14-Jul-2020

1) EUR/USD Stays Strong Despite Risk-Off Correction
2) Stocks Drop As Risk Aversion Returns, UK GDP Disappoints
3) Will US Banks’ Share Prices Suffer As COVID-19 Takes Its Toll?

 

 

1) EUR/USD Stays Strong Despite Risk-Off Correction

Yesterday’s sentiment on risk was constructive for most of the day, but a flaring up of geopolitical tensions between the US and China and negative headlines on corona from the likes of California finally caused US equities to return most gains (Dow) or close in the red (S&P; Nasdaq). The TW dollar followed the swings in sentiment intraday, but in the end the dollar didn’t profit while the euro held up well. EUR/USD jumped from the 1.13 area to test 1.1375 intraday and preserved part of its gain despite the late session risk-off (close 1.1340). USD/JPY even maintained gains to close at 107.29. The USD/JPY performance probably was also supported by a solid bid in EUR/JPY which tested the 121.95 resistance.

This morning, Asian markets joined the correction on WS late yesterday. The dollar again hardly profits (TW DXY stable near 96.55). The yuan is losing modest ground (USD/CNY 7.01 area) even as China June trade data (imports and exports) printed better than expected. EUR/USD (1.1345 area) and USD/JPY (107.25) are also little affected by risk-off.

Today, the calendar is better filled compared to previous days including German ZEW confidence and EMU May production. In the US NFIB small business confidence is expected to rise only modestly. US June headline inflation is expected to rise to 0.6% Y/Y but core is expected only at 1.10%. Global sentiment remains the driver for overall USD moves. That said, it looks that ‘usual’ USD gains due to the risk-off is a bit hindered by negative US corona developments. EUR/USD (and also EUR/JPY) are nearing intermediate resistance, suggesting a constructive sentiment on the euro. We saw EUR/USD developing a buy-on-dips pattern, with the 1.1255 area providing good support. A break above 1.1375/1.1422 would further improve the ST picture. A constructive message from the EU summit later this week might reinforce the euro bid.

Sterling returned a big part of last week’s gain against the euro yesterday with EUR/GBP returning north of 0.90. Euro strength played a role but we didn’t seen any UK specific news. This morning, May UK GDP and production data were weaker than expected, confirming that the road of the UK recovery will be (very) long. Sterling is losing a few ticks. The UK currency recently decoupled a bit from the usual risk-on/risk-off pattern. Even so, yesterday’s poor performance suggests that a sustained return below EUR/GBP 0.90 won’t be that easy, especially if sentiment on risk turns more cautious.

 

2) Stocks Drop As Risk Aversion Returns, UK GDP Disappoints

Risk aversion returns with stocks opening on the back foot after UK GDP dramatically misses forecasts, amid elevated US China tensions over offshore resources in the South China Sea and intensifying coronavirus fears. Upbeat China data showing a strong rebound in both imports and exports has been shrugged off.

A late sell off on Wall Street spilled over into Asia and is dragging on European stocks on the Open.

Sentiment soured on Wall Street after the state of California imposed new restrictions on business as coronavirus cases spiral out of control and hospitalisations soar. The shutdown fuels fears that the growing number of coronavirus cases will hamper the fragile economic recovery.

The fresh US restrictions come after the WHO gave a stark warning that the pandemic could get worse and worse with too many countries headed in the wrong direction. The comments from the WHO Chief came after 230,000 new daily cases were record, in the worst day of the crisis so far.

UK economic growth massively undershot expectations increasing just +1.8% month on month in May as lockdown measures were gradually eased. This is a very shallow rebound given the -20.4% contraction in April. Analysts had been expecting a 5% jump in GDP in May. The data reveals that the UK economy is recovering at a much slower pace than initially expected pouring cold water over any V-shaped recovery talk.

However, it was only at the end of May that non-essential shops reopened and the leisure and hospitality sectors remained behind closed doors. With these sectors reopening in June, the data should steadily keep improving. Patience will be the name of the game here. Andrew Bailey pointed out yesterday there are signs of economic recovery, but there is still a very long way to go.

A bright spot in the raft of UK data released was UK manufacturing production which rebounded at a much stronger rate than expected, jumping +8.4% mom in May, rebounding from -20.9% in April. Whilst the manufacturing sector only accounts for around 10% of activity in the UK economy, the data was offering some support to the Pound which dropped just 0.1% following the disappointing GDP reading.

Looking ahead big swings are expected in the US banking sector as JP Morgan, Citigroup and Wells Fargo kick off the banks’ earnings season. Financials have been badly hit in the coronavirus crisis and have underperformed the broader market in the recovery. The second quarter earnings are expected to be the nadir. We could see investors looking to buy the bottom once the scale of the coronavirus impact is out in the open.

US inflation data is expected to show +0.5% increase mom in June, up from -0.1% decline in May. Whilst the data would show the US economic recovery is on the right track optimism could be offset by fears that the rolling back of reopening measures could undermine the economic recovery.

 

3) Will US Banks’ Share Prices Suffer As COVID-19 Takes Its Toll?

As we look ahead to the next quarter and the second half of this year, with the Covid-19 virus still spreading across the US, the latest results from the US banking sector will be released this week.

It’s a bumper week for US bank results, with Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase and Wells Fargo all revealing how they fared in Q2. These results are likely to be closely scrutinised for further evidence that US banking chiefs are concerned about setting aside higher provisions in respect of large-scale loan losses, after the $25bn set aside at the end of Q1.

The impact on the US, UK and European banking sectors has been fairly similar in terms of share price performance, with banks a serial drag on all of the major indices. The S&P 500 is now back to slightly negative year-to-date, while the CMC Markets US Banks share basket is down 35%.

One shouldn’t read too much into this similar performance given that US banks have come down from a much higher baseline. But the declines do highlight where the pressures lie when it comes to the weak points in the global economy, as rising unemployment puts upward pressure on possible loan default rates.

This higher baseline for US banks came about in the aftermath of the financial crisis, when US authorities took much more decisive action to shore up their banking sector in the wake of the collapse of Lehman.

The thought process as the crisis was unfolding was that capitalism needed to take its course in allowing both Bear Stearns, as well as Lehman, to collapse in order to make the point that no one institution was too big to fail. It’s certainly a sound premise, and in most cases allowing a failing business to fold wouldn’t have too many long-term consequences.

Unfortunately, due to the complex nature of some the financial instruments designed by bankers and portfolio managers, it was a premise that was destined to fail. Its failure still scars policymakers’ reaction function when they make policy decisions today.

It soon became apparent in the fall of Lehman, that allowing one big player to fail caused widespread panic in the viability of almost every other financial institution. Like pulling one Jenga block out of a tower of financial complexity, it undermined the stability of the entire construct.

Some institutions continue to be too big to fail, as well as being too big to bail out, meaning that global policymakers only have the tools of annual stress tests to ensure that these institutions have the necessary capital buffers to withstand a huge economic shock.

Since those turbulent times when US authorities forced all US banks to clean up their balance sheets, by insisting they took troubled asset relief program (TARP) money, whether they needed to or not, the US banking sector has managed to put aside most of its problems from the financial crisis.

As can be seen from the graph below, the outperformance in US banks has been remarkable. However a lot of these gains were juiced by share buybacks, as well as the tailwind of a normalised monetary policy from the US Federal Reserve from 2016 onwards, and a US economic recovery that peaked at the beginning of 2019.

It should also be noted that while Bank of America has been by far the largest winner, it was also one of the biggest losers in 2008, due to its disastrous decision to purchase Countrywide. The deal prompted the Bank of America share price to plunge from levels above $50 a share to as low as $3 a share, costing the bank billions in losses, fines and aggravation.

UK authorities have also gone some way to improving the resilience of its own banking sector, though unlike the US, we do still have one big UK bank in the hands of the taxpayer, in the form of Royal Bank of Scotland. Others have been left to fend for the scraps in fairly low-margin banking services of mortgages, loans and credit cards.

UK banks’ trading operations were also curtailed sharply in the wake of the financial crisis, in the mistaken belief that it was  so-called ‘casino’ investment banking that caused the crisis, rather than the financial ‘jiggery-pokery’ of the packaging and repackaging of CDOs of mortgages and other risky debt.

In Europe, authorities have made even fewer strides in implementing the necessary processes to improve resilience. The end result is that the banking sector in the euro area is sitting on very unstable foundations, with trillions of euros of non-performing loans, and several banks in the region just one large economic shock away from a possible collapse.

While we’ve seen equity markets remain fairly resilient in the face of the massive disruption caused by the coronavirus pandemic, the same cannot be said for the banking sector, which has seen its share prices sink this year.

Nowhere is that better illustrated than through our banking share baskets over the last 15 months.

Despite their fairly lofty valuations, the share price losses for US banks have seen a much better recovery from the March lows than has been the case for its UK and European counterparts.

This has probably been as a result of recent optimism over the rebound in US economic data, although the recovery also needs to be set into the context of the wider picture that US banks are well above their post-financial-crisis lows, whereas their European and UK counterparts are not.

Another reason for this outperformance on the part of US banks (black line) is they still, just about, operate in a largely positive interest rate environment, and also have large fixed income and trading operations, which are able to supplement the tighter margins of general retail banking. They have also taken more aggressive steps to bolster their balance sheets against significant levels of loan defaults.

In Q1, JPMorgan set aside $8bn in respect of loan loss provisions in its latest numbers, while Wells Fargo set aside $4bn. Bank of America has set aside $3.6bn, while Citigroup has set aside an extra $5bn. Goldman Sachs also had a difficult first quarter, largely down to setting aside $1bn to offset losses on debt and equity investments.

With New York at the epicentre of the early coronavirus outbreak, Bank of New York Mellon’s loan loss provision also saw a big jump, up from $7m a year ago to $169m. Morgan Stanley completed the pain train for US banks, with loan loss provisions of $388m for Q1, bringing the total to around $25bn.

As we look ahead to the US banks Q2 earnings numbers, investors will be looking to see whether these key US bellwethers set aside further provisions in the face of the big spikes seen in unemployment, and the rising number of Covid-19 cases across the country.

Another plus point for US banks will be the fees they received for processing the paycheck protection program for US businesses. It’s being estimated that US banks that are part of the scheme have made up to $24bn in fees, despite bearing none of the risk in passing the funds on from the small business administration.

In the aftermath of the lockdowns imposed on the various economies across Europe, the Eurostoxx banking index hit a record low of 48.15, breaking below its previous record low of 72.00 set in 2012 at the height of the eurozone crisis. It’s notable that UK banks have also underperformed, though it shouldn’t be given the Bank of England’s refusal to rule out negative rates, which has helped push down and flatten the yield curve further.

This refusal further suppressed UK gilt yields, pushing both the two-year and five-year yield into negative territory, and eroding the ability of banks to generate a return in their everyday retail operations.

It’s becoming slowly understood that negative rates have the capacity to do enormous damage to not only a bank’s overall probability, but there is also little evidence that they can stimulate demand. If they did, Japan, Switzerland and Europe would be booming, which isn’t the case.

Our various share baskets allow the user to diversify their risk exposure across a wide range of sectors, either by spreading the risk of exposure across numerous assets, or alternatively acting as a hedge to an underlying long position.