Spotlight on a trio of pitfalls – Economy



During this summer period, markets may be calmer and liquidity slightly less. However, we must remain vigilant and take the opportunity to address various pitfalls and potential risks. What events could disrupt financial stability? We consider the case where central banks withdraw their support. A rapid and uneven recovery A first danger could come from a disorderly and uneven recovery in growth. Economic recovery depends in part on the success rate of local immunization programs. The growth path towards narrowing output gaps will also depend on the priorities set by central banks and local governments. And there are growing signs that a synchronized global economic recovery will not be forthcoming. It is to be hoped then that central banks will curb asset purchase programs in a concerted manner, for if they choose to act independently of each other, reducing monetary support or tightening financial conditions on the basis of national economic indicators – especially inflation – this could do damage to the markets. Governments are faced with different situations. For example, countries where tourism, hard hit by the pandemic, constitutes a significant share of GDP will behave differently from countries heavily dependent on industrial exports. Yet the recovery in financial markets has been broad, propelling most players and sectors up, in both equities and credit. Stock valuations in hard-hit sectors are approaching their late-2019 levels, while credit spreads suggest an even more salient positive outlook as quantitative easing has sharply narrowed the differences between issuers. However, a lack of consultation between economic blocs (EU, USMCA, RCEP) could result in lower growth than what the current consensus predicts for 2022 and 2023, and divergent monetary and / or fiscal strategies could lead to a sudden interruption. market growth. (In) stability of the banking system A second problem could arise from the (in) stability of banking systems. Last week, all 23 US banks passed the Fed’s stress tests. They are able to withstand a severe global recession that would hit commercial real estate and corporate debt holders, peak unemployment of 10.8% and a 55% drop in the stock market. And while 50% of US banks posted a return on equity above 10% in Q4 2020, only 7% of European banks did! Europe has, like the United States, increased capital reserves since 2009. However, the lack of consistency of risk-weighting methodologies in the European banking sector, the absence of disintermediation by the market (which leads to large corporate loan books) and the sovereignty-bank-business link add complexity to the euro zone equation. The market forecasts an average return on equity of 3% at the end of 2021 and 6% in 2022 for euro area banks, as loan loss provisions are recovered. However, the allocation and migration between stage 1, 2 and 3 loans is the Achilles heel of these banks. In 2020, the migration of risks from stage 1 to stage 2 for the hospitality sector has increased fivefold, from 5% to 25%. Current estimates indicate that the stock of level 2 assets is expected to drop from 13% for the fourth quarter of 2020 to 17% by the end of 2021 across all euro area banks. This sector will have to be carefully monitored over the next two years and the level of banks’ credit spreads assessed against this situation. The procyclicality of funds A third problem is linked to the procyclicality of investment funds. Market-based funding has remained strong since summer 2020 and has returned to its pre-pandemic level of 20% of total external funding. However, in the second and third quarters of 2020, purchases by the official Eurosystem sector were roughly the same size as those of investment funds, insurance companies, pension funds and other financial institutions combined. . Imagine a scenario in which the ECB announces that it will reduce its support from the second quarter of 2022, when the pandemic emergency purchase program ends. Even if replaced by a strengthened purchasing program, European credit markets could experience a small episode of crisis. This could worsen if, in 2022, bank lending losses increase and as banks and investors pull out, strain increases on high yield bond spreads. In contrast, an orderly and modest hike in long-term rates would not be a problem.