In our view, this divergence cannot continue for much longer without materially increasing the probability of a US and/or global recession and in turn, ending the business and credit cycles. At minimum, a pause in trade tension escalation seems required to end this divergence.
As our team’s investment universe is more concentrated in debt issued by large banks and financial institutions, we always consider the condition of the credit cycle in that context. Heading into 2020, we need to consider the risk that trade tensions via weakened global growth trajectories and aggressive central bank easing will negatively impact banks’ earning capacity. While earnings are a more important consideration for equity analysts and investors, the ability of banks’ to organically accrete capital through earnings is an important factor in fundamental credit assessments.
In general, slower economic growth and lower interest rates are negative for bank earnings, especially if or when lower rates do not spur demand for private credit. Given the persistence of low and negative rates in Europe and Japan, earnings capacity in those sectors are particularly challenged, which weakens the first line of defense against bank balance sheet devaluation in the event of weaker global growth, as strong operating income levels help absorb higher credit losses, preventing banks from generating earnings losses and the erosion of its balance sheet’s book value.
In last year’s Credit Research Outlook, we identified the European banking sector as the most vulnerable in our focus universe to the end of the credit cycle. The same factors we identified last year as rationale for vulnerability persist for 2020. The inefficient and inadequate structure of the European financial and political systems, as well as the prolonged period of ultra-low to negative interest rates for the continent’s banking system. The risk associated with these factors could be mitigated if progress is made in improving the structure of the European Union. For example, near-term prospects of progress towards completing the development of a full banking union with Pan-European deposit insurance are only modestly better than they were a year ago.
Yet another theme from last year’s Global Cash Outlook is despite the risk factors outlined, we reiterate that we broadly view the global banking sector as a source of strength in mitigating macro-economic impacts when the cycle ends due to the significant evolution of banking regulations since the Global Financial Crisis. These regulations, especially as they pertain to systemically important banks, assure that bank capital buffers are materially higher, and funding and liquidity conditions are more stable. Even European banks have materially improved their credit profiles in these capacities. Indeed, when the cycle does end, and the most leveraged areas of the corporate credit markets suffer material degradation, we believe that the strength and soundness of the reformed banking system will prevent systemic impacts and broad contagion. As such, we also believe that credit events are more apt to be idiosyncratic or industry-specific than systemic.
For the last two years, our Credit Research team motto has been: “Don’t worry about the end of the credit cycle: be ready for it.” To us this means continuing to select cash investment counterparties that are best-equipped to maintain their fundamental credit profiles when a downturn inevitably occurs.