Summer seasonality and the search for yield

- Overview: "Seasonal patterns may provide support for rates markets but current levels look unsustainably low unless the economy deteriorates markedly."
- "Elevated curvature in Euro and Sterling and still too high volatility in short expiry options provide opportunities to enhance returns without duration risk, in our view."
- US Rates Strategy: "As yields fall, speculation has risen as to the possibility of a further squeeze. We examine the tail scenario of a double dip and conclude that it is unlikely that we will see 10yr yields fall as low as Dec 08 levels."
- Euro Rates Strategy: "We examine the market impact of Solvency II and conclude that it is unlikely to show the aggregate position of EU insurers as being significantly under capitalised, if at all. It is unlikely to herald further significant shifts out of risk assets, but there may be some marginal shift in this direction. The likely impact on the vol market remains uncertain but should not be dramatic unless yield levels continue to fall sharply."
- "It seems to be only in 2012 that countries start to reduce their debt burdens. Portugal and Ireland look particularly vulnerable to an increase in yields. The countries reducing their average funding costs by the most over coming years are Germany, Finland and the Netherlands. 5y5y swap spreads in Spain and France look out of step with their fundamentals.""
- Sterling Rates Strategy: "Despite the improving fiscal outlook, we see little appeal in duration risk in the UK."
- "With policy rates likely to remain stable for an extended period, as fiscal tightening takes hold, short expiry gamma looks like a sell."
- APAC: "We remain bearish on JGB yields in the medium term but think risk aversion and cash balances could continue to provide near-term support."
- "In Australia, we retain our bias for paying the belly of a 2s-3s-5s butterfly. While in NZD we think hikes are too aggressively priced relative to the AUD market."
- Euro Supply Outlook for July: "Redemptions (€77bn) and coupons (€40bn) easily outweigh gross issuance (€69bn). This €48bn imbalance should put further downward pressure on yields. We identify the countries with the most and least supportive net cash requirements in July."
- Relative Value Analysis: "We highlight switch opportunities in the 6-8y and 30-yr areas of the Bund curve and in the 8-10yr sector of the DSL curve."
Citigroup International Interest Rate Strategist 20100701

Banking on Markets

- Challenging Macro Backdrop: "The combination of heightened European sovereign risk fears, the US 'flash crash', increased regulatory uncertainty and renewed deflationary concerns made for a tough backdrop for the capital markets business. While April was generally consistent with the 1Q10 strength, May presented challenging trading conditions, while client activity was subdued in June. This was highlighted in Barclays’ recent trading statement."
- FICC Trading Hit By Credit: "1Q10 was characterized by across-the-board strength, notably in credit trading and mortgages. However, a sharp widening in credit spreads from May is likely to have caught some players off-guard in credit trading. We believe that the global macro businesses - Rates & notably FX - are likely to have fared better, together with mortgages."
- Equities Impacted By Derivatives: "The combination of a spike in correlation and volatility together with a significant drop in dividend expectations is likely to have made for challenging conditions for the equity derivatives business. The cash equities and prime brokerage operations continue to be relatively lacklustre."
- WM operating leverage delayed: "Weak investor confidence and the low interest rate environment continue to pressure wealth management margins. Together with negative market performance in 2Q10, the positive operating leverage story for the wealth management business is likely to be delayed to 2011. Nonetheless, the business model continues to offer significant leverage to an upward shift in the yield curve, as highlighted in our recent report Swiss Banks – Feedback from Zurich Meetings (30 June 2010)."
- Estimate Changes: "To reflect the tougher operating environment for both investment banking (weaker capital markets) and wealth management (margin pressure and lower managed assets), we downgrade our 2011E EPS for Credit Suisse (-10%) and UBS (-10%). Following our more recent update (German Banking M&A, 6 May 2010), we have further trimmed our Deutsche Bank estimates (-5%). Our new target prices for CS (SFr55), Deutsche Bank (€53) and UBS (SFr19) reflect these lower earnings and a higher cost of equity."
- Preference for UBS and SocGen: "In our previous Banking on Markets: Upping the Regulatory Ante (20 April 2010), we downgraded our view on capital markets on the basis that 1Q10 FICC strength had largely been priced-in while regulatory concerns were likely to remain heightened through the US Senate debate. Although there is greater clarity on the regulatory front, we do not see any nearterm catalysts on the earnings front. Our preference remains for UBS driven by the ‘self-help’ story, as well as SocGen which should benefit from the turn in the corporate and international credit cycle."
Citigroup Banking on Markets 20100701

July 2010: Focus shifts to the US economy, yen strength

- "Pullback in European shares has been modest — In June, the S&P Global Equity Index retreated 3.6%. Emerging economies were down 0.7% and Europe was down 2.3%. In continental Europe, movements were minor: Germany was down 0.1%, France 1.1%, and Italy 0.8%, while Spain was up 0.2%."
- "Pullback in US equities sharpGermany and other eurozone countries benefit from euro weakness. Japan and the US were relatively big fallers in June, retracing 4.3% and 5.5%, respectively. We see the focal points on the equity market as moving to unease about the US economy and yen strength rather than the Greece crisis."
- "US long-term interest rate falling fast — It has fallen 1.06ppt, from 3.99% on April 5 to 2.93% on June 30. Japan’s long-term interest rate has fallen only to 1.09% from 1.38% over the same span, so the interest-rate gap between Japan and the US has narrowed 77bps, which we regard as one cause of yen strength and dollar weakness."
- "Downside to where? — TOPIX plunged to 811.01 at the time of the Dubai turmoil last November (down 16.9% from its high three months before). TOPIX is currently 15.8% off its April high. A break below 811.01 would mean no obvious targets for a bottom until the March 2009 low of 700.93."
- "Investment strategy — We expect the uptrend in share prices to continue. We highlight makers of consumer goods that stand to benefit from a rising renminbi. With the government emphasizing fiscal discipline, we think it could push deregulation in tourism, real estate, and telecoms as economic growth measures. Domestic-demand stocks are likely to benefit substantially."
- "Beneficiaries — We think beneficiaries of current trends include Sumitomo Realty & Development (real estate), a play on the Basic Urban Strategy Law, ANA and Central Japan Railway (transportation), likely beneficiaries of moves to nurture the tourism industry, Komatsu (machinery), a global infrastructure investment play, and Unicharm (toiletries), a core China-related name."
Citigroup Japan Portfolio Strategist 20100701

UK/Pan-European — Stress Busters

- Down: Leading indicators are rolling over and turning less positive. Fears of double-dipping global economy on the rise. Not our economists’ core view.
- Headwinds: Strong correlation between US ISM index and European earnings. ISM suggests earnings growth to moderate over the next 6 months. We agree.
- Groundhog day: 1st year of recovery = strong equity gains. 2nd year = the grind. Fears of China slowdown and equity weakness reminiscent of 2004.
- Risk off: Weaker macro has driven risk assets lower. Equities hit hard. 2Q10 was one of the worst quarters for equities vs bonds in the last 20 years.
- Defensive growth: Defensives = downside protection in falling markets. Growth = upside participation in rising markets. We still back defensive growth.
- Stress-busters: Earnings resilience since 2005 and strong forecast growth. BAT, SAB, Syngenta, Sodexo, Smith & Nephew, SAP, Inditex and Nestle feature.
Citigroup European Portfolio Strategist 20100701

US Rate & MBS Strategy

- "10-year yields are floored at 2.5%: We judge that 10-year yields are floored at 2.5% even in severe growth slowdown. Long-term inflation expectations will have to decline by 100 bp to get 10-year yields below 2%."
- "NFP Effect on UST: 100k NFP mismatch is worth 7.6bp in 10yr Treasuries."
- "Rates are a good hedge for stocks: Interest rate volatility is about 20% cheaper than equity index implied volatility to hedge the tail risk of lower equities."
- "Fed’s Back in Agency MBS, Convexity’s Not: The Fed's coupon swap operations should target 30yr production coupons. Convexity flows should remain light as the Fed (a non-hedger) owns the most negatively convex MBS."
- "Agency Debt: Choice of lockout on callable agencies is highly correlated to economists’ consensus forecast for the first Fed hike. We continue to recommend that investors extend options on callable agencies aside from the relative value argument to do so."
- "US Rate Strategy Model Portfolio: The portfolio is currently down 0.3% month-to-date."
Citigroup US Rate MBS Strategy Weekly 20100701


- Overview: "If China falls asleep?"
- ECB: managing liquidity: "Despite the EUR442 bn 12-month LTRO matured on the 1st of July, liquidity in the Eurosystem isstill above needs by more than EUR 130bn. The ECB injected EUR 243bn through a 3-month LTRO and a 6-day FTO. While short-term interest rates, therefore, are expected to remain moderate, given the amount of liquidity present in the system, tensions could appear on maturities longer than 3 months. The Security Market Program (SMP), under which the ECB is buying debt securities in the secondary market, has not yet reached its end and, given persistent tension in financial markets will probably be expanded further over the coming months."
- Eurozone: Fragile recovery and low inflationary pressures: "Buoyed by a strong rebound in industrial output, GDP growth probably accelerated in Q2 2010. Yet growth could ease in the coming quarters as persistently tough labour market conditions and fiscal consolidation measures adopted by several countries put a significant strain on domestic demand. Rising commodity prices and a weaker euro are driving up inflation, but there is no inflationary threat on the horizon. Shaped mainly by domestic forces, core inflation is expected to continue easing in the quarters ahead. With low inflationary pressures and a fragile recovery, the ECB will be in no hurry to raise the refi rate before 2012."

Bracing for the headwinds of financial stress

- "Last week we reported a significant deterioration of financial conditions in recent quarters based on an update of the USMPF FCI. This week we consider the implications for growth ahead, based on both a statistical analysis of the relationship between financial conditions and growth and a review of parallels and differences with developments during 2007 when financial conditions first began to deteriorate in this cycle."
- "While the statistical relationship between the FCI and subsequent GDP growth is not especially robust, it does show evidence of strengthening during times of financial stress. Based on our analysis, we conclude that to this point, the deterioration has probably knocked several tenths off GDP growth over the quarters ahead."
- "The damage will be limited if, as we expect, event risk in Europe recedes in the months ahead and financial conditions recover from much of their recent drop. But a further and more extended deterioration in financial conditions would pose significant downside risks to the outlook."
- "Even so, we see a double-dip recession as relatively unlikely at this juncture. Discretionary spending in the US has already been pushed to six-decade lows relative to GDP, and significant progress has already been made in mending private sector balance sheets."
DeutscheBank Global Economic Perspectives 20100630

A More Global GLI: Easing from Very High Levels

- "Our Global Leading Indicator (GLI) has become an essential part of our toolkit and
arguably the most critical indicator in our overall monitoring of the state of the cycle and
of cyclical assets. It has continued to guide us well through the deep and unusual events of the last two or three years."
- "The global economy has changed significantly since we first introduced the GLI in 2002, prompting us to revise it comprehensively in 2006. And, while the 2008-2009 crisis and recession proved an excellent ‘stress-test’ for the GLI, another four years on, we have once again improved both its components and underlying methodology, to better reflect the new global economic landscape. The improved GLI is now more global, better correlated with the industrial cycle and more stable."
- "Our improved GLI comes at a particularly important time for assessing the cycle. We
have been highlighting for some time now that the original GLI was indicating some slowing in momentum. The improved version shows this message more clearly, with a peak in the headline already visible. This suggests that the pace of industrial growth is set to decelerate, although from extremely high levels, an outcome that would be consistent with our GDP forecasts."
- "Markets are increasingly focused on what this kind of slowing in momentum will mean. Moderation in growth at this point in the cycle is generally consistent with lower but positive returns, rather than with significant negative returns. Although our US forecast is still firmly below consensus, our global forecast does not envisage a sharp slowdown. That said, we will continue to pay close attention to the incoming data on this front, starting with the new release of the GLI tomorrow."
GoldmanSachs Global Economics Weekly 20100630

EM Recommendations

- "So far in 2010, the emerging markets have done very well. The benchmarks for both hard- (EMBI) and local-currency bonds (GBI) posted positive returns; EMBI and GBI posted returns of 3.55% and 17.64% during the first four months of the year. We are still bullish about the asset class for the period ahead, but we admit that the ongoing turmoil in relation to Greece and the Exchange Rate Mechanism constitutes a risk for the Central and Eastern European countries in particular. So far, the emerging markets are relatively isolated from the Greek problems, since the public debt and budget deficit of the EM countries are generally much lower. There-fore, the EM countries are not as vulnerable as the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain). In the short term, there is a risk, however, the Central and Eastern Europe will underperform the other EM re-gions due to a higher sensitivity to the euro-zone problems. Provided that the cooperation be-tween Greece and the EU/IMF functions smoothly, we see no reason to reduce exposure to EM bonds. How-ever, investors who overweight Central and Eastern Europe may consider reducing their exposure to the bene-fit of other EM regions. The Greek tragedy is not the only risk factor for the emerging markets. Investors should take into account the many elections in the emerging markets, the possibility of further intervention in the market (like the 2% tax in Brazil and Colombia selling the peso) and the exit strategies from the very relaxed fiscal- and monetary policies pursued around the globe. This publication gives you an overview of our recom-mendations for local-currency bonds."
JyskeBank EM Recommendations 20100702

Subpar Pace of Recovery in 2010

- "We continue to anticipate subpar growth in 2010, with both the pace and composition of the expansion being very different than what we are used to or what we may wish. We are far from a sustainable growth trend in line with our historical experience. The expected pace of the expansion is characterized by real growth of 2.0 percent in the second half of 2010 with inflation (core PCE deflator) at just 1.2 percent (Figure 1). Positive contributions to growth will likely come from rising consumer spending, business investment—particularly equipment and software, and of course, federal spending. The problem remains that the recovery represents a different type of cycle with the added complication of atypical behavior among core sectors—especially consumer spending and housing."
- "Our forecast shows federal spending stimulus will continue to be applied in the second half of 2010 and will only gradually begin to slow as election-year imperatives take over. Hopes for a swift recovery continue to meet with disappointment due to housing and the slow growth in consumer spending relative to historical averages. For the United States the modest pace of expansion implies only slow improvement in the labor market with a persistently high unemployment rate."
- "The convergence process to a new economic equilibrium has been more difficult than policymakers estimated. Job growth has been limited. Credit growth has been restrained and the recovery in housing far less significant than promised by policy makers. Slow real economic growth will likely create political pressures in the fall as economic realities fall short of political rhetoric."
- "Finally, concerns remain about the long-run pace of growth in the economy as well as the ability of the recovery to sustain itself at a pace that meets the expectations of consumers and workers. It is not yet clear how much of the recent economic upturn can be sustained without government support over time."
Wells Fargo Special Commentary 20100701

G7: a fragile and somewhat unorthodox recovery

- "After three consecutive quarters of growth, and two in the UK due to the VAT hike, the revival of G7 economies is now confirmed. With varying degrees of recovery from one country to another, the upturn in demand is much stronger in the United States than Europe, and even more so in Japan. While there are marked discrepancies in household consumption and productive investment, the revival in foreign trade and stock replenishment is seen virtually across the board."
- "Yet this recovery remains fragile and somewhat unorthodox:
• It is fragile because there is continued fiscal stimulus to sustain household consumption in the United States (personal tax) and Japan (net transfers), while in most of Europe this stimulus (scrapping premiums) has now been exhausted.
• It is somewhat unorthodox in that the widespread revival in foreign trade is resisting the movements in real exchange rates and stocks are being replaced when anticipated demand remains frail. These paradoxes suggest that the recovery owes a lot to the financial conditions, following the example of the 2008 world recession."
- "Monetary stimulus is also proving effective. Beyond a few mildly encouraging signs in private investment, the fall in real rates has helped reduce US and Japanese household saving rates substantially due to wealth and substitution effects."
- "Lastly, while growth can no longer be sustained over the next few quarters due to the depleted fiscal stimulus, the ongoing monetary stimulus is helping to narrow the risk of a relapse in the G7, unless of course the situation is aggravated by contagious effects from the sovereign debt crisis."
Natixis Flash Economics 339 20100701

Reform of the Spanish labor market

- "Spain currently has the highest employment rate in the European Union and among OECD countries. The characteristics of the labor market, heavily focused in terms of collective and dual bargaining (highest level of temporary contracts in the eurozone) largely explain such a violent deterioration. In the absence of any agreement between management and labor (after some two years of discussions), the government has finally decided to take its own measures to make the labor market more flexible. Adopted by decree, these measures will subsequently be submitted to Parliament during the summer."
- "The reform’s major advances are its relaxation of derogations to company agreements and reduction in redundancy costs. Lastly, the reform takes one important step with its creation of an individual capitalization fund, based on the Austrian model."
- "After reviewing the position of Spain’s labor market, we present the main measures of the reform and end by providing a brief qualitative assessment of their effects."
- "We thus consider that while this reform was necessary and overdue, the main problem of Spain’s labor market is as much due to its lack of flexibility (traditional unemployment) as its underemployment of factors (Keynesian unemployment), hence economic growth."
Natixis Flash Economics 331 20100628

What questions arise about the developments in the International Monetary System?

- "Many uncertainties surround the developments in the International Monetary System:
• will the US trade deficit disappear or resurface? In the recent period, the renewed decline in the savings rate of US households - despite their wealth loss - has led to a fresh increase in the US external deficit;
• will the trade surpluses of many emerging countries disappear due to the rapid growth in these countries? If we put together the first two questions, will the "global disequilibria" persist, will they disappear, or will the US deficit perhaps be offset by surpluses in countries other than emerging countries (Europe, oil producers)? If the global deficits disappear, the generation of liquidity worldwide will be markedly reduced. If trade surpluses appear in other regions, what will be the consequences?
• will there be a transformation of the various currencies’ role as an international reserve currency? The euro is in trouble as a result of the sovereign debt crisis, the dollar due to the deterioration in the financial situation of households and the quality of the Federal Reserve’s balance sheet. Asia is becoming a more integrated economic and financial region; several emerging countries have solid economies; will there be a faster switch than expected to the currencies of certain emerging countries (Chinese RMB, Brazilian real)? However, the financial markets in these countries are insufficiently developed; could there be a return of the yen, the pound and the Swiss franc? Could there be an increased role for gold (end of "fiat money")?"
- "If there is an increase in the role of emerging-country currencies, the capital flows to these countries will cause them even greater problems than in the past."
Natixis Flash Economics 330 20100628

The issue of reducing the total debt ratio (public + private) in Europe

- "The analysis of excess indebtedness in Europe has recently focused on public debts, given the risk of sovereign defaults. However, we should not forget the risks linked to private debts - household and corporate - which, if they are excessive, may lead to a serious banking crisis. We therefore believe it is necessary to look at the risk linked to the total debt, public and private, something that changes the appreciation of the relative risk of different countries."
- "The outlook is worrying:
• the low nominal potential growth in many countries makes a reduction in debt ratios difficult;
• inflation cannot return soon, and real interest rates are relatively high, especially in countries attacked by the financial markets. There is therefore a very significant need to generate additional savings (primary surpluses in the case of public debts) to reduce debt ratios, leading to a pronounced slump in demand;
• defaults can in reality be ruled out, for countries as well as for banks, even though they are sometimes mentioned as a possibility."
- "So it is likely that the only solution will be a huge monetisation of both public and private debts, i.e. a transfer of risky debts to the balance sheets of the ECB and the Bank of England. We still have to analyse the effects of the considerable increase in liquidity (in the size of the balance sheet of the ECB and the Bank of England) which this massive monetisation would lead to; as well as the effects of the deterioration in the quality of these balance sheets."
Natixis Flash Economics 328 20100628

What happens if the money supply is linked to central bank purchases of assets whose value will drop?

- "Central banks (Federal Reserve, Bank of England, ECB) are now buying risky assets in order to restore liquidity in the markets for these assets and prevent defaults among economic agents. However, the prices of these assets may decline: this would mean that part of the money supply is not linked to the central bank’s holding of assets of an equivalent value. This amounts to a "helicopter money" situation: the central bank distributes money to economic agents ex nihilo. Conversely, central banks may in certain cases make capital gains on the purchased assets."
- "We look at the effects of "helicopter money". If its quantity is substantial and if economic agents spend it on goods and services, it can lead to inflation (except if the elasticity of the supply of goods to demand is perfect). If economic agents spend it by purchasing assets, there will be an asset price bubble; if they keep it in the form of money, nothing happens, which is the case currently."
Natixis Flash Economics 327 20100625

Should the euro zone abandon everything that makes a currency area appealing in order to survive?

- "The sovereign debt crisis in the euro zone seems to have resulted in the following developments:
• strengthening of budgetary rules;
• pressure for countries to reduce their macroeconomic imbalances - or what is now perceived as macroeconomic imbalances: external deficit, growth in indebtedness, loss of competitiveness."
- "Some of these developments are quite desirable: replacement of the Stability Pact by
budgetary rules regarding fiscal deficits at the top of the cycle which countries are complying with; correction of overruns in the countries’ growth models: excess private indebtedness, excessive growth in construction, asset price bubbles."
- "However, it is important not to prevent the implementation of mechanisms that create
additional well-being linked to monetary unification:
• savings have to circulate freely and head to countries where they are most efficient; a currency area between countries that force each other to balance their trade balances has no appeal; countries must therefore accept that their savings finance investments in the other countries - provided that these are useful investments;
• monetary unification enables productive specialisation; all euro-zone countries cannot (should not) be industrial countries, and they should specialise according to their comparative advantages. This means that cost-competitiveness does not play the same role everywhere, that it is normal for euro-zone countries to have either external surpluses or deficits; and that they have different long-term growth rates."
Natixis Flash Economics 326 20100624

Situations leading to multiple equilibria must be prevented in the future

- "An economy may be in a situation of multiple equilibria (generally double) if a favourable equilibrium and an unfavourable equilibrium can exist, both perfectly consistent, and if the economy can jump from one equilibrium to the other merely because of a change in expectations."
- "In the recent period we have thus seen the situation of countries where:
• private-sector indebtedness is linked to wealth (United States, United Kingdom, Spain for example); if asset prices (particularly real estate) are expected to rise, indebtedness increases, and this actually pushes up asset prices; if the expectation of asset prices reverses, the increase in indebtedness stops and asset prices actually decline;
• debt is largely in foreign currencies (Hungary for example); if the country’s exchange rate is expected to be stable, there can be a high debt ratio without any difficulty; if the country’s exchange rate is expected to depreciate, it is also expected that borrowers in foreign currencies will be in trouble and that the country will be in a crisis, resulting in capital outflows that actually cause an exchangerate depreciation and a crisis;
• the public debt is very high (we take the examples of Greece, Portugal, Italy and Belgium); if fiscal solvency in the country is expected, interest rates remain low and fiscal solvency is actually ensured; if a fiscal solvency crisis is expected, interest rates on the public debt rise, and the country actually becomes insolvent."
Natixis Flash Economics 325 20100624

Thinking ‘outside the box’ on economic policy

- "The markets are currently imposing on Europe a more brutal tightening of fiscal policy earlier than expected. But that does not mean that the two other constraints have disappeared: central banks should normalise the settings of their monetary policy as soon as conditions are met, while there is a ‘strong obligation’ to maintain a certain level of growth. How this can be done is not at all clear, and there are fears that the markets will find it difficult to extract themselves from this new ‘Bermuda Triangle’ – not forgetting that the triangle can easily shift from one place to another within the region formed by the advanced countries."
- "Recent European experience shows that the management of fiscal policy appears to be a more complicated issue than previously thought: how is the decision made when to cut off stimulus and start coming back to fiscal discipline? Cutting it off too soon is taking the risk of the economy plunging into a new downturn; letting it run for too long could build more investor fears and create a hard landing scenario. Defining the main risk between Scylla and Charybdis is never easy. Perhaps the choice should depend on the importance of both private domestic savings and the ability to attract foreign capital."
- "The decision of the ECB to purchase government bonds on the secondary market has triggered a debate about the impact on its credibility. The latter would be reduced because of too close proximity to the behaviour of governments. From an academic standpoint, a distinction has to be made between an environment of high inflation or of very limited inflation. In the face of high inflation, often related to excessive monetisation of government debt, a central bank’s independence is its cardinal virtue; if very limited inflation is associated with weak growth and fiscal austerity, greater co-operation between the central bank and the government is more easily understandable."
- "The link between the sovereign debt crisis and banking crisis has been borne out historically. However, the aim of the rescue plan for member states from the European Union, with IMF support, no doubt changes the nature of that link. In fact, the plan is designed to head off for a period (almost two years in the case of Greece) the emergence of liquidity
risk for the Greek Treasury, with the breathing space gained being devoted to reducing solvency risk via credible public account rebalancing plans. For a short time, therefore, the plan staves off the transfer of risk from the sovereign to the banking sector. It is, in fact, a sort of ‘mutualisation’ of risk between sovereigns: from the weaker to the healthier. In this respect, it is probably not entirely legitimate to link the two types of risk so strongly."
CreditAgricole Macro Prospects 2010Q3

Stress testing the French banks

- "Trimming target prices by c12% on average after our comprehensive stress test. Although valuations have become more attractive in recent weeks, we believe caution is still de rigueur, given uncertain market and economic conditions and the sovereign crisis. We have conducted a comprehensive stress test on French banks to measure their ability to withstand a deteriorating environment. We are cutting our target prices by c12% on average and reducing our EPS forecasts by single digits over 2010E–12E. We also provide our Q2 forecasts in this report."
- "We stress test 2012E TE, earnings and solvency for eight risks, (hopefully) encompassing all of investors’ main concerns: sovereign risk, market-related revenues, banks tax, Basel III, funding cost, asset quality, toxic assets and loan growth. In total, we estimate that French banks’ solvency in our stress test would drop 3.4pp to 6.0% in 2012E proforma, equivalent to a hit to capital of about €60bn. The sector’s earnings would nearly halve to €12bn, and the TE would drop 14% to €135bn."
- "Under this scenario, only BNPP would have an ET1 above 7%, and Natixis would be close at 6.5%. Both CA and SG would have significant capital deficits versus an ET1 ratio target of 7% (€11bn and €6.6bn, respectively). While our stress test suggests the gap might have to be bridged by a rights issue, we note that a phasing and possible wateringdown of new regulation proposals could help CA and SG build more capital than we actually model in our stress test, therefore reducing the need for fresh capital. That said, BNPP and Natixis too would likely build more capital, which they could redeploy via buy-backs or acquisitions."
- "BNPP looks to be the most solid French bank, in our view, and has been unjustifiably hit by market concerns. We reiterate our Outperform rating and view recent share-price weakness as a good buying opportunity."
- "We remove Natixis (Outperform) from the Credit Suisse Focus List. Natixis is resilient in our stress test but after a strong relative performance, we believe a pause for a breather may be justified in the short term: we remove it from the Focus List. SG and CA both look cheap but in our stress test face significant capital deficits, thus at times of risk aversion we prefer to err on the side of caution. We reiterate our Neutral ratings on both."
CreditSuisse French Banks 20100702