European banks are venturing into riskier lending according to the European Banking Authority (EBA) in our first featured podcast. Next, private equity firm Blackstone discusses how they are finding that their portfolio companies are investing less and suffering higher wage costs.
Bucking these negative stories we have two positive podcasts on China. First, Deutsche Bank’s China economist Yi Xiong sings the praises of the Chinese consumer. And second, Chinese academic Jun Pan argues that the Chinese credit market is now more appropriately reflecting credit risk.
Finally, in our last podcast UBS talks energy transition. They make the case that it will be tough for renewables to replace fossil fuels completely, so a mix of the two will be necessary.
Risks Mount In European Banks, EBA Warns (FT Banking Weekly, 18 min listen) Along with a panel of banking experts, FT’s financial editor Patrick Jenkins and Mario Quagliariello of the European Banking Authority (EBA) analyse the EBA report on mounting risk in the European banking system.
• The EBA found that the era of banks shrinking their balance sheet post 2008 (deleveraging) has come to an end. However, this is driven by growth in riskier assets, i.e. lending to riskier sectors like commercial real estate and SME’S.
• Growth in these riskier assets is attributable to a prolonged period of negative interest rates in the Eurozone. Another recent trend with unknown inconvenieces is how negative interest rates are now being passed on to consumers and corporates.
• In contrast, Quagliariello highlights the positive aspects of the reports: strong capital buffers and the steady decline of non-performing loans.
• Despite these trends, Quagliariello is still concerned about European banks’ profitability. He believes they have a branch density that is too high, but data shows that European banks that were able to leverage the fin-tech soloutions reduced cost and increased profitability.
Why does this matter? Over the past ten years, European bank shares have lost 50% of their value vs US banks, which have risen by 80%. Just 28% of all publicly traded European banks have a price-to-book value of more than one, compared with 81% in the US. This does make European banks attractive in terms of valuations. However, with current low profitability, excess capacity (high branch density), riskier lending, and a slowing economic outlook, it is hard to see a quick turnaround.
Insights from Blackstone’s Private Equity Portfolio (Blackstone Podcast, 11 min listen) Blackstone conducts a survey of private equity companies in their portfolio, focusing on challenges and opportunities CEOs are facing. Prakash Melwani, a chief investment officer of Blackstone’s private equity group, along with Chief Investment Strategist Joe Zidle discuss their findings in this podcast.
• First, growth is decelerating globally. They attribute this to a reduction in capital spending by firms, especially the industrial sector, because of trade frictions between the US and China.
• Second, profit margins in the US are exhibiting a downward trend mainly driven by higher wage costs.
• Third, finding and retaining qualified workers was cited as the number one risk by CEOs in the US.
• Finally, Malwani and Zidle believe US corporate has a stable outlook. Unlike prior cycles, liabilities are sustainable and spreads are appropriately penalizing the firms with higher risk and weaker fundamentals.
Why does this matter? The signs coming out of the Blackstone survey resemble a late-cycle economy characterized by slowing growth, rising inflation due to a tighter labour market, and profit margins falling. This indicates a risk of higher-than-anticipated inflation currently priced in by the markets.
China’s Consumer Decade (Podzept – with Deutsche Bank Research, 13 min listen) Yi Xiong, China Economist at Deutsche Bank analyses the Chinese economy over the next decade, highlighting the crucial role of consumption in driving growth.
• Historically faster growth in exports and investment have overshadowed growth in consumption.
• Consumption spending per person has grown around 8% per year in real terms during the last four decades.
• Xiong projects that with the current rate of 12% growth in consumption, China will soon become the largest consumer market in the world, leaving the US and the EU behind.
• When questioned about the potential risk of consumption slowing down (as in Japan), he counters with two arguments. Firstly, a large income gap between cities (Gansu vs Shanghai) implies a large potential for consumption upgrades. Second, 66% of income is saved (vs 4% in OECD), which implies large spare capacity to increase the propensity to consume in the future.
• Xiong further draws attention to factors that will change China’s consumption pattern. First, the rural population (60% of the whole) is increasingly shopping online. Second, China’s baby boomers (25% of the population), who benefited from the economic liberalization policy in the 1970s, are set to retire in the next decade.
Why does this matter? China’s current economic outlook remains gloomy as 3Q growth slows down to a 27-year low at 6%, US-China trade frictions remain uncertain, and the Chinese credit crunch worsens with total debt to GDP rising to 300%. Amid this, consumption appears as a silver lining that could single-handedly drive the growth of China in the next decade, making a bullish case for Chinese consumer-oriented sectors – especially E-commerce.
How Bond Defaults Are Changing China’s Markets (Bloomberg Markets Odd Lots, 20 min listen) Jun Pan, Professor of Finance at Jiao Tong University, has a flair for insightful communication and is an expert researcher of Chinese corporate bond markets. In a recent paper she analyses whether the spreads in China’s corporate bonds appropriately reflect the risk in companies.
• China’s corporate bond market (locally and USD denominated) went from nonexistant to $3tril in the last ten years. Market traded debt vs bank loans in 2008 was 4.6%; it was 19% in 2018.
• Professor Jun explains simply the Merton model for credit risk and shows how no link to fundamental of the companies to risk in credit spread was found due to implicit government guarantees, which has changed recently.
• The credit market can be summarized in three phases: 1 pre-default; 2 post-defult up to 2018, where the spread between state-owned and private companies was still 20bps; post-2018, where spreads widenend significantly and one state-owned enterprise in Tianjin proposed a 64% haircut for bond investors in what could amount to the first de facto default by an SOE in more than two decades.
Why does this matter? Chinese bond markets are opening up and becoming increasingly friendly to international investors. Future developments on regulations and fungible funding between SOE and non-SOE companies (to be reflected via difference in credit spread) can provide an excellent opportunity to participate in real Chinese growth. In a world of low yield, Chinese corporate bond sector provides a diversified source of alpha.
Long-Term Investment Theme: the Energy Transition (UBS On Air, 18 min listen) UBS energy experts analyse long term investment themes around energy transition and the opportunities it presents for investors.
• Energy demand is rising and stems from population growth and increasing global urbanization rates (especially in emerging markets).
• Demand for renewable energy is outpacing that for non-renewable because people see this as a way to reduce global warming. Meanwhile, a number of governments are also set to reduce CO2 emissions.
• Technological advancement has made renewables like solar and wind cheaper. Despite this, total transition from non-renewable energy is still unfeasible within the next decade due to its current size (annual sales of the fossil fuel sector are about $4.5 trillion) and the cost of global infrastructure replacement.
• The experts are still bullish on fossil fuel companies but only those which are readily incorporating ESG consideration, taking steps to reduce emission, and investing in renewable sectors.
Why does this matter? ESG investing and the green revolution around the world is creating major head winds and negative sentiment for the traditional energy sector. Transitioning energy companies with a mix of ESG and fossil fuel provides a good investment opportunity. The energy sector has gone from 13% weight in S&P in 2010 to 3% in 2019, but is set for a turnaround.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
For access to our Slack Chat Room, where we discuss all things markets with our researchers and subscribers