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Banks to undergo more and tougher stress tests

Clogging up the newswires more than ever these days are the views of all and sundry regarding the necessity for European banks to be urgently recapitalised. Europe’s politicians also appear (somewhat belatedly) to recognise this as an imperative – the FT reported yesterday that EU finance ministers are looking at ways of undertaking a substantial recapitalisation in a coordinated fashion. International leaders have been pleading with European leaders for weeks to resolve this issue and finally the message seems to be getting through.

Even Angela Merkel seems to be coming around, intimating for the first time yesterday that the EFSF could be used for this purpose. Especially sensible were the observations made by the IMF’s European department head, Antonio Borges. He claimed that EU banks might need up to EUR 200bln of fresh capital, was encouraged that European leaders were now working on this and he suggested that a European resolution authority should be established to end the inter-relationship between bank balance sheets and sovereigns.

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Quite apart from the question of whether bank recapitalisation will be the panacea for Europe’s ills, there is also the critical question of where the money will come from. Europe’s politicians may prefer that it comes from the private sector, but amidst enormous uncertainties on both sides of the balance sheet of many of Europe’s larger banks, this will be no easy task, despite the fact that the cost of providing that capital has already fallen substantially. Investors would presumably require greater assurance on both the valuation of bank assets and the stability of funding before stumping up more capital. The ECB can help with the latter, while the former will probably require credible asset write-downs. According to today’s FT, the European Banking Authority (EBA) has already commenced a new round of stress tests which is expected to incorporate much more realistic markdowns for peripheral European sovereign debt. This is a very welcome development. If the private sector does not come to the party, then governments would be on the hook, as the revamped EFSF is taking longer to set up than initially expected. For many governments already carrying high debt loads and facing huge fiscal challenges, funnelling more public cash into dodgy banks will prove extremely difficult politically. European bank recapitalisation is a necessary but not a sufficient requirement for eurozone stability.


The depressing UK economy. There are a plethora of details to be digested in the latest UK GDP data, not least given that it coincided with annual revisions.   The upshot of these revisions is that the recession was deeper but shorter than previous thought, the peak-to-trough contraction now 7.1% vs. the previous estimate of 6.4%. This peak-to-trough decline is now deeper than that experienced by Germany, which was hit hard by the collapse in world trade in late 2008 and early 2009. The revisions to the more recent quarters’ data mean that the economy has essentially stagnated over the past nine months. In Q2 itself, household consumption collapsed once again; in the first half of 2011, household spending removed nearly 1% from headline GDP growth overall. It was only the positive contribution from government spending that allowed the economy to keep its head above water in the 2nd quarter. As such, this GDP data merely underlines the fact that the UK economy is facing some severe headwinds at the moment, headwinds which are hitting household spending particularly hard.   Current conditions in the labour market, combined with the government’s determination to continue with its fiscal consolidation plans, mean that these impediments will continue. For today’s MPC meeting, things still hang in the balance. Whilst there remains a statistical tendency for the MPC to move in inflation report months (around half of interest rate changes), this does not preclude moves outside this window when events warrant. The issue is that these latest revisions do bring in fresh questions about not only where the economy is going, but also where it has been. This could well mean that the MPC want to put this into context and crunch the numbers ahead of next month’s meeting and inflation report where more measures to support the economy are more likely to be announced.

Inflation relief may be on the way. In the midst of this maelstrom of pervasive negativity, finding a shaft of light and encouragement is an invidious task. Many major economies are poised to re-enter recession, the single currency’s future looks decidedly shaky and there are justifiable question marks over whether major banks in Europe are sufficiently capitalised. Households are deleveraging, at a time when real incomes are either stagnating or declining. However, amidst this generalised global financial suffering, there might be some relief at hand. With aggregate demand slowing markedly in recent months, prices for many raw materials have fallen significantly: 1) Brent crude fell below USD 100 a barrel briefly Tuesday, down 20% from the highs achieved in April, while West Texas dropped to USD 75 a barrel, a decline of one-third in less than six months; 2)  The copper price has collapsed, down more than 30% in two months; 3) Aluminium has dropped 22% since the end of April; 4) Wheat prices plummeted 19% last month, down 38% since peaking in February; 5) Corn prices plunged 24% last month. Some of the major retailers are cognisant that cost pressures are easing somewhat. In the UK, Tesco announced two weeks ago that it was launching a major discounting campaign focused on essentials such as milk, fruit and vegetables. An attempt to stimulate flagging demand against the backdrop of financially-constrained shoppers is clearly another incentive for retailers to discount so aggressively. As always, it takes a little time for these lower raw materials prices to feed through into final goods prices. However, consumers ravaged by declining real incomes over the past couple of years will welcome any relief once it starts to come through. At a time of much collective misery, it would be at least one crumb of comfort.

The stumbling US labour market. Given large layoffs at Bank of America and in the military, the 91K increase in private sector jobs reported by ADP Employer Services for September was actually fairly respectable. It follows an 89K increase in the previous month and suggests that the US labour market continues to tread water. In August, private sector payrolls (according to the BLS survey) rose by just 17K. Separately, Challenger reported that layoff announcements spiked 212% YoY last month, with 70% of the layoffs accounted for by BofA and the military. It may not be great news, but at the same time it does not suggest the economy is falling back into recession.

Something to smile about in Portugal. An underlying assumption made by many investors and traders is that once Greece defaults, Portugal will be the next in line. For those who hold to this view, it is a relatively easy case to make – Portugal is a zero growth economy with a government debt-to-GDP ratio expected to reach 100% by the end of the year. However, the government of Prime Minister Pedro Passos Coelho has implemented a stringent fiscal austerity program, in order to comply with the conditions of the EUR 78bln bailout provided by the EU and the IMF. Portugal is likely to remain in recession both this year and next in response to these higher taxes and reduced government spending. Interestingly, investors may just be warming to the progress being made in Lisbon. Last month, the IMF claimed that Portugal may achieve a primary budget surplus (excluding interest charges) of 3% of GDP next year. According to Bloomberg, some investors in a puttable seven-year note have just decided that they are prepared to remain invested, rather than demand repayment. For PM Coelho, it is a welcome reward for his efforts thus far.

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