I’ve read so many reports & analysis on the ECB stress tests that my eyes are blurry. I’m not a bank analyst, but here are my take aways:
The main reason for these tests is to rebuild market confidence and allow the banks to lend. Indeed, substantive EU growth can’t occur without balance sheet expansion.
However, even though almost all the banks passed the tests, many of them seem to have only passed by a small amount. Italian banks performed especially poorly. In addition, there are additional capital requirements that will take effect in the future for which many EU banks’ balance sheets remain woefully inadequate.
- RBS notes that nearly a quarter of banks passed the test only narrowly.
- GS: Credibility of stress-test inputs is high. However, we expect the capitalization debate to continue for those banks that show a shortfall when “phase-in” hurdles are replaced by those demanded by the market: “fully-phased” B3 CET1 and T1 leverage ratios. Our analysis shows that, under those parameters, the number of failures, and hence capital shortfalls, increases meaningfully… In our view, current market benchmarks have moved towards a 10% fully-loaded CET1 ratio, and a 4% Tier 1 leverage. We recalibrate AQR/test results to a fully-phased CET1 hurdle, but current disclosure does not allow for a leverage overlay. AQR: fully-phased B3 CET1 hurdle: (i) at 8%, shortfall would rise to €11.6 bn, amongst 16 banks; (ii) at 10%: €63 bn, amongst 49 banks. Test: fully-loaded B3 CET1 of 5.5%, for the adverse scenario: a shortfall of €42.5 bn materializes, amongst 27 banks.
Another way to phrase this is that the tests were for solvency, when they were actually designed to allow economic profitability. As a result of these differing goals, it should not be a complete surprise that the tests will fall short of their ultimate goal.
The fact is that individual EU countries (including those in the core) were likely aggressively against a strict stress test that would’ve failed their banks. This is at least partially because the additional taxes needed for recaps may doom the current political leadership. Against this, the ECB did not have sufficient clout to push for more aggressive tests, which is at least partially because they depend on the national regulators for enforcement.
As a result, it is not clear if the much hoped for lending wave will materialize. That is a clear negative, IMO, and leaves EU in the no-man’s land of marginal solvency but nominal growth rates below debt costs. If the Goldman’s numbers above are true, in lieu of raising capital, EU banks will need to reduce risk weighted assets by another 770bn! (52.5 / 5.5%)
This view seems somewhat discounted by the market. The Eurostoxx bank index, for example, is currently trading at a price to book of 0.81, (bottom panel) which essentially means that the market continues to believe that further write downs and/or bank recapitalizations are necessary. For comparison, the S&P 500 bank index trades at a 5% premium over book, and has fairly consistently traded above book value since mid 2009.
The failure of the tests to appreciably improve the price to book ratio also points to a continued period of weak loan growth. The chart below shows the Eurostoxx Bank index price to book (orange) vs YoY loan growth to non-financial corporations. (white) The historical relationship suggests non-financial loan growth will remain close to zero in a year’s time:
Another interpretation of low price to book, however, is that market participants are expecting a long period of low growth and deleveraging, which will necessarily pressure loan margins and volume. In such an environment, there will be limited exit opportunities for loan portfolios unless priced at a substantial discount.
Draghi’s combative turn towards the Germans may have been a result of his realization that EU banks need much more capital before they are willing to lend, (which they will probably not get) and as such will continue to impair the ECB’s transmission mechanism.
The Goldman Commodities team cut their oil price targets with WTI at 75 vs 90 prev. They think that WTI prices need to decline to $75/bbl to slow shale production, and it will take 6 months of low prices to affect shale production, and thus forecast a low in oil prices in 2Q 2015. In addition, they forecast a rise in OECD inventories to the highest levels since 2009 next year:
They think the marginal WTI barrel is $80 and $90 for Brent. In addition, they see a potential ~10% cost deflation for production costs across the curve over time:
It’s all pretty interesting, even though their about face from their ‘oil will bounce’ note last week was a bit of flip-flopping. Another take away is that historically, per the 1st oil chart, after adjust for noise, oil inventory surpluses & deficits tend to persist for multiple quarters. The crossing into inventory building suggest that we may indeed be in a new paradigm.
Finally, Citi’s latest GPS report had some very interesting charts. (h/t FTA)
In the US,
- German IFO declined to 103.2 vs 104.5 exp and 104.7 prev
- US Markit Services PMI declined to 57.3 vs 57.8 exp and 58.9 prev
- Dilma Rousseff was re-elected with 51.6% of the valid votes and 48.4% for the opposition candidate Aecio Neves,
- The Shanghai/Hong Kong trading link had been expected to launch by the end of Oct but it will miss that deadline and it isn’t clear when the initiative will actually go into effect.
- WSJ: Single Firm Holds More Than 50% of Copper in LME Warehouses. At today’s prices, a 50% to 80% share of LME copper inventories would be worth anywhere from roughly $535 million to about $850 million. Although the exchange doesn’t identify the owners of metals, eight traders and brokers working for different firms active on the LME said they believe Red Kite Group, a London hedge-fund manager that focuses on metals trading, was the one buying. Red Kite Group manages $2.3 billion, according to its website.
- Tue: US Durable Goods Orders, Consumer Confidence, New Zealand Business Confidence
- Wed: Oil Inventories, FOMC, RBNZ, AU New Home Sales
- Thu: UK House Prices, German Unemployment, CPI, US Jobless Claims, 3Q GDP, NZ Building Permits, Japan Employment, CPI, UK Cons Confidence
- Fri: Month End, Japan Housing Starts, EU Unemployment, CPI, Canada GDP, US Personal income, PCE Deflator, Chicago PMI, China PMI
- Weekend: AustraliaMfg PMI, Australia Building Approvals, China Non-Mfg PMI,
- Mon: EU PMI, CanadaPMI, US ISM, Australia Trade Balance, Retails Sales, RBA, Japan PMI