Monday Musings: July 6, 2020

Jul 06, 2020

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Public Trust Credit Team
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Impressive economic data: does it signal brighter days ahead or how far the domestic economic has fallen?

This morning’s ISM non-manufacturing PMI reading of 57.1 came in substantially higher than estimates (50.2) and the prior month’s reading (45.4). It appears the purchasing managers are increasingly optimistic following last week’s 52.6 reading of the Manufacturing PMI versus consensus of 49.8. Additionally, last week’s non-farm payroll number was up nearly 33% while the unemployment rate was nearly 150 basis points lower than estimates. 
 
With a few exceptions, recent economic readings have been slightly more positive than expectations, indicating the economy is growing again. And while any growth from the current point is positive, the path-dependency of growth (meaning 5% growth off a base of $60 is different than 5% growth off a base of $95) means that there is still a substantial gap between current state and ideal state. It also shows that impressively large growth numbers could be the only way to quickly get back to the prior economic state. In short, the Credit Team encourages readers not to read too much into a brief period of positive data; a consistent pattern of positive monthly readings is the only way to return the economy to a more robust state.

Q2 2020 bank earnings are right around the corner

The largest U.S. banks are scheduled to report Q2 2020 earnings next week. Public Trust expects to see material loan loss provisions for the banking sector as a whole this quarter, as economic expectations that bank management teams incorporated into the Q1 2020 results were generally too optimistic. Forecasting loan performance and credit quality levels has become particularly challenging as the government implemented a number of stimulus measures and forbearance and deferral arrangements have distorted the true financial condition of borrowers, both for households and businesses (see Lack of transparent deferral data makes quantifying consumer risk difficult for lenders). Net interest margins will be particularly pressured this quarter given a combination of multiple factors, notably the Fed’s 150 basis point rate cut in March; record deposit levels; high levels of low-yielding Paycheck Protection Program loans; and low securities reinvestment rates. Positively, capital levels are not likely to be an issue based on the latest Fed’s stress test results, but capital returns levels have been capped by the regulator (see U.S. banks have been stressed). Pubic Trust views capital preservation as essential for the banking sector, particularly in times of economic stress and uncertainty. On a brighter note, trading revenues and investment banking fees are likely to be robust this quarter for banks that participate in these activities, and mortgage refinancing levels should be strong thanks to the low interest rate levels.

Eurozone bank M&A may gain steam as the European Central Bank looks to relax regulatory obstacles

Among the most fragmented globally, banking systems throughout the Eurozone are facing challenging years ahead as the structural weaknesses of higher credit losses and lower-for-longer interest rates weigh heavily on profit outlooks. Over the past several years, M&A activity has been stagnant among European banks, owing in part to the hefty regulatory burden that has inhibited deal transactions. On July 1, 2020, the European Central Bank (ECB) published a draft guide outlining the potential easing of regulatory hurdles, citing that a pick-up in M&A has the potential to strengthen the soundness of the financial system as many European banks currently have excess capital capacity to acquire. Acknowledging the upside of future deal transactions as economies begin to recover from the COVID-19 fallout, the ECB has suggested it will offer regulatory flexibility by limiting the adverse capital treatment of negative goodwill, providing assurance that capital buffer requirements will not necessarily increase following a business combination, and allowing internal capital models to risk-weight assets after acquisition. The favorable capital treatment proposals may entice banks to entertain future transactions as they look to capitalize on potential business synergies in 2021.
All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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