The Sleep of Reason

Big picture risk assessments today, and worries about the prevailing style of regulation - we look at where the next bank blow up maybe. We’re assuming this will again be caused by regulators and their herding behaviour. On the upside, an improving medium-term market outlook. Also, dollar danger.

But before I begin…

First of all, many thanks to those who replied to our sentiment survey, you are a cautious crowd! Over half (53%) sitting on the fence, alongside us. The largest directional group is bullish on equities (18%), but it is a pretty even bull/bear split with bonds, and quite a few equity bears too.

Regulatory Myopia and Declining Banks

Bank boards (and auditors) are still clearly confusing regulatory approval with sound banking, in the odd belief that excuse will wash, when they implode. In particular we worry about the vast amount of debt that is sitting on bank balance sheets, at below current market levels, and not in this case issued by governments.

We have notable anxiety about two areas, fixed rate mortgages and investment grade debt where, especially for the former, the numbers are vast. Perhaps the tightening steps to date appear so ineffective, just because so much of this old low-cost issuance, is only very slowly rolling off .

Big picture – the effect of long dated low-cost loans, with rising interest rates

This leaves cheap money in the system, funded by banks, that have to pay way more to keep funding these long-term deals. They’re doing this typically with short-term sources, like deposits. In sub-prime, asset finance, trade finance, consumer finance, none of it matters much, as they are pretty short duration.  Which is where most people worry, because of default rates, we don’t.

But in mortgages especially the regulator typically issues the future economic scenarios to banks, who then price (originate) and provide for losses against that projection.

If that projection is absurdly few rate rises, for a decade (as it was till fairly recently), it seems banks just follow obediently along. As a result, they have issued vast amounts of long dated, low cost loans based on false or unrealistic assumptions.

Those regulator driven economic assumptions/scenarios are key, and yet are lost in the detail. Each bank has to publish them if you dig deep enough.  (Some are on p155-157 of the HSBC accounts, for example, if you have the stamina.)

Re-mortgages – what they contribute to our big picture

The other part is refresh rates, in a falling interest rate world, borrowers re-mortgage every few years, but in a rising one early redemptions virtually stop. So, the whole system gums up, without fresh liquidity. Regulators have not seen, and have no data, on such a ‘higher rates for longer’ world. So, it is assumed that world cannot exist. While the key thing (still) on these scenarios is that interest rates are still assumed to be like rockets, straight up straight down.

Now if you assume that, there is some short term pain, but normal service resumes soon enough with no long-term issue. But is it realistic? It is a vast slow moving market as in this publication of the FCA’s mortgage lending statistics .

Inevitably the scenario dispersion used is small, indicating a regulatory finger remains on the scales. So, most banks take the Central Bank forecast as the middle way, with say 10% either side. All as at the historic balance sheet date. Last year they were nonsense even before publication, two months on.

That is aside from Hong Kong, where real economic models, with real outcome ranges are visible. For most markets you see a skein of twisted rope drifting laconically into the future, but on HK they produce an exploding ammunition graph, smoke trails looping everywhere.

To a lesser extent BP debt (a classic investment grade, big, global borrower) is a similar problem. It has half fixed, half floating issuance, but the fixed is at 3% with a fourteen-year average term and the floating at twice that, at 6%. Now someone holds that fixed debt, and if regulated it will have to now be held below par. Are BP going to prepay it? Despite the roar of cash coming in, why would they? It is stuck, unusable for 14 years, unless inflation (and rates) collapse as fast as predicted.

What else is driving markets?

The big upside drivers to us are, the end of COVID, the end of the energy spike and falling rates. The first two will help through 2023 and 2024. Rising rates are still hurting, but again 2024 and beyond  looks good.

While the biggest current downside driver is the recession, which will impact 2023, but again rebound in 2024. So, the issue is: will the rather timorous monetary tightening and anaemic reductions in the absurd fiscal overdrive, be enough to defuse all that good news coming in the next year?

Markets apparently think not.

We are particularly struck by the NASDAQ up 18% year to date, yet our tech bell weather share, Herald Investment Trust (HIT) is still (marginally) down YTD. So is this a bitcoin-type story (all about liquidity) or is it based on tech fundamentals? If the latter, then why is it seemingly glued to the US, and not translatable? Even failing to reach non-US holders of US companies.

For now, until the price of global tech shifts, I treat the US as a special case; growth is not back yet.

While the currency charts are unclear, it does also feel like the beginning of the end of the great dollar story, with sterling persistently ticking higher of late.

Graph showing the dollar share of global reservesFrom: this page published by the NY federal reserve.

That’s a real danger for portfolios that thrived on dollar power last year.

We close wishing you a happy Easter break. We will be back with St George.


Thin ice skaters or savants?

photograph by charles gillams

Are we drifting out further from the shore of reason, confident we can slide gracefully back to safety, or do we have insight others lack? Perhaps rates just can’t rise, whatever the inflation rate? If so, they are a paper tiger. While in a week others have pondered the failure of UK investing during this century, we look at why our biggest bank seems to hate the country.

I’m talking about the economics prognostications from HSBC, our largest bank. Following an intellectually flawed change in accounting standards (yes, another one), on top of the insanity of “mark to market” comes the “predicted loan loss model”.

Now professional bankers (unlike those in fintech) don’t make loans to lose money.

So, the politicians have instead required them to assume that they do.

Do the regulators know the industry they’re regulating?

Imagine portfolio management where you assume a certain portion of your buys always fail. Might be true, but how?   And if you admit you have to buy a certain number of your holdings to instantly lose money, what do your investors feel?

But although banks advance money on the basis of their credit committee assessments, the  hordes of regulators deem some of it is immediately lost. Being rational people on the whole, the banks, not great fans of predicting the future (given their record), hire economists to do this for them.

Economists, as we know, actually know little, but they do build nice econometric models. The regulators, who know even less, tweak the models, the bank Boards (see above) also tweak them. Soon every model is so tweaked that the economists wonder why they bothered.

UK shown as the riskiest of places to lend

Which leads us to page 62 of the HSBC Interim Report. We read it, so you don’t have to. There on the excitingly named, but dull as ditch water section called “Risk” it is set out.

Now HSBC lends globally: Mexico, India, Vietnam, Peoples Republic of China. So, guess where “The highest degree of uncertainty in expected credit loss estimates” relates to?   Apparently, the basket case to end all wicker weaving is . . . Yes, the UK.

How?

Well first up their ‘central scenario’ model sees the short-term average UK interest rates for the next five years, as 0.6%. Which at least is positive (unlike France, as they hate Macron even more), France (i.e., the Euro) rates are assumed to stay negative till after 2026.

This gloomy central scenario has a 50% chance, although for France it is a tiny bit better at 45%.

Now these are central estimates, but their “downside scenario worst case outcome” for the UK is heavily weighted, with a chunky 30% chance, and oops, France then gets a 35% chance of that disaster, neatly using up the slack just given to them, by the central scenario.

From this OECD page - our particular selection of countries.

Oh, and there’s worse: house prices crater, double figure unemployment is locked in etc.

And that’s a combined 80% of outcomes sorted; for a bank, that is pretty near certain.

China compared to the UK and France

What about Mainland China, then, their biggest market, if you now include Hong Kong. Well like the US (75%), China is at a high (80%) central scenario certainty, with Hong Kong at 75%. The worst-case scenario for the PRC is ranked at just a measly 8%, the lowest of any of their major markets.

Call it impossible - a prediction that China can’t fail.

Well, if that’s what the economists believe, who are the dumb Board to argue? Well of course they can, to cover their well-appointed posteriors, they then chuck another couple of billion of extra reserves in on top of the doomsday forecasts.

So, you see the vortex, everyone, regulators, economists, non-executives are just adding to reserves, like the good old days.

Maybe they are right, but we are seeing very little sign of those incredibly low global interest rates for five years, negative in France, 0.6% in the UK, 1.1% in the US? Really? If they are right, the markets are wrong.

And it is not just technical, with a 35% chance of France hitting the worst-case scenario, no wonder the Board has shipped out their French operations to a fin tech start up, albeit one backed by private equity giants Cerberus. Not an outfit known for overpaying. With five-year rates at 1.1% the dash for cash in the US makes sense too, selling out of their retail side as well. While with a virtually nailed on, global leading, 5% five-year average GDP growth in the PRC included, surely time to expand there?

Their loan book does not bear out HSBC’s bullish estimates of Chinese infallibility

So it is with some trepidation that we look at their loan book, on Real Estate, in China. It must be massive? Certainly, markets apparently assumed so last week. But no, a paltry $6.336 billion, for HSBC that’s a rounding error. Luckily too, all rock solid, just $28m of reserves needed, although given their certainty that almost feels excessive. The Board probably slipped that bit in.                      

I have great admiration for HSBC, and for me personally it is a long-term hold, but I have much less regard for regulators and ‘economists’ models, about which only one thing is certain. They are wrong.

So, I try to just strip out the predicted loan loss nonsense, but it is still driving asset allocations, even when palpably false. It explains much of the last two year’s volatility in bank share prices and reported profits, it also justified the highly damaging dividend ban.

Yet the HSBC share price is still not much above 50% of its pre-COVID peak. Great investor protection that was, it hammered HMRC receipts too, for what? Based on what? 

Does anyone challenge those weird scenarios internally at HSBC?

Is there really a 35% chance of France virtually collapsing in the next five years?

Or is this just part of cozying up to China? In which case as the IMF has shown, bankers accused of fiddling data for China, are not always seen as professionals and can lack credibility.

Regulators should not impose those odd fictions on real investment decisions either.

If they do real economies and yes jobs, suffer. 

Charles Gillams

Monogram Capital Management Ltd