Credit Research Update
Some Gloom, But No Expectation of Doom
The global economy is in a synchronous downturn, but the absence of material imbalances and the private sector’s financial surpluses should help mitigate the ill-effects of a recession on the global cash investment universe
Despite pockets of strength, the global economy is in a synchronous downturn. The growth headwinds provided by aggressive monetary policy tightening, a brewing energy crisis in Europe and continued COVID-19 related disruptions in China are enough to materially enhance the risk of recession over the short and medium terms for developed market economies.
While this should help to lower inflation, uncertainty about the global inflationary path remains high, which should mean central banks will continue with their hiking cycles in the foreseeable future. It is also not clear whether central banks will need to “force recessions” to bring inflation down to acceptable levels. But we continue to believe that the current lack of financial imbalance within major global economies will help to limit the depth of recessions.
Global Private Sector Financial Balance Strong
Deep and protracted recessions typically coincide with private sector deficits, which amplify the business cycle through wealth and deleveraging channels. Certainly, the Global Financial Crisis (GFC) was the most pronounced example in recent history. However, we enter the current period of recessionary concerns with private sectors in the world’s largest economies sitting in a position of strength – the sectors’ financial surpluses should reduce its vulnerability to tightening financial conditions and falling real incomes (Figure 1).
Figure1: Private Sector Financial Balance at a Position of Strength
To put things into perspective, right before the GFC, the median private sector financial balance averaged only 1.8% of GDP across major economies, with the US running a deficit 5% of GDP, versus a surplus of nearly 10% of GDP at present. In general, factors that undermined growth in the 2010s – such as austerity, deleveraging in the household sector and systemically weak banking systems – are not present today, and should serve as cushions to the global economy as central banks work to weaken aggregate demand in order to fight inflation.
Global Cash Investment Universe
With regard to our global cash investment universe, there is a growing list of reasons for us to focus on the European banking sector as we navigate through economic and market volatility. For one, the energy crisis in Europe means that its economy is at risk of experiencing a material recession. Further, as we have noted before, the European banking sector is structurally weaker than other banking systems that are in our investment universe.
However, we have reasons to be optimistic that credit quality degradation within the sector will not be material in the short-to-medium term. Our relative optimism stems from our expectation of government support to households and businesses to mitigate any potential impact from the energy crisis. Governments in the United Kingdom, Germany, France, Sweden, among others, are putting together fiscal support packages to help mitigate economic crisis in their respective countries. Although these measures may not prevent recessions over the upcoming quarters, they could limit the depth of downturn in these economies. As a result, we believe that large-scale loan defaults in bank portfolios are unlikely at this time.
The situation is not dissimilar from the pandemic period, which suggests that largescale asset-quality degradation is unlikely in the European banking sector. For sure, some stress will inevitably develop in the form of higher loan-loss provisions and more challenged business lines (such as commercial real estate lending) and some banks will perform better than others. However, we believe that the credit performance to date is a good lead indicator of structurally lower exposure to high-risk credit in the banking system now versus the past. Further systemic support is provided by the fact that Europe’s large banks have strong liquidity and capital metrics, which held up well during the pandemic. At present, European bank management teams expect that the positive profitability impact from higher interest rates will largely offset the expected increase in loan loss reserves from economic headwinds.i
Across our investment universe, global banks continue to tread a thin line between: 1) rate hikes providing net interest income strength and 2) deteriorating economic growth and inflation. Low unemployment in developed economies is the major mitigating factor for banks against the worsening economic data at present. Risks are certainly skewed to the downside as far as credit quality trends in our investment universe are concerned, and we continue to adjust our credit approval list to account for such developments. However, the foundation of credit profiles for banks on our approval list gives us confidence that the credit profiles of most of our investment counterparties will remain resilient in the short-to-medium term. This means, despite the sense of gloom, we do not expect any doom in our cash credit universe.
US bank earnings have been resilient on the back of very strong loan growth, higher rates, controlled expenses and still-low credit costs. This has helped to offset weaker fee income, driven by capital markets, and a slowdown in deposit growth, which has caused liquid assets to move lower. Broadly speaking, many of these trends are expected to continue heading into FY23, though loan growth could slow as banks tighten lending standards and demand wanes.
Despite reporting solid performance, bank credit spreads have underperformed those of industrial counterparts in recent months as market participants contemplate a broader economic slowdown. While there is broad acknowledgement of the risks associated with a slowing global economy and ongoing geopolitical uncertainty, major US banks do not see signs of an evident recession given the health of commercial and consumer clients, which is supported by a strong labor market. This is also supported by a bottoms-up analysis of the industry, which shows 30+ past due loans – typically a canary in the coal mine for loan losses – not only good, but close to all-time lows, and nonperforming loans substantially below what are usually seen ahead of recessions. This could foreshadow an extended credit normalization cycle.
Moving toward FY23, many of the largest US banks are focused on building capital, which is a positive for bank creditors, reflecting higher regulatory buffers. However, these capital requirements, which often are focused around year-end, have the potential to cause volatility in funding markets.
Aside from some notable exceptions (Credit Suisse, Danske and to a lesser extent UBS), most European banks’ earnings were above estimates for 2Q22. Those with non-Eurozone exposure are starting to see net interest income increasing (ECB only began hiking in July 2022). The investment banking divisions also posted decent earnings for most banks, with FX and rates income partly mitigating the drop in IPOs and origination activity amidst market volatility.
In general, all banks have minimal, below-the-cycle loan losses. The banks also still benefit from loan loss allowances built-up during the pandemic, which were ultimately not needed due to government support of consumers and businesses. In the near term, bank management are guiding that they have seen no asset quality issues in 3Q22. Yet economic data continues to worsen, and inflation remains stubbornly high. It is too early for this to significantly filter-through to banks’ loan portfolios, but the second half of 2022 is likely to be more challenging – a function of inflation bearing on costs, weaker investment banking activity and fees, gas shortages, lower GDP and some asset quality normalization.
Despite the uncertain economic outlook, the end of zero-policy rates in Europe is an undeniable positive for banks’ revenues. The rising net interest income provides a buffer to offset some of the aforementioned negative events. This is supplemented by banks’ enlarged capital bases, European Banking Authority stress test performance and European Union solidarity, taking the form of backstops such as, Outright Monetary Transactions, the European Stability Mechanism and now the Transaction Protection Instrument. All these factors support the view that many European banks can successfully navigate this current downturn phase of the credit cycle.
Canadian banks reported solid 3Q22 results in August, with aggregate net income trending higher on the back of robust loan growth, particularly in commercial lending, and growing margins due to higher rates. Revenue diversification across business lines and geographies remains a point of differentiation from a credit standpoint, though weaker capital markets income weighed on some banks.
Similar to the United States, credit costs remained low but did increase year-over-year due to higher forward-looking provisions. While they are likely to trend higher moving into FY23 due to the macroeconomic outlook, reserves generally remained above pre-pandemic levels and loss-absorbency improved by virtue of higher capital levels.
Elsewhere, liquidity and funding profiles continue to be solid though wholesale funding is increasing after hitting a trough last year. Looking ahead, all eyes turn to the macro backdrop as central banks raise rates aggressively to tackle inflation. Areas to monitor include the housing market and household debt, both of which have been labeled as vulnerabilities by the Bank of Canada, though consumer health and the labor market are supportive factors. Further, as it relates to rising rates and the impact on consumers, the greatest impact will mostly be toward late 2025 and beyond.
A major Australian bank reported its half-year results during the quarter while other banks provided trading updates. Results generally rhyme with other jurisdictions as profitability levels continued to be satisfactory, benefitting from positive emerging trends on loan growth and margins. Moreover, since an above-average proportion of the banking sector’s revenue is sourced from net interest income, a brighter outlook on net interest margins is a key takeaway as the Reserve Bank of Australia undertakes a more aggressive hiking cycle.
On credit, asset quality is holding steady and is supported by strong private sector balance sheets, including a record stock of consumer savings. Forward-looking indicators also remain positive. Capitalization stands at above-average levels on an internationally comparable basis while funding is a bit weaker but has improved over time.
Looking ahead, the focus will be on the impact of rising rates on the economy, home prices and consumers given Australia’s mortgage market is largely variable rate and is sensitive to changes in monetary policy. At this point, higher rates appear manageable given strength in the labor market, below-average debt servicing metrics, large household savings, debt skewed to higher income cohorts and lending standards having steadily improved since 2016.
The major Japanese banks saw improved FY21 results with net income up but profit levels remaining relatively anemic. In 1Q22, net interest income was stronger, but earnings were impacted by one-off write-downs and credit costs. Common trends of late have included improved performance in domestic retail and global corporate banking offset by higher credit costs in the Japanese corporates business and poor performance from global markets, due to gains booked a year earlier and mark-to-market losses on investments. Indeed, while rising rates and stock market weakness led to sizable declines in unrealized securities gains, these remain large and continue to boost capital ratios.
Overall, while the majors have decent capitalization and benefit from sovereign support, the operating environment is hampered by structural challenges including low rates, a declining population, overbanking and inefficiencies. To combat this, the banks continue to pursue international loan growth, which is growing at a double-digit pace year-over-year compared to low or negative growth in Japan.
Looking ahead, the Bank of Japan appears committed to easing monetary policy even as other major central banks tighten, apparently willing to accept substantial yen weakness on the hope that stimulus will drive an economic recovery and spur faster wage growth. While this introduces volatility for the banking sector, it also could boost revenue via the yen value of profit denominated in foreign currency.
Despite a string of adverse shocks through the first half of the year, global non-financial corporate profits continued to expand at a healthy pace through the second quarter of 2022. Bolstered by higher profitability, the global business sector has been a key source of this resilience as hiring continued and investment spending on equipment and inventories strengthened.
Although the sustained recovery in profits is encouraging, the momentum was clearly waning at the conclusion of Q2. While earnings growth over 2021 and the beginning of 2022 was broad-based across countries and sectors, the more recent gains have been concentrated in energy with signs of a sharper deceleration across other sectors. Considerable profit gains have been realized in the materials and industrial sectors as well, albeit far less than in energy.
Beyond these three sectors, however, profit growth momentum has reversed. Moreover, corporate margin pressures are building, as tight labor markets will likely keep wage inflation sticky and rising interest rates lift the cost of credit and add to the margin squeeze.
With regard to credit fundamentals for investment grade (IG) non-financial issuers, it is quite clear that from a leverage and profitability standpoint, peak credit quality is well behind us. For firms in the US, net leverage metrics were higher for the median IG-rated firm over the past year, while in high yield (HY) there has been little recent directional momentum, a trend that has persisted since early 2021. US HY firms are managing their balance sheet strength more conservatively than their IG peers. For both IG and HY firms in the US, cash balances have declined materially with median cash to total assets now only marginally above pre-pandemic norms.
The profit and margin performance for European IG firms has been weaker than US peers, with sequential profitability flatlining, in aggregate. While energy aid packages may mitigate the impact of rising electricity costs on corporate fundamentals in the very near term, this is only a short-term solution. Net leverage for European IG firms remains elevated in historical terms, which poses “fallen angel risk” for BBB-rated companies next year.
i Theodore, S. (2022, September 8). The wide angle – Five reasons why European banks will remain a no-drama sector. Scope Group. ii Lupton, J. (2022, September 22). Global profits bolster resilience but pressures build. J.P.Morgan, Global Economic Research. iii Karoui, L., Rogers, S., Mori, R., Puempel, M., Shumway, B., Viswanathan, V., & Manzo, M. (2022, September 8). Global Credit Trader – The pandemic balance sheet liquidity buffer is gone. Goldman Sachs, Credit Strategy Research. iv Bailey, M., Lamy, D., & Sriram, M. (2022, September 6). High Grade Themes – 2Q22 Credit Fundamentals. J.P Morgan, Europe Credit Research.
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