Financials

Last year's sharp tightening in financial conditions is wreaking havoc on the S&P capital markets index. Capital formation has dried up, and the persistent erosion in economic expectations, as measured by the total return ratio of stocks-to-bonds (S/B), warns of little chance for an imminent recovery. The chart shows that new stock issuance is probing the low end of the range, while M&A activity is cooling quickly. The S/B ratio provides a good indication of investor risk appetites, and the current message is that risk tolerance is ebbing. That will constrain the availability of capital, and dent fees for capital markets firms. Tack on historically low trading volumes, and profit prospects darken another notch. Against this backdrop, the only way to preserve profitability is through massive cost cutting, see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5CAPM - GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM. (Part I) Capital Markets: From Bad To Worse (Part I) Capital Markets: From Bad To Worse

Gold seems to be leading global share prices. Gold prices have rolled over since March 10. Hence, odds are that the U.S. dollar is about to bottom, and that global and EM stocks, as well as commodities prices, are about to relapse. We recommend two new trades in central Europe: Go long central European banks / short euro area banks and buy 10-year Polish domestic bonds.

The ultimate driver of bank profitability is loan growth. A brighter economic backdrop in the U.S. compared with both the euro area and Japan paints a rosier picture for relative credit growth opportunities (third panel). Already, bank credit growth in the U.S. is outpacing Japan and the euro area (top panel). This divergence has staying power, given that the U.S. economic expansion is becoming self-reinforcing, while the export-dependent euro area and Japan remain fragile. While loan volume generation is a key profit center for banks, loan pricing is equally important. On this front, negative interest rate policy (NIRP) in both the euro area and Japan are worrisome. NIRP puts an interest rate floor on deposit taking institutions that are reluctant to pass negative deposit rates onto their customers. Concurrently, NIRP forces banks to lend out new money, or roll over existing loans, at declining interest rates. This is especially constraining in the euro area periphery where mortgage lending is financed at the very short-end of the curve. The end result is a net interest margin squeeze (bottom panel). Meanwhile, each country is in a different phase of its credit cycle. U.S. and Japanese NPLs are probing multi-year lows, whereas euro area NPLs are very elevated (second panel). Tight labor markets in both the U.S. and Japan argue for a continuation of the downtrend in NPLs, although the rise in corporate bond spreads suggests that business loans are more at risk. The euro area's double-digit unemployment rate warns that NPLs will sap European bank profitability for a while longer. Bottom Line: U.S. financials are the best of a bad lot, while euro area and Japanese financials will continue to struggle to keep pace with broad market returns. For additional information on global financials please refer to the March 18 Global Alpha Sector Strategy report titled "Happy Days?". (Part III) What To Do With Global Financials? (Part III) What To Do With Global Financials?

Bank stocks comprise the bulk of financials indexes' market cap weights in the G3 (U.S., Euro Area and Japan). Thus, bank profit growth should largely define each region's financials sector earnings path, and by extension, relative performance. The top panel of the chart shows that the euro area and Japan have massive banking sectors as a percentage of GDP, especially compared with the U.S. Bank deleveraging is ongoing in the euro area, as banks continue to retrench from emerging markets and because of domestic economic slack. Sustained asset shedding in Europe is inherently negative for bank profitability, at least in the near-term, as bankers simultaneously become more conservative and reluctant to extend credit. Moreover, bank leverage ratios are stretched in Japan and in the euro area versus the U.S. (second panel). In other words, the equity capital cushion remains insufficient in the euro area and in Japan to absorb a local or global credit shock. U.S. banks are well capitalized following the Great Recession TARP recapitalization, but euro area banks continue to be plagued by ongoing and extremely dilutive equity capital raisings. Worrisomely, despite sporting higher leverage ratios, both Japanese and euro area financials ROEs trail the U.S. by a wide and rising margin (bottom panel). Steeply diverging regional ROEs should continue to drive a relative rerating of U.S. financials versus both euro area and Japanese financials (see the bottom panel of the previous Insight). Meanwhile, diverging credit and economic growth profiles, NIMs and NPLs, all favor U.S. versus both European and Japanese financials (please see the next Insight). (Part II) What To Do With Global Financials? (Part II) What To Do With Global Financials?

While relative financials stock returns tend to be highly correlated across regions, especially in the developed world (top panel), extremely divergent monetary policy developments and operating metrics suggest that these long-standing tight correlations are destined to loosen. Thus, Global Alpha Sector Strategy has broken down global financials sector coverage into three geographies: U.S., Europe and Japan, following in the footsteps of our recent disentangling of global consumer discretionary coverage (see the March 17 Insights). In that light, the euro area and Japanese financials sectors are at a particularly acute disadvantage relative to the U.S., given diverging leverage, capital cushions and ROEs (please see the next Insight). (Part I) What To Do With Global Financials? (Part I) What To Do With Global Financials?

Chinese GDP growth may have picked up slightly in the first quarter, and growth numbers will likely continue to exceed expectations in the coming months. The market is overly bearish on China's earnings outlook, and may be on the verge of reassessment. Stay positive on H shares.

The Fed is unlikely to derail the housing recovery.
In this report we detail our structurally bullish U.S. housing view and how to profit from it.

There are a number of warning signs that the global and EM equity bounce is unsustainable. The latest episode of housing recovery in China will prove temporary due to still-large imbalances. Overweight Indian stocks: the credit cycle in India is less vulnerable compared to other EMs. However, the outlook for Indian equities in absolute terms is not bullish.

Both the demand for and availability of capital favors consumers over businesses, on the margin. The latest Fed senior loan officer survey showed that banks are tightening standards on C&I loans, the most rapidly growing component of bank assets. This reflects the broad-based deterioration in corporate sector balance sheet health. Conversely, willingness to extend consumer credit remains high. Previous deleveraging has vastly improved household balance sheets. Debt servicing payments are historically low as a share of income. Consumer spending is outpacing capital spending, which is driving a rise in personal loans relative to business credit. A narrowing yield curve has much more bearish implications for banks than it does for credit card companies, whose interest rate spreads are far less susceptible to yield curve swings. This is borne out in the tight inverse correlation between the yield curve and the share price ratio (bottom panel). Consequently, we recommend initiating a pair trade in the undervalued consumer finance/banks share price ratio. Please see yesterday's Weekly Report for more details. bca.uses_in_2016_03_22_002_c1 bca.uses_in_2016_03_22_002_c1

Consumer finance stocks have been among the worst financial sector performers in the last six months creating a negative divergence with bullish macro drivers. For instance, relative performance has far undershot the level implied by the decline in unemployment claims and the housing market (top panel). Household net worth has spiked back toward all-time highs as a share of disposable income courtesy of the recovery in financial markets and residential real estate value. Importantly, wages & salaries growth is robust, courtesy of U.S. dollar strength and the collapse in fuel prices, which should underpin consumer appetite for debt. Revolving consumer credit, a good proxy for credit card debt, has been growing at a pre-financial crisis clip since last autumn. That is a major change from the first few years after the crisis, when debt growth was extremely volatile, which created uncertainty about the sustainability of credit card company receivables growth, and capped valuations. A more stable outlook should translate into a higher multiple, all else equal. We recommend an overweight position, and a new long/short trade vs. banks, please see the next Insight. The ticker symbols for the stocks in this index are: AXP, COF, SYF, DFS, NAVI. bca.uses_in_2016_03_22_001_c1 bca.uses_in_2016_03_22_001_c1