European Weekly Outlook

From Goldman's Ben Broadbent. Apparently the weather in Chiswick was not sufficiently balmy for your regularly scheduled update.

Good morning.

The coming week sees the release of key monthly business confidence indicators in the Euro area – the Ifo is released on Friday, the French INSEE and flash PMIs on Thursday – but the key event is the publication by the Council of European Banking Supervisors of the banking stress tests (also out on Friday).

The significant rise in banks funding costs since the spring hasn’t come out of nowhere. As we explained in the last European Weekly Analyst, some of the biggest moves in banks’ CDS spreads occurred on days in which there was significant fiscal news. This suggests that the sovereign debt crisis has been a significant contributor. The link goes beyond a simple “mark-to-market” impact on banks’ capital. Taking account of declining yields in core countries, the aggregate value of banks’ holdings of sovereign debt has actually gone up slightly this year. But it does mean that, whatever the impact of the stress tests, the credibility of the sovereign bailout fund (the European Financial Stability Facility) is still critical for preventing a renewed tightening in financial conditions across the continent.

That said – whatever the underlying trigger for the sell-off – the deterioration in sentiment about the banks in aggregate has almost certainly been amplified by a lack of trust within the system, polluting investors’ ability to distinguish the good from the bad. It is this distrust that the stress tests are designed to address and our equity analysts are confident that, in this respect at least, it will succeed:

This is from their latest report:

“Overall, we believe the stress tests should be positive for our European banks coverage, as it is likely to bring

1) Pressure to consolidate smaller, more fragile institutions;

2) Recapitalization of select institutions (although this depends on the parameters used);

3) Additional disclosure on key exposures (including sovereign debt), a key element to reduce contagion risk and boost confidence;

4) Reaffirmed clarity on the strength of the large listed institutions (including the major Spanish banks).”

What recapitalisation might be required? A back-of-the-envelope calculation in our own EWA suggests that a 3% hit to the level of GDP (said to be one of the parameters in the test) would increase aggregate loan losses by around 0.7% of balance sheets (€175bn for the Eurozone banks in total). But only if additional losses pushed its capital ratio below a certain threshold – press reports have suggested 6% Tier 1 – would any individual bank be required to raise more capital, whether from the market or its government. Our analysts conclude that substantial, system-wide  recapitalisations are therefore unlikely. But, as we argue in the EWA, it’s really the bank-by-bank aspect of the tests, not their aggregate results, that matters.

Finally, returning to the data, the UK is slightly out of synch with the rest of Europe next week – Markit doesn’t yet publish “flash” PMIs for the UK, and the main release is the preliminary estimate of Q2 GDP, also next Friday. The surveys suggests something quite a bit stronger than this (more like 0.9%) – and it’s worth noting that, on average, the last four prints have already been revised up by an average of 0.2% pts (with, we suspect, more to come) – but the hard output data available so far suggests the ONS will publish 0.6% or 0.7% for the quarter.

Ben Broadbent

Comments

[aint no fortuna...]

or maybe he took a well deserved trip to a detox