- by GJ Prasad
Poor equity – Same old pain…
It is not even a full working week into 2019 and we are seeing large volatility across asset classes – yet some of the themes that are likely to persist throughout the year are already getting confirmed:
- Global growth slowdown, especially in China and Europe;
- Disinflation or inflation staying well below target;
- Tightening financial conditions and slower credit creation;
- Strained liquidity conditions;
- Large and sudden bouts of market volatility; and
- Populist measures getting traction
This potentially means that the main central banks in the developed countries – Fed, ECB, BOE and BOJ resort to the old playbook of slowing/reversing rate hikes; become more dovish in forward guidance and decrease the speed of balance sheet reduction. And the Chinese central bank may go one step further and add further monetary stimulus to tide over a credit contraction.
Whilst this may help risk markets to bump along, the implication for the European banks is more downbeat as it would impact profitability. Lower loan growth (due to credit impulse slowing down) and margin compression (both due to competition and lack of profitable lending opportunities) may see banks struggling to improve top-line revenue growth. Add to this the high cost base and a potential increase in loan losses, one can see earnings trajectory to reverse or at best stay flat. In this environment, most banks likely to struggle to generate ROE close to COE.
Earnings recession is likely to lead to lower shareholder distributions in the form of dividends and/or buybacks. And this lack of earnings visibility is what has caused equity valuations of the major banks to drop 30% or more in the last 3 to 6 months. And in many cases, they trade at P/TNAV of 0.6 times or lower.
Some of the European banks have leverage issues and may yet need to either restructure their operations or reduce their risk assets. Plus, home bias should see some of them retrench and reduce global footprint and /or get out of non-profitable operations or businesses.
Credit may yet become an unintended beneficiary
Although the above backdrop is not hugely optimistic, in a perverse way, credit investors may be the biggest beneficiaries, especially given the reluctance of European governments to let banks fail.
Looking at the situation differently:
- Lower loan growth and/or asset de-leveraging may lead to higher capital ratios and better solvency metrics;
- Ample central bank accommodation and alternative funding arrangements may result in limited issuance in capital markets;
- Poor or low dividend yield results in investors chasing higher yields in sub-debt; and
- Coupon suspension risk is eliminated as capital buffers improve
Barring a full blown deep economic recession and/or unexpected tail risks due to political risks, most of the national champion banks in Europe have more than adequate capital to continue as going concern entities and don’t need re-capitalisation. The other area of market concern in terms of liquidity may get addressed through the renewal of the TLTRO program for another 3 years and hence eliminating the need for primary markets to be open for debt rollover.
Suddenly, this low growth, low inflation, asset de-risking set up is creating a situation where bank credit is starting to become attractive given current spread level. Current yields on many of the LT2s and Holdco Senior paper issued by national champion banks in Core European countries are more than compensating for the tail risks out there. And AT1s issued by the large cap banks getting close to fair value and attractive to buy and hold.
The contrarian view is that AT1s issued by banks that meet the following criteria are very attractive and likely to see significant price appreciation on a 6-9 month view:
- Yield to Perp is close to 80% of the bank’s COE;
- AT1 yield is double the bank’s dividend yield;
- No more issuance to meet regulatory capital thresholds;
- Significant headroom on both coupon paying ability test and conversion trigger test;
- The bank’s equity is trading at or above 0.6 P/TNAV;
- Issue level rating likely to move to IG at all 3 agencies
Ask yourself this question – would you want to own AT1s issued by systematically important banks (yielding 7% or more) or HY bonds issued by firms in highly cyclical industries and with low visibility/transparency? I believe the answer is the former.
And I repeat my view from my 2019 outlook:
2019 is going to be a very interesting year for bank capital and, clearly, there is significant scope for generating substantial returns based on single name selection and dynamic portfolio risk management.
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