Monday Musings: May 11, 2020

May 11, 2020


Public Trust Credit Team

The economic alphabet

A deluge of poor economic news last week included the worst unemployment number since the Great Depression and contractionary PMI numbers. Overall, economic data is showing some very poor signals; the unemployment number of 14.7% is one of the worst readings in history with manufacturing and services PMIs of 40 showing poor economic activity. All eyes are now set on how states reopen and what that looks like for economic activity. Unfortunately, it appears that not only is the pain here to stay, but a V-shaped economic recovery (a rapid and sharp collapse followed by a fairly quick rebound to pre-virus economic levels) now seems highly unlikely in the U.S.
This view is driven by a number of factors. Most notably, state lock downs have already lasted longer than initially expected while reopening economies risks generating new COVID-19 outbreaks;  the U-6 unemployment rate (including discouraged workers and the underemployed) already reached 22.8% in April and may still get worse. Continued social distancing efforts will not allow for a rapid return to old habits anytime soon, and it is still too early to assess the mitigation effects from the various government bailout programs on the real economy. A number of polls indicate that a majority of Americans overwhelmingly support keeping social distancing measures in place to slow the spread of COVID-19 with recent government estimates predicting we might be facing 3,000 deaths per day in the U.S. by June 1. Put into perspective, that is closely equivalent to a 9/11-scale disaster every day. 
This all begs the question of what an economic recovery could look like. We are now seeing an alphabet soup of options for the GDP-to-time graph; it could take the shape of a U, W, Z, or even an L, a scenario where the economy never fully recovers from the shock. Many economists are now predicting more of a “swoosh” recovery, resembling that of the Nike logo, in which it takes a while to return to a 2019 level of output.

Provisions for loan losses hammer European bank earnings while balance sheets remain well positioned to weather economic downturn

With a few exceptions, European banking groups have concluded first quarter earnings with mixed results. In general, top lines have held up relatively well thanks to robust corporate activity and solid loan growth as banks work around the clock to mobilize government support funds. In the years following the Global Financial Crisis, European banks made significant progress de-risking their loan portfolios and strengthening their balance sheets by enhancing capital and liquidity buffers. Over the past several years, persistently low interest rates across Europe have incentivized banks to reorganize their business profiles by investing heavily in digitization and aggressively cutting costs in effort to preserve their bottom lines as margins continue to compress tighter. 
Liquidity remains very healthy, and while risk-weighted capital metrics are likely to experience volatility over the course of the year, capital levels should remain well above regulatory requirements, further reinforced by most banks’ decision to postpone any shareholder payouts until at least the third quarter. Investment banking revenues for European banks were mixed, with fixed-income, currencies, and commodities performing very well, helping to offset equity and derivatives that were crushed after banks bet big on dividend paying stocks. As expected, provisions for future loan losses were the primary driver of profit decline. Whether or not current provision levels prove adequate will become more evident as the severity and duration of the economic downturn continues to unfold.
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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