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For Cash, 2020 Was a Year of Sustained Strength

Starting in the middle of 2020, the global economy and the global banking system endured the worst recession since World War II. During March and April, the credit research team had to assess the impact of an economic sudden stop and the onset of a deep global recession on the credit profiles of banks in our coverage universe.

Credit Research

Pandemic Reflection

The sudden stop and plunge into a recession prompted immediate adjustments to our credit approval list, most frequently through changes in the maturity restrictions we place on approved investment counterparties. Detailed assessments were made on each issuer and the degree of adjustment varied. For example, banks exhibiting higher risk in their corporate loan books (especially for obligors whose business is most immediately impacted by the pandemic: energy, travel/leisure, and retail), relatively weaker capital levels, and/or challenged business models pre-virus often experienced the most pronounced maturity restriction adjustments.

Encouragingly, the credit profiles of most major global banks held up quite well over the remaining course of 2020, due to their fortified balance sheets (high capital levels,  conservative liquidity and funding profiles), extraordinary monetary policy support and unprecedented levels of fiscal stimulus. According to the IMF, the pandemic has produced a combined fiscal response equaling 12% of global GDP from the world’s governments. For context, the fiscal support provided in the wake of the 2008 Global Financial Crisis (GFC) was equivalent to around 2% of global GDP.1 Public sector support was the catalyst that prevented bank asset quality metrics from deteriorating at a rate that would be typical of a deep recession. The support included enhanced unemployment benefits, loan guarantees for small- and medium-sized businesses, payment holidays and central bank lending recovery funds. Through the pandemic, many large banks and financial institutions within our investment universe also benefited from income windfalls associated with capital markets businesses and loan growth associated with credit line drawdowns. These windfalls have allowed many banks to absorb elevated credit costs and remain profitable year-todate, while also building incremental loan loss absorbency. Importantly, capital ratios have actually improved from the onset of the pandemic to the most recent reporting period for many major global banks in our coverage universe.

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We do expect that these capital ratios could drop modestly, as capital relief measures tail off and if or when risk-weighted assets grow again. However, the story for bank credit fundamentals during the second half of 2020 has been positive relative to our expectations back in March and April. Indeed, during this most recent quarter our credit research team reversed some of the initial maturity restriction cuts that we made at the start of the pandemic, as it was clear that many of the banks in our coverage universe have avoided a worst-case scenario from the COVID-19 recession. Profitability levels for a portion of banks in our coverage universe have approached more normalized levels during the most recent reporting period. As we’ve noted in previous publications, the ability of banks to organically accrete capital through operating profit is an important factor in fundamental credit assessments.

It is our view most major global banking systems are moving into 2021 from a position of relative strength, with tailwinds provided by positive vaccine developments and the continuation of targeted stimulus in most major economies. However, a full recovery from the pandemic for some major economies and their structurally challenged banking systems (Europe and Japan), could prove trickier than expected, as low interest rates hamper profitability and a resurgence of virus cases add downside risk.

2021 Outlook: Damage Done?

While the outlook has improved, we remain of the view that there are still capital costs from the pandemic to be allocated in economies and credit markets. These costs could even increase if the pandemic intensifies further and/or the degree of fiscal support from governments does not persist. Some of the affected segments of the credit markets are obvious — cruise ships and certain retailers — but we also believe there will be damage to broader swaths, even if the damage is limited to credit profile deterioration (i.e. credit rating downgrades). Even after global labor force participation gradually normalizes and furlough schemes are dialed back, unemployment rates in many economies could remain higher for longer than previously thought. According to the Global Economics team at Citigroup, the unemployment rate will likely remain above pre-pandemic levels in most countries until at least 2022 and in some as long as 2024. The protracted recovery path of global labor markets will likely result in a higher share of discouraged workers and long-term unemployed. Long-term unemployment is detrimental for workers’ skills, productivity and wages.2

Throughout the duration of the pandemic we have favored banks that have provisioned for future loan losses in a conservative manner. In general, US, UK, Australian and Canadian banks in our investment universe have taken large provisions. Conservative assumptions associated with those provisions give some confidence that credit losses will not materially burden fundamental credit profiles going forward. For example, most major US banks are still provisioned for an economic environment in which the unemployment rate at the end of 2020 is in the 8.0% to 11.0% range and 2021 ends in the 7% to 8% range, whereas the actual unemployment rate as of November 30, 2020 had already decreased to 6.7%.3 Bank management teams forecasted that 3Q20 was the end of building loan loss reserves but not the start of releasing the reserves despite improvements in economic forecasts. Still, some European banks have been less conservative in provisioning and only delaying the likely eventual loss recognition while exposing themselves to modest credit profile deterioration in the future.

It is from this basis that we summarize our specific global bank sector outlooks for 2021, as well as post some commentary on non-financial corporate credit fundamentals, as some issuers in this category are also investment counterparties of Global Cash:

US Banks - We expect that asset quality metrics will weaken modestly in 1H21 as borrower support measures (government and bank-specific programs) fade. Profitability will likely weaken in 1H21 because of ongoing net interest margin compression and limited ability to cut expenses. However, sector capitalization remains sound supported by pausing share buybacks which increased the capital buffer to absorb losses. Loan loss provisions will likely decline from the elevated (conservative) levels, but we expect that bank supervision and regulation (the Comprehensive Capital Analysis and Review process) will continue to impose conservative assumptions (i.e. not take into account unemployment rate improvement or vaccine news) on major banks in assessing capital adequacy until the pandemic is well behind us.

Canadian Banks - During the most recent reporting period, the Big Six Canadian banks generated earnings that produced return on equity in the mid-teens, which were enviable results given the challenging operating environment and also exemplary of a best-in-globe operating model. Capital levels continued to increase while loan loss reserves also rose, albeit at a more modest pace than the preceding two quarters. Sector asset quality continues to be supported by government and bank support measures. Loan deferrals have fallen materially, which is also encouraging, especially given the low delinquency rates for the loans coming off deferrals. As with all our covered sectors, we expect that nonperforming loans will rise modestly during 2021 but credit profiles will stabilize, given elevated capital levels, expectation of relatively strong profitability and prudent risk management.

European Banks - Although we expect recent improvements in loan performance to reverse as the effects of supportive government policy measures wane, the timing of the reversal is unclear given the uncertainty with regard to the path of the pandemic and the pace of support withdrawal. Profitability will likely erode further as loan impairments rise and as low long-term interest rates flatten the yield curve, accelerating margin pressure. Indeed, earnings capacity is particularly challenged relative to most other major global banking systems. This has the impact of weakening the first line of defense against bank balance sheet devaluation in the event of weaker macro-economic conditions, as higher operating income levels can help absorb higher credit losses. Resilient capital and liquidity are key strengths that help mitigate the pressures. Further, we expect most of this deterioration will be borne by shareholders from dividend bans and banks which have the capital resources to adequately manage non-performing loans through the difficult environment. Lastly we would highlight the progress on EU unity and cohesion, relative to the period of its sovereign debt crisis which began in 2010. The European Central Bank has been committed to pushing sovereign bonds yields to historical lows (even for its fiscal laggard sovereigns) and a joint recovery fund will help some of the worst impacted countries (France and Italy) over the next few years.

Nordic Banks - As is the case with other baking sectors in our coverage universe, we expect that loan quality will decline in lagged response to the recession of 2020 and phased withdrawal of government support measures. However, profits should remain resilient as the regional economy recovers and as banks benefit from early loan loss provisioning in 2020. Capital levels should remain among the strongest in Europe.

UK Banks - Economic contraction will be deeper than the European average and recovery to pre-pandemic levels will take longer, impairing business opportunities. Net interest margin compression will pressure revenues, while nonperforming loans will increase as government measures and bank forbearance taper off (although timing remains uncertain). The Brexit impact will not materially worsen weak profitability or credit losses caused by the pandemic. High capital, strong regulatory oversight and liquidity reserves are strengths that support the UK banks on our approval list. On December 11, 2020 UK bank regulators announced that UK banks would be permitted to start paying dividends again “within an appropriately prudent framework”. The decision was an expression of confidence in the UK banks’ strength through COVID-19 and Brexit risks. Regulators have now carried out two stress tests of banks capital positions and have judged that banks are resilient to a wide range of economic outcomes, including economic scenarios that are materially more severe than current central expectations’.

Asian (Japan and Singapore) Banks - Asset quality risks remain and nonperforming loans will likely increase, albeit modestly. However, core capital ratios and overall credit profiles for the major banks in our sector coverage universe should remain relatively stable. The current domestic political environments suggest that even more government support will be forthcoming if needed, as governments and regulators are very sensitive to the comfort levels of senior creditors (much more so than other jurisdictions in our coverage universe). As with many European banking sectors, earnings capacity for Japanese banks was in a particularly challenged state even prior to the pandemic. The pandemic will, at minimum, prolong and further pressure this dynamic, potentially weakening the first line of defense against bank balance sheet devaluation in the event of a slower than expected recovery.

Australian Banks - Banks in the sector continue to benefit from operating in an economy with a high degree of economic resilience, institutional and government financial strength, and relatively low susceptibility to event risk. The consistently strong operating performance through the pandemic also reflects major banks’ strong pricing power as a result of a highly concentrated industry structure. However, Australia’s private sector leverage is high and will remain elevated because it will take time to for the domestic economy to return prepandemic levels. The acceleration in private sector leverage raises the overall loan quality risk of Australian banks, but this risk is mitigated by a range of fiscal, monetary and regulatory measures aimed at alleviating the repayment stress of borrowers until the pandemic subsides. We have a stable outlook on the sector for 2021.

Non-financial Corporates - We expect that investment grade non-financial corporate credit fundamentals will recoup a considerable portion of the damage inflicted by the sudden stop in the global economy. This should translate into a relatively benign backdrop for credit rating migrations and corporate defaults relative to our expectations in March and April. The biggest risk to this view is a more severe deterioration in the pandemic outlook and/or long delay in the vaccine timeline. Another pronounced risk is a premature return of active re-leveraging, via debt-funded mergers and acquisitions and shareholder returns. We expect there will be material differences in developments between industries, based on factors like vaccine sensitivity, cyclicality and re-leveraging risk (i.e. M&A is more prevalent in particular industries).

While these sector-specific summaries represent our credit research team’s base case for 2021, we also recognize the downside risks to these outlooks (as all Cash money managers should). Immediately, it is the risk that the winter wave of COVID-19 is worse than expected. As of this writing, cases in the US are making new highs, while European cases are still materially higher than they were a few months.

1H21 Prominent Risks

Premature monetary or fiscal policy tightening in major economies could slow recoveries - In our view, fiscal and monetary tightening after the GFC contributed to the euro-zone crisis which started in 2010. Then in 2013, the mere suggestion the US Federal Reserve might slow its asset purchases sent emerging market assets tumbling during the “taper tantrum”, which tightened financial conditions. We expect that central banks have learned from the post-GFC experience and are unlikely to tighten policy prematurely, especially as there is less of a moral hazard association with current expansionary policies, given the health and human crisis. However, with public debt levels skyrocketing, there are bound to be concerns regarding an eventual pivot toward tighter fiscal policy in some countries, especially if the credit rating agencies opine in a negative way. Indeed, we have seen fiscally conservative Congressional leaders in the US delay additional stimulus measures despite the resurgence of COVID-19 as an economic disruptor. We expect this risk to be realized to some degree in many countries, but the timing and severity are quite uncertain. We’ve accounted for this risk in our sector outlook above but also assumed a gradual withdrawal of support that correlates with a pronounced public health recovery.

The global vaccine rollout might disappoint - Expectations for both the timing and effectiveness of multiple vaccines have increased materially in recent weeks. We now expect that many developed market governments should be able to remove restrictions by 2H21. However, there is clearly scope for disappointment with regard to vaccine distribution capabilities and citizen consent with worries of significant portions of the populations refraining from getting vaccinated in 1H21.

Economic scarring or structural change could slow the economic rebound more  than expected - It is hoped that the relatively short nature of global recession should mean that a rebound in activity can be achieved without many long-lasting effects, unlike what occurred in the aftermath of the GFC. However, there is risk that the unprecedented size of the contraction could lead to protracted impacts. For example, firms in the hardest hit industries had to lay off significant numbers of staff and some may well struggle to re-hire at the same pace to meet a rebound in demand. Further, the crisis may have accelerated structural trends, such as a consumer lean towards online businesses. These types of structural trends could negatively impact segments of global bank loan portfolios, such as commercial real estate. However, we’d also note that structural changes generally happen over time, which helps mitigate risks associated with them as banks are better equipped to manage these risks over time.

We are encouraged by the relatively strong starting point for most global banks in our coverage universe for 2021. However, we are also cognizant of the continued risks posed by the pandemic, as well as by risks that pre-existed the pandemic, and are likely to persist in the future: namely, the challenges to credit markets posed by low growth, low inflation, erennially low interest rates, and high global debt. During 1H21, we are optimistic that vaccine deployment and the persistence of fiscal and central bank support will limit the risk of credit profile degradation for most of our coverage universe. Government initiatives to help finance businesses affected by COVID-19 and partially cover employee wages will not save all jobs or companies, but we expect that the programs will continue to allow banks to manage any deterioration in their respective loan portfolios over time. Slow-burning vents are far more manageable than shocks with regards to the preservation of bank credit profiles.

The concluding paragraph of our Credit Research Outlook 2020 publication last year stated the global banking sector would be a source of strength in mitigating macro-economic impacts when the credit cycle ended, due to the significant evolution of banking regulations since the GFC. Although we certainly did not expect a global pandemic in 2020, the stresstesting, liquidity and capital measures that were put in place after the GFC prepared banking systems to be part of the solution when the pandemic hit, as opposed to the basis of the problem, as they were during the GFC. Major global banks’ balance sheet strength and sustained lending capacity through the crisis have provided a sound basis for economic recovery.