An important factor to consider in evaluating credit conditions is the debt-servicing costs, which have risen across developed market economies. We expect credit conditions to weaken more materially in countries that have seen leverage rise (even if modestly) and debt service ratios increase.
Our update at the end of Q1 focused on the brewing crisis in the US regional banking sector. While the elements that caused the US regional bank failures in March were not prevalent in the banks on our credit approval list, we expressed concern that stress on US regional banks could materially weaken the US and global economy if it led to materially less bank credit availability. There was concern that weakened credit conditions would imminently push the US into recession. So what happened thereafter?
In the US, bank deposits and loan assets have been relatively stable, even within the regional bank sector, for over two months since the extreme volatility of March (source: “US Bank Brief,” Jason Goldberg, Barclays Equity Research, 26 June 2023). While credit conditions continue to tighten modestly, the trajectory has not changed since the US regional bank failures. Indeed, the latest Senior Loan Officer Opinion Survey in the US does not reveal any ramifications from the bank failures, nor do similar surveys in other jurisdictions. This type of survey is particularly important for economies where financial intermediation is more bank-based than in the US, such as Europe, where declines in bank lending activity are more consequential for the economic outlook.
Meanwhile, the global economy continues to demonstrate modest resilience. Labor markets remain quite strong, supporting global services sectors. Even housing markets have proved resilient, especially in the US, despite significantly higher interest rates. While core inflation rates in the US and the eurozone have begun to ease modestly, they remain above the US Federal Reserve’s (Fed) and the European Central Bank’s comfort zones. Inflation rates in the UK, Australia, and Scandinavian countries have proven more sticky. None of these factors indicates pervasive economic weakness, let alone recession.
Credit conditions in the banking and debt capital markets have remained broadly healthy through most of this monetary policy tightening cycle. The cost of credit is higher, but there has not been a rationing of credit to qualified borrowers. In a “credit tightening,” qualified borrowers can obtain funding even if they have to pay a higher premium for it. A higher cost of credit should restrain growth, but not cripple it. This is what we are seeing at present, rather than the imminent threat of a full-blown “credit crunch,” wherein high-quality borrowers would not be able to obtain credit at a rational cost.
An important factor in the consideration of credit conditions is the debt-servicing costs, which have risen across developed market economies, but sit broadly at levels lower than during the expansion in the 2000s (“Debt service costs rising for most interest sensitive,” J.P. Morgan Global Economics Research, 26 June 2023). The current health of balance sheets (in particular, consumer balance sheets) reflects the sharp deleveraging that took place in the aftermath of the Global Financial Crisis (GFC), and partly mitigates the impact of rising rates on debt-servicing costs, as has the increase in income levels for households and businesses.
The largest increases in debt-servicing costs over the past year have occurred in Canada, Australia, and Scandinavian countries – all countries with more flexible-rate debt and higher leverage, and thus higher estimated initial sensitivities to rising rates.
We expect credit conditions to weaken more materially in countries that have seen leverage rise (even if modestly) and debt service ratios increase. Notably, there are some important global cash investment counterparties in the countries with higher relative leverage, such as Canada, Australia and Sweden. While those counterparties will continue to be under close scrutiny by our credit research team, we take comfort in the continued strength of the banks on our approval list with regard to profitability, asset quality, liquidity and capitalization. In other words, there is significant scope for these banks to maintain a relatively stable credit profile while the economy weakens.
Finally, we take comfort in the fact that the US regional banking stress has not materially spilled over to non-US banks in our investment universe, such as those in the European, Canadian, Australian, and Asian banking sectors. The lack of stress generally reflects stickier deposit bases, more limited scope for unrecognized mark-to-market losses on securities portfolios, less acute commercial real estate (CRE) concerns, and “smaller banks” being a less material portion of their respective banking sectors. These fundamental factors give us comfort that risks of systemic financial stress from the banking systems in our investment universe are limited.
Still, we believe that most of the negative macroeconomic impact from this aggressive monetary policy tightening cycle is yet to be felt, as the rate hikes work through the economy in a typical lagged manner. The conditions that trigger reductions in credit supply and credit demand are expected to continue for the foreseeable future. The ultimate impact will depend on the persistence of inflation, the response of central banks, the trajectory of credit markets, and the underlying resilience of the economies.
We are hopeful that the strength of banking systems, and the relative health of consumer and corporate balance sheets will mitigate the depth and duration of recessionary conditions in global economies. The onset of recession will always weaken banks as it pertains to profitability and asset quality, but our major investment counterparties continue to demonstrate strong measures of capitalization, liquidity and funding stability.
The failure of Silicon Valley Bank (SVB) in early March, followed by the collapse of Signature Bank (SBNY), sparked substantial market anxiety around the health of US regional banks due to the unprecedented pace of Fed policy tightening. All eyes turned to the mid-April earnings season and balance sheet trends. In general, while the industry’s deposit balances declined and wholesale funding rose, with smaller banks underperforming, the overall magnitude of the decline was not comparable to that of SVB, which saw a host of idiosyncratic challenges. Moreover, uninsured operational deposits actually proved more resilient than some had anticipated, and banks weathered the storm by defensively building liquidity. Overall, the feeling post the SVB failure was that prior revenue tailwinds from rising rates had morphed into headwinds, and that while the actions taken by the authorities had helped to stabilize matters, the operating environment had become more challenging for revenue, funding, credit and regulation.
As for Q1 2023 results, large G-SIBs (global systemically important banks) with scale and diversification were relative winners, in our view. Credit costs trended modestly higher but continued to show only a gradual normalization, including in CRE. On the balance sheets, loan growth slowed but liquidity rose, as previously noted, and capital trended up. The industry’s performance was generally better than expected (despite guidance trending lower), except for the beleaguered First Republic Bank (FRCB), which fell victim to the collateral damage following SVB’s failure.
FRC failed shortly after reporting poor results in late April and was acquired by J.P. Morgan Chase from the Federal Deposit Insurance Corporation (FDIC) on 1 May. Thereafter, regional banks came under renewed pressure as investors piled on certain names despite signs of deposit stabilization. While sentiment has since calmed, recent happenings evidence the critical role of confidence in the banking sector, and are a reminder that the signaling effect of lower stock prices can weaken fundamentals if depositors become skittish, even if unwarranted per fundamentals. This is different from the dynamic in non-banking sectors and should garner close attention, in our view, with no broad expansion in deposit insurance coverage seemingly on the horizon in the near term.
Looking ahead, banks expect new regulatory proposals to be a key theme over the remainder of 2023 but also anticipate a long phase-in period of years to come into compliance. Earnings expectations have generally weakened following the June conference season given comments around margins, growth, and credit. Revenue guidance is trending flat-to-lower for 2023 due to slower loan growth (reduced demand, less supply) and higher deposit costs. Deposits are down, but are in line with expectations, with some challenges on the horizon, including quantitative tightening. In fees, capital market trends are weak, though some banks see “green shoots” moving into H2 2023.
On the macro front, the “good news” is that while the likelihood of an imminent recession appears to have declined of late, banks are still preparing for tougher times with reserves, considering the 5%–6.5% unemployment rate vs. 3.7% in June. If a potential recession is pushed out, credit deterioration could remain gradual. In the interim, consumers remain healthy due to a solid labor market and low debt, but a bifurcation is emerging across Fair Isaac Corporation (FICO) bands and renters vs. homeowners, and the end of student loan forbearance is a headwind. Overall, problem loans remain historically low but are starting to trend higher, with office CRE an area to watch, despite manageable exposures and a long runway.
Much of Q2 2023 was dominated by the US regional bank turmoil. Europe has been largely immune from its effects. The long-held perception of the region – as low-growth and underperforming – is now working in its favor. “Regional banks” as a stock sector does not exist in Europe. Its smaller banks are mostly cooperative or savings bank networks, which do not have stock prices that can spook depositors. The members of these networks benefit from collective support as well as supervision from the head banks in the network. Unrealized losses within banks’ available-for-sale securities books are already recognized in capital calculations (which was not the case for the US regional banks that failed).
European bank results confirmed the idiosyncratic nature of both SVB and Credit Suisse. In terms of profit and return on equity, Q1 2023 was the best quarter for European banks since the GFC. Almost all banks easily beat estimates and experienced very high net interest income growth. This more than offset some of the (minor) negative trends emerging, such as unrealized losses on the treasury books, slowing loan growth (mainly mortgages), and declining deposits. Loan losses for many banks remained near zero – a consequence of provisions taken in H2 2022, better global gross domestic product (GDP) assumptions in banks’ Q1 2023 models, and minimal actual loan defaults in the quarter.
European banks continue to defy expectations. Inflation has weakened; but mortgage demand has not affected consumers’ credit quality (yet). The sugar-rush of rate hikes is still driving record revenues and earnings for banks. These exceptionally strong results will not last and are expected to moderate in 2023, as funding costs rise from the pass-through of rates to depositors. These headwinds are partly tempered by the improved economic outlook, banks’ adequate capital bases, and the good starting point of earnings. The majority of the sector is still better positioned than when it was barely profitable under negative rates.
Canadian bank earnings in Q2 2023 were a bit of a mixed bag. While pre-provision earnings were much stronger vs. the prior year due to higher rates and better net interest margins, results were weaker sequentially due to softer trading income and mixed net interest income, which fell victim to rising funding costs and slowing loan growth. Net interest margins appear to be peaking, or have peaked, and, while the return on equity was satisfactory, most banks missed estimates due to higher expenses, pushing 2024 consensus estimates down, on average.
In credit, there are signs of gradual normalization across impaired loans, impaired loan formations, delinquencies and net charge-offs, which are holding below pre-pandemic levels. Areas to monitor include CRE, though exposures appear manageable, and the domestic consumer, which is supported by a strong labor market and a low starting point. On capital, the trend for banks remains higher, with ~12%+ Common Equity Tier 1 (CET 1) ratio a new de-facto benchmark, influenced by yet another late quarter change in the Domestic Stability Buffer by +50 bp due to risks related to private sector debt.
Overall, the major banks continue to boast above-average profitability vs. global peers with diverse revenues a point of differentiation, modestly offset by high/growing wholesale funding needs and concerns around high private-sector household leverage. Canada continues to grapple with inflation and re-started its rate hiking during the quarter as home prices found a trough. This remains an ongoing dynamic to monitor closely.
Three of the four major Australian banks reported their results this quarter, following Moody’s affirming its ratings of the Big 4 with “stable” outlooks earlier in the quarter. In general, themes continue to be fairly positive for credit investors even as management teams are turning a bit more cautious on the environment. Fundamentally, higher rates and decent loan growth have served to boost pre-tax pre-provision profits, the first line of defense against credit losses, which have grown at a double-digit pace from the prior year. While this benefit is especially important for Australian banks, given that ~80% of revenue comes from net interest income (NIM), NIM benefits appear to have peaked and sequential results were weaker.
In credit, trends remain remarkably benign, including delinquency metrics, losses and impaired loans, in part reflecting a strong labor market, but higher provisions and higher proportional reserve weightings toward adverse outcomes foreshadow the potential for inflection.
On capital/funding, CET 1 ratios trended up and remain top-tier globally, while deposit trends were mixed but still generally higher. Looking ahead, the focus is on a slowing macro environment, the pace of Reserve Bank of Australia (RBA) rate hikes, and the degree of tightening that can be practically achieved given inflation dynamics and the high sensitivity to hikes. Home prices are showing signs of troughing of late, bolstered by extremely strong immigration, and, to this point, the most acute pain from higher rates appears more at the tails than at the average (i.e., recent buyers having higher debt and/or lower cash buffers are most at risk). However, the RBA continues to grapple with inflation dynamics and surprised the markets with a rate hike in June, a dynamic that must be watched very carefully given the immediate impact on consumer budgets and consumption.
The Big 3 reported their FY 2022 results in May and showed decent performance, generally reporting improved net interest income and lower credit costs. Loans rose at a mid- to high-single-digit pace compared to the prior year. While domestic loan margins did not change much sequentially, international margins continued to improve. In the major segments, international and Japanese corporate banking divisions performed better, while global markets businesses were mixed and domestic retail saw profitability declines.
Importantly, asset quality remains good, with non-performing loans either lower or flat sequentially. An area worth monitoring is the unrealized losses within the securities portfolio, driven by rising rates and stock market declines. Overall, the systemically important banks have decent capitalization and continue to benefit from sovereign support.
Looking ahead, Japan’s domestic operating environment continues to be hampered by structural challenges including rates, population, and overbanking, each of which weakens profitability. In addition, a recent preference for international loan growth is a risk factor that should be watched closely. On the macro front, Japan is also grappling with inflation (core), which hit a 42-year high in June, indicating that the Bank of Japan’s April forecast now looks too low. This is worth monitoring in the context of a country that consensus generally sees as having a lower probability of recession than many of its developed peers, including the US, Canada and Australia.
For investment grade (IG) non-financial companies in our investment universe, we are starting to observe weaker credit metrics due to the impact of slower economic growth, as well as the fact that inflation is stickier on the cost side than it is on the revenue side. Leverage is moving up modestly while interest coverage is moving down more quickly, as interest expense rises with higher market yields. Profit margins have deteriorated further as expenses have been slower to respond to the central bank tightening efforts. These negative impacts have been more pronounced for US-based companies (“HG Fundamentals: 1Q23 Review,” J.P. Morgan North American Credit Research, 31 May 2023). On a positive note, most IG companies in our investment universe are responding conservatively to the challenging environment by keeping debt growth low (and below nominal GDP), and reducing shareholder rewards.
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