June 2017

June 2017

Commentary

We held off this month’s issue until after the election and the events of the last week did prove worth waiting for. Two things stand out for us – one strongly negative event and one strongly positive. Re the election result, the view in the Centrus office on Thursday afternoon was that while no one could predict the outcome, there would be some happy people and some unhappy people and not many in the middle to mediate in the post-election “discussion” on Friday. But in the event everyone came in scratching their heads. Was this an example of the “wisdom of crowds” (decentralised analysis and decision-making involving a large number of independent thinkers) or a monumental failure of leadership, notwithstanding that plenty of people thought that May calling an early election was a jolly good idea at the time? We will leave the reader to add their own thoughts at this point … The positive one is Banco Popular in Spain and its acquisition by Santander for a symbolic 1 Euro. The Spanish government had been running a sale process for some time and it was acknowledged that Banco Popular had problems with bad debts and issues in its property book. The result has been a clean sale and bail-in of both shareholders (with the 1 Euro presumably split between them) and junior bondholders (not sure whether they were even that lucky). This isn’t a test of every aspect of the post-financial crisis resolution regime, but it is a clear example of providers of debt to a failing bank being “bailed in” i.e. taking losses.

The failing which so rightly aggravated voters during the financial crisis was the fact that taxpayers were obliged to bail out banks’ creditors when various banks went to the wall, in order to keep the system at least vaguely functional. The person in the street might have thought, had he or she considered it (and they consider it more now than pre-2007), that that there was no guarantee of professional investors’ exposure and that if banks leveraged themselves up that was their risk and that of their funders – not taxpayers. But the lack of rigour in the system forced taxpayers to step in. Some might argue that a few more Lehman Brothers scenarios might not have been such a bad thing – but the consequences were seen as unpalatable so that was generally not the route followed. “The rest is history” in terms of the travails of the world’s economies and employment performance since then, with the latter a particular issue in much of the Eurozone and we are all aware of some of the political consequences. Banco Popular was Spain’s sixth-largest bank. Until recently it had c.EUR10bn of tier 1 equity including EUR1.25bn of “Additional Tier 1” capital instruments (basically various types of bond). All of that has been wiped out through the terms of the sale to Santander. The political impact remains to be seen but it is positive that what could have been a car crash has been dealt with quite neatly and reasonably – and in a way which can broadly be portrayed as ‘fairer’ than the previous process would have dictated, suggesting that regulators and legislators may have got something right in the arena of banking regulation, although arguably even this regime is unlikely to adequately stem systemic risk arising from difficulties at one of the “too big to fail” banking institutions. The next test may well be the weaker Italian banks and we shall see what is the outcome there.

The last area briefly to mention is the fact that we have just all been getting used to the idea that smaller (or medium-sized, at least) housing associations which could not sensibly access the market of listed debt, were able to access funding from private placements on reasonable terms. Pricing has generally been reasonable albeit with adjustment for a somewhat notional “illiquidity premium” of say 25 basis points. However, a number of investors have been reporting a strength of demand in the public market which has not filtered across to the private side, and after a short period of widening spreads within the housing sector in particular they have all bunched back together again at relatively tight credit spreads against gilts which has left private placements looking more expensive, more like 35-50 basis points than 25 in terms of the pricing premium relative to a public issue. In a nutshell: the private market looks ripe for another round of innovation and entry by new investors (and we are currently working with a couple of potential new entrants), because while 25 bps may be reasonable for the privilege of accessing capital markets by small borrowers, 50 bps is starting to look toppy. Indeed, the whole concept of an “illiquidity premium” against a public market where “liquidity” seems to disappear in a puff of smoke at the merest hint of trouble is somewhat moot. In the past, some smaller and medium sized borrowers have challenged this type of position by accessing the US private placement market. However, we remain sceptical of the idea of smaller and less sophisticated borrowers taking on contingent cross currency risk in the event of pre-payment. It has been reported that THFC and GB Social Housing may soon be seeing some competition from a potential third aggregator. Any intermediation itself has a cost (and it may be that THFC will be the cheapest given the size of its back-book and its established name in the market), but the backdrop is this market dynamic which creates a space. Investors willing to play in the private market will need to put their best foot forward if they want to keep all of their modestly-priced lunch, in terms of the returns from making capital available to smaller borrowers.

Financial Markets and Economics Overview

UK inflation continues on its upward trajectory with the YoY CPI and RPI inflation measures increasing to 2.7% and 3.5% respectively in the month. In its Inflation Report for May, the Bank of England’s Monetary Policy Committee (“MPC”) outlined its expectation that CPI inflation will continue to rise through the year, peaking at circa 3% in Q4 2017.

A key element of the MPC’s rationale for tolerating inflation above the 2% target is the apparent weakening of economic conditions since the turn of the year; in May the Q1 2017 GDP growth rate was revised downward to 0.2% (previous estimate at 0.3%) from 0.7% the previous quarter. This decline was largely attributed to pressures on household income and spending, with the MPC expecting conditions to remain weak through 2017 before improving in the medium term with wage growth projected to “recover significantly” as the UK approaches full employment.

Despite the continued uncertainty around the UK’s political leadership and approach to Brexit, the FTSE 100 index rallied in the month to reach an all time high of 7,457 on 26th May (although after the election it has continued its rise and now stands at above 7,500).

Long-term Gilt yields (1.69% for the 30 year tenor) and investment grade credit spreads (as measured by iBoxx AA and A corporate indices) tightened slightly in the month, together implying a lower cost of borrowing on new long-term debt issuance.

House price growth slowed again in May with Nationwide and Halifax both reporting a softening of house price increases to YoY 2.1% and 3.3% respectively. The graph on the following page shows the YoY growth rate of house prices since 2000 as measured by the Nationwide HPI; notably YoY house price growth is clearly on a downward trajectory and tracking below the long-term average of 6.7%. Despite headwinds from increasing pressures on household disposable income and continued political uncertainty, Nationwide expect that the “subdued level of building activity and the shortage of properties on the market are likely to provide support for prices”.

Interest Rates

Inflation

Capital Markets

Bank Credit