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Mark R. Kiesel
Uncertainty leads to rising risk aversion and fear, but it can also lead to opportunity. Financial markets are focused on the European sovereign debt crisis, growing political and policy risks and a slowdown in global economic momentum. At the same time, a dark cloud of heightened regulation overhangs the global banking industry while the market awaits the release of the European bank stress test results in mid-July. Naturally, investors have lost some confidence in risk assets and in banks due to a lack of clarity surrounding peripheral Europe, global banking regulations and the world economy.
We believe the probability of a near-term default in Greece has increased due to many factors. Greece has high debt levels and lacks sufficient growth, and is also facing bank deposit outflows, credit tightening, deep austerity, rising social unrest and challenging political realities. Greece lacks fiscal union with the EU despite sharing a currency and monetary union with the rest of Europe; this makes policy coordination a challenge and deep austerity measures difficult to enforce. The country’s inability to devalue its currency or set independent monetary policy means Greece can’t regain competitiveness, grow fast enough to service its high debt burden or inflate it away. Fundamentally, Greece has a solvency problem and not a liquidity issue. Although a Greek default and restructuring is likely just a matter of time given these dynamics, the potential spillover into the overall global economy varies dramatically.
The opportunity in today’s market is to distinguish between the strong and the weak in an uncertain world where most investors tend to go from “risk on” to “risk off” with relatively limited differentiation. We prefer to take risk in areas we believe have high expected risk-adjusted returns and avoid risk in areas with low expected risk-adjusted returns. In addition to Greek and sovereign debt concerns, heightened macro and regulatory uncertainty is putting pressure on global banks, creating opportunities for investors willing to do their homework.
Several members of PIMCO’s global credit team specializing in banks and financials recently traveled with me to New York for on-site due diligence meetings with CEOs, CFOs, treasurers and senior executives at several U.S. banks and specialty financial firms. Our meetings reinforced our conviction that today’s dark clouds may give way to clearer skies, particularly if the economy regains momentum and Greek and European sovereign concerns ease during the second half of this year. This could not only improve most risk assets but also shine sunlight on select banks that appear positioned to benefit from a gradually improving outlook. Despite near-term uncertainty, we believe credit investments in many banks, and in particular U.S. banks, should outperform various investment alternatives in fixed income (e.g., mortgages, municipals, non-financial investment grade corporate bonds, high yield corporate bonds and emerging corporate bonds) over a longer-term secular horizon due to deleveraging and stronger global banking regulations.
Banks in the New NormalInvestors in global banks and financials face two simple realities over the next several years. First, economic growth in the developed world will likely be below trend due to continued deleveraging of stressed public and private sector balance sheets. Second, global banking regulators are likely to make banks and financial institutions safer by requiring more capital and liquidity buffers.
The combination of subpar economic growth and heightened regulation suggest most entities (e.g., the government, consumers and banks) in the developed world will continue deleveraging. Given this environment, which PIMCO has referred to as the New Normal, it is not surprising in the U.S. that bank lending (and demand for loans) has been and remains weak (chart 1). Nevertheless, the secular journey of deleveraging banks’ balance sheets in developed economies, while a headwind for economic growth, should lead to improving credit trends and fundamentals for bondholders.
Global banks can meet higher capital requirements through retained earnings, restricting and limiting dividends and stock buybacks, asset divestitures or equity infusions. Higher capital buffers under Basel III will likely be the main driver of lower return on equity (ROE) as banks are required to build more equity cushion:
Return on Equity = Return on Assets * Assets / Equity
Global banks vary dramatically in their asset quality and ability to meet Basel III capital requirements over time. As a result, we believe financial markets will continue to reward the strongest and safest banks and penalize the weakest and riskiest banks. Re-regulation will only act to accelerate this trend through improving transparency and accountability.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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