Tuesday May 30

After a strong week last week stocks started the holiday shortened week on soft footing. The S&P 500 fell 0.1% to 2,412 and the Dow Jones fell 0.2% to 21,029. The KBW Bank index fell 1% while utilities lost 0.4%. Economic data today showed that personal income and consumer spending both rose 0.4% last month which was in line with consensus. The PCE Price index rose 0.2% on the month and 1.7% yearly which was in line with expectations as well. Core PCE came in at 1.5%. The Case-Shiller HPI showed strength in home prices rising above consensus. Falling oil prices today weighed on sentiment. Energy stocks in the S&P 500 fell 1.1%. Investors also focused on renewed political risk in Europe as a possible new electoral system in Italy could allow elections to take place this fall instead of in 2018. On that backdrop rates fell in the U.S. and in Europe. The 2 year Treasury yield fell 1bp to 1.29%. The 10 year Treasury yield fell 4bp to 2.21%. Accordingly 2yr vs 10yr bull flattened to 0.93% which is the flattest since October. The dollar was weaker on the day against peers. USD fell 0.2% against EUR to $1.1191 in spite of dovish comments yesterday by Mario Draghi. USD fell 0.4% against JPY to Y110.77. USD fell 0.1% against GBP to $1.2856. Oil prices were softer on the day. WTI fell 0.4% to $49.58. Brent fell 1% to $51.78.

Last year energy at this time energy was the big problem sector in equity and debt markets, and many were concerned that energy exposure could bring down some banks. This year the big problem sector is retail, however banks haven’t been as adversely affected as they might have been from the oil meltdown. Year to date there has already been 21 announced U.S. retail bankruptcies, which outpaces the full year total for the last four years. The exposure of banks to the retail sector is also larger than it was for energy. However a key difference is that the loans given out to retail companies are collateralized by better assets than they were for energy, and many banks expect to be repaid in full as a result. “Asset based loans” are typically collateralized by inventories and accounts receivable. When commodity prices were selling off dramatically, asset collateral values were very volatile and the downturn was very broad across the industry. The assets that collateralize retail loans are much less volatile and historically have had good recovery rates. Banks have also carefully scrutinized their exposure to retail, including the retailers themselves, the real estate exposed to it, as well as suppliers. Smaller banks could be more negatively impacted according to KBW.

As the Trump administration focuses on financial deregulation, one of the first areas to change will be the $50bn regulatory designation. In Dodd-Frank, all banks with greater than $50bn in assets are subject to much greater regulatory requirements. That includes capital requirements as well as annual stress tests, both of which are very expensive for banks to perform. Many people have complained that these requirements disproportionately hurt banks on the smaller end of the $50bn designation. There is widespread support to increase that number. Even regulators that are proponents of strict financial regulation believe the number should be increased. Those include Daniel Tarullo as well as Barney Frank whose name is in Dodd-Frank. Recently Frank said “All numbers are arbitrary, and in the rush, $50bn seemed like a much bigger number” … It clearly seems unreasonable to assume that a small regional bank with assets of just over $50bn poses the same systemic risk as a large international institution with assets in the trillions with derivative exposure, and other complex assets on its books. It therefore also seems to make sense to also take into account the riskiness of a bank’s activities when subjecting them to certain regulatory requirements. The numbers being tossed around now include $250-500bn on the Republican side and $100-150bn for democrats. Both would free up a decent amount of banks from those strict regulations. In the most optimistic scenario, under which $500bn would be the limit, that would benefit banks including US Bancorp, PNC, TD, and Capital One since all of those have less than $500bn in assets. When regulators were initially drafting Dodd-Frank, they felt that it wouldn’t be ideal to only supervise a small handful of the largest banks, and that by designating just a handful of banks they would be sending the signal that those could be bailed out. They therefore erred on the side of caution, however now there is support on both sides of the aisle to raise the limit. In the current political environment that could be difficult however, especially when taking into consideration more controversial elements of Dodd-Frank such as the Volcker Rule.

Investors are expressing concern about the junk bond market given current valuations. Over the past 12 months spreads have tightened nearly 240bps and the spread to US Treasuries for U.S. junk bonds is currently just 3.6%. Junk bonds have performed well year to date returning 4.7% for investors. However many are wondering how much further the rally can go. The average junk bond yield is currently 5.5% which is well below the long term average of 8.3%. Recent polls of institutional investors by Bank of America show that 20% of investors are holding below average allocations to non-investment grade debt which is the highest percentage since 2008. Additionally nearly half of the investors polled say they are holding higher levels of cash than normal. That will allow them to weather the storm in the event of a downturn and buy when prices are lower. However a main concern is that if investors sell today, they may not be able to buy tomorrow if valuations rise even further. Defaults aren’t forecast to increase, and there are favorable tailwinds from potential economic policies in the US as well as the macro market environment. International investors especially from Asia and Europe like high yield in the US in spite of valuations because they can’t find any returns like that in their home markets. Year to date investors have pulled money out of high yield mutual funds according to Lipper however yields have still decreased. Also reflective of the search for yield is emerging market bonds. Traditionally emerging market corporate bonds yield +150 to US high yield, however now that spread is just +50 as investors pour into riskier assets.

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Tuesday May 30

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