Estimates from the IMF suggest that banks, predominantly in Europe, will reduce their balance sheets by just under US$4 trillion over the next two to three years . The main factors driving this de-leveraging are not just the regulatory requirements to increase capital and boost liquidity buffers but also the weak economic environment that has led to a declining trend in credit demand and financial transactions.
The key questions for investors are, firstly, what the economic impact of deleveraging will be, secondly, how will it affect investment returns and, finally, how asset allocation might change. Hedge funds will want to know whether there will be opportunities to purchase loan portfolios from banks while real estate, infrastructure and private equity funds will be interested in opportunities to buy more illiquid longer-term assets.
After the recovery in OECD demand and growth in 2009, the last year has seen a deceleration in activity in most major economies with purchasing managers indices (PMIs) either close to 50 or below 50 – in other words, in recessionary territory. There are currently three areas of deleveraging affecting the global economy; consumer deleveraging with savings being rebuilt and consumer borrowings reduced; government deleveraging where fiscal deficits were unsustainable and bank deleveraging.
It is difficult to quantify precisely the negative economic impact of bank deleveraging. But, clearly, where the process is rapid, a negative reinforcing cycle is created in which banks reduce their balance sheets, leading to a downturn in economic activity which, in turn, results in an increase in non-performing loans and leads to further stress on bank liquidity and solvency. Although surveys of lending standards have seen some recent improvement in the US, the weakest banking systems are clearly in the stressed countries in Southern Europe with PMIs in Italy, Spain and Greece close to 40.
The related credit downgrades of banks is reflected in the high level of their Credit Default Swap (CDS) spreads, low P/E and P/B ratios for bank equity and the persistence of the trend for spreads on bonds issued by financial companies to be significantly higher than those for industrials. While the process of deleveraging persists, central banks will be forced to maintain near-zero interest rate policies and, as shown by their elevated balance sheets, to continue to inject significant volumes of liquidity into markets.
One result of this pressure on the banking system has been an on-going change in investor behaviour with a clear switch in asset allocation into corporate bonds, including an element of high yield, and into emerging market debt. Arguably, the low level of G4 (US, UK, Euro Zone and Japan) bond yields reflects not only investor risk aversion to the stressed sovereign bond markets in Europe but also a reduced allocation to bank risk. Given the high level of corporate liquidity, reasonable free cash flows and the low level of corporate debt, the focus will remain on corporate rather than bank risk, and financial spreads are likely to remain higher than industrials for at least another two to three years. As investors look to pick up yield in the corporate sector, there has also been a steady flow of capital into higher-dividend equity sectors such as healthcare and energy and into defensive sectors such as utilities and consumer staples.
A number of hedge funds have stated their intention to either set up new funds focused on buying assets from the banking sector or to expand the activities of their existing funds to do so. The hedge fund industry currently has assets under management of approximately US$ 2.2 trillion and, although performance has been mixed over the past five years, there is a high probability that assets could exceed US$3 trillion by 2014. Most models analysing conditions for hedge fund investment imply that, in contrast to 2007-08, current market conditions should support a sustained period of performance with hedge funds increasingly being treated as an integral part of fixed income and equity allocations rather than a separate asset class.
Over the last five years, high yield bonds have outperformed the leveraged loan market so the loan market is arguably undervalued at present relative to high yield, implying that hedge funds are most likely to seek out loans to purchase. The major caveat to this is the need to reach to a pricing level acceptable to both the banks and the hedge funds. Clearly, at present, banks are unwilling to sell at distressed prices which would mean crystallizing losses relative to book values.
While over the next couple of years investors might acquire credit portfolios being sold off by European banks, over the longer-term pension funds, sovereign wealth funds, endowments, insurance companies and family offices are also set to increase asset allocation to longer-term illiquid assets, most notably in infrastructure, real estate and private equity. Optimisation models show that a 10– 20% portfolio diversification into real estate improves portfolio risk/reward. Although certain Asian real estate markets showed stretched valuations, in real estate yields in Europe and the US are attractive relative to fixed income returns while offering limited downside risk.
Although infrastructure spending will be most pronounced in emerging markets over the next three years, in Europe there will be demand for transport assets, particularly in the rail supply market. There have been a number of examples, over the past year, of banks disposing of infrastructure assets, notably in transport leasing, and the next few years should see an upturn in the launch of infrastructure funds with the limited partners predominantly being pension and sovereign funds.
Bob Parker is a Senior Advisor at Credit Suisse. He is a Member of Credit Suisse’s Investment Committee. He also has responsibility globally for the management and development of new business and client relationships for Credit Suisse’s Asset Management business.