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Update of the Shadow Banking System

(March 25, 2011)

Dear Subscribers and Readers,

Even though the European Sovereign Debt Crisis is still burning, we must concede the fact that yield spreads of “systematically important” countries such as Spain and Italy have been coming down—even after the Portugal Prime Minister resigned yesterday.  This is not entirely surprising, as only 50% to 60% of the sovereign debt of Spain and Italy is owned by domestic investors—while those of Greece, Ireland, and Portugal are 80% to 95% owned by foreign investors.  Furthermore, Spain is now running a trade surplus against other European countries, while its banking system is still relatively stable compared to that of Ireland.  Finally, Germany is only “coming down hard” on countries such as Ireland (whose 15% corporate tax rate is unacceptably low relative to that of Germany and France)—and is providing support to systematically important countries as they do not want the European Union nor the Euro to break down.  Is the European Sovereign Debt Crisis finally stabilizing?  It's too early to tell—especially with the European Central Bank likely to hike rates early next month—and more important, the sovereign debt remains a structural one across the developed world, especially with baby boomers now retiring en masse.  This will be an ongoing theme for the rest of this decade.

In our February 25, 2011 commentary (“Is the Shadow Banking System Recovering?”), we noted that while bank lending and private equity lending remain depressed, global economic growth, with the exception of Japan, is still humming along.  Within the US, the Federal Reserve, with its weekly net purchases of about $18 billion of Treasuries, is providing much-needed liquidity to the US economy and financial market.  In addition, we noted that while there isn't a clear sign, both the CMBS and the ABS markets (i.e. the “Shadow Banking System”) might be in the beginning of a recovery.  More specifically, we mentioned that the US commercial real estate market was “hanging on,” especially given the spike in global CMBS originations in February (to $6.5 billion).

However, as shown in the following chart and table (courtesy of Commercial Mortgage Alert), global CMBS originations in March has since dropped—suggesting that the global “shadow banking system” (at least on the commercial real estate side) is still having problems:

More distressingly, CMBS spreads and yields bottomed in February have since spiked, as shown in the following chart (again courtesy of Commercial Mortgage Alert).  This is especially distressing given the tightening policies of the European Central Bank, not to mention the inevitable expiration of the Federal Reserve's loose monetary policy in June (as QE2 expires):

At the same time—while global  issuance of asset-backed securities remains steady relative to that of last year—subscribers should note that last year was a tough year for ABS issuance (following courtesy of Asset-Backed Alert):

In other words, the global “shadow banking system” remains challenging.  Compared to the lack of bank lending revival, the ongoing European Sovereign Debt Crisis, and now the lingering concerns about the Japanese economy, subscribers should remain cautious on risky assets in general.  Speaking of leverage and liquidity, I now want to address the steady rise in leverage within the stock market, as exemplified by the amount of margin debt outstanding.  Since the February 2009 bottom, total margin debt outstanding has increased by 75%, and has retraced nearly 70% of its peak-to-trough decline from July 2007 to February 2009. Total margin debt outstanding increased by$22.1 billion during February—standing at $349.0 billion, its highest level since month-end March 2008:

No doubt margin debt outstanding is now very elevated—and given the ongoing rise in geopolitical risks, commodity prices, as well as the negative technical divergences we've covered over the last couple of months, we expect the current correction to continue for the foreseeable future.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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