Following a continued weak 2011, the banking sector has been reinvigorated by an unexpected year end gift from the ECB through its first long-term (3 year) re-financing operation (LTRO). With unlimited funding on offer, European banks' liquidity constraints, many of whom rely on wholesale markets for up to one third of their funding requirements, have dramatically eased. This has had two key effects culminating on easing pressure on forced asset selling: stabilizing balance sheets from near-term funding strains and loosening the contagion ties to sovereign debt related strains on bank liquidity and solvency. Access to long-term liquidity also eased knock-on effects of European bank Q3 and Q4 retrenching in other markets and activities. In response, global bank stocks have rallied and key indicators of liquidity, credit risk and inter-bank lending spreads are narrowing steadily. YTD, European banks are up 18%, US banks 11% and EM banks 17%, making both the direction and magnitude of performance noteworthy, at least since the beginning of this recent financial crisis.
In addition to the length of the LTRO, the structuring of the LTRO is noteworthy. While banks participating in the LTRO are nominally borrowing from the ECB, ultimate exposure to each bank is recorded on the home country central bank balance sheet, transferring ultimate risk to national taxpayers. Despite the ECB being guaranteed and funded via individual country central banks, this now explicit communication has rendered mute the incessant political and citizen bickering over shared responsibility for the others profligacy and related misdeeds. Simultaneously, growth in the ECB's balance sheet, which will likely exceed the Federal Reserve's, is optically manageable. Importantly, this action has partially disengaged the rollercoaster connection, enabling better discrimination among still plentiful utterings out of the still dysfunctional EU political process.
With improvements emerging on other front, where we go from here looks guardedly cheering. First, evidence of the nascent US recovery is comforting. This combined with low interest rates, modest inflation, below long-term average velocity of money, three years of savings re-build and low inventory levels is reassuring for continued the trend. Cynically, it is also an election year which should provide a more compliant political environment. Common themes from year end reporting for the large US banks showed an up tick in lending growth across all segments and downward trends in loan losses continuing. The coincidence of economic and loan growth is consistent, they are mutually reinforcing and rarely occur in isolation. Federal Reserve commitment to low short-term interest rates continues to support bank revenue trends which combined with renewed efforts to trim costs sustains earnings. Talk of dividends has more robust support, including solid capital ratios.
Consensus expectations for Europe are a 2012 first half recession. However, evidence of coordinated, rapidly imploding economies and banking systems has meaningfully diminished. With credibility rising for Spanish and Italian progress and discussions in Greece approaching their end-point, some mitigation of the economic decline seems plausible. While the risk of Greece exiting the Euro is still a possibility, the probability has diminished substantially. As indicative in the current rally, stocks hardest hit have sustained the best recovery. With capital raising still to be completed, prospects for successful completion are improving and the sector is in a better liquidity position.
In many respects some emerging markets were unexpectedly caught in the European cross-fire despite having limited direct exposure. Q3 weakness has reversed strongly. Larger EM economies such as India show promising renewal, though sustaining it will be key. Current risk from China is to the downside, but with trillions in reserves, so are the resources and proven intent towards a rapid solution. Amongst others, Indonesia, Malaysia and Peru offer solid opportunities.
As the global macro picture stabilizes, the year-to-date recovery in the banking sector shows sustainability. At such points, sector indices offer viable prospects for the generalist investor. The banking system can never be counted out - it remains one of the largest sectors, at the heart of the economy and thus, key to any economic recovery.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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