Some thoughts on the bullish narrative

We have started an experiment at Real Vision on our Daily Briefing where we have guest commentators more often. Our usual European commentator, Roger Hirst, is out for two weeks. And so we thought it would be a good opportunity to mix things up. Last night, we had Jay Pelosky of TPW Investment Management on the program. And he spoke in very bullish terms. Here’s the link, if you want to watch his commentary.

I like Jay and was glad to see him give a bullish turn on what sometimes seems a parade of downbeat analysis. So, I want to riff off of that today and give you a few thoughts on where the bullish analysis could pan out. I think it goes to the policy response, both monetary and fiscal, with bank stocks being the canary in the coalmine.

I have talked about European financials in particular as being poorly capitalized and vulnerable – hence their low price to book ratios. However, Jay, for his part, talks about those same beaten-up European financials as one place to be if you think this is a new bull market.

Spanish banks

Let me use Spanish banks as a jumping off point here. Now, if you think about where the bodies are buried, it’s in the retail and hospitality space I spoke to yesterday, using the Munich Hofbräukeller example as the jumping off point. These are predominantly small and medium-sized businesses.

Big companies in hard hit sectors like International Airlines Group, which owns Spanish Airlines Iberia as well as British Airways, will get bailouts. We see Europe’s largest carrier Lufthansa getting a bailout from the German government. And even its Austrian subsidiary is getting a bailout from that government. That’s not to say there won’t be job losses. Just today, Lufthansa said it was cutting 22,000 jobs. But, the company itself will stay in business with government aid. That’s great for the banks that lent it money.

Small and medium-sized companies don’t have this luxury. All of the government bailout schemes in the world won’t prevent a mass of failures there. And so, for the financial sector, the question becomes, who is going to take the losses. And then you need to know how manageable those losses are.

In Spain, the Spanish banks with the highest exposure to small and medium-sized businesses aren’t systemic institutions like BBVA and Santander. Bankinter comes first with 24.6% of their outstanding loan portfolio to smaller companies. They are followed by Abanca and Ibercaja, both with 16.2%. The average is 11.7%. Both the systemic institutions are under that level. BBVA has 11.4% exposure, while Santander only has 10.1%. That’s not problematic when you consider that the Spanish banks had massive exposure to the construction and developer sector when the real estate bubble burst, at 60% of their outstanding loan portfolio.

The European bad bank

Add to this fact that the ECB is cooking up a scheme to remove problem loans from European bank portfolios by placing them in a ‘bad bank’ financed by the European Stability Mechanism. Here’s Reuters on the plans:

One blueprint under discussion would involve the European Stability Mechanism, an EU institution which can provide financial assistance to euro zone countries or lenders, standing in as guarantor for the bad bank, the people said.

The bad bank would then issue bonds which commercial banks would buy in exchange for portfolios of unpaid loans, neutralising the virus shock for Europe’s lenders. The banks could then lodge those bonds with the ECB as collateral for central bank funding, one of the people said.

Major European commercial banks could be called on to join forces to underpin the scheme, the second person said.

While European countries are now focused on launching a 750 billion euro plan to help economies hit by COVID-19, the idea of a bad bank, and the ECB blueprint, could come up for discussion among central bank governors and ministers later this year.

Asked on Tuesday about bad banks, Andrea Enria, the ECB’s chief bank supervisor, said while he supported the concept, it was “premature” to discuss one now because it was not clear how severe the impact of the coronavirus outbreak would be.

My read here is that the ECB is saying that they don’t want to do a bad bank. But if it’s necessary because the Covid-19 crisis demands it, they will go down this road. The takeaway, then, is that the EU will do whatever it takes to put policies in place that will underpin their economies. They will not let the virus create a Great Depression without doing everything they possibly can to support individuals, businesses and the financial sector. This includes direct transfers to workers and households for lost wages, bailouts for companies affected by the virus, and, in extremis, a removal of toxic loans from bank balance sheets.

My view

At a minimum, policy responses like these take the tail risk of Great Depression scenarios off the table. Yes, we can get second and third waves of the virus. But what policymakers are telling you is that they will fill in enough of the demand shortfall gap to prevent a Great Depression. That’s bullish for risk assets.

This is the narrative underpinning bullish momentum in the markets. We saw Federal Reserve Board Chairman Jerome Powell saying pretty much the same thing about US monetary policy options yesterday. Michael McKee asked him directly about the possibility that Fed policy was causing a bubble in shares. And this was his response:

our principal focus though is on the state of the economy and on the labor market and on inflation. Now inflation of course is low, and we think it’s very likely to remain low for some time below our target. Really it’s about getting the labor market back and getting it in shape. That’s been our major focus. I would say if we were to hold back because, we would never do this, but the idea that, just the concept that we would hold back because we think asset prices are too high, others may not think so, but we just decided that that’s the case, what would happen to those people? What would happen to the people that we’re actually, legally supposed to be serving? We’re supposed to be pursuing maximum employment and stable prices, and that’s what we’re pursuing.

The question now is not about the policy support narrative. It’s whether asset prices have priced in too optimistic an earnings outcome from that support. For example, Handelsblatt reported earlier today that Tesla now has a market capitalization larger than the entire German auto sector – BMW, Mercedes and VW – combined (link in German).

Sorry, folks, that’s just not rational. It’s Internet bubble pricing. This kind of market momentum has the hallmarks of a mania written all over it. I have said, it’s time to exit stage left. But Credit Writedowns is not a trader’s newsletter. So I am not giving advice on how to mitigate downside risk from these levels. Kevin Muir, over at the Macro Tourist newsletter has some great thoughts on that. And I invite you to read his newsletter. He says he’s buying the SPY 315/290 July put spread as a ratio on a 1×2 basis.

That means for every 10 contracts I buy of the SPY Jul 315 put, I will short 20 of the SPY Jul 290 puts.

I will pay approximately $2 bucks for the spread (as opposed to just buying the 315 puts outright for $8.43), but will have long exposure below the 290 strike. I can live with that, and in the meantime, it cheapens my put purchase.

That’s a reasonable way to fade this bubble. But, remember, the speculation now is in bankrupt companies like Hertz and in the bubble stocks like Tesla, which has almost tripled in value since the March lows. If you had bought naked out of the money Tesla call options, your gains would have been 30x or 40x, not just 3x. This is the kind of lottery ticket win the Robinhood crowd is looking for. So, we may actually see an increasing rotation out of the SPY writ large into more juiced up indices and ETFs as punters try to get exposure to the highest beta shares to crank their returns.

Meanwhile, as I wrote this post, the latest US jobless claims report came out:

In the week ending June 6, the advance figure for seasonally adjusted initial claims was 1,542,000, a decrease of 355,000 from the previous week’s revised level. The previous week’s level was revised up by 20,000 from 1,877,000 to 1,897,000. The 4-week moving average was 2,002,000, a decrease of 286,250 from the previous week’s revised average. The previous week’s average was revised up by 4,250 from 2,284,000 to 2,288,250.

That doesn’t sound like the real economy is at bottom yet. Sure, you’re bottoming, but from extreme levels.

GDPNow 2020-06-11

I see job losses continuing, particularly in retail and hospitality and at state and local government levels, which shed 585,000 jobs last month.

So, having supplied you with some thoughts on the bullish narrative supporting shares, I still have problems with what I am seeing in equity (and oil) markets right now. Maybe Jay Pelosky is right about the longer-term play for European financials. I gave you the analysis to support that thesis. But, over the next few months, I won’t touch the highest flyers. A reckoning is coming. The question is when.

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