Category: Money Moves Markets

British banks’ profits should rise strongly over 2010-12 as impairment charges fall, suggesting that tax-payers will gain from their stakes in Lloyds Banking Group, the Royal Bank of Scotland (RBS), Northern Rock and Bradford & Bingley lending.

British banks in aggregate lost £2 billion in 2009, according to recently-released annual results. Underlying net income rose to a record £51 billion – the prior peak was £42 billion in 2007 – but was outweighed by impairment charges of £53 billion*.

Impairments, however, fell by 19% between the first and second halves and should continue to decline steadily – assuming no “double-dip” recession. Guidance about their trajectory is provided by bad debt experience in the early 1980s and early 1990s, associated with the 1979-81 and 1990-91 recessions. Impairments totalled 4.7% of “assets at risk” over the five years 1982-86 and 7.1% over 1989-1993.  The first chart shows projections based on losses over 2008-2012 falling within this range – low real interest rates suggest that higher numbers are unlikely. From £53 billion in 2009, impairments are forecast to fall to £30-40 billion in 2010, £15-32 billion in 2011 and £8-25 billion in 2012.

On the conservative assumption of no further increase in underlying net income from its 2009 level of £51 billion, this would imply a recovery in profits after charges to £11-22 billion in 2010, £19-36 billion in 2011 and £26-43 billion in 2012. In other words, profits could surpass their 2007 peak of £31 billion as early as 2011 – second chart.

Lloyds and RBS lost a combined £13 billion last year, with underlying net income of £27 billion offset by £40 billion of impairments. If charges fall in line with the industry average, and the underlying surplus is stable, the two banks could earn profits of £8-21 billion in 2012. Taking the mid-range figure of £14.5 billion and applying a corporation tax rate of 28% and a price/earnings ratio of 10, the equity of the two banks could be valued at about £104 billion in 2012, up from £65 billion at Friday’s close. (The P/E of UK banks averaged 10.8 between 1965 and 2009, according to Thomson Datastream.) Assuming no change in equity outstanding, this would be consistent with share prices of 96 pence for Lloyds and 71 pence for RBS versus 60p and 44p respectively on Friday, implying a paper profit on tax-payers’ stakes of about £25 billion. (The National Audit Office has estimated average in-prices of 50p for RBS and 74p for Lloyds, with each 10 pence increase boosting the value of the stakes by £9 billion and £3 billion respectively.)

* These numbers cover the main high-street banking groups: Santander UK, Barclays, Bradford & Bingley lending, HSBC Bank (the UK subsidiary of HSBC), Lloyds Banking Group, Northern Rock and RBS.

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AUTHOR: lavorare da casa
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DATE: 09/04/2010 12:19:39 PM

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Markets pay undue attention to the monthly US payroll numbers, which are at best a coincident economic indicator and are often revised heavily.

The latest figures show a rise in private sector employment of 235,000 in the three months to August, down from 450,000 in the prior three months. Such a slowdown was to be expected given a fall in GDP growth from 3.7% annualised in the first quarter to 1.6% in the second.

Commentators were relieved that private jobs continued to increase in August, by 67,000, with some having feared a contraction, signalling the dreaded “double dip”. In fact, such an increase is perfectly compatible with the economy having entered a recession last month, allowing for lags and the usual margin of error. The news content of today’s release, therefore, is minimal.

Monetary trends, unlike labour market developments, lead demand and output, typically by about six months. A firmer reason for optimism that the economy will avoid a double dip is a recent stabilisation and pick-up in real M1 growth – see first chart.

In other news today, the UK purchasing managers’ services survey for August confirmed the message of slowdown delivered by the earlier manufacturing survey. A weighted average of the new orders / business indices from the surveys suggests a fall in GDP growth to about 0.5% in the current quarter from a break-neck 1.2% in the second quarter – second chart. This is hardly grounds for MPC doves to push the “panic” button, particularly as survey inflation indicators remain elevated.

Posts since the spring have suggested a defensive investment stance on equities and other “risk” assets, for two reasons. First, the annual growth rate of G7 real narrow money, M1, fell beneath that of industrial output in February (firm data available in early April). Historically, equities have underperformed cash on average under this condition, while outperforming significantly when real M1 has outpaced output.

Secondly, the US monetary base started to contract in early 2010 – markets have exhibited a lagged correlation with base fluctuations since the Federal Reserve embarked on “QE1” in late 2008. The fall in equities from April followed a decline in the US monetary base from late February while the slide in markets during August may have been a lagged response to Eurozone base weakness from early July – see first chart.

Both factors, however, may now be improving at the margin.

The six-month increase in G7 real M1 has recovered recently, with a move above slowing industrial output expansion possible in August – second chart. A convergence of annual growth rates, however, is unlikely before late 2010 – a “safety-first” strategy would be to wait for this signal before turning more bullish.

The US and Eurozone monetary bases, meanwhile, appear to be stabilising after their declines. Central banks are likely to maintain an ample liquidity supply in the near term given jittery markets and “double-dip” worries, with a rise in the US base possible if the Fed moves to “QE2” or asks the Treasury to suspend the supplementary financing programme (which has effectively sterilised the reserves impact of $200 billion of Fed securities purchases). Again, however, it may be advisable to await such steps before abandoning caution.

Chinese monetary base developments may also be relevant: annual growth has been strengthening, in contrast to a slowdown in the M2 and M1 money supply measures – third chart. Interestingly, the Chinese domestic “A” share market has outperformed global equities recently: the FTSE / Xinhau China “A” all-share index rose by 4.1% during August versus a 4.7% decline in the S&P 500.

Bank of England Governor Mervyn King and other MPC members continue to claim that the current inflation overshoot reflects transitory factors including the weak exchange rate and higher global energy prices, while underlying inflationary pressures are weak. This is not supported by a national-accounts-based measure of domestic inflation.

The “implied deflator for gross value added at basic prices” measures the domestic cost – in terms of wages, profits and rents – of producing a unit of output. It excludes, by construction, indirect taxes and import prices, including the cost of imported energy and other commodity inputs. The GVA deflator rose by 2.5% in the year to the second quarter and by an annualised 3.2% in the latest six months. 

These numbers probably understate domestic inflationary pressures because the GVA deflator implicitly assumes that the recent VAT rise was passed on in full to buyers of goods and services. In practice, part of the increase will have been absorbed by suppliers in the form of lower wages, profits or rents. The deflator for GDP at market prices – which adds in indirect taxes – rose by an annual 4.1% in the second quarter. Assuming 50% pass-through of indirect tax changes, the annual GVA deflator rise would have been 3.3% rather than 2.5% in the second quarter if VAT and other rates had remained stable (i.e. the average of 2.5% and 4.1%).

The annual increase in consumer prices has averaged 0.6 percentage points less than that of the GVA deflator since the MPC’s inception in 1997 (i.e. 1.8% versus 2.4%). This shortfall, however, partly reflects falling import costs in the late 1990s and early 2000s due to globalisation and sterling strength. With import prices now adding to, rather than subtracting from, domestic pressures, a rise in the GVA deflator of 2.5% per annum or more is likely to imply a continued overshoot of the 2% CPI inflation target. 

Key UK money supply measures were unchanged in July but have grown at a faster pace since early 2010, supporting hopes of a continued economic recovery. Corporate liquidity, in particular, has improved further. Unusually, households failed to expand their money holdings last month, probably reflecting a combination of low interest credited, an ongoing switch into mutual funds and use of spare cash to repay borrowing.

• Broad money (i.e. M4 holdings of households, private non-financial corporations and financial corporations excluding intermediaries) stagnated in July but has still grown at solid annualised rates of 5.6% and 5.9% over the last three and six months respectively.

• Narrow money M1, comprising currency and overnight deposits, was also unchanged but has grown by 8.3% annualised over the last three months and by 7.6% over the last year. M1 is universally ignored by economists but is usually a better leading indicator than broad money: it contracted as the economy entered a recession but recovered strongly in mid 2009 ahead of the current GDP upswing – see first chart.

• Within broad money, non-financial companies’ holdings rose by 0.9% in July, pushing annual growth up to 4.0%. Excluding the troubled real estate sector, the corporate liquidity ratio (i.e. bank deposits divided by bank borrowing) is at the top of its historical range, suggesting a continued recovery in business spending – second chart.

• Very unusually, households’ broad money holdings were unchanged in July – the only previous month since 1997 when they failed to expand was October 2008, when financial stability concerns led to a flood of cash out of banks and building societies into Treasury bills, gilts and national savings instruments. (Monthly statistics begin in 1997; quarterly figures going back to 1963 have never recorded a fall.) There has been no such “safe-haven” flow recently but households have been switching into mutual funds, net retail sales of which totalled £2.1 billion in June (July figures are due next week). In addition, interest credited to accounts has slumped in line with deposit rates, while higher lending / deposit spreads may be encouraging some borrowers to use any spare cash to repay debt.

• There was broad demand for gilts in July, with banks, foreign investors and private non-banks buying respectively £4.8 billion, £5.6 billion and £6.7 billion. Banks have increased their holdings by £25.7 billion since “QE” was suspended in January.  

US deflation fears have been fanned by a fall in annual core CPI inflation – excluding food and energy – to 0.9%, the lowest since 1966. The decline, however, from 2.4% when the recession started in December 2007 is entirely explained by the “shelter” component. Excluding shelter, core inflation was an annual 2.0% versus 1.9% in December 2007 – see chart.

Shelter has a 42% weight in the core CPI while 78% of the shelter component is accounted for by “owners’ equivalent rent” (OER) – statisticians’ estimate of what homeowners would pay if they rented their properties. OER inflation has fallen from an annual 2.8% in December 2007 to -0.2% by July. To repeat, no consumer actually pays OER.

OER inflation tends to follow house price inflation with a lag. The 12-month rate of change of the Case-Shiller 20-city house price index has recovered from a trough of -19% in January 2009 to 5% by May this year. OER has started rising recently, with a 0.7% annualised gain in the three months to July. Allowing for the normal lag, this recovery may be sustained over the remainder of 2010, putting upward pressure on core inflation.

The consensus interpretation is that US core inflation, unlike its UK counterpart, has been responsive to a large negative “output gap”. The rise in the core ex. shelter measure since the beginning of the recession casts doubt on this view. Even in the US, it seems that the disinflationary impact of economic slack has been small and offset by other factors, including “QE”, via its effects on the exchange rate and inflationary expectations. 

Posts earlier in the year argued that global economic momentum would fade in the second half in lagged response to narrow money supply weakness in late 2009 and early 2010. A slowdown would also be consistent with the typical cyclical pattern, involving strong stocks-led growth in the first year of a recovery followed by a “resting phase” before a sustained upswing driven by final demand.

The US Institute for Supply Management (ISM) manufacturing new orders index is a useful summary measure of global industrial momentum. A chart presented in a post in June suggested that this index, then at a recovery peak of 66, would fall back to the break-even 50 level over the summer. An update is provided in the first chart below – ISM new orders dropped to 53 in July and this week’s regional manufacturing surveys by the New York and Philadelphia Federal Reserve Banks suggest a further decline in August.

If the index continues to follow the “five-cycle average”, it may stabilise at around the 50 level before restrengthening in early 2011. It would need to fall to 45 or below to signal a recession. Sub-45 readings have historically been preceded by a significant contraction in US real narrow money but this has expanded recently – second chart. A further indication that the ISM measure may be approaching a trough is a small rise this month in the Philadephia Fed future orders index (in contrast to the decline its current orders measure) – third chart.

The latest public finances numbers remain consistent with a substantial undershoot of the Office for Budget Responsibility (OBR) forecast of net borrowing of £149 billion in 2010-11 (excluding the temporary impact of financial interventions).

Attempting to adjust for seasonal factors, borrowing averaged about £12 billion in the first four months of the fiscal year, or £144 billion annualised – see chart. The OBR forecast, therefore, implies a worsening over the remainder of 2010-11.

This is unlikely because, first, the benefits of economic recovery should grow as the year progresses and, secondly, the coalition has announced £8.1 billion of spending cuts and tax rises in 2010-11, most of which has yet to take effect. Put differently, even assuming no further impact from an improving economy, these measures together with the recent run-rate imply borrowing of £136 billion this year (i.e. £144 billion minus £8 billion), £13 billion less than the OBR’s forecast.

The evolving undershoot increases doubts about the wisdom of the coming VAT rise – projected to raise £2.9 billion and £12.1 billion in 2010-11 and 2011-12 respectively. This increase threatens to weaken the economic recovery and was not strictly necessary to meet the new fiscal target of current budget balance by the end of the parliament, even according to the OBR’s June forecast.

The fall in annual consumer price inflation from 3.2% in June to 3.1% in July reflected a larger decline in the “core” rate – excluding energy, food, alcohol and tobacco – from 3.1% to 2.6%, offset by a rise in food inflation from 1.7% to 3.0%. The core number was a favourable surprise but the impact on the near-term inflation outlook is offset by the likelihood that food price rises will remain stronger than previously expected, given recent increases in raw commodity costs.

Incorporating today’s figures, CPI inflation is projected to ease back below 3.0% over coming months before moving up to this level again in early 2011 as the standard VAT rate is raised to 20% – see chart. This implies that Bank of England Governor Mervyn King may avoid having to write a fourth explanatory letter to the Chancellor this year. The VAT hike is expected to boost annual inflation because consumer-facing companies are expected to pass on a greater proportion of the 2.5 percentage point increase than for the identical rise in January 2010, partly because the latter was a reversal of a previous cut.

The Bank of England’s modal forecast in the August Inflation Report is similar to the profile shown in the chart until next spring but the Bank then expects a sustained decline to below the 2% target in 2012. This is partly explained by the mechanical effect of the VAT rise dropping out of the annual comparison but the Bank is also assuming a significant fall in core inflation as a lagged consequence of the large-scale spare capacity it believes was created during the recession. The view here remains that the Bank is overplaying the excess capacity argument – the “output gap” is probably no greater than 2% of GDP – while core inflation will be underpinned by a continuing economic recovery, further upward pressure on import prices (barring a strong rebound in sterling) and an upward drift of inflationary expectations resulting from the current prolonged overshoot.

US equities, and “risk assets” generally, remain unusually sensitive to Federal Reserve liquidity operations – a relationship established after the Fed embarked on “QE1” in late 2008.

Stock markets began to fall in late April, 8-9 weeks after a peak in the US monetary base (i.e. currency in circulation plus banks’ reserves at the Fed), while the rally starting in early July similarly followed a trough in the base 8-9 weeks before in early May – see chart.

After an initially strong recovery, however, the monetary base drifted lower again during June and July, creating a “negative divergence” with a further rally in stocks. Equities buckled last week, after the Fed disappointed hopes of an immediate move to “QE2”, involving an expansion of its securities portfolio financed by further monetary base creation. (Instead, it plans to stabilise its portfolio by reinvesting maturing principal in Treasuries.)

With the monetary base moving sideways recently, equities may similiarly remain within the range spanned by the July low and last week’s high until the next Fed meeting scheduled for 21 September.

Aside from embracing “QE2”, the Fed could boost the monetary base by asking the Treasury to suspend the “supplementary financing programme” (SFP), under which it has effectively sterilised $200 billion of the Fed’s “QE1” by issuing additional Treasury bills. The Fed used the SFP to drain liquidity this spring and may prefer this less-public method of providing support to markets and the economy, should “double-dip” worries intensify.