April 2013 - Sacrificing Cyprus and impairing uninsured depositors
Last month's Cyprus crisis has been a barely forgivable fiasco for European leadership, judging by its clumsy implementation of the country’s banking sector bailout.
The Cyprus episode has created a new precedent and has sparked new fears within the European banking sector that senior bond holders and uninsured depositors (>€100,000) in weak banks could be impaired. Admittedly, Cyprus was a special case, with an over-indebted sovereign state, insolvent banks and an outsized offshore banking sector (according to Moody’s, Russian banks and corporates hold USD 31bn in deposit in Cyprus). So Russia will end up paying most of the bailout.
But, despite the specific situation of Cyprus, when Eurogroup President Jeroen Dijsselbloem spoke of Cyprus as a template, it meant the authorities are willing to consider all parts of the capital structure – equities, subordinated debt, senior debt, uninsured deposits – in upcoming resolution processes of failing banks.
The poorly executed Cyprus bailout plan only had a limited negative impact on global financial markets as US stocks continued to gain with the S&P500 breaching its all time high last week. Other countries’ equity markets are lagging in this uptrend (see table below).
The US economy is benefitting from strong housing activity, better employment numbers and better than expected spending numbers from both corporates and consumers than we could have expected post Fiscal Cliff and Sequestration. Besides maintaining strong earnings performance, US equities continue to benefit from corporates issuing debt at all-time low levels to buy their own shares and others', through M&A.
Our model portfolios, which are heavily biased towards US assets, have performed well in the current markets. As before, we continue to be underweight European assets as the Euro area remains in recession, Italian political risk is still high and capital controls on Cypriot deposits may lead to important deposit withdrawals elsewhere in Europe.
Across risk assets we are witnessing important return differences on a year-to-date basis between equities, which are rallying and commodities and corporate bonds, which are seeing no gains, very much unlike last year. Commodities are delinking as there are no growth upgrades in emerging markets.
Corporate bonds are stagnant as most investors are already massively overweight the asset class and the Fed is hotly debating the end of their QE program.
In terms of our strategy we continue to favour high dividend yielding equities and high-yield bonds, both heavily overweight in US assets.
Equity is the asset class which continues to offer the highest risk premium and the most value. Our equity model portfolio generates an average 5% yearly dividend and is exposed to oil stocks, precious metal companies, US REITs and global consumer goods company with a strong global brand.
On the high yield bond side, fundamentals continue to remain constructive. Although US corporates showed a slight deterioration in credit metrics vs. the previous quarter (increase in overall leverage with higher debt outstanding), default rates are remaining low (below 2%), revenues and EBITDA have been increasing, liquidity remains high and refinancing risk is low.
Now more than ever, with bank deposit rates being so low and valuations in some corners of the market looking expensive, good name picking and rigorous risk management are essential.