Takeaways: A new era awaits. The Fed’s final QE hurrah was flagged, but we expect more market discretion, volatility, disruption and currency oscillation without this safety net. The cost of debt capital will rise. Weaker/exposed nations and companies can expect a rougher ride. Brazil and Turkey look exposed. AQR ran just about to script, but banks with passes won’t automatically start lending more –borrowers will still need to explore the alternatives. Meanwhile, companies are finding this a tough economy to compete in and read, as the latest rise in profit warnings shows. They need to catch-on soon, shareholders are losing patience.
Just like starting over
Four days, two potentially pivotal events. Yesterday, the Fed called time on QE (see below) and last Sunday, we finally saw the results of the ECB’s much awaited Comprehensive Assessment (CA) of Europe’s most important 130 banks. The central bank’s attempt to try and draw a line under the Eurozone crisis and set the region on a surer footing.
In undertaking this review, the ECB was trying to identify problems and fix balance sheets where needed, akin to the Fed’s SCAP Program in 2009. Arguably, the US is further along the recovery road because its banks wrote down loses quickly. But, we are where we are. Of course the process is not without imperfections. However, the ECB has succeeded in shaking the tree without knocking it down – which suggests they have the balance about right. The AQR has flushed some of the issues that were holding back investment and lending – too high valuations, too low provisions – and quickly created a more even playing field across the region’s banks. This is a crucial step to enable the direct supervision of the largest banks by the ECB and to lay the foundations for banking and economic recovery.
However, the CA doesn’t constitute banking recovery in and of itself – even if most banks manage to raise the necessary capital to satisfy the stress tests. The attitude of national governments and regulators is vital at this point, because complacency isn’t an option.
For a start, passing the tests doesn’t automatically make banks Basel III compliant – there is still a 3-4 year window for banks to get over that line. As a result, the treatment of some loans and assets critically differs across the countries. Looking at the results in this light, more banks ‘fail’, some quite significantly, when analysts apply ‘fully loaded’ Basel III numbers to capital ratios. So, while we may not see a huge amount of restructuring now, especially if markets accommodate most of the banks’ capital shortfall, there could be more to come.
The results also highlight the need for consolidation amongst small lenders to strengthen banking systems. As the FT’s Lex column comments: “Banks with less than €10bn of risk-weighted assets overall also had the biggest proportional RWA shortfalls. This suggests many banks keep bad loans going simply because they are too small to take the hit to capital from resolving them”. Italy, which performed so disappointingly in these results, has a startlingly lopsided banking system with two large banks and many much smaller ones. Theoretically the AQR makes consolidation easier by providing common standards and opening the bonnet – but will banks need a match-making nudge from regulators?
This process also won’t make banks lend more. Again, it’s a first step to building confidence, but a quarter of banks had a near miss, many are still working towards Basel III compliance, and it will take some time for risk appetite – especially in SME lending – to return, as the Japanese and now the US examples highlight. Alternative lenders are increasingly filling this gap across Europe. Moody’s reports that more than 60 new private debt funds in Europe were raising capital exceeding $33 billion as of May 2014. Many more companies will find funding outside of banks. Although, the European market could look more crowded once restrictions on US CLO lending are in place, potentially restricting the US leverage loan market.
Part of the fall in lending is also a fall in corporate appetite for debt. Companies are reluctant to raise debt to invest and acquire in weak economies. It’s with good reason that it’s Mario Draghi’s constant refrain that the Eurozone needs fiscal, monetary and structural reforms, on top of banking measures. The Eurozone needed to show it could apply discipline to its banking system and the ECB needed to show it was ready to increase its balance sheet. These are virtual prerequisites to boost growth and arrest deflation, but they won’t be enough alone. Deflation and slow growth remain a serious risk
So, the Fed’s balance sheet will grow no more – for now – and the clock has stated ticking down to the first US rate rise. ‘Taper Day’ had been flagged for many months, helping to promote a subdued initial market reaction. However, this wasn’t just a statement that ended QE with nothing more to see here. This sounded decidedly more hawkish. The US central bank kept its forecast of low interest rates for a “considerable time”, but they suggested they may move sooner if the economy improves faster than expected. They even suggested that low inflation may not last much longer.
And now we’re moving into uncharted waters and, therefore, more volatility. QE has been a safety net – helping to absorb sales of riskier capital – as well as being safety blanket that helped to cushion bad news. Raising capital will get tougher and more expensive as we move closer to US – and UK – monetary normalisation.
We also expect more currency volatility as central bank policies and timetables shift. This more hawkish Fed tone has pushed the dollar up across the board, with the hardest hit being felt by emerging market currencies. The impact of the Fed’s actions shouldn’t be overplayed. QE hasn’t been emerging markets’ only saviour– just as its ending isn’t their only problem. The risk of systemic crisis looks small, with most emerging market balance sheets in a much stronger position than previous crises. However, recent trading statements suggest consumer markets in particular are slowing again and those nations vulnerable to capital outflows and consumer slowdowns – e.g. Turkey, Brazil – are the ones to watch.
Sunny spells, interrupted by squally profit warnings
The UK’s Met Office has just announced it will spend £97m on developing a new supercomputer to deliver a ‘step change’ in the accuracy of its weather forecasting and climate modelling. It seems – contrived link alert! – that UK plc needs a similar leap forward in its modelling and forecasting. In Q3 2014, profit warnings reached 69 – their highest third quarter total since the recession. How is this happening when the UK recovery looks well set and the global outlook, whilst mixed, surely shouldn’t be triggering this level of warnings?
The answer is in the data. A fifth of companies have blamed pricing and competition pressures in 2014 against 7% in 2013. The shape of this recovery, in particular low levels of insolvency, has created overcrowded sectors with too much capacity, leading to intense competition, pricing pressures and wafer thin margins that leave little room for error. The economy has changed, with value expectations reset across the recession. Disposable income and consumer spending are still below their 2008 highs. Customer and business relationships are also being reshaped by technological change. Companies are finding this a tough environment to grow sales and margins – and a tough economy to read.
However, without a handle on these changing dynamics, companies will struggle to adapt their business models. They will continue to find investor communication challenging and forecasting with confidence difficult – laying the foundations for the next wave of profit warnings, almost irrespective of the quality of underlying earnings. They will also come under more intense shareholder scrutiny. The average share price fall on the day of profit warning is 13.4% so far in October, compared with 8.7% a year ago.