Higher corporate indebtedness and slowing GDP growth pose cyclical risk for European banks. Some are more vulnerable than others.
Climbing debt and deteriorating credit quality for U.S. companies has become a major theme among investors over the past year. Could the corporate credit cycle in Europe also be cause for concern?
While corporate indebtedness in most regions in Europe has recently come down in absolute terms, total corporate debt as a percentage of gross domestic product teeters above 100%, vs. 90% around the time of the 2008 financial crisis.
Corporate Indebtedness Has Been Declining
in Aggregate but Is Higher vs. Pre-Crisis
Higher levels of corporate leverage, coupled with all-time low financing costs, add up to uncharted territory for European banks. While this new terrain may mean added risk for some areas of the European banking sector, it may also mean opportunities for well-positioned investors.
“The majority of corporate funding in Europe is still done via long-term loans and debt, with banks as the largest underwriter and source of funding," says Magdalena Stoklosa, Head of Research for European Banks and Diversified Financials. “Roughly half of credit exposure sits on bank balance sheets."
Total Credit Risk: Across Loan and Debt
Approx. Half of Credit Exposure Sits on Bank Balance Sheets
(By counterparty, left, and by issuer, right)
In a recent report from Morgan Stanley Research, Stoklosa and her colleagues examine what the full impact of a deteriorating credit cycle could mean for European bank earnings over the next three years.
On the positive, banks have been de-risking their balance sheets over the past three years via capital raises, resolutions, low credit growth and high savings growth. And while total bank exposure to corporates is up 7% since 2013, in aggregate terms, more leverage has moved to corporate bonds, intra-industry financing and private credit.
“At the same time, however, depressed profitability and low interest rates make earnings per share very sensitive to any slight changes in the credit cycle," she says. “The next two years will serve as a test of how improved balance sheets stand up against an economic down cycle in Europe."
Broadly speaking, consensus earnings estimates for 2020 may contain a 6% downside risk, with a great deal of variability within Europe, both in terms of geographic and sector exposure. The banks most at risk have concentrated exposure to export-driven and manufacturing heavy economies, including Germany, Italy, Belgium and the Netherlands.
Banks best positioned to weather the downturn are either globally diversified or focused on services-driven economies, such as in France and Spain. Despite a general economic slowdown, the consumer looks resilient and consumer debt remains tame.
As it stands, no major cracks have surfaced in what is now a nine-year-old credit cycle in Europe. But, with corporate costs of financing at an all-time low across bank loans—and economic growth slowing—there is little room for error. This is true of nonfinancial companies that have come to rely too heavily on easy money, and it's true for banks, whose margins may be pinched by any increase in funding costs.
Although defaults in European credit remain low, more selective funding markets are likely to weigh on the weak tails, resulting in rising default rates. One indicator of potential trouble to come, the distressed ratio—the proportion of bonds trading with a spread above 1,000 basis points—has risen over the past year from about 1% to nearly 5%.
To truly get a handle on credit risk, however, investors need to look at the idiosyncrasies of each market. Morgan Stanley economists are forecasting a 1% year-over-year slowdown for Europe's overall GDP growth—but that masks what is happening at a country level. “Our biggest concern is a diverging GDP growth cycle in Europe," Stoklosa says.
With that in mind, Stoklosa and her team scored European banks on five factors: overall exposure to countries and sectors they view as higher risk, growth in corporate lending since 2016, banks' positions within their own credit cycles, preprovision profitability and current asset quality.
The banks most vulnerable to a change in the credit cycle have concentrated operations in countries with slowing economic growth and sectors that are most exposed to rising rates, such as telecoms, utilities, autos, pharmaceuticals, as well as the household and personal products and food, beverage and tobacco sectors.
Investors need to tread carefully, but recognize that diverging outlooks may mean heightened risk in some areas of the European banking sector, and possible opportunities in others. “We do not foresee an indiscriminate turn in our 2019 base case," Stoklosa says. “Instead, we believe that the market will retest the weaker links within the European credit universe."