economy. Retail banks with emerging market exposure can increase lending and eventually help reduce their loan loss provisions (if lend wisely there!)

3. The lack of credit demand from consumers and the lack of credit availability as banks build up core tier 1 capital will not be a positive factor for growth. We do, however, see equity financing help provide the necessary investment power for corporates. This money is likely to be channelled in greater quantities to emerging countries rather than developed countries

4. Stability in bank balance sheets will be a big catalyst for a strong multi year run in equities, especially if markets fall below fair value during the wait. As a reference, for the S&P 500, I see fair value as between 930 – 950. History would suggest the next cycle of price/earning multiple expansion could start within 4 – 6 years. We have now been in a multiple contraction period for 10 years

5. We feel for a small cost insurance options should be considered in the portfolio (up to 5% of the portfolio, to protect against extreme situations). For example, (1)buying put options on a relatively low volatily asset as it has been increasing strongly recently and we feel is expensive. An article by Dylan Grice at Soceite Generale recently suggested using Silver. This takes advantage of its perception as being a “cheap gold”; whilst also being heavily affected by the industrial cycle. One can also do as Seth Klarmen has recently done; (2) by cheap “deeply out of the money” long dated put options on government bonds. This can offer significant returns if long term government bond yields increase greater than say 8%, offering a money making security in a quasi hyperinflation environment. Though the probabilities of such events occurring are perceived as low, their consequences are sufficiently damaging for portfolios that they should not be ignored. This is especially true considering the huge amounts of leverage in the economy and the large policy responses we have seen. Deflation protection is most cheaply offered by holding cash in hand.

6. Though a long term problem, one can never ignore that demographics has a huge role to play on the interest rates of an economy. A large aging population may have played a big role in keeping rates low in Japan. Once these investors start drawing from their capital rather than buying new Japanese government bonds, funding costs could rise as dependence on foreign investors increases. Indeed, increasing oil prices in the 1970s can be interpreted as having occured as the USA became a larger oil importer, allowing foreign oil producers to have sufficient power to create a cartel. Previosly, the USAs lack of foreign dependence on oil simply did not make the cartel stable. These two examples of shifting to foreign dependence for an asset (be it oil or money)can play a big role in the evolution of the pricing of that asset. Your author sees debt in the same manner. Once a company issues debt; its existence becomes dependent on foreigners, people outside the company. Partial control of the company is removed from within the company. Initially, this removal is invisible. As debt increases, this transfer of control becomes more apparent. Until, like a virus, the foreign body controls the entire victom until it has sucked all the goodness it has, and it moves to the next victom. Beware of expensive leveraged companies that promise growth!


Sincerely yours,

Alessandro Sajwani