Credit - The Regret Theory

"In history as in human life, regret does not bring back a lost moment and a thousand years will not recover something lost in a single hour."  - Stefan Zweig

This year, we have on numerous occasions touched on game theory in our posts (The European iterated prisoner's dilemma, Agree to Disagree) and we also used an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept (Schedule Chicken). We even ventured towards computational analogies in our title selection process (Bankers' algorithm). Given the latest raft of European PMIs, pointing to a continued (albeit much smaller) divergence between the United-States Growth and Europe (Growth divergence between the USA and Europe), reason being the lack of credit provided to the real economy due to:
-inappropriate European Banking Association decision of imposing banks to reach a 9% Core Tier 1 ratio by June 2012 
-unrealistic budget deficit targets (A Deficit Target Too Far), 

We came to the conclusion that we ought to use in our title a reference to the Regret decision theory.

The divergence between US and European PMI indexes - source Bloomberg:

The Regret theory (also called opportunity loss) being defined as the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen by our European politicians. The Regret theory is also a model of choice under uncertainty defined as the difference between the outcome yielded by a given choice (credit crunch, economic recession) and the best outcome (muddle through) that could have been achieved in that state of nature (deflationary forces at play). 

As far as Europe is concerned, one can wonder what would have been the "economic outcome" if a different course of action would have been undertaken. On that matter we wonder why our "European elites" did not use the minimax regret approach being a decision rule used in decision theory, game theory, statistics and philosophy for minimizing the possible loss for a worst case (maximum loss) scenario. One approach is to treat this as a game against nature (deflation in our case) and using a similar mindset as "Murphy's law" ("Anything that can possibly go wrong, does"), taking an approach which minimizes the maximum expected loss, but we ramble again...

And what could possibly go wrong in relation to European growth in 2013? After all, one might posit it is only a game of confidence. Well, looking at consumer confidence in Europe, "Murphy junior" would certainly comment that his father is probably too optimistic when looking at European Consumer Confidence.

European consumer confidence indicators for some European countries - source Bloomberg:

We already looked at the link between consumer confidence and consumption back in our June conversation "Yogurts, European Consumer Confidence and Consumption" where we undertook at an interesting exercise following Yogurt giant Danone profitability warning announcement (affected by Spanish woes), namely plotting Danone share price against consumer confidence - source Bloomberg:

We wrote at the time:
"Yogurts matter as an indicator? One has to wonder...

As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit."

In relation to European Consumption, Consumer Confidence is key. The latest data relating to car sales in Europe, confirms the deflationary forces at play in Europe with car registrations falling plunging 19.2% in November in France on a monthly basis and 13.8% in the first 11 months of the year and Italian care sales by 20.1% in November (for a lengthy analysis on the subject of the car market in Europe please check - "The European Clunker - European car sales, a clear indicator of deflation").
As far as 2013 is concerned, European car sales are at risk on weaker consumer consumption as indicated by Bloomberg:

"Bears suggest discounting by automakers may not be enough to boost unit sales in Europe. Austerity in Europe is straining disposable incomes, with consumer household expenditure falling for three consecutive quarters. Car sales in Europe fell 4.2% yoy in the first three quarters of 2012 and any sustained recovery will be challenging as economic pressures mount." - source Bloomberg

One could also look at car sales and European Consumer confidence since 2007, the relationship seems pretty clear even though the cash for clunkers program have indeed been highly supportive of car sales whenever consumer confidence needed some government "artificial boost" - source Bloomberg:

Weak economy, low consumer confidence and high unemployment are indeed the deflationary forces at play plaguing European consumption and impacting car sales in the process. 2012 will be the fifth consecutive year of declines in the European car market below 12.8 million units, 20% below pre-crisis levels.

Strong macro drivers such as consumer confidence set the trends for the demand in the auto sector but for consumption levels as well.

France Consumer Confidence and Household Consumption YoY since 2001 - source Bloomberg:

For instance, another indicator of the divergence between Europe and the United States, comes from the auto sector where demand for US light vehicle sales were up 7% year over year in October and 14% year to date, whereas Europe was the only region to decline in 2012, down 4.6% in October and down 6.9% in 10 months. Even China, passenger car sales were up 6.4% in October and nearly 7% year to date. In Europe the European Automobile Manufacturers Association, or ACEA, indicated in November car sales decreased 6.9 percent to 10.7 million cars. The ACEA indicated Europe’s car sales would reach a 17-year low in 2012. It also estimates that as much as 30 percent of production capacity is not used.

We think our European politicians would be wise to look at the minimax regret approach given Intrade is now putting a 30.6% chance of breakup of the Euro by December 31st 2013 as reported by Stephen Rose from Bloomberg on the 3rd of December: 
"Following is a table listing the odds that one country currently using the Euro will change its official currency by the expiration date, based on bets made at Intrade.com."

Europe is still a story of deleveraging and as pointed out by a recent note from Credit Agricole Cheuvreux from the 29th of November entitled "EU, The Road through purgatory", should our European politicians decide to tackle the minimax regret approach, there are indeed four possible recipes: "There are four basic recipes for deleveraging: austerity, inflation, growth, and default. The optimal is growth but Europe as whole cannot export its way out of its challenges and nor does it need to. Europe overall runs a current account surplus; the challenge lies in the balance within the Union. Europe needs further debt restructuring, inflation and a rebound in consumption (domestic growth). Deflation is the key risk here, but Draghi appears to understand this danger and has proved a better lateral thinker than his predecessor." - source Credit Agricole Cheuvreux.

Yes, our "Generous Gambler" aka Mario Draghi has been clearly a better lateral thinker in preventing a financial meltdown following the acute liquidity crisis of the financial sector in 2011. But as far as our Regret Theory is concerned, we previously indicated that in the case of Europe, causation implied correlation:
"Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth."


Looking at the prospect for the younger generation of Europeans and high level of youth unemployment, maybe Murphy junior is correct in assessing his father's law after all:

-source CA-Cheuvreux / Eurostat.
"These unemployment trends are very worrisome and if they are not reversed in the short term they may lead to increased social tensions and structurally higher long-term unemployment, which has negative effects on a country's growth prospects as part of the workforce becomes impaired. Also, youth unemployment leads to emigration, which will have a negative impact on demographics, as will be seen in most European countries in the medium term." - source Credit Agricole Cheuvreux.

Deleveraging leads to lower domestic consumption while tax rates are increasing with a shift from income taxes to consumption taxes:
"As taxes increase, and penalise an already fragile economy, consumption decreases exponentially and corporate investment is postponed, which leads to lower tax intakes. This means that more taxes are levied on the economy to try to cover the shortfall and a vicious circle is perpetuated." - source Credit Agricole Cheuvreux.

Maybe the minimax regret approach is the right approach after all. Oh well...

On a final note and in relation to struggling peripheral countries, Spain has indeed very apt in avoiding "tapping out" for help in this European fight of the Century, given it has so far managed to retain market access with timely sales as indicated by Bloomberg Chart of the Day:

"The CHART OF THE DAY shows Spain, which has auctioned about 82 billion euros ($106.7 billion) of bonds this year, sold the most debt when borrowing costs were at their lowest. That’s allowed it to retain market access and so far avoid a sovereign bailout even as 10-year rates surged to a euro-era record. “Spain has been smart in timing the issuance in the market,” said Alessandro Giansanti, a senior rates strategist at ING Groep NV in Amsterdam. “A loss of market access in July this year could have easily driven Spanish yields to the 8 to 9 percent area.” The nation’s 10-year bond yielded about 5.32 percent on Nov. 30, down from 7.75 percent on July 25. The yield touched 5.20 percent last week, the lowest since March 20. Spain sold the biggest proportion of its debt in January, when the 10-year yield averaged 5.30 percent, and auctioned the lowest amount of bonds in August, when yields ranged from 6.15 percent to 7.44 percent. The Treasury completed its program of medium- and long-term debt sales earlier this month, and has used subsequent auctions to raise funds for 2013." - source Bloomberg

"Uncertainty is the worst of all evils until the moment when reality makes us regret uncertainty."

- Alphonse Karr, French critic

Stay Tuned!

Yogurts, European Consumer Confidence and Consumption

"Consumption may be regarded as negative production."
Alfred Marshall - Economist

Looking at European company Danone's profitability warning leading to a drop in the share price in conjunction with a dismal German investor confidence Zew index (ZEW institute reported that its monthly confidence index dropped by 27.7 points to a level of -16.9 points — its strongest decline since October 1998) has made us reflexionate around Yogurts, European Confidence level and Consumption.

Danone share price taking a beating - source Bloomberg:

As reported by Dermot Doherty in Bloomberg, Danone, the world's biggest yogurt maker cut its profitability forecast as Spanish consumers switch to less expensive products and raw-material costs rise, sending the shares down the most in three years - Danone Cuts Profitability Goal on Southern Europe, Costs:

"Danone is losing market share in dairy in Spain, where about one in four people are unemployed, and will take measures such as cutting costs and introducing new products to react. That will reduce profitability in southern Europe, Chief Financial Officer Pierre-Andre Terisse said today.

“The competitive environment in Spain is a lot tougher, so they’re having to invest more in promotion and pricing,” said Martin Dolan, head of equity research at Espirito Santo in London. “This is very Danone-specific rather than sector wide because of milk raw-material costs, and Danone’s exposure to Spain is far greater at about 8 percent than for other big food companies.”

Danone also indicated in relation to consumer spending in the same article:

"The French yogurt maker in April said it expected consumer spending to remain “under pressure” this year in western Europe. European companies are wrestling with the fallout from a drop in consumer spending as the sovereign debt crisis rocks the region’s economies. Carrefour SA, the biggest European retailer, last week said it would withdraw from Greece and carmaker Fiat SpA said it would cut investment in the region by 500 million euros ($630 million)."

In similar fashion to the trend in shipping with shipping giant Maersk is in fact shifting its business away from Europe (Shipping is a leading deflationary indicator) while Airlines are benefiting from growth outside Europe where traffic to the Americas have been the biggest beneficiary (Air Traffic is a leading deflationary indicator), Danone said sales growth target of 5-7% was unchanged; with robust performance in Asia, Americas, Africa, Middle-East, CIS offsetting pressure in Western Europe.

Leading us to an interesting exercise, plotting Danone share price against the gauge for consumer sentiment which last came at minus 19.3 (from minus 19.9) at the end of May 2012: Danone share price versus European Consumer Confidence since 2006 - source Bloomberg:

At the end of May Consumer Confidence in Europe fell to a two and half year low, following the previous inconclusive Greek elections, Spanish woes and fears of a euro break up.
Yogurts matter as an indicator? One has to wonder...

As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit.

We already discussed the difference between the growth differential between the USA and Europe (Growth divergence between US and Europe? It's the credit conditions stupid...), which continue to improve in the USA for now as indicated by my friends at Rcube Global Macro Research:
"The private sector credit growth (one of the most reliable Fed Fund leading indicator) has spiked(15% yoy).
The % of US commercial banks reporting stronger commercial & industrial loan demand is back to 2004 levels."

"As a result, US commercial banks will adjust balance sheets to the rising demand for loans, buying fewer Treasuries in the process. Their stock of government securities has risen from less than 10% of total assets in Q4 2009, to 15% today. While the incentive to do so was large over the last 4 years (extremely steep yield curve, falling inflation, broken credit channel), it is less so today. Their pace of purchase has already slowed from 25% YoY in Q3 2009 to less than 10% today, and should weaken further."
- source Rcube Global Macro Research - 18th of June 2012

As far as European Staples are concerned, according to a recent study by Morgan Stanley, impact of private consumption in Europe could be very significant in "European divorce" scenario playing out  - "European Consumer Testing Defensiveness – Downside Case Priced In?" - 14th of June 2012:
"Better prepared for an even worse scenario? In a “European divorce” scenario, the impact on private consumption in Europe could be worse than in 2009 due to the reduced scope for fiscal and monetary policy and higher unemployment. On the positive side, the Consumer Staples sector could see less of a relative de-rating because a) financial leverage is lower, b)inventory levels are generally at more manageable levels, c) commodity inflation is lower, and d) many companies have also expanded their lower-price point offerings. The relative re-rating has also been more measured this time, as the PE premium (60%) has not yet reached the peak from Nov 2009 (80%)."

It isn't only Danone facing similar exposure to weakening consumption levels in Western Europe with a slowdown in consumption levels in peripheral countries such as Spain. Heineken, L'Oreal, Reckitt and others are also exposed to similar trends as indicated by Morgan Stanley in their recent note:

"Within the region, Southern Europe only accounts for less than 10% of group sales on average across the sector. Imperial Tobacco is the most exposed to the region (Spain accounts for around 2/3 of its sales in Southern Western Europe). It is followed by Diageo and Heineken with more than 15% of group sales in the region (mostly Ireland and Spain for Diageo, and mainly Spain and Italy for Heineken). In Food, Danone has the largest exposure to Southern Europe, as Spain (~14% of group EBIT) is its most profitable market." - source Morgan Stanley - "European Consumer Testing Defensiveness – Downside Case Priced In?" - 14th of June 2012

No surprise Morgan Stanley's conclusion:
"Mix is Key
Our Bear case analysis illustrates the importance of having diversified portfolios and geographic exposures. Geographic mix (which we define as higher-margin regions growing faster than the group average and vice versa for lower-margin regions) plays a crucial role in determining the magnitude of downside risk in our Bear case scenarios."

In regards to European Consumption trends, CreditSights in their recent Euro Consumer Takeaways from the 18th of June made the following interesting points:
"-Italy: Confidence has fallen to its lowest level ever as of May; minus 38.6. Spending had already fallen by 2.4% in the 12 months to the first quarter, which is as large as the fall in the 2009 recession. Consumer spending can only fall so far before households fall back on subsistence levels, and prolonged declines in spending are rare. As such they believe that full-year spending decline will be less negative than the 2.4% fall in the year to the first quarter, but we are still expecting to be at least 1% lower over 2012 as a whole in real terms.
-Households debts in France, Germany and Italy are much lower versus national income; compared to the UK (96% down from 103% of GDP in 2009); respectively 55%, 60% and 45% of those country’s annual GDP. Household debt-to-GDP for the Eurozone as a whole is 65%. But while households in France, Germany and Italy are less encumbered by debts and do not, therefore, have to divert income to servicing that debt, low interest rates should still act as some motivation to bring forward spending by borrowing. They believe that is especially the case of borrowing costs are barely any more than households expect their salaries to grow by.
-Consumer borrowing costs , adjusted for wages, in Germany are roughly in line with the crisis low in 2007 at 2%. However, at 4% in France and 6% in Italy, the interest rates on unsecured debts are well above the lowest rates they reached in the 2000s. Additionally, these lower real borrowing costs have not obviously generated greater increases in household debts.

Wealth holdings – the “housing” conundrum:
"In the UK most peoples’ primary provisioning for retirement is their house, that tends to mean that changes in house prices are closely associated with changes in spending. Therefore the stabilisation in UK house prices is good in that falls are not actively undermining spending any more, but in their view it will be a long time before rampant house price appreciation once again drives a boom in consumer spending.
In Germany and France, house prices have, since 2009, been growing strongly. Prices were not over-inflated by a bubble in mortgage lending in the pre-recession years. And to some extent that growth may feed through to a greater willingness to spend in those countries. But their UK contemporaries and so while booming prices in Germany may provide some inclination to spend less, they believe that more consistent income growth and falling unemployment (leading to greater job security and consumer confidence) will be more important drivers of any increases in household spending.
In contrast to France and Germany, Italian house prices have been falling for some time. And falling incomes, tax-induced increases in prices, rising unemployment and worries about the government’s fiscal position are all likely to ensure that spending by Italian households remain depressed with or without the additional impact of house price declines."

UK wise:
"The government’s attempt to tighten its belts at the same time as the private sector is also cutting spending will not only be self-defeating for the government’s fiscal position but is prolonging the period that it takes UK consumers to reduces their debts and feel confident once again about the outlook for their incomes. They expect UK household spending to be centered around the 0% range this year."

With consumer confidence and investor confidence in the doldrums, in conjunction with struggling Southern Europe no wonder yogurts are taking a beating...

"The shelf life of the average trade book is somewhere between milk and yogurt."
Calvin Trillin

Stay tuned!