Don’t Stop Believin’
Geopolitics and Terrorism Don’t Mean You Can’t Believe in Banks

by Jeffrey Miller, Partner, Eight Bridges Capital Management
March 27th, 20156
The past few weeks have been quite important on the central bank/central planning circuit. On March 16th, China’s National People’s Congress passed its 13th Five Year Plan. It is more a set of goals and policies than a specific plan – individual bureaucracies will come up with precise implementation steps later. But it lays out what is important to the top of the Communist Party and in particular to Xi Jinping (this is the first Five Year Plan created under his watch).

Quoting from the Association of Foreign Press, here are some of the main targets of the plan:

1. To grow China’s economy, the world’s second-largest, by an average of at least 6.5 percent a year over the period. Gross domestic product (GDP) to go from 67.7 trillion yuan (R162.3 trillion) last year to more than 92.7 trillion yuan in 2020.

2. The service sector to account for 56 percent of GDP by 2020, up from 50.5 percent in 2015.

3. To cap total energy consumption under five billion tonnes equivalent of coal by 2020, compared with 4.3 billion tonnes equivalent of coal last year.

4. To cut energy consumption and carbon dioxide emissions per unit of GDP by 15 percent and 18 percent respectively from 2015 levels by 2020.

5. City air quality to be rated “good” or better at least 80 percent of the time by 2020, up from 76.7 percent in 2015.

6. To raise installed nuclear power capacity to 58 gigawatts by 2020, when another 30 gigawatts are scheduled to be under construction. Currently, 28.3 gigawatts are installed, with 26.7 under construction.

7. To expand the high-speed railway network to 30,000 kilometres (around 18,600 miles) by 2020, from 19,000 kilometres last year, and build at least 50 new civilian airports.

8. To boost per capita disposable income by 6.5 percent or higher every year. The figure grew by 7.4 percent in 2015.

9. To create a total of 50 million jobs in urban areas over the five years.

10. Permanent urban residents to make up 60 percent of China’s total population by 2020, up from 56.1 percent last year. The proportion of people with urban “hukou”, or household registration, is to reach 45 percent of the total population.

Can they do it? Beats me. But they will probably get close – at the end of the day, the Chinese Government dictates who gets capital and for what. That goes a long way towards making things happen. The one that stuck out to me was number 7 – increase their already large high-speed rail network by over 50% and add 50 airports. That’s a lot of infrastructure, and will definitely help with the GDP goals, even if the airports are sparsely used.. But I’m not sure where the urban service jobs are going to come from – that is a big shift in just 5 years in a massive economy. Saying it should happen is one thing, but making it happen, in an economy with significant amounts of graft and regulation, is going to be tough. Good luck…I see lots of smokey back room deals over wine.

Workin’ hard to get my fill
Everybody wants a thrill
Payin’ anything to roll the dice
Just one more time
Some will win
Some will lose
Some were born to sing the blues
Oh, the movie never ends
It goes on and on and on and on

  • Don’t Stop Believin’ by Journey

A headline from US News and World Report on March 10th exclaimed:

“The European Central Bank has cut all its main interest rates, expanded its bond-buying stimulus program, and offered new cheap loans to banks, an unexpectedly aggressive move to boost inflation and economic growth in the 19 countries that share the euro…

ECB President Mario Draghi said the bank’s decisions at the meeting of its 25-member governing council were the best answer to recent questions about whether central banks were reaching the limits of what they can do.

‘We don’t give up in our fight to bring inflation back to our objective,’ Draghi said. He added that the steps to increase bank lending would ‘reinforce the momentum of the euro area’s economic recovery and accelerate the return of inflation to levels below, but close to, 2 percent.’ ”

What I find funny is that at the same time these steps he’s taking will “reinforce the momentum of the euro area’s economic recovery,” he finds it necessary to further cut interest rates and increase stimulus.  I guess he meant to reinforce the downward direction of the recovery – he just forgot to mention that part. Because his prior actions haven’t done anything to boost the economy of Europe, which is on the brink of disaster due to the ECB’s ruinous policies. The ECB keeps wrecking the profitability of banks with low and negative rates, with crazy regulations, and with odd asset risk-weightings, and yet, they wonder why the banks won’t lend more. Gee, I don’t know, because the banks don’t get paid to do it and even if they did get paid to do it, the economy is so tenuous there that their credit costs are likely to be so high that any profits would be quickly erased. So they sit on their funds, try to manage their capital ratios, and hope that things will eventually get better. Hoping isn’t a strategy, which is why Italian banks are sitting on 20% non-performing loan ratios. Worries are that, absent a significant turnaround in their economies, other countries in the Eurozone aren’t far behind, if not to quite that extent. Things are still bad. Don’t let the “momentum of the recovery” fool you…Some will win, and some will lose. I’m guessing the winners are going to be those who stay far away from European credits.

ISIS struck Belgium last week, and unfortunately it doesn’t appear like this will be the last time Europe will be victimized by these barbarians. At some point the political leadership in Europe (and America) needs to stop being apologists and accommodators for radical Islam and realize that they are playing a zero-sum game – us or them. They want to rid the world of western values and return it to a barbaric Middle Ages-like existence. The West is at war, only we don’t want to admit it. Peggy Noonan wrote a great article in the Weekend Wall Street Journal – I have linked it here via a different site so you can read it free. It’s worth the time. We need to attack ISIS and eradicate it, not try to appease or contain it. Evil isn’t appeasable. In the meantime, this is also a terrible blow to the tourist economy of Europe – first Paris, now Belgium, with terrorists freely operating under the nose of Belgian intelligence services. I traveled to Africa 2 weeks after 9/11, but I’d have to think long and hard about a trip to Paris or Belgium or Berlin right now. I don’t think I’m alone in that.

Against this lovely backdrop of global banking problems, central planning, and terrorism worries, I’m actually bullish on a quite a few stocks here in the U.S.  I’m trying hard not to let the macro worries scare me out of the good solid companies I like. As I’ve mentioned in the past few Musings, I am bullish on community banks. A few weeks ago I attended a sell-side conference for regional and community banks, and came away with the following observations:

  1. Credit outside of energy remains solid.  Credit within energy is “not good” –  look for issues there. The place for crazy lending is in subprime unsecured and auto loans, which makes me feel good long-term about the shorts I have in that group.
  2. Interest rates at these levels are manageable, but ROEs will really turn higher once rates are 50 to 100 basis points higher. Higher would be better. But banks are making it work.
  3. Regulators are driving good, solid bankers nuts. For the most part, the banking regulators are new to the industry and don’t have a clue what they are doing. They are questioning great loans and asking for all sorts of unnecessary paperwork, which is driving good bankers to wonder why they bother. Ironically, these regulators mostly work for the same institution that is cutting rates in the hope that banks will lend more. Maybe they should talk…
  4. Because of “3” above, expect to see more mergers in the industry. Regulatory costs are higher for banks once they hit certain asset thresholds, so it makes sense for banks near those levels to do deals to get enough scale to pay the bill. One investment banker at the conference, only half-jokingly, said “I wonder what I’m going to do in a few years, because most of these companies are going to be gone by then.”
Just a small town girl
Livin’ in a lonely world
She took the midnight train
Goin’ anywhere
  • Don’t Stop Believin’ by Journey
Janet Yellen is in a lonely world, as the only central banker talking sensibly about the fact that rates should be higher. If you want lending to drive GDP growth, maybe let the banks make a little money on the loans? Just a thought. Some at the Fed even seem to be beginning to understand that low rates may be creating low inflation due to the lack of income being earned by savers. After not moving at their March meeting, Fed governors have recently made it clear that moving at the April meeting is a possibility, and that two hikes are definitely on the table for 2016. Given that in February the Street was thinking one or none, two sounds pretty good. They’re slow, but eventually they might get there…So where do we go from here?  I think the S&P 500 is range-bound for now between 1950 and 2100, with a tighter range between 2000 and 2050. As we approach the end the quarter, we could see stocks drift down into earnings, as investors take a wait and see attitude towards new investments. Bond replacement stocks (staples, utilities) are incredibly expensive, while stocks with some issues (energy, financials, international stocks) look attractive. Terrorism and geopolitics continue to be the overhang. China worries cast a shadow as well – can the bureaucrats monetize their debts and assume their banking system’s bad loans without triggering a run on the Yuan? We’ll find out. European financials continue to be in a lose-lose situation, with capital and credit problems in a no-growth economy run by clueless technocrats.  As a result, we’re sticking with the US market, but keeping ourselves very well hedged.
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This week’s Trading Rules:
  • Trading into earnings reporting periods has a downward bias, as buybacks go quiet and investors await the new information before committing capital. Get smaller.
  • Hedging geopolitical worries is incredibly difficult. If you’re too early, the costs eat away at your returns. If you’re too late, you take big hits to capital. Goldilocks had a tough gig.

Markets in the U.S. have moved on higher oil, a weaker dollar, and a trade into the higher end of the trading range. Nothing has really changed, and now we head into the quiet period ahead of earnings. Expect lower volume and watch for exogenous shocks, which can have an outsized influence during these times. Right-size positions and get ready to play a little defense if needed.

SPY Trading Levels: Last Musings’ levels worked out really well. The market is coloring within the lines. The SPY stopped right at the 205 resistance we mentioned before backing off a bit.

Support: 201/202, 200, 195, 191/192, then 183/185.

Resistance: 204.5/205, then a lot at 209/210.

Positions: Long and short U.S. stocks, ETFs and options. Short XLP, XLU.

European Banks