AT1s – Don’t write down the asset class.
The write-down of Credit Suisse subordinated bonds triggered a volatile week for AT1s. The market quickly re-priced the whole asset class, with subordinated debt of European banks under pressure. Over the week, the subordinated CDS index widened 60 bp, and AT1 lost 3-6 points across major European banks. Equities are now more than 15% lower than the peak in early March.
Overall, we see the recent price action unjustified and the current market juncture as a great opportunity on the asset class. European banks are solid, liquid and well capitalized. Average CET1 capital for major systemic banks is 14%, and liquidity coverage ratios are 160%, on average. The write-down of Credit Suisse AT1 was possible only thanks to specific features of the prospectus, unique to the Swiss banking system and not shared by European counterparts. In fact, the ECB promptly clarified a very clear view of the capital structure order in Europe. Both fundamentals and the legal framework thus suggest the moves are largely overdone.
Good fundamentals stand in stark contrast to stressed valuations. AT1 of major European banks now offer in excess of 15% yield-to-call, and 8-9% yield to perpetuity. In other words, the market does not expect most subordinated bonds to be called at the first window, despite high reset spreads. T2 and senior debt offer, respectively, 220 and 115 basis points in spreads, close to the 5y highs, despite strong capital buffers. European banks equities trade, on average, at 70% of their tangible book value.
Overall, we see the recent volatility episode as a byproduct of the banking fears originated from US regional banks, with a non-existent read-across for European banks as a whole. While the same applies for Credit Suisse, the latter was already suffering a wave of deposit outflow, and market action exacerbated panic, which led to the actions taken by regulators over last weekend. Major, systemic European banks are liquid, capitalized, and aren’t suffering deposit outflows. Any market attempt to price stress should be seen by medium term investors as a great opportunity across the capital structure.
Fed – Closer to the end.
The Fed hiked rates last week by 25bp to the 4.75-5% range, and thereby followed the ECB with hiking despite the recent banking sector turmoil. Yet, Powell surprised market with dovish guidance and made us think the end of the cycle is near. The statement read that “additional policy firming may be appropriate”, a downshift from previous guidance that “ongoing hikes will be appropriate”.
Further, Powell confirmed that the tightening of lending standards by US regional banks is likely to affect economic outcomes going forward, and compared this to the equivalent of one or two hikes. This balances out very strong economic data since early February, which on its own would have warranted a more hawkish stance.
As a result, the 2023 dot was left unchanged at 5.1% (against expectations for a rise), signalling just one more hike from here and no cuts until year end. The 2024 dot was raised by 0.2% to 4.3%, thereby implying only 80bps of cuts next year. Markets see a 50% chance for one last hike in May but are pricing cuts worth 75bps from May-peak to the December meeting.
US data – Credit conditions point South.
Tighter financial conditions will play a crucial part in slowing down the US economy faster than anticipated and raise the odds for a “hard landing”. 38% of all loans outstanding in the US are issued by small and medium-sized banks, whereby for consumer loans it’s 48% and in commercial real estate even 67%.
As US regional banks shore up liquidity to ensure they hold enough cash to meet deposit requests, lending standards have tightening strongly overnight and thereby delivered “one hike, or two”, as estimated by Powell last week. US yield curves have steepened strongly as a result of the 2Y yield falling quickly, something that usually happens as we enter a recession already and markets expect cuts soon.
The US 2-10Y yield spread jumped from record lows -110bp to -46bp currently, while the Bloomberg US recession probability forecast is unchanged at around 60% for the year ahead. Consensus forecasts see quarterly GDP growth at -0.4% in Q2-23 and -0.1% in Q3-23, which meets the technical definition of a recession but is nowhere near the pessimistic hard landing scenario that’s being priced. The Fed lowered their annual GDP growth estimates by 0.1% to 0.4% in 2023, and by 0.4% to 1.2% in 2024, which is in line with a growth slowdown, but not a hard landing.
We think market pricing is too extreme currently, in particular the Fed cuts from the June meeting onwards.
Algebris Investments’ Global Credit Team
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