Commentary by the Credit Research Team at BNY Mellon Cash Investment Strategies (CIS), a division of The Dreyfus Corporation
The credit environment continued to improve during the third quarter of 2017 on the back of synchronized global economic growth, higher commodity prices, benign asset quality conditions and buoyant global equity markets. This has led some central banks, in addition to the U.S., to either raise policy rates or pull back quantitative easing in an effort to gradually reduce extraordinary accommodative monetary policies that had been in place since the financial crisis. For the most part, this favorable backdrop facilitated better underlying earnings during the quarter for financial and corporate issuers, to varying degrees. However, the earnings benefit was muted for some as lack of volatility and lower customer activity pressured trading results among global investment banks, particularly within fixed income, currencies and commodities (FICC). Credit ratings remained generally stable for corporate issuers during the quarter while a select number of banks were upgraded due to further progress towards building capital buffers.
Looking forward, we will be monitoring certain areas of potential risk and the impact they may have on money market issuers. One area of focus will be the rise in consumer debt and house price appreciation in certain markets, such as Canada, Australia and the Nordic region; however, this has not been problematic for the banks so far due to macro-prudential measures implemented by regulators and tighter underwriting standards. We will also be keeping tabs on U.S. commercial real estate, as well as credit card and auto lending. Lastly, geopolitical risks associated with North Korea, Brexit negotiations and ongoing debate in the U.S. around taxes, health care and the debt ceiling may create headlines.
In summary, we believe that the large corporate and financial issuers that dominate our approved list have defensible business models and solid credit profiles representative of minimal credit risk. Our thoughts about the various sectors are as follows.
U.S. banks generally saw improved earnings in 3Q17 as higher short-term interest rates boosted net interest income, particularly among the regional banks. However, loan growth remained moderate as commercial borrowers have been able to access funding from non-bank lenders or via capital markets. So far, U.S. banks have repriced loans more quickly than deposits during the current rising-rate environment, but increased competition for commercial deposits could push funding costs higher going forward.
On the fee side, there was a decline in mortgage banking revenues as higher interest rates slowed refinancing activity. For the large banks, capital market revenues continued to be adversely impacted by declines in FICC revenues due to low volatility and lower client activity. That being said, it should be noted that related revenues from a year ago benefited from several tailwinds, including increased market activity reflecting macro events such as the Brexit vote and the lead-up to U.S. elections. Investment banking showcased strength with broad-based improvement, particularly within the advisory segment. Cost discipline was also a positive contributor with efficiency programs bearing fruit. Overall, the credit environment in the U.S. remained benign, although provisions were up modestly as some banks booked credit costs against hurricane-related exposure and added to credit card-related provisions. Liquidity remained a strong point, with U.S. banks noting healthy reserves and coverage metrics well above regulatory requirements. Capital ratios remained flat but solid, despite increased dividends and share buybacks related to the implementation of approved capital plans following recent stress tests. While it’s too early to draw any firm conclusions regarding proposed tax reform, U.S. banks have noted a neutral impact thus far in terms of engagement with clients, but the more internationally focused banks suggested that tax reform in the U.S. could be a positive catalyst.
Canadian banks continued to exhibit positive operating performance in 3Q17 as they benefited from a favorable environment in Canada, particularly as it relates to the recent increase in interest rates. The major Canadian banks continued to showcase positive recurring income from their domestic banking franchises with core profitability among the highest of its peers. For the quarter, there was broad-based volume growth, margin expansion and an increase in average fee-based client assets, partly offset by a decline in trading. Credit quality remained a good story for the banks as they reported lower levels of provisions for the quarter. That being said, the banks face headwinds related to real estate price appreciation and high household indebtedness, notwithstanding continued favorable performance. Importantly, policymakers have taken several actions as a measure of prudence, the most recent being the consumer affordability stress testing under the Office of the Superintendent of Financial Institutions’ (OSFI) Residential Mortgage Underwriting Practices guideline being extended to include uninsured mortgages.
While the banks remained reliant on wholesale funding, balance- sheet liquidity and funding remained positive, reflecting their positive core deposit base combined with their affordable access to the capital markets. Capital levels remained strong, with an average Common Equity Tier 1 (CET1) ratio of 11% vs. a regulatory minimum of 8%. Total loss-absorbing capacity (TLAC) requirements and bail-in rules are set to be finalized by year-end or early next year and implemented shortly thereafter. Moody’s has noted that once the resolution regime takes effect, its government support assumptions in ratings will be reduced. However, the proposed application of its loss given failure (LGF) to the banks’ ratings is expected to result in upgrades to ratings, therefore resulting in a net positive impact on ratings.
Our European bank universe performed adequately in 3Q17, although results were seasonally lower compared to the prior quarter and down noticeably year over year. Earnings were primarily impacted by weakness in capital markets-related activities from lower equity and FICC trading due to low volatility and customer activity. To be fair, 3Q16 was strong as volatility and customer activity were positively affected by the result of the Brexit vote and the run-up to the U.S. elections, so it was not an apple-to-apple comparison. Although this was a common trend among global investment banks, European investment banks have been losing market share to U.S. competitors as a result of reorganization and business mix alterations. Positively, wealth management operations were strong, cost-cutting initiatives helped and the expense drag associated with running off legacy non-core operations has diminished. The difficult rate environment remained a headwind to interest income across Europe despite positive lending volume trends. While rates in Europe are expected to remain low, the European Central Bank (ECB) recently cut its monthly open market purchase target in half as a sign of reduced stimulus while the UK banks may receive a boost from the recent Bank of England policy rate increase.
Some banks experienced deterioration in oil and shipping-related portfolios, but this was offset by improvement in other sectors. The liquidity and funding positions of the European banks were solid, with liquidity coverage ratios and net stable funding ratios exceeding regulatory requirements. Capital levels remained comfortably ahead of regulatory requirements despite a slight decline in the quarter due to balance-sheet growth, with new accounting rules in 2018 requiring quicker recognition of impaired loans expected to have a minimal impact on capital. In fact, progress towards TLAC and minimum required eligible liabilities (MREL) requirements resulted in a handful of European bank upgrades during the quarter by Moody’s. Subsequent to the quarter-end, S&P revised most UK banks from negative to stable with one positive outlook to reflect sound underlying earnings, effective completion of non-core asset run-off and progress towards TLAC.
Australian banks rounded out their fiscal year ended 9/30/17 with generally improved results from the prior year and a favorable average return on equity (ROE) of 14% (CIS, 9/30/17). Earnings were supported by ongoing cost savings with banks focusing on technology, headcount reduction and reallocation of capital towards core-business segments as a way to improve efficiency further. Net interest margin pressure persisted due to a continuation of low interest rates and higher funding costs, but targeted loan repricing and moderate loan growth kept net interest income flat. Benign credit conditions continued with provision costs and non-performers trending lower. High levels of household debt, predominantly mortgages, remained a key risk for Australian banks; however, there are tentative signs that macro-prudential measures are working to stem this risk as interest-only loans broadly declined. An increase in mortgage-risk weights was one macro-prudential measure that has resulted in banks reporting a higher average CET1 capital ratio of 10.35%, which is close to the ARPA’s 2020 requirement of an “unquestionably strong” 10.5% (Australian Prudential Regulation Authority, July 2017). Reported liquidity coverage ratios (LCR) were well above the 100% requirement with indications that net stable funding ratios (NSFR) are easily in compliance with the requirements that come into effect on January 1, 2018.
Banks in Singapore reported good results in 3Q17 as fee income from wealth management and transaction banking trended higher while general improvement in net interest margins and a rebound in loan growth aided spread income. Underlying revenue growth was held back by weaker trading income for some banks. For the most part, asset quality conditions remained benign except for the oil and gas sector, which was a headwind to varying degrees. Similar to their European counterparts, banks in Singapore will be subject to new accounting rules in 2018 with respect to how they set aside loan loss reserves, which prompted one bank to accelerate provisioning for its oil and gas exposure while booking gains on other reserves as a partial offset. Singaporean banks continued to compare favorably against global peers with respect to capital and liquidity, with all metrics easily above regulatory requirements.
The operating environment for Japanese banks improved during 3Q17 on better economic growth, continued benign credit conditions and a favorable market for equities with the Nikkei hitting new highs. As such, earnings in the quarter benefited from equity-related gains and low credit costs, which in some cases were additive to earnings due to the release of reserves. That said, the low-interest-rate environment and tepid loan growth served to further pressure the already-thin net interest margins. While still positive, bond-related gains declined sharply among the megabanks. Overall, Japanese banks continued to report robust unrealized gains, but this is now almost entirely equity-related as some banks posted moderated unrealized losses on domestic and international bond holdings. Given the aforementioned revenue challenges, the major Japanese banks announced plans to reduce costs via technological efficiencies and reduced headcount in an effort to boost the moderate level of profitability. Capital metrics continued to improve to sound levels even with unrealized securities gains excluded while liquidity metrics continued to be well above regulatory requirements aided by a sizable, sticky deposit base.
Corporate earnings in the third quarter of 2017 continued to reflect better global economic conditions with positive earnings across our corporate universe. Improving commodity prices helped the oil and gas sector. Organic revenue growth in consumer products was helped by geographic and product diversity. There still remain a number of headwinds in the global economy, such as geopolitical risk in certain markets.
Nevertheless, overall liquidity and credit profiles remained positive and credit ratings were pretty stable in the quarter. We believe there is a commitment to strong investment-grade ratings in our coverage universe.
President Donald Trump recently revealed his proposal for U.S. corporate tax reform. Some of the more notable highlights include lowering the corporate tax rate from 35% to 20%, allowing companies to repatriate foreign earnings at a one-time lower rate, instilling a territorial system to tax overseas profits based on the country in which the money was made instead of the U.S. tax rate and immediately expensing U.S. capital investments. While the details and timing remain uncertain at this point, we believe that these changes will generally be positive for U.S. corporates and will help free up resources for investments.