Equities Advance on the Back of Improved Data and Supportive Monetary Measures
The global economic outlook improved in February, helped by encouraging data from some of the largest countries as well as supportive monetary policy measures. Monthly job additions in the U.S. exceeded expectations in February, continuing the robust trend from last year. Though wages are yet to see meaningful growth, the strengthening labor market should help the U.S. economy sustain the current pace of expansion. The Euro-zone also showed signs of improvement as the cheaper euro is helping exports while lower fuel prices have lifted consumption, especially in healthier economies such as Germany. The European Central Bank announced its anticipated bond purchase program, which is expected to continue through much of 2016. Sovereign bond yields in the Euro-zone countries as well the currency weakened further as the ECB is expected to start bond purchases in March.
Concerns about a potential Greek exit from the currency union eased after the country arrived at an agreement with the European Union and the International Monetary Fund to extend financial support. In Japan, export growth for the month of January was well above expectations and the country’s trade deficit declined sharply as lower oil prices pulled down the value of imports. Some of the major emerging markets are also seeing positive economic data trends. Exports from China surged in February, though some of the gains were due to the lower base of last year. Growth in Chinese retail sales and industrial production has remained healthy so far this year, though the pace was moderately lower than the last quarter of 2014.
Global equity markets advanced during February, helped by strong gains in Europe. Emerging market equities also gained, though they moderately underperformed the developed markets. Manufacturing and services output growth continued in most large economies in February, except some of the emerging countries that are major commodity exporters. The healthy new order flows suggest that this trend is likely to be sustained in the coming months. Oil prices saw a moderate recovery during the month, though they remain well below the levels seen last year.
GLOBAL INDUSTRY SPOTLIGHT FOR THE MONTH: BANKING
The global banking industry is in a much better position to survive severe market volatility, as confirmed by the several stress tests run by the major central banks in recent years. The legal costs related to charges of unethical business practices in the U.S. before the 2008 financial crisis, as well as charges of currency market manipulation in Europe, have been mostly settled or sufficient provisions have been created by the banks. While regulatory restrictions have been tightened, U.S. banks have reported further declines in trading income in recent quarters. Nevertheless, aggressive quantitative easing has restricted net interest margins for banks in the major developed countries. In the large emerging countries, banks should see improvements in net interest margins as central banks lower benchmark rates and credit demand revives.
After being under intense regulatory scrutiny ever since the global financial crisis, large banks in the developed markets are likely to see some easing of restrictions on them. In October of last year, the European Central Bank cleared all the large banks in the Euro-zone as having sufficient resources to meet severe market stress. Only a handful of smaller banks were asked to raise additional capital and strengthen their balance sheets. The U.S. Federal Reserve, which has made the stress tests for banks an annual exercise, is expected to release the results of its most recent examination in March. Again, all the major U.S. banks are expected to clear the tests. However, it remains to be seen whether the dividend and capital return plans of select banks that were denied last year would get Fed approval.
In recent years, several banks in the U.S. and Europe have paid substantial financial penalties to settle charges of unethical business practices and market manipulation. These payouts had cut down earnings and increased the need for additional capital. As of now, most of the major regulatory probes have been settled by the banks. The likely penalties on inquiries that are close to conclusion are mostly known and have been provided for. This should improve the earnings outlook for the large banks.
At the same time, banking regulators across the world remain cautious about business lines of banks that are perceived to be riskier. Many banks have wound down or scaled back their proprietary trading desks and other businesses that are not viewed favorably by the regulators. Most large U.S. banks reported weaker than expected revenues from trading operations, especially in fixed income trading. This trend is expected to continue while the equity, fixed income and commodity markets continue to be volatile.
Nevertheless, the exit of some banks from riskier businesses could create opportunities for other banks to consolidate their position in the market. This is more likely to play out in Europe where pressure from governments that still have large shareholdings in banks is forcing some to sell or wind down trading operations and other businesses. However, the regulators could impose higher capital requirements on banks that are retaining these businesses.
Quantitative easing by the European central banks is not expected to significantly change the earnings outlook for the region’s banks. As longer-term interest rates decline as a result of central bank action, the net interest margins of banks are likely to decline. The expected increase in credit demand could offset some of the potential earnings decline, with credit volume growth. On the other hand, banks with large bond portfolios should benefit from higher bond prices.
Banks in some emerging markets are likely to see improved profitability in the coming quarters as central banks cut interest rates, even as economic growth sees moderate improvements. Lower inflation risks due to cheaper oil should allow central banks in China, India and other countries to reduce benchmark rates further this year. Central banks are also expected to take other steps, such as lower reserve ratios, to help banks lend more.
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