What Happened within the Espirito Santo Group?

Observations on the Capital Markets – Week Ended July 11, 2014

It was a tough week for Europe over all last week – industrial production declined in Germany, Italy, France, and the UK, with the details broadly downbeat. Trade (import and export) data, especially from Germany, was disappointing as well. But the big story in Europe last week came from Portugal, where Banco Espírito Santo (BES), a leading Portuguese bank, suffered a share price crash and trading was suspended after reports of financial irregularities.

Those irregularities were reported in an entity (Espirito Santo International (ESI), which owns 49% of Espirito Santo Financial Group, and in turn owns 25% of Banco Espirito Santo), several steps from the bank. ESI (to which BES has no direct exposure) missed payments on some commercial paper and Portuguese newspapers reported that some clients of BES were not able to get their money back on ESI paper. It is now clearer that ESI and its 100%-held subsidiary, Rioforte, have a significant amount of commercial paper on the liability side, and that some of that paper may have been miss-sold, which is likely to lead to impairments on the debt issued by that entity. The key question for the market is what the actual exposure to the ESI paper BES is accountable for and what impact it will have on its capital position. There have been various statements from the group and the bank attempting to reassure investors that their capital provision for this event is adequate and will not impact their regulatory capital ratios.

Pioneer’s View: Systemic Risk Fears Are Exaggerated
We believe the bank is suffering from contagion arising from the other group entities. While some uncertainty remains surrounding these events, we believe the sell-off was overdone, as BES is being more ring-fenced from the holdco companies (as the government and regulator have highlighted). Management changes have been proposed and are supported by the Portuguese regulator, and ESFG may have to reduce its stake in BES, pushing BES – which we believe has adequate solvency levels – further away from the troubled entities.

In the U.S. – Encouraging Data, Few Surprises

  • The minutes of the June 17-18 Federal Open Market Committee (FOMC) meeting contained no surprises.
    • Discussion focused on the mechanics of policy normalization, not the timing.
    • Markets feared a rising sense of urgency about normalizing policy in the face of stronger labor market data and higher inflation. The lack of discussion around the topic was viewed as reassurance that the Fed is not ready to act.
  • Labor market data was encouraging and consumers were more active.
    • The number of job openings ticked up from 4.5 to 4.6 million. The hire, quit, and discharge rates were little changed. Initial unemployment claims dropped to 304k.
    • The consumer is increasingly willing to borrow and spend. April’s big rise in consumer credit card (or, more precisely, revolving credit) borrowing wasn’t just a fluke; borrowing accelerated further in May. Auto loan borrowing continues to rise as well. This bodes well for the personal consumption expenditures segment of Q2 GDP.

Consumer Credit (2)

  • We saw more signs of economic strength…tempered by business caution.
    • The budget deficit is shrinking even faster than forecasted: the latest forecast for this fiscal year (which ends 9/30) is $583 billion, down 17% year over year (y/y).
    • Wholesale inventories rose in line with sales, leaving the inventory:sales ratio relatively low. Inventory liquidation detracted from Q1 GDP; rebuilding inventories should boost Q2 GDP.
    • The NFIB Small Business Optimism Index faded from 96.6 to 95.0.

In Asia – No Inflation Pressures in China, Softer Economic Data from Japan

  • Chinese June CPI was up 2.3% y/y…not rising. PPI was -1.1% y/y, down for the 28th consecutive month (rising productivity).
  • Chinese exports and imports were below analyst expectations in June.
  • Japanese machinery orders were far below expectations, leading to fears for the broader economy

Last Week in The Capital Markets

Dovish Fed minutes, soft European economic data and banking fears produced a risk-off week.

  • Currencies: With the FOMC meeting minutes not hinting at early tightening, the dollar was a bit weaker against most currencies, with the Yen (up almost 1% against the dollar) the strongest developed market currency.
  • Bonds: It looked like a flight to quality last week as Banco Espírito Santo Puerto Rico fears roiled muni bond markets. The 10-year Treasury yield fell 12 basis points (bps) to 2.53%; the 10-year TIP yield fell 12 bps to 0.25%. The BoA Merrill Lynch High Yield Index widened 17 bps to 3.61%. German 10-year Bund yields fell to 1.20%, within a few basis points of all-time lows, while peripheral European yields rose.
  • U.S. Equities: The Dow Jones Industrial Average couldn’t stay above 17,000 and the S&P 500 Index was down 0.9% last week. It was a risk-off week within the S&P 500 as well: Telecom Services (1.7%) led; Utilities (0.8%) and Consumer Staples (0.3%) also managed to post gains. Energy (-1.9% as oil prices fell again) and Financials (-1.5% on Portuguese banking system fears) were the weakest sectors.
  • International Equities: Portuguese banking fears and weak economic data drove MSCI Europe down 3% last week; Portugal and Greece were down almost 10%. MSCI Japan was down 2%; the market was down every day of the week, depressed by a stronger yen and disappointing economic data (the decline in Q2 GDP may be larger than anticipated). MSCI EM was close to break-even.
  • Commodities: WTI oil fell 2%, to $100.83, on more Libya supply hopes and fewer Iraqi supply fears. Gold was up about $13, up for the fourth consecutive week, to $1,335.

 Download this copy in PDF format.

Data Sources: The Wall Street Journal, Financial Times, Bloomberg.

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