Explainer

Credit Suisse: what is happening at Swiss bank and should we be worried?

Plunge in bank’s share price adds to fears over weaknesses in banking sector following collapse of SVB

• Credit Suisse shares fall to record low as top investor rules out more funding

Panic has gripped global banking stocks for the second time in a week: the wave of fear prompted by the collapse of California’s Silicon Valley Bank (SVB) has been followed by fresh jitters over the stability of major European bank Credit Suisse.

What’s happening at Credit Suisse?

Shares in the Swiss lender plunged more than 30% at one point on Wednesday to a record low of about 1.56 Swiss francs (£1.40) a share, after its top shareholder, the Saudi National Bank (SNB), ruled out providing it with fresh funding because of regulations that cap its stake – now 9.9% – at 10%.

SNB’s chairman, Ammar Al Khudairy, told Reuters that Credit Suisse was “a very strong bank” and was unlikely to need more cash after raising 4bn Swiss francs (£3.59bn) to fund a major restructuring plan in autumn last year. However, his funding cap comments spooked investors, who feared it could limit emergency cash from investors in the Middle East.

That compounded panic about potential weaknesses across a global banking sector still reeling from SVB’s collapse as well as fears over continuing problems at the Swiss lender, which as Europe’s 17th largest lender by assets is far larger than SVB and deemed systemically important to the global financial system.

How worried should we be?

The Bank of England reiterated its statement that the UK banking system is not at risk and “remains safe, sound, and well-capitalised”. The Guardian understands that staff at the Bank are continuing to monitor developments in the financial sector closely.

Stocks in many other European banks also plunged on Wednesday as traders took fright. However, it is important to remember that share prices reflect investor sentiment rather than the real strength of balance sheets.

Market movements can cause customers to panic and pull cash, creating a run on deposits that is risky for smaller banks that rely more heavily on client cash. However, larger banks such as Credit Suisse are meant to be in a much stronger position, in part due to government rules and regulators’ annual stress testing brought in after the financial crisis.

So are post-financial crisis rules not working?

After the chaos of 2008, regulators around the world introduced tighter restrictions – particularly for banks deemed to be important to the global financial system. Most central banks and national regulators have introduced annual stress testing to check whether banks can withstand severe economic shocks and market turmoil, while still supporting their customers.

In the worst case scenario, systemically important banks are meant to have enough capital, and so-called “living wills” in place, to ensure they can fail in a relatively orderly way. However, these living wills have yet to be tested by a real-life banking failure.

Switzerland’s regulator, Finma, approved Credit Suisse emergency wind-down plans last year, but said some of its plans were “still not adequate”.

But US banks are collapsing too: is this is a re-run of 2008?

Panic over Credit Suisse comes after the collapse of crypto lender Silvergate last Thursday, SVB on Friday and New York-based Signature on Sunday. However, Credit Suisse’s problems are also relatively unique and not new, with a string of major financial losses and scandals that have worried investors and fuelled a recent client exodus.

Credit Suisse customers – primarily wealthy clients and businesses rather than everyday savers – have been pulling money from the bank for months, leading to more than 111bn Swiss francs (£99.7bn) of outflows late last year. It was not immediately clear on Wednesday whether client withdrawals had gathered pace as a result of its plunging share price.

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Some investors are also worried about potential unrealised losses lurking in the investment portfolios of European banks. SVB’s troubles accelerated after it suffered losses on the bonds it tried to sell as customers pulled cash.

In an attempt to calm fears, Credit Suisse chair Axel Lehmann said on Wednesday morning that government assistance “isn’t a topic” for the lender, adding: “We have strong capital ratios, a strong balance sheet. We already took the medicine.” The Financial Times reported unnamed sources suggesting the lender had appealed to both Finma and the Swiss National Bank for a public show of support in an apparent bid to shore up investor confidence.

How far back do Credit Suisse’s problems go?

The bank is in the process of a major restructuring plan, meant to stem major losses, which ballooned to 7.3bn Swiss francs (£6.6bn) in 2022, and revive operations hampered by multiple scandals over the past decade involving alleged misconduct, sanctions busting, money laundering and tax evasion.

In the past three years alone, Credit Suisse has been caught in corporate espionage after hiring professional spies to track outgoing executives; admitted to defrauding investors as part of the Mozambique “tuna bonds” loan scandal, resulting in a fine worth more than £350m; and been embroiled in the collapse of the lender Greensill Capital and the US hedge fund Archegos Capital in 2021.

It also came under fire after the release of the Suisse secrets investigation by global reporting outlets including the Guardian in 2022, which showed it had served clients involved in torture, drug trafficking, money laundering, corruption and other serious crimes over decades.

That same year, Swiss prosecutors found the bank guilty of helping to launder money on behalf of the Bulgarian mafia, although the bank has denied wrongdoing and intends to appeal against the ruling.

But problems have not yet gone away. Earlier this week, the lender admitted there had been “material weaknesses” in its internal controls linked to financial reporting, but assured bosses were working on a plan to “strengthening the risk and control frameworks”.

Kalyeena Makortoff

Banking correspondent

Wed 15 Mar 2023

https://www.theguardian.com/business/2023/mar/15/credit-suisse-what-is-happening-at-swiss-bank-and-should-we-be-worried

The economist who won the Nobel for his work on bank runs breaks down SVB’s collapse—and his fears over what’s next

Shawn Tully

Thu, March 16, 2023 

Small wonder that most Americans are stunned and confused by the sudden fall of Silicon Valley Bank. How did a cornerstone of the dynamic venture capital community, the nation’s 16th-largest lending institution that until recently enjoyed the growth worthy of the tech startups it served, fall so hard, so fast? Is its failure the legacy of poor practices specific to SVB, or is the Fed’s policy of drastically hiking rates that hammers the value of banks’ investments endangering fellow midsize lenders? Even if bad management destroyed SVB, why didn’t its top regulators, the Fed and the California banking authorities, see this runaway train wobbling on the tracks, and force the drivers to throttle back before it derailed?

I thought of just the expert to skirt the usual dense jargon and provide easy-to-grasp answers. He’s Douglas Diamond, professor at the University of Chicago’s Booth School of Business who shared the 2022 Nobel Prize for Economics with his research partner, Philip Dybig of Washington University in St. Louis, and former Fed chairman Ben Bernanke. The Diamond-Dybig research that captured the Nobel stressed that banks are inherently fragile and vulnerable to “runs,” because if customers exit en masse, the lenders may need to sell their bonds or loans, which would have fully paid off on maturity, at fire-sale prices. Hence, a panic can unnecessarily ruin an otherwise healthy bank. Diamond and Dybig emphasize that both sound regulation and prudent management that broadly diversifies the risk in both the loan and investment portfolios, and makeup of customers, are essential to instilling client confidence required to keep America’s banks out of harm’s way.

In October, just after receiving the prize, Diamond warned in a Fortune interview that the Fed’s policies of raising rates at a brutal, virtually unprecedented pace would trigger dangerously big losses in the bond portfolios of companies and banks that believed inflation-adjusted yields sitting at near-zero for years would stay there for years to come.

But in our hour-long interview on the SVB debacle, Diamond stated that though Fed policy hurt, it wasn’t the main reason for the implosion. Nor did SVB suffer the classic “sound bank wrecked by a stampede” scenario. Instead, SVB deployed just about every bad policy on both the assets and liabilities sides of its balance sheet. For Diamond, SVB is a case study in how setting a rickety structure to enable breakneck expansion created daunting risks that prudently run banks, despite the Fed’s huge run-up in rates, have avoided.

What make banks work, and how SVB broke the mold

Diamond described the template for how banks secure their customers’ trust, and protect themselves from a wave of withdrawals. “The papers that the Nobel Committee recognized explained how banks should be structured,” he explains. “On the asset side, banks make loans to lots of different types of people and businesses. Ideally, banks create safe assets out of risky ones by diversifying. They have diversified funding sources so that since depositors all don’t need their money on the same date, that diversification allows the bank to economize on what they hold in cash and liquid assets.” As for liabilities, he adds, it’s key that banks serve a wide, varied range of depositors. Having loads of retail customers is a boon. When rates on Treasuries jump, they’re less likely to empty their savings or money market accounts to get some extra yield than are corporate clients.

As Diamond notes, it’s crucial to understand the role of the two classes of investments on SVB’s balance sheet. The first grouping is called Available for Sale, or AFS. It consists of securities in the trading account banks are free to sell at any time. All bonds in the AFS designation must be “marked to market” at the end of each quarter. If a bank is holding Treasuries it bought early last year at extremely low yields, and rates jump, the prices of those bonds fall sharply, hitting the bank’s capital. The second investment category is Held to Maturity, or HTM. It comprises the fixed income securities that the bank intends to keep on its balance sheet until they’re redeemed at their full par value. Once each quarter, banks can shift securities between AFS and HTM—if they need to replenish their equity, they’ll transfer bonds from the long-term hold to the trading account. But if a bank transfers HTM securities that have an unrealized loss, that would raise liquidity but hit their book equity even harder. This is a quandary SVB faced before the deluge.

At the close of 2022, SVB counted $26 billion in AFS, virtually all in Treasuries and “agency” mortgaged backed securities issued mainly by GSE’s Fannie Mae and Freddie Mac. As Diamond points out, those AFS bonds were all highly liquid; they’d easily sell at full market price, and stood no danger of suffering a haircut if dumped fast. SVB’s balance sheet also contained $91 billion in HTM bonds, of which over 90% sat in agency-issued mortgage securities that also benefit from a deep, active market. Its $74 billion credit portfolio was highly concentrated, consisting primarily of loans to tech startups, as well as their founders and managers. Those companies and Silicon Valley bigwigs also were also their main depositors. It’s been reported, in fact, that SVB often placed covenants in its loan agreements requiring that a borrower keep its deposits at the bank.

SVB mismatched its investments to the deposits funding them

The bonds in AFS, the ones SVB would need to sell in an emergency, were generating a puny yield of just 1.79% as of mid-March. Clearly, it had purchased most of those securities well before rates started spiking big-time in the spring of 2022. The average maturity on the AFS portfolio was a substantial 3.6 years. At the end of 2022, nearly 90% of the HTM loans carried maturities of over 10 years, and the return on that bedrock portfolio was just 1.63%—once again, SVB had bought almost all those bonds way before rates exploded. Its loan portfolio was also garnering low returns of well under 4% after provisions for credit losses.

“Their investments were pretty long-term, and they were generating very low yields,” says Diamond. “They must have figured that scenario would work fine if every depositor stayed forever, and they kept accepting zero rates on checking accounts and sub-1% rates on money market funds. In that case, they could hold their bonds to maturity and get full value.” It’s clear that SVB’s strategy to “go out on the yield curve” to garner an extra 0.5%, say, on a five-year versus a one-year Treasury, was a mistake. The crunch came in 2022, when yields on five-year Treasuries competing with the ones they bought a just a year before jumped from under 1% at the start of the year to the mid-4% range by fall. Suddenly, SVB was forced to pay 4.5% on savings accounts, a multiple of what it offered a year before.

It appears that before mid-2022, SVB’s deposit base was extremely stable. Not only did it keep adding new customers at a rapid clip, but its existing clients kept their deposits in place. But when rates surged, depositors who’d parked billions in SVB’s checking and money markets pulled their cash in pursuit of the sumptuous yields on Treasuries. In 2022, SVB lost 8% of its deposits, and the exodus accelerated in January and February. On March 8, it issued an 8K stating that it had sold all of its AFS bonds to raise money and pay fleeing customers, and sought to refill its coffers via a $1.25 billion stock offering. The AFS sale raised $21 billion, causing a pre-tax loss of around $2.4 billion, or 11%.

For Diamond, SVB faced two fundamental problems of its own making. The first was the fall in the value of its bonds, which had long maturities compared with a deposit base potentially far less stable than those at a JPMorgan Chase or Bank of America. “The rise in rates hit their bonds and cut their capital down,” says Diamond. “They had to write down the AFS bonds whether they sold them or not. The management claimed it was a fire sale, but it wasn’t a fire sale. Those bonds were highly liquid. SVB didn’t take any discount for selling in a hurry.” Hence, he says, SVB was far from the traditional disaster case where a flight of deposits forces a bank to jettison hard-to-sell assets at distress prices.

Diamond posits that even before the 8K announcement ignited the run, SVB was close to insolvent, and rapidly heading for failure. “As their cost of ‘funding,’ meaning the interest they had to pay on deposits, kept rising to 4% and higher, they’re forced to pay that higher interest needed to keep their customers. But their bond portfolio, where the money comes from, is paying them less than 2%,” he says. “Put simply, you’re getting less than 2% on your assets and paying out, say, 5% on your liabilities.” That deficit of interest coming in and out meant that SVB was destined for big operating losses.

To cover those losses, SVB would need to raise cash by shifting its longer-maturity HTM securities to the trading account. But doing so would have pounded its capital even harder. And in a footnote to the 8K, SVB noted that if it marked its HTM securities to market, the adjustment would wipe out all of its book capital. “The downward adjustment on long-term bonds carrying low rates would be even steeper than on the three-to-five-year bonds in AFS,” says Diamond. Even if they were able to hold the HTM portfolio to maturity, the operating losses would eventually render the bank insolvent. “It appears that they were already dead or dying before the meltdown,” says Diamond.

It also astounds Diamond that although SVB was highly vulnerable to a rise in rates, it did little hedging to offset the obvious risk that yields would eventually jump from their historic lows. Rate hedging is practiced extensively by well-run institutions such as JPMorgan.

SVB’s failure to diversify the deposit base increased risks of a run

For Diamond, besides failing to match its investments’ maturities to its depositors’ quicksilver demands, SVB also violated the second tenet of sound banking: attracting a broad mix of customers. He points out that SVB had an extremely small proportion of retail clients to balance all the Silicon Valley startups and their wealthy founders. “SVB reportedly looked for companies that were getting new VC funding, and offered them large loans,” says Vivian Fang, an accounting professor at the University of Minnesota. “That’s how they grew their business so rapidly.” Adds Diamond, “Keep in mind that money had been flowing out for six months. These weren’t programmers or teachers leaving. They were CFOs. Almost all of their deposits were wholesale.” Once again, the CFOs were much quicker to pull cash from checking accounts and grab those big Treasury yields than regular folks would have been.

An incredible $48 billion in deposits departed in a single day. “It was the fastest bank run in history,” marvels Diamond. “The customers in the Silicon Valley community all talk to one another. When Peter Thiel and Y-Combinator, the startup hub, say to get your money out, when that happens, the run will be fast and complete.”

On contagion, Diamond is concerned about lax regulation and the Fed’s super-tough policies

Of course, most midsize banks aren’t risking the funding mismatch and all-in-on-a-single-client approach that sank SVB. Still, Diamond worries that the Fed’s oversight of regional banks, in itself, is far too light to prevent further blowups. In the early years following the passage of the Dodd-Frank legislation in 2010, the central bank imposed the same tough annual tests on midsize lenders as the likes of Wells Fargo or Citigroup. But in 2018, the Trump administration successfully championed a regulatory relief bill that greatly reduced the frequency and severity of the stress exams for regionals. “I looked at the latest stress test, and the Fed was assessing how the banks would perform at rates from 0% to 2%, as if 2% was as high as they’d ever go. So almost any bank would pass. The standard should have been 0% to 7%.” (SVB was exempt from what would have been its last stress test in 2021 because its assets were still below the required level. It was not scheduled for testing in 2022 when its assets passed the threshold.) In SVB's case, Diamond is surprised that the Fed and California Department of Financial Protection and Innovation didn’t see the red flags raised by SVB’s slender, restless clientele and holdings of low-yielding, long-duration bonds.

Obviously, the Fed will need to predict the midsize banks’ outlook using much higher rate assumptions in the future, a shift that could require lenders to hold far more capital. Since marking their AFS securities to market is already denting their equity, it’s conceivable that regionals will need to float equity to restore their capital. In turn, announcing you need to sell stock could send depositors for the exits. Of course, it’s the super-tough Fed policy that’s put banks in this difficult position. “When the Fed takes rates from 1% to 5% in a year, it shouldn’t be surprising if that causes trouble in the system,” says Diamond. “When we spoke after I received the Nobel, I talked mainly about how fast-rising rates would hurt companies. But the incredible speed of the hikes hurts banks a lot too.” Diamond believes that the Fed should be “much more slow and deliberate” in raising rates, in part to forestall more SVB-like shocks to the system.

Doug Diamond won his Nobel for, in the words of the National Bureau of Economic Research, providing “insights [that] form the basis of modern bank regulation.” For Diamond, the sound management practices and regulation that he extolled in his research, that make banks safe, was sorely lacking in the SVB catastrophe. Banks get in trouble when they veer from the Diamond model. We can only hope that SVB was a lone case, and that the Fed’s relentless march and weak regulation won’t produce a flurry of renegades that roil America’s credit markets just as our economy teeters on the brink of recession.

This story was originally featured on Fortune.com

https://finance.yahoo.com/news/economist-won-nobel-bank-runs-160025143.html

Malaysian banks rating intact despite US bank failures - RAM Ratings

 

Malaysian banks rating intact despite US bank failures - RAM Ratings

Publish date: Sat, 18 Mar 2023, 08:06 AM

KUALA LUMPUR - RAM Rating Services Bhd (RAM Ratings) sees no rating impact on Malaysian banks from the failure of the United States Silicon Valley Bank (SVB) and two other smaller banks last week.

The rating agency said that in Malaysia, banks' credit fundamentals remained robust and resilient supported by strong regulatory supervision to weather heightened volatility in global financial markets.

"Compared to SVB, we see fundamental differences in the business and balance sheet profiles of commercial banks in Malaysia.

"Domestic commercial banks typically engage in more lending activities as opposed to relying on bond investments which are exposed to market volatility. The proportion of domestic banking system assets invested in bond securities is less than 25 per cent," it said in a statement today.

SVB, on the other hand, had more than 50 per cent of its asset base in such securities, which led to huge unrealised losses amid rapid and steep interest rate hikes in the US.

Moreover, less than 40 per cent (on average) of bond holdings in Malaysia's eight major banks are classified as held to maturity (HTM), while the rest are marked to market.

"This means that fair value losses on bond securities are already largely reflected in the banks' capital position. In contrast, SVB classified almost 80 per cent of bond securities as HTM (only a little over 20 per cent were marked to market), indicating that unrealised losses had not yet been reflected in its equity.

"HTM bonds are carried at amortised cost in the balance sheet given the intention to hold these securities to maturity, so fair valuation losses are not captured in the capital," it said.

RAM Ratings said fair value losses in Malaysian banks were also significantly smaller, thanks to Bank Negara Malaysia's (BNM) milder pace of rate hikes and banks' prudent strategy of holding shorter-tenure bonds in recent times.

The domestic banking industry's common equity tier-1 capital ratio stayed at a robust 14.9 per cent at end-2022 from 2021's 15.5 per cent.

"Further valuation losses, if any, should be less severe given the central bank's cautious stance on further rate hikes," said the rating agency, adding that banks in Malaysia are predominantly funded by customer deposits, with high granularity.

Their liquidity profiles are also sound with liquid assets to deposits ratio of around 20 per cent and a net loans to deposits ratio of 88 per cent, it added.

According to BNM, domestic banks have no direct exposure to the three failed US banks.

"The central bank's robust prudential oversight and good track record - which have been evident in previous financial crises - should ensure the continued financial stability of the Malaysian banking system," it noted.

- BERNAMA

 

https://www.nst.com.my/business/2023/03/890196/malaysian-banks-rating-intact-despite-us-bank-failures-ram-ratings

 

What has gone wrong at Credit Suisse - explained

Updated: 15 Mar 2023,Edited By Sayantani Biswas

Credit Suisse's Chief Executive Officer Ulrich Koerner told Bloomberg that the reshaped bank will be more focused and less risky. (AFP)

The annual bonus pool has Credit Suisse hanging their hopes on a 70% jump in stock prices

Credit Suisse Group AG's annual bonus pool plunged 50% to 1 billion francs after 2022 brought a loss that wiped out a decade’s worth of profit. Reasons? 

• A plunging share price, 
• an exodus of wealthy clients and 
• erosion of bank’s credibility.

Currently, the annual bonus pool has them hanging their hopes on a 70% jump in stock prices. At such a time Credit Suisse's Chief Executive Officer Ulrich Koerner told Bloomberg that the reshaped bank will be more focused and less risky. “We will be very profitable and we will reward shareholders."

Meanwhile, Credit Suisse Group AG’s top executive said he expects to take the firm’s carved-out investment bank, First Boston, public by 2025, Bloomberg reported.

What went wrong with credit Suisse?

On Tuesday, 14 March, Credit Suisse said in its 2022 annual report the bank 

• has identified "material weaknesses" in internal controls over financial reporting and 
• not yet stemmed customer outflows.

The reporting weaknesses come as Credit Suisse is seeking to recover from a string of scandals that have undermined the confidence of investors and clients. Customer outflows in the fourth quarter rose to more than 110 billion Swiss francs ($120 billion).

Where did it all begin?

In the 1980s and 1990s, Credit Suisse merged with First Boston to create Credit Suisse First Boston, which was its investment banking division till 2006.

At the end of 2021, Credit Suisse reported over 1.6 trillion Swiss francs in assets and over 50,000 employees in the institution.

Credit Suisse has a domestic Swiss bank plus wealth management, investment banking, and asset management operations.

Credit Suisse's Troubles

In 2019, the Chief Operating Officer, Pierre-Olivier Bouée was discovered to have hired private investigators to spy on high-level employees and was fired shortly after. The private investigator also mysteriously "took his own life," the bank reported, while announcing Bouée's removal.

In March 2021, a month before the Archegos scandal went public, Credit Suisse also announced that it was closing and liquidating several investor funds, worth $10 billion, provided to another financial services company, Greensill capital. Greensill declared insolvency in March 2021.

Investors reportedly lost close to $3 billion because of this.

In February 2022, a massive leak of over 30,000 of Credit Suisse's clients revealed over $100 billion in wealth held by people who had profited from "torture, drug trafficking, money laundering, corruption and other serious crimes," according to The Guardian.

This revelation also hurt the bank's reputability further, amplifying investor concerns.

The bank has also changed top leadership multiple times since 2019, with the most recent changes coming in July 2022, with the group getting a new CEO.

The group's Chairman Axel Lehmann only took over from previous chairman Antonio Horta-Osorio in January 2022, after Horta-Osorio resigned for breaking quarantine rules during the pandemic.

Will the 2025 IPO be their salvation?

Ulrich Koerner, the chief executive officer of Credit Suisse, on Tuesday informed that the bank plans to take Credit Suisse's carved-out investment bank First Boston public by 2025. 

This comes amid a search for investors. 

While the First Boston spinoff is a centerpiece of Koerner’s restructuring plan, the CEO seeks to protect the best-performing investment bank parts, such as advising on mergers and acquisitions, while pivoting the parent company further toward wealth management.

Credit Suisse announced earlier today that senior leaders in the carved-out unit are expected to receive up to 20% of shares. Employees would receive restricted share units after an IPO, which would vest three years later and be subject to a further holding requirement.

https://www.livemint.com/

EPF delivers competitive returns amid tough investment climate in 2022, reaffirms focus to rebuild members’ savings

Summary of EPF’s 2022 Investment Performance; EPF’s Dividend Chart from 2010 until 2022; and EPF’s Investment Assets as at 31 December 2022.

Tables of EPF Year-To-Date December 2022 Members/Employers Registration; Savings of EPF Members by Age Group (as at 31 Dec 2022); Savings of EPF Members by Race Group (as at 31 Dec 2022).

Savings of EPF Members by Savings Level Group (as at 31 Dec 2022).

https://www.theborneopost.com/2023/03/05/epf-delivers-competitive-returns-amid-tough-investment-climate-in-2022-reaffirms-focus-to-rebuild-members-savings/

 

Europe Outlook 2023: Is a recession really avoidable?

MARCH 12, 2023, SUNDAY AT 12:09 AM

ON the back of macroeconomic data which has come through better than expected, the biggest drivers of the rally to date in the STOXX 600 can be attributed to the 

• weakening of the USD, 
• lower rate expectations and 
• falling bond yields.

After posting one of the worst years in decades in 2022, equities and bonds had one of their best Januarys on record year-to-date, rallying more than 20 per cent from its lows in late September 2022, as it has become clear that Europe has managed to avoid the near term energy crisis this winter.

However, the rally is likely driven by investor sentiment rather than fundamental reasons, with 

• systematic algorithms, 
• trend-following investors buying back into equities, and 
• hedge funds massively short-covering from an overly pessimistic positioning from last year.

Furthermore, with strong economic data coming from the US and Eurozone inflation numbers falling back to single digits, investors are increasingly hopeful of a potential soft landing. Combined with the expectation that central banks are heading towards the end of the monetary tightening cycle this year, investors have a renewed sense of optimism, resulting in a risk-on climate.

However, we argue that the markets may be overly optimistic, and the current rally is not sustainable. While high frequency indicators suggest that the Eurozone may defy the odds of potentially avoiding a recession, it is unlikely that the European economy will go unscathed from the delayed effects of the rapid ECB tightening, so there could be more downside risk ahead should Europe experience an economic contraction, especially after the recent rally.

 

STOXX 600 has rallied furiously ever since bottoming in late September 2022.

Growth outlook has improved from before but remains weak

With the recent release of GDP figures, Europe managed to narrowly avoid a fourth-quarter contraction projected in November 2022, on the back of a warmer-than-expected winter and a strong labour market.

Since the last economic projections, there have been favourable developments which have improved the growth outlook for 2023. The diversification of supply sources and a drastic drop in consumption has left gas storage levels above the seasonal average of past years, and wholesale gas prices have fallen well below pre-Ukraine war levels.

Furthermore, Europe’s labour market continues to remain strong, with unemployment rate coming in at 6.7 per cent for 2022, which is the lowest figure in the past few years, well below the 5-year and 10-year rolling average figures (Figure 2).

In addition, consumer confidence is slowing rebounding ever since bottoming in September 2022, but figures remain at secular lows even as conditions have improved in the short term.

However, looking at leading economic indicators such as the PMI, the data points towards a possible mild economic contraction. Although there has been a small uptick in the both manufacturing and services PMI, manufacturing PMI continues to be contractionary territory, dimming the near-term growth outlook.

Next, the tightening to date has begun to pass through to less supportive conditions for households. Higher borrowing costs have significantly increased the debt service costs of existing borrowers and made new mortgage borrowing less attractive and these have led to a decline in home prices.

As home prices fall, there will be a negative impact on household wealth, which can lead to a decrease in household spending and ultimately impact economic growth.

With the recent turn of events and rosier than expected macroeconomic backdrop, GDP forecasts for the Eurozone have been revised upwards on a quarterly basis. However, coming off a low base, these revisions are likely to be overly optimistic as Europe still faces longer-term issues, like the ongoing energy crisis which is structural in nature, and lagged effect of policy tightening which has yet to be reflected in consumer spending.

Even with the recent revisions to the upside, GDP in Europe is expected to expand by only 0.3 per cent in 2023 for the entire year, which lags behind that of US and Japan, making it the weakest developed market within our coverage.

 

Labour market continues to remain tight as unemployment rate trends down.

Euro area inflation remains elevated

Next, headwinds arising from rising prices continue to persist, which affects both consumers and businesses detrimentally.

Although the headline inflation in the Eurozone has been trending down towards single-digit territory from its peak of 10.6 per cent year-over-year back in October 2022, it is still currently running at multi-year highs.

Furthermore, core inflation (which excludes volatile items such as energy and food) has yet to peak and was still rising in January, which erodes the purchasing power of households.

Although the surge in European inflation was initially concentrated in energy and goods, the problem has become more broad-based. The more alarming issue is the pickup in nominal wages, on the back of tight labour markets. Higher incomes can cause a self-reinforcing cycle of spending, making it more difficult for the ECB to achieve its two per cent target inflation.

As these inflationary pressures persist, it would be difficult for the ECB to put the brakes on monetary tightening, at least until they see a meaningful deterioration in economic and labour market conditions, which will weigh on business activity and could cause a drag on investments.

Combined with the fact that the ECB is set to start quantitative tightening in March, which further lowers the availability of money circulating in the economy and drains liquidity away from the financial markets, these concerns look under-reflected in the relatively optimistic pricing of European equities.

 

Services PMI may have rebounded but Manufacturing PMI remains in contractionary territory.

Energy situation unlikely to be resolved soon

With the help of a milder than expected winter and targeted government policies to curb the use of natural gas, Europe has managed to escape the worst-case scenario of a severe energy crisis, with natural gas prices falling sharply from their previous peaks.

This has helped to partially diminish the effects from the rapid rise of headline inflation, and has provided some cushion to real spending.

However, the energy problem in Europe is structural, with a lack of sufficient and proper infrastructure to keep up with the demand of energy consumption in Europe.

Today, more than half of Europe’s energy consumption still comes from imported sources, leaving it vulnerable should there be any political or economic wars with other countries.

This issue has been brought to light during the Russia-Ukraine war, which has led to huge investments into renewable energy to accelerate the path to energy independence.

With that being said, the setting up of these supply chains and infrastructure upgrades require time, thus energy prices are set to continue remain elevated in the near to mid-term.

Furthermore, Russia has stated that they will cut oil output by about five per cent in March this year, after the West imposed price caps on Russian oil and oil products. This can exacerbate the supply side constraints for energy in Europe and keep energy prices higher for longer, further fueling inflation concerns.

 

Earnings may be revised downwards

The fall in European equities in 2022 was due multiple compression on the back of rising real interest rates. Just as the expected recession has not arrived yet, neither has the anticipated sharp downgrade to corporate earnings.

In fact, earnings estimate for European equities have seen strong revisions to the upside in the past few weeks, as fear of an energy crisis subsides and better than expected macroeconomic data has buoyed investor sentiments.

However, consensus estimates of EPS growth and resilient margins may be too optimistic, as we have yet to fully grasp the delayed effects of the fastest pace of rate tightening in the ECB’s two-decade history. As it stands, current projections are pricing in a mild recession or soft landing with markets pricing in the end of the tightening cycle soon.

Nonetheless, a hot labour market does not offer much room for a policy U-turn just yet, especially when core inflation has not peaked yet.

Fortunately, if the unemployment rate does not spike, it is possible to avoid a negative spiral seen in many past recessions, where falling demand leads to falling employment, which further compounds falling demand. Therefore, even if Europe experiences a recession, the downturn might be shallower than most expect.

With European equities currently trading below its historical average P/E ratio, there is room for further upside.

However, the margin of safety is shrinking as P/E multiples have rebounded from its recent lows and is approaching its long-term average (Figure 9), leaving considerably less room for any disappointment moving forward.

https://www.theborneopost.com/2023/03/12/europe-outlook-2023-is-a-recession-really-avoidable/

What history says about the past. A basic appreciation of how valuation dictates the future can go a long way.

Why bonds produced such dreadful returns after 1945

In the 1940s, interest rates had been falling for the better part of 20 years as the Great Depression drove knee-jerk risk aversion, and hit record lows as various policies and incentives moved to cheaply finance wartime deficits. 

According to Yale economist Robert Shiller, 10-year Treasuries yielded 

• 5% in 1920, 
• 3% by 1935, and 
• 2% by the early 1940s. 

The consensus came to believe low rates were a permanent fixture. "Low Interest Rates for Long Time to Come," read one newspaper headline in 1945.

But as the saying goes, if something can't go on forever, it won't. 

• By 1957, 10-year Treasuries yielded 4%. 
• By 1967, 5%. 
• They breached 8% in 1970, and zoomed to 
• 15% by 1981 as inflation scorched the economy. 

Since bond prices move in the opposite direction of interest rates, this was devastating to returns. Deutsche Bank has an archive of Treasury returns in real (after inflation) terms, which tells the story:

Period	Average Annual Real Returns, 10-Year Treasuries
1940-1949	(2.5%)
1950-1959	(1.8%)
1960-1969	0.2%
1970-1979	(1.2%)

Source: Deutsche Bank Long Term Asset Return Study.

Don't underappreciate how awful this was. In real terms, $1,000 invested in 10-year Treasuries in 1940 would have been worth $584 by 1979 -- this for an investment often trumpeted as "risk-free."

Lessons

No one knows if the same performance will be repeated over the coming years. 

Japan is a good example of extremely low interest rates sticking around for decades. 

But the risks are obvious. 

• With 10-year Treasuries yielding 1.5%, there is virtually no chance of high returns over the next decade. 
• The odds of being hammered and suffering negative real returns are, however, quite good.

http://www.fool.com/investing/general/2012/07/10/stocks-or-bonds-the-easy-choice-.aspx