Two weeks back, I suggested that a confluence of factors were shaping up to elicit a response from the US Federal Reserve (Fed), specifically that the markets and economic data would force policymakers back toward an accommodative bias. Speak of the Devil… St Louis Fed President James Bullard, whose hawkish quote I referenced in the last blog, executed a textbook about-face and went ahead to suggest that the Fed could “pause on the taper at this juncture, and wait until we see how the data shakes out in December.” The interest rate markets had fully priced for such a response (and accompanying delay of the first policy rate hike), but risk markets were then weak. So far, the Bullard comments have marked a distinct bottom in risk sentiment and Treasury yields. As I’ve said here before, I don’t think we should get overly pessimistic on growth once a market move is well underway, nor is it appropriate to get overly optimistic when it seems the policymakers are creating flawless miracles out of nothing. The economic data is noisy, and as annoying as it is, the global political and monetary framework continues to be reactionary. Importantly though, “reactionary” still works. Stuff happens, policymakers respond, and the responses have impact. Our economic outlook acknowledges this pinball-like evolution of economic data and of fiscal and monetary policies, but is still anchored in a consistent base case: that lackluster global growth is likely to continue, and that the potential for above-trend growth is still larger than that of a global recession.
The global monetary and political framework, as it evolves and reacts to economic developments, should be sufficient to sustain lackluster growth. In contrast, a static framework, say one in which the Fed or the European Central Bank (ECB) refused to react to flagging inflation data, might not be sufficient to confidently stave off a recession. Fortunately we still have the former. Central banks are still pulling levers*, and as discussed in Help Wanted, are essentially demanding fiscal stimulus and structural reforms from their political counterparts. Will they collectively do only the bare minimum necessary to maintain lackluster growth? Probably, which is one reason why that remains our base case. However, policy-supported lackluster growth isn’t so bad for asset prices, nor is it bad for certain critical fundamental indicators such as default rates. Absent a recession, default losses in diversified High Yield, Investment Grade, and certain Asset Backed Securities are not expected to materially increase. As long as we remain confident in our expectation of positive, if unexciting, growth through the market gyrations like last week, lower prices are simply higher risk premiums meant to be harvested. After all, policy-supported lackluster growth has been the norm for most of the current bull market.
*Despite plenty of public worry that global central banks are “out of bullets,” new policy prescriptions continue to surface. I personally doubted the mainstream adoption of negative nominal policy rates but the ECB have cut twice into negative territory. Some Secular Stagnation adherents have called for raising central bank inflation targets, to allow real policy rates to be set even more negative. Well, according to some recent hearsay, Ben Bernanke himself is now calling for that one too: http://www.valuewalk.com/2014/10/ben-bernanke-imf/
The wait is almost over! The results of the AQR/stress tests will finally be published this Sunday 26th October at 1200 CET. The comprehensive assessment includes an asset quality review (AQR) carried out by the European Central Bank (ECB), which is then joined up with a European Banking Authority (EBA) coordinated stress test. This join up should ensure quality and compatibility of stress test inputs. The AQR assesses the end-FY13 balance sheet, while the stress tests apply the specified baseline and adverse scenarios from the YE13 balance sheet into 2014/15 and 2016.
What to expect? A credible and positive exercise
The actual outcomes of this exercise are difficult to predict, but consensus is for the major listed banks to pass, with fails largely concentrated in some weaker peripheral banks. Despite our expectation of a relatively high pass rate, we think this will be seen as a credible and positive exercise – not least given the almost €100bn of capital raising measures that we have seen in the sector since the announcement of the assessment. We think the exercise more broadly will improve confidence in bank balance sheets, provide greater asset quality visibility and better disclosure and comparability. We expect banks that were seen as borderline and then pass the test to rally, and likewise for banks that unexpectedly fail the assessment to come under pressure. Post-stress tests, and if Spain is anything to go by, we may also see a pickup in M&A, for instance, in the Italian banking sector.
Devil will be in the details
There will be a lot of data provided (12,000 data points per bank!), including composition of capital, risk weighted assets (RWAs), exposures to sovereigns, and credit risk. This will take time to analyze, but will significantly aid transparency and potentially provide new information which may result in changes in how analysts view a bank’s creditworthiness. Capital measures such as equity raising/AT1 issues done during 2014 will be taken into consideration, alongside litigation costs. We therefore expect a number of so called ‘technical failures’, i.e. banks with a headline capital shortfall versus thresholds that has already been addressed via capital measures during 2014. Moreover, the EBA will, for the first time, disclose a fully loaded CRD4 Common Equity Tier 1 (CET1) capital ratio for each bank for information purposes. Banks that are ‘weak passes’ or banks that pass the test on a transitional ratio basis, but fail on fully loaded CET1 ratios could be penalized by the market.
What are the timelines?
What are the thresholds for the tests?
How can shortfalls be closed?
Primarily with fresh equity, and the first point of call is expected to be the private sector. A failure under the AQR and baseline stress test requires the capital gap to be filled 100% with CET1 (AQR shortfalls can be offset by 2014 retained earnings). A failure under the adverse scenario can be filled with CET1 but also – to a limited extent – via high trigger contingent convertible capital instruments (CoCos). Large scale asset sales will only be eligible as ‘exceptional measures’. While equity markets seem less receptive to equity raisings than earlier in the year, several of the weak banks’ share prices are already sufficiently discounted, and with greater confidence in balance sheets/asset visibility, we think capital raises should get done. Public recapitalizations may be required in certain situations when banks cannot raise funds privately, and be subject to state aid rules and potentially sub debt burden sharing.