Archive for May, 2017

A Long Time In Politics

This morning’s most widely-read headline on Bloomberg was “Pound Falls on Tighter Polls as Traders Wake Up to Election Risk”. As the article puts it:

Sterling fell against all of its 16 major peers on Friday after a poll showed the Conservative Party’s lead over the main opposition Labour Party has narrowed to five percentage points with two weeks to go until the June 8 election. That comes after weeks of surveys showing a bigger Tory lead had made the vote all but a foregone conclusion for the market . . .

If the swing to Labour were uniform across the country, May would lose seats in the House of Commons, with the Tory majority falling to two from 17, the Times said.

As Harold Wilson is supposed to have said, a week truly is a long time in politics.

When Theresa May announced the election at the end of last month her lead in the polls was so towering that the contest looked cruelly unfair to her opponents. One April survey put her party on 50% against only 25% for Labour. Predictions were being made of electoral wipeout for the latter and a landslide victory for Mrs May on a similar scale to that achieved by Tony Blair in 1997.

And then the Conservative manifesto was launched.

This contained a novel commitment to strip those of the nation’s elderly unfortunate enough to suffer dementia of their family homes after death. At the same time the existing commitment to preserve the real value of the state pension was dropped. The coup de grace was delivered a few days later, when May – slogan, “strong and stable” – U-turned abruptly on the Dementia Tax proposal by suggesting that the raid on the estates of the mentally ill would be subject to an unspecified cap. Now branded “weak and wobbly”, and having stamped all over some of her party’s core vote, Mrs May’s victory is no longer in the bag. Indeed, with a 25-point lead reduced to a slender 5-point advantage in less than a month it is arguable whether she could have done a better job of throwing the contest on purpose.

To investors today, then, falls what had seemed like a redundant exercise: we need to assess the possible consequences of a Conservative defeat.

Those traders mentioned by Bloomberg have identified sterling weakness as a product of this, either at the hands of a Labour-led coalition or a hung parliament. But the fall so far has actually been rather muted: yes, the pound is a cent and a bit weaker against the dollar but it is still well above its January low. It has fallen by less than a cent against the euro. So far, it has stabilized above its morning bottom against both currencies.

Staying with sterling, uncertainty can cut both ways. Our 8 June vote was billed as the Brexit Election. The Labour manifesto commits to remaining in the single market and customs union (i.e. no economic, nor much political change from the status quo) and ditching the “Great Repeal” of EU law. It also rejects a “no deal” / WTO rules exit and commits to a parliamentary vote on the final offer from Brussels. And the Lib Dems are calling for a second referendum. So a Tory defeat could well see the end of Brexit altogether, or at least its indefinite postponement. Would this not be taken as positive for the pound?

A Labour triumph, now no longer unthinkable, would have consequences far beyond the currency of course. The party commits itself to £250bn worth of spending on railways, energy projects and data networks. It also commits to £250bn of lending to “small businesses, co-operatives and innovative projects” via a National Investment Bank. That is comfortably more than the level of current annual lending to SMEs by the entire British banking system, and not far off the total group balance sheet value of customer lending at RBS (£352bn in 2016). Might there not be some consequences for bank profitability here?

Similar points could be made about plans for price caps on energy bills, or railway nationalization. And then there is the broader point about the national debt, and interest costs. The latter are already troubling and for 2016-17 were set to bust through the £50bn mark, only a little less than the entire education budget – and that’s with gilt yields of around 1%. Adding to the nation’s debt burden by more than a quarter would push it past 110% of GDP and see interest costs rise still further. Again, this might well have consequences for the pound, the gilt market, stocks . . .

Despite the headlines, then, it is safe to say that a Conservative defeat is not being much priced in at all. It is true that it would still be a surprise, and that there are almost two weeks of the campaign left to run. But it is now a real possibility.

This election is turning out to be much more exciting, and potentially more consequential, than anyone could have expected.

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26/05/2017 at 5:37 pm

Banking On It

With equity markets reaching ever dizzier heights this year, oil stable and government bonds serene it is difficult to think back to how the financial world felt about a year ago. Back then, an eye-watering collapse in risk pricing apparently presaged a rerun of the Great Recession. The clear catalyst was to be a systemic financial crisis just like that of 2007-9, though this time originating in a China riddled with insurmountable debt problems. Bank worries persisted into the summer, with the European Banking Authority’s July “stress test” widely expected to demonstrate the insolvency of many weak banks (and especially those in Italy).

These fears – intense as they had been – eventually dissipated. Since its post-referendum nadir the UK’s FTSE All Share Banks Index has risen by 51%, comfortably outpacing the broad market ex banks by more than 30%. Yet the G7 Finance Meeting summit on in Italy right now has continued to generate headlines about bank solvency in that country. So has the problem gone away? And should risk assets head south once more, would it be a financial collapse that Mr Market, once again, was banking on?

The numbers in Italy are indeed problematic – for Italy. But they are too manageable and too well-known to foment a systemic crisis more widely. To answer the question more broadly, however – which in times of panic is invariably how it is phrased – we can take a look at various data on bank solvency and non-performing loans across the world to see where it stands today, where it stood during the crisis years and what happened to it in the supposed nightmare period of 2016.

Let’s start with non-performing loans. This is the most obvious cause for concern in the banking system: when a bank lends money to a sufficiently large number of customers who default on their loans its income falls, its balance sheet weakens and it can in extremis go under.

In the UK, the combined value of reserves for loan losses at Barclays, Lloyds and RBS (including all their current subsidiaries) peaked at £51.4bn in 2011. By the end of 2015 this had fallen to £15.0bn, and it fell further last year to £11.4bn, which is below the pre-crisis levels of 2007. In the US, where the subprime debacle saw the most severe financial bloodletting anywhere, the figures for the Big Four (Bank of America, Citi, JP Morgan and Wells Fargo) have charted a similar trajectory. The peak was reached earlier, in 2010, at $158.8bn, had fallen to $49.9bn by 2015’s close and ended last year at $48.5bn.

Taking a more global view, the IMF collects data by country on actual non-performing loans after the event, and this naturally tells the same story as individual banks’ bad debt provisions. Starting again with the UK, the banking system in aggregate saw the proportion of non-performing loans to total gross lending peak at 4.0% in 2011, falling to 1.0% in 2015 (data for last year is not available yet). The US hit a more severe peak of 5.0% in 2009, which had run down to 1.5% by 2015. It also posted that level last year.

Turning to the market’s bogey men in this department: Euro area banks didn’t see their aggregate loss ratio peak until 2013 on the back of the double-dip recession there (at 7.9%). But this has since fallen, reaching 5.8% in 2015 and continuing to fall to 5.4% over last year. And in China, while the same ratio did actually increase in 2016 this was only by 0.07% (the figure was a stable 1.7% from 2015-16 at only one decimal place). Note, too, that the Chinese peak was all the way up at 29.8% back in 2001, which ought to put this squarely into context.

As well as the incidence of loan defaults, the resilience of balance sheets is another key moving part when it comes to assessing the vulnerability of a banking system. So we can also look at bank capital ratios to see just how much sleep we might expect to lose should those not-very-concerning loan loss numbers begin to tick up again.

Regulators tend to focus on “tier 1 capital”, which can be summarized as balance sheet equity plus whatever debt can be written down without putting a bank into distress. The EBA helpfully compiles data on this for the EU in aggregate. Before the financial crisis, the tier 1 capital ratio for EU banks was 8.0% (2006). With the assistance of vast sums in emergency state support and generous debt swaps this percentage actually rose slightly during the crisis itself before really taking off in subsequent years to hit 14.9% by the end of 2015 and 15.7% last year. In other words, just as loan losses have been falling, capital buffers have been increasing – to almost twice the strength they had a decade ago.

Turning to the IMF once again we can have a look at similar data for (balance sheet equity) capital ratios across the world. This rather more traditional measure of capital is narrower than tier 1 and so the numbers are smaller and not quite so illustrative. They do, however, tell a similar story: the euro area’s “pure” bank capital ratio increased from 8.0% to 8.5% in 2016, ahead both of its 2011 nadir (5.6%) and pre-crisis level of 6.6% (2006). The Chinese ratio has risen from 5% to 8% over the last ten years, in the US it grew slightly from 10.5% to 11.7% over the same period and here in the UK the increase was from 6.1% to 6.8%.

There have been some weaknesses visible in this data – in Russia, for example, and in Brazil, which both suffered so badly at the hands of weak commodity prices in recent years. Again, though, banking issues in these countries have neither the scale nor the surprise factor to cause a genuine, systemic upset elsewhere. And in most other places, including those over which the strongest concern has traditionally been expressed, we can see that banks, as a whole, are in rather better shape now than they were in 2015 – never mind during the subprime crisis and Great Recession.

“In times of crisis”, this blog wrote back in February last year, “it behoves us to seek refuge in facts.”  The view that last year’s funk was nonsense proved correct, and provided an opportunity. But it is not just when the market is in crisis that we need to mind our fundamentals. Greed is every bit as dangerous as fear. We might not have to fear for the banking system at present (especially in places where interest rates go up) – but just because Mr Market looks unlikely to stub his toe on the banking system in the near future that doesn’t make him immune to stumbling elsewhere.

 

12/05/2017 at 3:01 pm


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