“There’s always a reason” is the trader mantra, and we thought about that today as we watched US equity markets roll over hard. The headlines about COVID spread did not help, to be sure, but anyone with access to the Internet and a ruler could have seen that coming. Even our base case for stocks includes regional problems containing the virus, so we have to assume that’s the market’s assumption as well.
We do wonder, however, about what the market may have learned about the upcoming Federal Reserve bank stress tests. The first wave of information on this annual review is out tomorrow and features a never-before-seen and only recently announced (as of last Friday) Fed analysis of how the US banking system may fare over the next 12 months of COVID Crisis recovery.
Three points on all this:
#1: At first blush, the stress tests should not be that big a deal to markets:
- Bank market caps aren’t what they used to be.
The total S&P 500 weighting for institutions subject to the tests is just 4.8%. Financials are 10.3% of the index, but more than half of that weight comes from Berkshire (1.4% of the S&P) and other non-bank businesses like BlackRock (0.3%), S&P Global (0.3%) and CME Group (0.2%).
- Markets know bank stock buybacks are off the table for now and that there is some risk of dividend cuts. The average yield for the 22 banks in the S&P undergoing stress tests is 4.3%, some 70% above the S&P 500’s 2.5% payout.
Investors do seem to be pricing in some risk of dividend cuts at: Wells Fargo (7.7% yield), Fifth Third (5.4%), Key (5.9%), Regions (5.5%), Citizens (6.5%) and Huntington (6.3%).
#2: New for the 2020 stress tests is that the Fed is both doing its standard analysis AND adding an aggregated assessment of how the US banking system will fare under a variety of COVID Crisis economic recovery scenarios.
- Since their inception after the Financial Crisis, the Fed’s stress tests have focused only on the impact of a recession on bank balance sheets at the bottom of an economic cycle. The idea is to make sure banks have sufficient capital to continue lending in a recession rather than reducing credit exposure and exacerbating already-poor economic conditions.
- But… The COVID Crisis has been more damaging than the Fed’s 2020 “Severely Adverse” scenarios on many important counts.
Real US GDP is expected to fall by 35% in Q2, far more than the -9.9% in the stress test. Unemployment is running +13% (and worse if you adjust for BLS anomalies), again higher than the 10% in the Fed’s modelling. Corporate bond yields would have blown through the Fed’s 6.6% worst-case yield had the central bank not intervened in this market.
- And… As Fed Vice Chair for Supervision Randy Quarles put it in a speech last Friday, “There’s probably never been more uncertainty about the economic outlook.”
While the Fed does not want to put undue stress on banks during the middle of a deep economic downturn (i.e. now), Quarles also said “our first priority must be – and is – to understand the implications of quite plausible downside scenarios from our current position for bank capital.”
Long story short, tomorrow the Fed will be releasing a “sensitivity analysis” of the US banking system which covers 3 potential economic outcomes, as outlined by Quarles:
- A “V-shaped recovery that regains much of the output and employment lost by the end of this year.”
- A “slower, more U-shaped recovery in which only a small share of lost output and employment is regained in 2020.”
- A “W-shaped double dip recession with a short-lived recovery followed by a severe drop in activity later this year due to second wave of containment measures.”
#3: The issue we keep rolling around in our heads is “What does the Fed gain by showing this aggregate “VUW” sensitivity analysis, and what will the market make of it?” Three thoughts:
- The Federal Reserve has moved heaven and earth in response to the COVID Crisis and taken tremendous heat for its actions. Many Americans think they have “bailed out Wall Street, not Main Street” and nothing says “Wall Street” like the big banks.
- The smartest bank analyst we know told us the banks would “not look great” in the “W” scenario. Given the market’s fresh attention on COVID flare-ups around the country the Fed’s attention to this potentiality could filter into asset prices more generally. “U” isn’t much better (although at least it’s not a head fake and therefore easier to plan for) and “V” would be nice but now seems less likely.
- We assume that by releasing the system-wide sensitivity analysis the Fed is basically “showing its work” to 1) show it is paying attention and 2) support a moratorium on share buybacks through next year and also provide the backdrop for several (if not more) dividend cuts at individual institutions.
That would begin to address the first bullet about public perceptions.
The bottom line to all this: the stress test results and WUV sensitivity analysis are not market-moving developments because they will inform bank stock prices, but rather because they stand to alter market perceptions of US economic conditions over the next 12-18 months. Exactly why the Fed is doing this is unclear and the risks to investor confidence are extremely high if the “U” or “W” scenarios look especially poor.
Randy Quarles speech outlining the WUV sensitivity analysis: https://www.federalreserve.gov/newsevents/speech/quarles20200619a.htm
2020 Fed Stress Test Scenarios (page 14 for list): https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200206a1.pdf