Ireland – the sovereign implications of the banking crisis

- "A very costly bank restructuring process (amounting to 24-31% of GDP) and concerns about the impact of weak macroeconomic conditions on banks’ battered loan portfolios are unsettling the Irish bond markets. While the Irish treasury does not have immediate liquidity needs, the colossal fiscal effort which will be required to stabilise the public debt over the medium term leaves little fiscal space to deal with any further unexpected financial sector losses – this is a source of market instability."

- "In our view, the resolution of Anglo Irish Bank, by splitting it into a funding bank and an asset recovery bank, is essentially equivalent to a wind up of the bank in ‘slow motion’. Over the medium term, the remaining assets of Anglo Irish Bank will have to be sold, disposed of or liquidated to repay the bank’s liabilities. Further injections of public funds into Anglo Irish Bank cannot be discounted (so far, the government has pumped a total of €25bn into the bank)."
- "At this juncture, given the comfortable near-term liquidity position of the Irish treasury, we argue that the government does not need to draw on financial assistance from the EU-IMF – at least not yet. Yet should further unexpected financial sector losses materialise or macroeconomic conditions deteriorate beyond our baseline forecasts in the coming months, the government may need to seek outside help. On the IMF side, the “enhanced” Flexible Credit Line facility recently approved by their Executive Board could provide a suitable funding vehicle should this be required by the Irish government, in our view."

Lower debt yields should drive confidence

- "Firms have taken advantage of falling corporate bond yields and investor demand to issue new debt; this should support equities and global business confidence"
- "The improvement in financial conditions should help the Fed to proceed with a steady policy on September 21"
- "Political developments are likely to be significant during the next few weeks as EU countries complete their 2011 budgets, and with the focus on US mid-term elections and the forthcoming DPJ President election in Japan"
- "With the contribution of net exports to GDP growth swinging back again in China's favour, FX-related tensions could re-emerge"

Widening peripheral bond spreads: Is this time different?

- "Although peripheral euro area sovereign yield spreads have widened to levels last reached at the peak of the fiscal crisis earlier this year, the EUR has not weakened significantly. In our view, the banking stress tests are the main reason why this time is different."
- "The BIS’s triennial survey of FX markets allows a comparison of the pre- and post-crisis world. FX markets seem unchanged, but there are early signs of some new trends."

Barclays FX Weekly Brief 20100902

De-leveraging, deficits don’t spell ‘deflation’

- "Despite market risk aversion, we believe the Bernanke Fed has the power and will to forcibly resist deflation."
- "Even though de-leveraging among households continues, the pace of increase in saving ratios appears to be moderating, or even in some countries turning down."
- "The Fed's shifting stance is set to result in an easier global monetary policy – in Japan, we look for a more accommodative BoJ operational stance; unilateral FX intervention appears imminent."
- "In the euro area, the ECB is likely to continue with full allotments in its regular refinancings through until at least early 2011, though it appears to lack appetite to resume aggressive bond purchases."

Barclays Global Economics Weekly 20100827

The $300bn question

- "Commodity investments in July passed an important milestone when AUM surpassed $300bn for the first time as commodity inflows bounced back, up by $5bn compared with June’s $2.3bn and prices strengthened. Growth in index swaps was the main driver, more than offsetting a large outflow of funds from ETPs, especially from physically backed gold products. Over the past 10 years, commodity AUMs have risen by $290bn with investment inflows having amounted to $245bn, at an annual average rate of about $24bn."
- "Will those inflows continue? In our focus piece this month we examine two issues at the top of commodity investors’ list of concerns. First, the long-term demand growth outlook for commodities, and whether emerging market demand will be sufficient to offset slower growth ahead in industrialised markets. Second, we examine the recent close correlation of commodities with other risky assets, which has prompted debate about the value of commodities as a distinct asset class."
- "Trading strategy in commodities is more complicated than it was a few months ago when we still saw considerable upside potential across a wide range of markets. The bounce in a number of energy and industrial metals markets that we had been expecting finally arrived in July and early August, though it has proved short-lived. Also, with markets focusing on slowdown fears in the US and China we are reducing some risk by closing out long base metals positions and have instituted an outright short in US natural gas. However, we remain long crude oil, gold, corn and cotton."

Barclays Commodity Investor Aug2010

Watch out for the Fed backtracking

- "US jobless claims data were weak, but incoming data suggest a double dip is still unlikely. The US economic slowdown is certainly not due to malfunctioning credit markets. Mortgage yields are at all-time lows, and corporate debt yields are also very low."
- "We believe the data need to turn significantly worse than what we and the consensus expect for the Fed to decide to step up QE; if and when it does, it will need to be overwhelming, probably accompanied by an inflation target."
- "Beyond the US, disinflationary forces appear to be over globally, particularly as there is upward pressure on food prices."
- "In China, we expect authorities to remain on hold to balance risks, but even if they ease policy, we expect them to keep measures aimed at lowering housing prices."

Barclays Global Economics Weekly 20100820

Commodity review

- "Price moves remain diverse across the commodities complex. Market concerns on recent softer macro-economic data have pressured crude oil prices, while agricultural commodities – grains and cotton in particular – have been relatively immune after witnessing recent supply-side production downgrades on adverse weather conditions. We dissect commodity investment trends in this month’s Commodity Investor with commodity investments passing an important milestone in July with AUM surpassing $300bn for the first time, as commodity inflows bounced back and prices strengthened"

Barclays Commodities Weekly 20100820

No place to hide when rates are (near) zero

- "EM markets have benefited from the sustained bull-flattening in US Treasuries and calm global equities and commodity prices. This suggests investors have adjusted their view on global growth down, but have not made ‘recession’ their baseline scenario. Flows to EM have been sticky, underscoring a point we have made before: that low core market rates are a powerful floor for asset prices where there is no structural fault line, ie, in a large part of EM. We are not advocating a break of the range, but note that there is still room for selective receivers, constructive credit views and RV."

Barclays Emerging Markets Weekly 20100819

AUD: Seeing Green

- AUD: Seeing Green "National elections typically have little effect on the AUD, but a high probability of a hung parliament and a potentially important role for minority parties in the government have raised the level of uncertainty about this Saturday’s election. We discuss the potential implications for the AUD."
- EMEA FX: Picking your location carefully "EMEA currencies are being supported by inflows to local bond markets, but we feel that this support will be more selective in the future."
- VND: Vietnam weakens the dong to support growth "The State Bank of Vietnam weakened its currency against a backdrop of easing inflation. We expect a balance of payments surplus, allowing the build-up of FX reserves."
- MYR: A positive, albeit modest, step to improve FX spot convertibility "We expect USD/MYR to drift towards 3.05 in 12m, driven by the government’s divestment plans and the potential FTSE upgrade."

Barclays FX Weekly Brief 20100819

Bracing for the Fall of 2010

- "VIX is now trading in the low 20s as the SPX has rallied over the past six weeks despite a slew of weak macroeconomic data. Despite this headline normalization, under the hood, derivatives markets remain stressed across various metrics like skew, correlation and term structure. Indeed, Barclays U.S. equity strategist team believes that the summer rally in U.S. equity is ending and that the next significant move is more likely to be a return to early July lows rather than to April highs." - "Given this state of affairs, in our view, a somewhat bearish stance is warranted over the next few months. However, since a moderate pull back appears to some extent already priced in, we believe an outright short position is not advisable and we think put-spreads are a better instrument of choice."- "While put-spreads on SPX are an obvious liquid alternative, in this report, we attempt to quantitatively determine if other assets offer a better risk reward. Specifically, we make an assumption that various equity ETFs will return to their lows, reached in May or June 2010. We then compare the returns for a put spread position in each underlying asset to its cost to determine which one offers the best payout ratio."

Barclays Index Volatility Weekly 20100809

Correlation, Correlation everywhere, but not a drop to sell…

- "Equity correlation is close or higher than its high levels scaled during the credit crisis. This has profound implications even for non-derivatives investors in that it indicates that stock-picking skills are less useful in the current environment."
- "While much of the variation in equity correlation is driven by equity volatility, from a long term perspective it appears to have had a secular increase in value."
- "Since 2005, equity correlation has had a close relationship with the increased ETF volumes relative to the volumes in the underlying stocks."
- "Option implied correlation, which has traditionally traded at a premium to realized, is currently trading at a discount which would indicate that the option market is loathe to believe that the current high correlation is likely to persist. However, the fact that long dated implied correlation is also equally high and almost equal to its short dated version appears to provide a conflicting signal."
Barclays Index Volatility Weekly 20100726

Happy now?: Four questions on the European banks’ stress test

- Question 1: Will the sector bounce strongly? "The US bank sector surged 70% around
the time of its stress test, but we do not think Europe will follow suit. The US stress test proved the catalyst for massive equity recapitalisations, coincided with an economic recovery, and was performed on a sector trading one-third below its long-run valuation. We believe the July 2010 European stress test is unlikely to lead to any meaningful capital raising, was released at a time of growing economic uncertainty, and has been conducted on a sector trading within 10% of its long-run valuation."
- Question 2: Is the test credible? "We give a qualified “yes”. Two year loan losses of 3.6%
represent 30-year highs for the sector but are dwarfed by the US’s 9% stressed level. Whilst such comparisons can be misleading, there does appear to be more individual bank “wiggle room” for European banks, which we see as disappointing. In addition, pre-provision profit assumptions feel optimistic. There are substantial differences by country; in Spain, for example, the assumption is for a cumulative decline in commercial property prices of 55%, yet for just 7% in Greece. This may reflect an element of delayed recognition in Spain. The absence of testing for full sovereign default is understandable, but new disclosure allows investors to conduct their own stress test."
- Question 3: Who was the stress test done for? "Our view is not for us in equities, but for the debt markets. Whilst the US test last year was conducted in the shadow of nationalisation risk, this test was prompted by a renewed funding crisis. Indeed shareholders’ equity has not even been tested. So what is the debt market likely to make of it? We see a “cautious welcome” as the likely view."
- Question 4: Will funding costs come down? "This is perhaps the key question. To the
extent that the market feared what it did not know, the full sovereign risk disclosure is likely to be a positive. However, much of the sector’s funding pressure is, in our view, structural: too many balance sheets (banks and sovereigns) chasing too few funds. With or without a stress test, Europe’s banks still have €1.5trn of debt maturing by 2012, as well as the need to repay over €500bn to central banks. Well-capitalised banks with limited exposure to SGIIP (Spain, Greece, Ireland, Italy, Portugal) sovereigns, such as HSBC and BNP Paribas, should continue to be best placed to benefit. Of the big caps in Europe, BBVA appears to us the weakest positioned. We suspect structurally higher overall funding costs – and the differential in costs among banks – are set to remain."
Barclays Equity Research 20100726

European bank stress test results: A systemic positive, despite the oversights

- "We were biased to being long risk going into the tests: expectations were low, worst-case capital holes could, in our view, be filled within the scope of existing facilities, transparency would be a major positive, and weak banks would be forced to recapitalize. We believe the tests fell short in many respects, but we nevertheless have a positive view of the outcome. On the one hand, the tests exceeded expectations concerning disclosure of sovereign bond holdings. The majority of banks should be able to fund more cheaply. On the other hand, the tests were not stringent enough. Investors will perceive the banks that barely passed to be
undercapitalized; we expect poor spread performance from those names and they are likely to continue to face high funding costs."
- "In our view, the positives (creation of transparency) outweighs the negatives (too little forced capitalization). The majority of European financial risk in credit indices has been issued by banks that cleared the tests by a wide margin, where capitalization is not a concern, and where transparency is a key positive. The risk to our view is that, while systemic fears are likely to subside, the soft-handedness of the stress tests are likely to leave concerns over the capitalisation of some specific institutions – and that these idiosyncratic problems become so large that they overwhelm the systemic benefits."
Barclays Credit Research 20100726

European bank stress tests: A preview

- "We view the upcoming release of the European banks stress test results as a potentially important inflection point for the market. The experience in the US last year suggests that properly executed stress tests can greatly improve confidence in the stability of the financial system. In Europe, they may ease concerns by ensuring that the sovereign crisis and a likely slowdown in euro area growth will not result in widespread bank failures."
- "We have a bias to be long risk as the results of the stress tests are released. First, the capital needs we estimate are not insurmountable, particularly given the programs already in place to address them: FROB in Spain, the SoFFin in Germany, and the Financial Stability Fund in Greece. In each case, the total needs are within the potential scope of the programs. Even if some programs have difficulty funding, it is possible that the European Financial Stability Facility (EFSF) would provide a backstop, given the relatively small size of the needs. Second, although pessimism has retreated somewhat as markets have rallied over the past two weeks, many investors are still very sceptical of the stress tests, suggesting room for upside surprises. Finally, for the majority of banks, transparency alone may succeed in restoring confidence. Any market stabilization due to the stress tests would be beneficial to banks, particularly if it allowed them to issue term debt at lower spreads and move away from covered bonds and ECB funding that they have been forced to use recently."
- "To achieve this, the tests must: create transparency and/or stress balance sheets with respect to loans to corporates and individuals, as well as sovereigns; differentiate
between strong and weak banks using a sufficiently high minimum core T1 capital
hurdle; and force recapitalization of failing banks, with governments positioned to
backstop institutions that are unlisted/unable to raise capital privately."
- "In our view, the institutions most likely to “fail” the stress tests – meaning be forced to raise new capital – are Spanish cajas, German Landesbanks, and Greek banks. Based on some simple assumptions using the information available from the European regulatory authorities, supplemented with the methodology used in the US stress tests, we estimate capital needs of EUR36bn for Spanish cajas, EUR34bn for German Landesbanks, and EUR8.6bn for Greek banks. Importantly, these estimates are based on a number of assumptions and are designed more to compare the potential capital needs with the programs in place to address them than to predict the exact results of the tests."
- "There are admittedly a number of risks to a long bias going into the release of the
results. According to our estimates, FROB may have to issue EUR34bn. Although this
could be spread out over time, difficulties in issuing cannot be ruled out while Spain
itself remains under scrutiny. Regulators may fail to create the transparency needed or
to set sufficiently aggressive loss assumptions. Capital hurdles may be set too low by
looking at T1 capital instead of core T1 capital. Bank books may be treated too lightly.
Finally, spreads have rallied over the past two weeks, suggesting the bar is no longer set so low that any disclosure whatsoever will cause a rally."
Barclays Credit Research 20100714

The road to normalisation?

- "Risk appetite has stabilised and EGB peripheries have performed. The front end of Europe remains under pressure as Euro money market conditions continue to normalise. While confidence remains fragile, we have taken the first steps towards near-term stabilisation."
Barclays Global Rates Weekly 20100709

Quality Ideas with a Catalyst: Stock Specific Names for the Current Market

- "With last week’s strong market rally coming on the heels of the prior weeks’ strong re-entrenchment, we believe there is much investor scepticism over the future
direction of the market. Macro economic data remains weak: business and consumer confidence are soft, the manufacturing recovery has stalled and labor market growth is anaemic. On the other hand, valuations are potentially attractive in many stocks and sectors. Heading into earnings season, there is a potential for upside surprises in a number of stocks which makes a defensive positioning a risky scenario for investors."
- "We are recommending a combination approach for investors: going long highquality stocks that are attractive valued on a free-cash-flow basis that have also been experiencing significant upwards earnings revisions. We believe this combination of attractively valued high-quality names that are experiencing a “catalyst” in the form of upwards earnings revisions positions investors well for the current market. These are defensive stocks that could deliver better than expected earnings this quarter."
Barclays Equity Research 20100712

Spain: Solvent with risks

- "Spain has been a key focus of investor attention during the past few months. While its sovereign debt dynamics are somewhat challenging, the involvement of its banking system in the real estate sector has been the key source of uncertainty. Because of its size relative to other countries under investor scrutiny, the fate of Spain to a large extent may determine that of the euro area."
- "The Spanish banking sector is heavily exposed to the construction and developers sector (EUR445bn or 25% of total loans). We project losses net of provisions, profits and recoveries of about EUR46bn (ie, about 4.4% of GDP). The risks of bank exposures to residential real estate are limited, as LTV ratios for residential mortgages are moderate, household affordability levels remain contained, and provisions coverage and estimated recovery rates on collateral would be able to absorb expected losses."
- "Adding the quasi-fiscal costs for bank recapitalisation and other conservative assumptions (including lacklustre growth), the government needs a primary balance adjustment of about 12% of GDP over the next five years to stabilise the public debt-to-GDP ratio at around 80%. The government fiscal plan to cut the overall deficit to 6% of GDP by 2011 and to 3% by 2013 could be consistent with a sustainable debt path if the plan is extended beyond 2013."
- "While in principle Spain and its banking system are solvent, there is a series of key risks. First, any changes in ECB liquidity policy could put Spanish banks in a difficult position as, for the time being, they are heavily dependent on it. Second, by October a new budget will be presented by the government. Lack of support could precipitate a government crisis. Third, failure to implement the pension reform currently under discussion would cast solvency doubts."
- "Overall we do not want to downplay these implementation risks. Spain is certainly vulnerable to them as well as to an increase in global risk aversion. But at the same time, these risks are known and followed closely. Current problems are challenging but still manageable, in our view."
Barclays Economics Research 20100707

Derivatives reform: Evolution, not revolution

- "The Dodd-Frank Wall Street Reform and Consumer Protection Act stands to be the most sweeping overhaul of US financial regulation in decades. In this article, we focus primarily on those provisions in the legislation that deal with the regulation of OTC interest rate derivatives markets."
• "Almost all OTC derivatives, including those for interest rate swaps, swaptions and credit default swaps will be affected by the legislation. However, we expect the bill to lead to a continued evolution of the interest rate derivatives market – we do not foresee any immediate changes to market structure."
• "Central clearing is likely to be beneficial to the market, reducing systemic risk and improving market transparency, as long as the number of clearinghouses is not allowed to proliferate (as this reduces the benefit of multilateral netting)."
• "Clearing in itself should not impose a very heavy collateral or cost burden on large banks. The burden may actually be larger for users with higher funding costs."
• "Considering the potential systemic impact of the failure of a clearinghouse, it is crucial to ensure that margining methods and capital requirements across clearinghouses are consistent. We see a risk that clearinghouses could become the new GSEs: “too big to fail”, yet run for private profit."
• "Of all the provisions in the legislation, we view the requirement that trades be publicly reported as having the greatest impact on the liquidity of derivative markets. These requirements should lead to greater transparency around pricing and tighter bid-ask spreads for smaller market participants."
• "However, if real-time reporting is implemented in illiquid products that involve a small number of large trades among sophisticated investors, it may reduce the incentive for dealers to make markets, and significantly reduce depth."
• "For plain vanilla swaps, existing electronic platforms may be able to transition into swap execution facilities without too many impediments, as long as certain requirements are met."
• "However, for more illiquid products, the best possible outcome for investors would be the evolution of facilities where most trading is done via “block trades” with reporting delays as this could retain the benefits of bilateral trading."
• "Standardization of even plain vanilla products is non-trivial. We discuss the surprising challenges involved and their ancillary impact on accounting practices."
Barclays Interest Rate Strategy 20100630

In The Shadow Of Fear

- Overview: In the shadow of fear "The immediate economic and financial context remains market supportive. However, we expect market fears to cast a shadow on EM assets: investors are, justifiably in our view, increasingly focused on the riskier medium-term outlook, hence we are gradually fading our emphasis on the cyclical recovery as a market driver. Nevertheless, we continue to expect EM outperformance as emerging market countries are less vulnerable to the fiscal challenges facing industrial economies."
- Asia: Policy normalisation to continue "GDP growth is expected to slow to 7.6% in 2011 from 8.8% this year, as global PMIs peak, the inventory cycle draws to a close and fiscal stimulus dissipates. Excess capacity is largely absorbed, core CPI is close to trend and, outside China, credit growth is accelerating. Monetary conditions are likely to continue to normalise, driven by modest currency appreciation, cautious rate hikes and further quantitative measures."
- EMEA: Sustaining recovery in times of euro angst "In light of a weaker euro, fiscal consolidation in the euro area, and delayed rate hikes in core markets, we see EM EMEA also focusing on fiscal consolidation while leaving monetary policy looser for longer. Inflation trends support this; the growth outlook is unchanged."
- Latin America: Cruising "Amid a volatile world economy, Latin America’s economy has been remarkably uneventful. Growth has been fast and driven (almost everywhere) by domestic demand. While solvency conditions remain strong, fiscal policy is somewhat procyclical."
- Asia: Recovery on track; beware of tail risks "We enter the second half of the year still positive on EM assets and look to be cautiously positioned for a recovery. Headline risks continue to present tail-risk events, such as Europe, and regulatory changes. China’s currency reform may spark a rebound in risk-taking in Asia."
- EMEA: Sailing close to the wind "Price correction and de-positioning have improved the EMEA market technical outlook. However, the proximity to the key market risk – Europe – continues to produce crosswinds for EMEA assets and tail risk trades warrant greater attention than usual."
- Latin America: Reassessing risks "We remain comfortable with risky assets in Latin America, particularly in credit and FX, but we are keeping an eye on hedging strategies and relative value. In low beta credit space, Colombia remains our favourite pick, and we prefer Argentina over Venezuela.
- EM Corporate Credit: New issuance takes a vacation, but solid fundamentals remain "We view the recent pullback as an opportunity to add corporate exposure, given the strong fundamental backdrop, but expect credit differentiation to gain importance when technicals ease. Corporate liquidity, earnings and commodity prices are likely drivers."
Barclays Emerging Markets Quaterly June2010