Global Credit Research Update As of Second Quarter 2017 Market Commentary Global Credit Research Summary Perhaps the best way to describe the current global credit cycle is extended. While the exceptionally long period of global monetary policy accommodation is a primary driver of its extension, a marginally better operating environment for global banks and corporations over the past 12 months may be responsible for this latest leg of the cycle. As noted last quarter, we have observed evidence of synchronous growth across developed and emerging economies for the first time since 2010. During this period, improved earnings for financial and non-financial corporations have assuaged concerns regarding the vulnerability of the credit cycle as a result of a build-up in debt over the last several years. However, there have been conflicting signals as to whether synchronized growth will persist. While a stream of disappointing US data releases over the past couple of weeks, as well as a deceleration in Chinese growth data, have called into question estimates for above trend global growth in 2017, there are still many economists that believe global labor market strength and improved corporate profits will propel global consumption and investment in the second half of 2017. Further complicating the landscape is the current position of global monetary policy makers. Despite conflicting signals regarding economic growth momentum, low productivity growth, and subdued inflationary conditions, advanced economy central banks are decidedly more hawkish than they were 12 months ago. We find it reasonable to expect that the gradual and modest withdrawal of monetary accommodation would not materially impact the macro-growth trajectory or the fundamental credit cycle it may even improve the credit impulse from global banks and other finance companies. However, we can t discount the impact that global central bank asset purchases have had on debt capital markets, and the global cost of credit. If policy normalization remains on track, the US Federal Reserve will soon begin reducing the size of its balance sheet and the European Central Bank (ECB) will continue to taper its asset purchase program. While many market commentators feel confident that the supply-demand balance for credit products will not be materially impacted, we wonder if certain idiosyncratic risks will surface. For example, at present, the only significant buyers of Italian sovereign debt are Italian banks and the ECB (Citi Research Credit Products Strategist Presentation; 6/13/17). If the ECB ends its asset purchase program, will Italian sovereign spreads widen to the degree that it begins to have systemic market impacts? While European political risks have been mitigated thus far in 2017, the Italian political landscape is still fraught with the possibility of disruptive scenarios that could have systemic impacts, and the material devaluation of its sovereign debt could certainly trigger a series of negative events. Italian sovereign debt market dynamics is just one example to consider if we continue on an unprecedented monetary policy normalization cycle. To be sure, we would feel more positively about the strength of the global economy, and the global credit cycle, if it were sustained without excessive monetary policy accommodation. Further, we would feel more confident about sustainability through monetary policy normalization if there was assistance from global governmental policy makers. In particular, the Trump Administration s ability to legislate pro-growth tax reform and infrastructure programs, and the Chinese government s ability to manage a gradual economic transition without stunting growth, will be critical for the stability of global growth and the global credit cycle in the near term. These critical engines of global growth and credit performance have showed signs of slowing at the same time that monetary policy accommodation may be pared back. Global policies that could spur productivity gains, alongside deregulations and reforms, could go a long way towards combating the secular stagnation that has driven global central banks to be so accommodative since the global financial crisis. Financial Institutions United States While optimism in the US banking sector has remained in place over the course of the second quarter, the bloom is off the rose, in our view, as investors grapple with the potential for the administration to under-deliver on pro-growth policy initiatives. These slow and unpredictable political forces, which have been a drag on bank lending this year, are partially offset by momentum on interest rates as the Fed hiked 25bp in June and for the third time in six months. Despite the yield rate curve flattening since the start of the year banks remain particularly levered to rising short-term rates via their loan portfolios and slow deposit re-pricing. First quarter results for large US banks were some of the best reported in quite some time, in our view, as the impact of higher rates fed through the income statement. Asset quality remains benign despite emerging pockets of weakness in certain asset classes. We believe asset quality risk in the banking system is partially offset by fairly conservative post-crisis underwriting and regulatory standards. Nevertheless, we continue to expect higher provisions in 2017 as rates rise and net charge-offs normalize in the later stages of the credit cycle.
We previously spelled-out our views of potential avenues of deregulation. Recommendations that were proposed by Treasury Secretary Mnunchin in a June report are consistent with our view that deregulation will not comprise the safety and soundness of the financial system and present an opportunity to modify ineffective or overlapping rules. Moreover, the lion s share of deregulation will likely be addressed via changes in regulatory interpretation. While looser regulation is negative for bank creditors, it is consistent with the administration s focus on growth and reducing the burden on smaller banks. As indicated in results of the annual industry stress test, US banks maintain historically-elevated levels of capital which is likely to decline in future years as regulations are loosened. Europe European banks experienced a typical first quarter rebound. Modest 1Q17 profits were made possible by the preceding 4Q16 kitchen-sinking net losses. Apart from this seasonality; there was the emergence of some positive trends. This includes: improved investment banking client activity, the tailwind of normalizing US interest rates, and loan losses at cyclical lows. One of the year s largest sources of political risk dissipated in the quarter. As high-profile anti-euro candidates were defeated in the French presidential election. A number of capital increases (Deutsche Bank, Credit Suisse, and UniCredit) also contributed to the positive tone for creditors. While it occurred in the high yield space, several banks failures were notable this quarter. The market was well aware that these banks have been struggling to survive for years with excessive bad debt levels. Thus their failures caused no contagion. In Spain, Banco Popular was sold to Santander under resolution laws for one Euro. In Italy, two small banks in the Veneto region were put into insolvency. The government used payments and guarantees to persuade Intesa Sanpaolo to take-on certain assets & liabilities of the banks. The major similarities between the cases were that subordinated debt and equity holders were wiped-out. While senior debt and deposits were saved. Even under the new resolution regime, there is uncertainty and a wide range of outcomes for distressed banks (resolution laws vs local insolvency laws, state participation vs no state aid). The long-delayed clean-up of zombie banks is however positive for EU financial stability. Canada The Canadian economy has started the year on solid ground with momentum evident in retail, manufacturing and wholesale trade. However, domestic housing market concerns sprung up during the quarter as a large alternative lender, Home Capital Group (HCG), encountered financial challenges. Adding to this was a downgrade by Moody s of the major domestic banks. The situation at HCG was driven by fraud and exacerbated by a poor funding profile but was not systemic as the firm accounts for about 1.5% of the domestic mortgages (Wall Street Journal, Home Capital Group to Sell up to $1.1 Billion of Mortgages, 5/7/17). The downgrade of the major banks reflects well-known trends of rising household indebtedness. While we continue to monitor consumer trends and elevated home prices in Toronto and Vancouver, first quarter results proved resilient and evidenced stable asset quality metrics. Canadian Total Loss-Absorbing Capcity (TLAC) and bail-in rules were established in late June and we expect rules to be finalized later this year with an implementation date in 2018 (Office of Superintendent of Financial Institutions (OSFI) Canada, 6/16/17). The rules were broadly in-line with expectations with deposits, secured funding and unsecured funding issued under 400 days being exempt from bail-in. Unsecured debt issued prior to the implementation date will also be excluded. We look for banks to build up bail-in debt by refinancing legacy debt maturities through 2021. It remains to be seen how the rating agencies will react as lower government support is offset by a greater amounts of loss-absorbing debt. Moreover, for a period of time ratings may need to be bifurcated between TLAC eligible and non-tlac eligible debt. Australia The Australian economy continues to perform reasonably well and the unemployment has been trending lower. Similar to Canada, however, lingering concerns around home prices and household debt resulted in a one-notch downgrade late in the quarter across the major banks at Moody s (Moody s Investor Services; 6/19/17). The large banks have improved their underwriting standards in recent years, aided in part by macro prudential measures, and maintain very conservative portfolio Loan To Value (LTV) ratios. Still, there is a regulatory focus on interest-only and investor mortgages given the potential amplification of housing price cycles in a downturn. Although consumer trends remain closely monitored, any weakness to date has been modest and primarily concentrated in miningrelated states. The fundamental picture across the major Australian banks remains positive relative to global peers as higher returns and fairly stable asset quality has been partially offset by strained net interest margins. Capital levels have continued to improve and will likely rise further as Australian Prudential Regulation Authority (APRA) releases its plan to ensure unquestionably strong capital levels. However, one potential earnings drag going forward was the announcement in the Federal Budget of a levy on major banks. With respect to potential bail-in legislation, Australian regulators continue tread cautiously on the implementation of a resolution regime given the country s net external funding needs. 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Asia The operating environment remains relatively challenging, with low interest rates and intense competition continuing to pressure net interest margins (NIM) on lending activity and overall profitability. Fortunately, asset quality remains relatively benign, as recent sectors of weakness (oil and gas support) have shown stability. Going forward, NIM is expected to benefit from US interest rate increases and continued, albeir marginal, loan growth. The Asian banks on the Cash approval list hold large amounts of customer deposits, have a lower reliance on wholesale funding, high liquidity coverage ratios, and strong capital bases, which limit near term fundamental credit risk, despite the challenging operating environment. Chinese economic performance continues to have a significant impact on region. Over the last 6 to 8 months, policy makers in China have taken up tightening to manage financial stability risks. This has been broadly in three key forms tightening of monetary conditions via allowing the rise in interbank rates and stricter macro-prudential norms, restricting property purchases and slowing of on-budget fiscal spending growth. This has raised concerns that China will experience another episode of a material deceleration in growth, which would be sure to have a negative impact on the global economy and the region. However, there are some mitigants to this risk in the near term. First, global growth currently appears to have multiple engines, and as such regional economic performance should not be as dependent on Chinese growth as it has been in recent years. Second, while Chinese public sector investment has slowed, it is currently being offset by acceleration in the private sector investment cycle, including the continuance of property market growth, despite the tightening of property purchase restrictions. (Morgan Stanley Research: Will Tightening in China Challenge the Synchronous Global Recovery?, 5/7/17). Structured Finance Asset-Backed Securities (ABS) US Asset Type (in millions) Q2 2017 Q2 2016 Δ% Credit Cards $ 28.3 $ 15.0 88.7 Autos 48.0 48.2-0.4 Student Loans 7.3 5.6 30.4 Equipment 5.9 5.5 7.3 Floorplan 6.0 4.3 39.5 Other 19.7 11.8 66.9 Total $ 115.2 $ 90.4 27.4 The US ABS market is wrapping up a relatively strong 1H17. The year-to-date $115 bn of supply was the second highest half-year total in the past decade. New issues were readily absorbed by investors and generally well oversubscribed. Furthermore, spreads across most ABS sectors stand tighter now than at beginning of the year, and near post-crisis tights. US Consumer ABS Spreads to LIBOR As of 6/30/16 As of 6/22/17 52 week Δ 2 Yr AAA Auto 28 14 (-)14 2 Yr AAA Credit Card 25 9 (-)16 Source: Citi Research; Securitized Products; 6/22/17. From a fundamental credit perspective, performance trends continue to be within expectations. Collateral losses across credit card and student loan ABS remain at benign levels, while deterioration in subprime auto and unsecured consumer loan continues. Recently, Moody s reported a notable increase in (aggregate) US credit card charge-off rates in 1Q17, relative to the previous quarter (4Q16). While it was the largest QoQ increase since 2009, industry charge-offs remain below historical averages for nearly all regular ABS issues (Moody s Investor Services, ABS Spotlight, 6/20/17). For auto ABS sectors, while modest deterioration in credit performance is expected to continue in the year ahead, the current situation is far from distressed. For sure, we expect to see friction in the subprime auto lending sector, and there has already been some industry consolidation. We think there is probably more damage and headline risk to come, but we expect the issuers on State Street Global Advisors (SSGA) Cash approval list to perform well through this credit cycle. Further, ABS structures are well thought out, historically tested and well-protect bondholders from credit impairment, in our view. Some evidence of the strength of this structural protection can be seen in recent credit rating agency actions in the sector. Despite deterioration in loan credit performance, credit rating upgrades (for Moody s, S&P, and Fitch) in the subprime auto sector have remained very steady with 176 upgrades in 2017 so far, compared to 427 in full-year 2016. The prime auto loan ABS sector has also seen steady upgrades with 80 so far in 2017. Should loan pool performance worsen further, we will likely see the pace of credit rating upgrades in the auto ABS sector slow, but we would not expect downgrades in the near term for upper-tier ABS issuers (JP Morgan: Global Securitized Products Research: Assetbacked Securities, 6/16/17). Source: JPM BAS Weekly Volume Data Sheet; 6/23/17. State Street Global Advisors 3
Corporate / Industrial Global Corporate leverage has fallen in both Europe and in the US from record levels due to a modest recovery in earnings and a slowing in debt accumulation. However, with debt funding still cheap versus equity, shareholder support and a decent growth outlook all providing an incentive to borrow, debt accumulation could certainly resume on an expansionary trend in coming quarters. In Europe, in particular, the bulk of the corporate universe has barely lifted net debt from the cyclical lows, leaving some room for balance sheet flexibility. We will continue to monitor as to whether any rise in debt is offset by a cyclical rise in earnings, as further debt accumulation at a time where leverage is relatively high, raises the risk of a corporate downturn longer-term, when the earnings cycle eventually turns negative again. Regional commentary: US Investment Grade corporate credit metrics have stabilized after several years of deterioration. Improving revenue and operating profit growth is being aided by a slowly improving economy, stability in commodity prices, a weaker USD, synergies from prior M&A and slowly rising inflation. Of particular note, and encouragement, was the aggregate revenue growth, which was the largest in 11 quarters. That said corporate leverage remains high by historical standards and interest coverage continue to deteriorate (JP Morgan Global Credit Research, The global Credit Cycle.Stretching it, 6/22/17). European Investment Grade the European economy has finally begun to grow at an encouraging level, with GDP growth accelerating to a 2.5% QoQ SAAR pace in 2Q17. This has translated into improving credit metrics, with earnings growing at the fastest pace since 2012. As is the case in the US, leverage remains relatively high from a historical perspective (despite lower relative levels of corporate debt), which is limiting the room for corporates to engage in aggressive shareholder-friendly actions such as acquisitions or share buybacks (Citi Research: An invincible rally with an Achilles heel; 6/13/17). Asian Investment Grade generally credit metrics have peaked with leverage gradually rising, especially for nonmanufacturers, though manufacturers are still cautious on re-leveraging activities. Manufacturers/exporters are still in relatively good financial health but increasingly sensitive to external factors such as currency strength (in the case of Japan), geopolitics and trade friction. Chinese economic activity will continue to be the driver of regional sentiment and performance, and while growth has been relatively strong thus far in 2017, the impact of deleveraging given the authorities attempts to rein-in the shadow banking sector, will likely weaken the Chinese growth rate during the second half of the year (JP Morgan Global Credit Research, The global Credit Cycle.Stretching it, 6/22/17). State Street Global Advisors 4
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Hong Kong: State Street Global Advisors Asia Limited, 68/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. T: +852 2103 0288. F: +852 2103 0200. Ireland: State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered Number: 145221. Member of the Irish Association of Investment Managers. T: +353 (0)1 776 3000. F: +353 (0)1 776 3300. Italy: State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano) is a branch of State Street Global Advisors Limited, a company registered in the UK, authorized and regulated by the Financial Conduct Authority (FCA ), with a capital of GBP 71 650 000.00, and whose registered office is at 20 Churchill Place, London E14 5HJ. State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano), is registered in Italy with company number 06353340968 - R.E.A. 1887090 and VAT number 06353340968 and whose office is at Via dei Bossi, 4-20121 Milano, Italy. T: 39 02 32066 100. F: 39 02 32066 155. Japan: State Street Global Advisors (Japan) Co., Ltd., Toranomon Hills Mori Tower 25F 1-23-1 Toranomon, Minato-ku, Tokyo 105-6325 Japan. T: +81 3 4530 7380. Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #345), Membership: Japan Investment Advisers Association, The Investment Trust Association, Japan, Japan Securities Dealers Association. Netherlands: State Street Global Advisors Netherlands, Apollo Building, 7th floor Herikerbergweg 29 1101 CN Amsterdam, Netherlands. T: 31 20 7181701. SSGA Netherlands is a branch office of State Street Global Advisors Limited. 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United States: State Street Global Advisors, One Lincoln Street, Boston, MA 02111-2900. T: +1 617 786 3000. The views expressed in this material are the views of Peter Hajjar/Global Credit Research through the period ended 6/29/2017 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Information represented in this piece does not constitute legal, tax, or investment advice. Investors should consult their legal, tax, and financial advisors before making any financial decisions. Investing involves risk including the risk of loss of principal. Trademarks and services marks referenced herein are the property of their respective owners. State Street Global Advisors 2017 State Street Corporation. All Rights Reserved. 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