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Decoupling from the Fed, Banxico likely to hold rates in 2019 before easing off

Street Talk Podcast

Street Talk Episode 23 - As More Banks Reach for Yield, Advisers Urge Caution

Credit Analysis

Beyond Amazon, Alibaba Leads Disruptive Innovation In Race To $1 Trillion Valuation

Banking & Financial Services

CECL Could Create Large Capital Shortfall For Community Banks

An Activist's View Of U.S. Banks

Decoupling from the Fed, Banxico likely to hold rates in 2019 before easing off

Having pushed its benchmark rate to a 10-year high, Banco de México has run out of room to match hikes by its northern neighbor, analysts say, and with inflation easing, is set to diverge its monetary policy from that of the U.S.

Over the past year, Banxico has largely matched rate policy changes by the U.S. Federal Reserve. That level of parallelism is broadly a reflection of the economic ties Mexico has with the United States. The U.S. is the Latin American country's largest trading partner, accounting for more than 80% of its exports and nearly half of its imports.

Economists had thought that the October 2018 resolution of the tri-lateral trade talks among Canada, Mexico and the U.S. — replacing NAFTA with the new USMCA trade deal — would offer Banxico the ability to break its monetary policy link to the Fed and lean its decisions more heavily on domestic data. In a note posted shortly after the agreement, ING called the new agreement "the final greenlight" for the Mexican central bank "to decouple its monetary policy decisions from the U.S. Fed," predicting a "hawkish hold" on rates.

But in the months since, Banxico hiked rates twice more, including most recently in December 2018 following the Fed's own quarter-point hike. The Mexican benchmark rate now sits at 8.25%.

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The central bank has more recently signaled it will no longer follow the Federal Reserve as closely. Its 2019 calendar will have the monetary body meet eight times over the year, with only three of those events — in February, March and December — occurring in close proximity to the Fed's own rate decisions.

"The monetary policy stance is quite tight now, and so we think they are pretty close to the end of this cycle," Charles Seville, head of North America sovereign ratings at Fitch Ratings, said in a telephone interview.

Seville noted that Mexico's current inflationary trend supports a rate hold for now, and potentially a gradual reduction down the line. Inflation ended 2018 at around 4.90% and is expected to ease to 4.50% by the end of 2019, according to estimates from the Economist Intelligence Unit — sharply lower compared to the 2017 pace of 6.04%. A recent fuel shortage in Mexico — spurred by a government crackdown on fuel theft — and the recent strengthening of the peso could also reduce inflationary pressures, the Fitch analyst added.

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Some analysts believe that rates could start to come down as early as year-end, though reductions are seen as more likely in 2020. In a recent outlook report, FocusEconomics said an average of expectations from its panel of analysts' have the benchmark rate at 8.11% at year end, and down to 7.24% by the end of 2020.

"Most analysts expect the fourth-quarter hikes to be sufficient as calmer heads prevail; they do not expect any more hikes in 2019 ... a growing number of LatinFocus analysts now see rates [remaining] elevated through next year in response to pass-through pressures from the peso," FocusEconomics wrote.

Still, economists note that Mexico's central bank could take a less-hawkish stance should the country's new left-wing president, Andrés Manuel López Obrador, prove capable of maintaining a stable economy. The president, who took office at the start of December 2018, roiled markets early on by sending mixed messages about how he would govern. His decision to scrap a major airport project in Mexico City particularly rattled investor confidence, and spurred Banxico itself to voice concerns over the country's future economic policy direction.

However, his administration has also put forward an annual budget proposal that was widely hailed as "realistic" and "fiscally responsible," broadly maintaining the prior government's fiscal targets. The budget targets a primary surplus of 1% of GDP this year at the public sector level, up modestly from an estimated 0.7% in 2018. The change would be driven by a 6.1% growth in government spending and a 6.3% increase in revenue.

"If met, these targets should be enough to sustain debt-to-GDP at around 46% for the public sector and 35% for the federal government, supporting the sovereign's credit profile," Moody's said report.

"That could provide some scope for monetary policy to be loosened," Fitch's Seville said.

The budget proposal could signal that, despite his ambitious social project plans, the new president is keenly aware that he has limited capacity to add to Mexico's already elevated national debt, Jorge Sánchez Tello, an economist at Mexican financial sector research institute FUNDEF, noted.

"This government knows it cannot play with the debt situation and has little space to do so without pushing rates up at Banxico," Sánchez Tello said. "And that would anger people."

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Listen: Street Talk Episode 23 - As More Banks Reach for Yield, Advisers Urge Caution

More banks are reaching further out the yield curve in their loan portfolios to meet customer demands but, increasingly, advisers believe institutions need to proceed with caution. In the episode, experts from PIMCO, Sandler O’Neill, Chatham Financial and PrecisionLender discuss rate risk and how banks focused on funding will ultimately prove the winners.

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Credit Analysis
Beyond Amazon, Alibaba Leads Disruptive Innovation In Race To $1 Trillion Valuation

Mar. 20 2018 — The race to become the first trillion dollar company is heating up, with everyone paying close attention to the tech mega-caps — Alibaba Group Holdings Ltd. (NYSE: BABA) and Inc. (NASDAQ: AMZN).

Despite a lack of consensus over who will take the crown, one thing is evident: no two companies in the race are as neck and neck and as similar in business strategy and operations as Amazon and Alibaba. Both champion the e-commerce landscape in their specific countries – Amazon in the U.S. and Alibaba in China - and both have made their forays into new industries such as food and healthcare.

Wall Street is following these companies closely, with Alibaba slightly in the lead in terms of analyst recommendations. As of April 2, 2018, the Chinese e-commerce behemoth has received 37 buy ratings and just two hold, according to S&P Global Market Intelligence data. The average analyst price target of $226.44 suggests upside potential of roughly 23%. Amazon, in contrast, has received 31 buy ratings and two hold. The average analyst price target of $1,709.05 suggests upside potential of roughly 18%.

To keep a tally of the race, we used the RatingsDirect® Monitor, a data visualization portfolio monitoring tool that provides risk/return insights and helps track and analyze market movements for publicly-traded companies that are rated by S&P Global Ratings.

Figure 1: Tech Mega-Caps: S&P Issuer Credit Rating (FCLT) vs. 3M Stock Price Volatility (%)

Tech mega-caps: S&P Issuer Credit Rating (FCLT) vs. 3M Stock Price Volatility (%)

For illustrative purposes only.

At a market cap of $471.6 billion, Alibaba is not too far off from catching up to Amazon’s $700.7 billion cap. Alibaba stock’s price has observed a three-month price volatility of 40.1%, the largest among the tech titans and far surpassing Amazon’s 30.8%.

Although the higher volatility and lower S&P Global Ratings’ long-term credit rating present more risks for investors, Alibaba’s higher return on assets and lower P/E and leverage ratio suggest more opportunities for the Chinese e-commerce behemoth to grow and reach the $1 trillion valuation first.

Comparing disruptive levels of innovation

To compare the disruptive level of innovation in the various sectors that Amazon and Alibaba have entered, we selected comparable events between the two conglomerates and examined industry-level probability of default (PD) changes of the PD Market Signal Model, a structural model that calculates the likelihood of a company defaulting on its debt or entering bankruptcy protection over a one-to-five year horizon.

The war for groceries

Both Amazon and Alibaba have been stepping up their battle in the grocery business. Just last year, Amazon’s announcement to purchase Whole Foods Market Inc. for $13.7 billion shocked investors, with shares of some of U.S. food’s largest players – Kroger Co. Supervalu Inc., Costco Wholesale Corp., Target Corp., and Wal-Mart Stores Inc. – dipping on the news. The market perceived credit risk of the U.S. food retail industry also escalated. One week following the announcement, the U.S. food retail PD jumped from 3.73% on June 15, 2017 to 4.85% on June 23, 2017, or about a 30% increase in the industry’s probability of default.

Figure 2: U.S. Food Retail Median Market Signal Probability of Default: June 15, 2017 – June 23, 2017 (%)

U.S. food retail median Market Signal Probability of Default: June 15, 2017 – June 23, 2017 (%)

Alibaba also aggressively expanded its food footprint in 2017 with its rollout of new supermarkets under the Hema Xiansheng brand and its $2.9 billion investment in China’s largest hypermarket operator Sun Art Retail Group. Just this year, reports that Alibaba held early development talks with Kroger Co. left the Chinese food industry shaking. One week following reports of the discussions by Reuters and New York Post, China’s food retail PD increased 109.10% from 3.05% on January 23, 2018 to 6.39% on January 31, 2018. [i] [ii]

Figure 3: China Food Retail Median Market Signal Probability of Default: January 23, 2018 – January 31, 2018 (%)

China food retail median Market Signal Probability of Default: January 23, 2018 – January 31, 2018 (%)

The battle for pharma

Pharmaceuticals have been another potential battleground for the e-commerce giants.

According to an October 5, 2017 note published by Leerink Partners managing director Dr. Ana Gupte, Amazon is “hiring relevant talent and are in active discussions with mid-market PBMs [pharmacy benefit managers] and possibly even larger players such as Prime Therapeutics.” Following publication of the note, the U.S. drug retail PD escalated 22.55% from 16.16% on October 4, 2017 to 19.81% on October 12, 2017.

Figure 4: U.S. Drug Retail Median Market Signal Probability of Default: October 4, 2017 – October 12, 2017 (%)

U.S. drug retail median Market Signal Probability of Default: October 4, 2017 – October 12, 2017 (%)

Similarly, China’s drug retail PD jumped 90.67% from 1.55% on February 1, 2018 to 2.96% on February 9, 2018, following Alibaba’s February 2, 2018 announcement to partner with European pharma giant AstraZeneca PLC.

Figure 5: China Drug Retail Median Market Signal Probability of Default: February 1, 2018 – February 9, 2018 (%)

China drug retail median Market Signal Probability of Default: February 1, 2018 – February 9, 2018 (%)

The risks of innovation

In summary, our PD Market Signal model shows that Alibaba disrupts the short-term market perceived credit quality of firms more than Amazon does. The Chinese e-commerce behemoth is viewed by many investors as a proxy for China's consumer economy and growing middle class, whereas Amazon is not, and PD movements are reflective of this. As illustrated by our RatingsDirect® Monitor, Alibaba has a much lower leverage compared to Amazon, with a last-twelve-months Debt/EBITDA ratio of 1.4, compared to Amazon’s 2.9. Alibaba also has higher growth potential from the perspective of ROA and P/E. Alibaba’s ROA stands at 7.4%, compared to Amazon’s 2.4%. Further, Alibaba’s lower P/E ratio of 46.3, compared to Amazon’s 235.3, suggests that the Chinese firm may be undervalued.

Figure 6: Tech Mega-Caps: ROA (%) vs. Debt/EBITDA (x)

Tech mega-caps: ROA (%) vs. Debt/EBITDA (x)

For illustrative purposes only.

Figure 7: Tech Mega-Caps: ROA (%) vs. P/E Ratio (x)

Tech mega-caps: ROA (%) vs. P/E Ratio (x)

For illustrative purposes only.

Whether Alibaba will claim the $1 trillion title before Amazon, however, remains to be seen. A fast growing company, Alibaba faces significant challenges from China’s ever-changing business environment, including potential regulatory, litigation, and international expansion risks, as outlined in roughly 45 pages of the firm’s most recent annual report.

Despite the inherent risks, what sets Alibaba apart is its domination of China’s online marketplace, which is the single-largest in the world. Founder Jack Ma has also been faster than Bezos to expand his business lines. The use of Alipay, one of the world’s largest mobile payment platforms, and the firm’s roughly $350 million investment in Chinese electric-vehicle maker Foxconn Technology Group are just a few examples of the firm’s growing economies of scale.

[i] Alibaba, U.S. grocer Kroger had early business development talks: source. (n.d.). Retrieved March 01, 2018, from

[ii] To battle Amazon, Kroger eyes Alibaba alliance. (n.d.). Retrieved March 01, 2018, from

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CECL Could Create Large Capital Shortfall For Community Banks

Feb. 02 2018 — The implementation of a new accounting standard that changes the way banks reserve for loan losses could have a far more punitive impact on community banks than their larger counterparts.

The accounting standard, known as the current expected credit loss model, or CECL, becomes effective for many institutions in 2020 and will require banks to set aside reserves for lifetime expected losses on the day of origination.

The new standard will mark a considerable shift in how banks currently reserve for losses. Today, banks record losses when it becomes probable that a loan will be impaired. That means reserves are dispersed over time, but CECL will cause banks to significantly build their allowance for loan losses on the date of adoption, according to Josh Siegel and Ethan Heisler.

The two bank observers said in the latest Street Talk podcast that the increase will be even larger for institutions with higher concentrations of longer-term loans since reserves for those credits are currently spread out over longer periods.

"The same credit, the same view, the same company, if you have a two-year loan or a 20-year loan, the reserve you're going to have to put it against it is dramatically different," Siegel, managing partner and CEO of StoneCastle Partners LLC, an investor and adviser to community banks, said in the episode.

He said a reserve for a loan with a two-year term under CECL might not be dramatically different than the current methodology since it requires banks to look ahead 12 to 18 months for losses. Loans with far longer terms such as real estate credits, however, could require multiples of currently required reserves. The burden of the new accounting standard could prove far greater for community banks since those institutions are much more heavily concentrated in real estate.

Siegel and Heisler — president of the Bank Treasury Newsletter, which highlights industry trends impacting bank treasurers — co-authored a white paper analyzing CECL's impact on banks with less than $50 billion in assets. The analysis found that hundreds of banks could be at risk of falling below well-capitalized status after adopting CECL, at least when it comes to meeting total risk-based capital requirements. Any reserve build required through CECL will be deducted from capital and could have the greatest impact on total risk-based capital ratios because the Basel III rules cap the inclusion of reserves at 1.25% of risk-weighted assets.

The required build under CECL could push reserves well above that level, according to Siegel and Heisler's analysis. They examined the banking industry's results since 2004 and assumed institutions adopted CECL beginning in 2005. The analysis further assumed that all loan portfolios had five-year terms, loans were originated at year-end and bankers were fully aware of the losses that would come between 2005 and 2016. The analysis assumed provisions equaled cumulative net charge-offs in the five years after adoption and considered a number of scenarios, with CECL implementation beginning in different years.

In the most severe scenario, where banks would have adopted CECL beginning in 2007, the analysis found that banks in aggregate would need as much as $70 billion to repair the capital shortfall. In the least severe scenario, with CECL adoption beginning in 2011, banks would need to raise close to $10 billion.

"It's not just a small change. You could today be very well-capitalized and wake up and not even be adequately capitalized," Siegel said. "You could be deemed undercapitalized and immediately be put under a cease and desist order."

Siegel said banks should begin calculating CECL's impact, even in a rough approximation, to see if they have a capital shortfall. For an institution falling short, they recommended that banks should consider issuing subordinated debt to bolster their balance sheets.

Siegel has encouraged community banks to utilize sub debt in the past, given that it allows banks with holding companies to raise funds, downstream them to their banking subsidiaries and count them as equity capital in far more cost-effective manner. He and Heisler noted that issuing sub debt today remains relatively cheap while interest rates continue to be low.

"Sub debt is a natural offset, a way to prepare for CECL," Heisler said in the episode. "Think of Tier 2 sub debt almost as a CECL buffer."

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An Activist's View Of U.S. Banks

Dec. 22 2017 — Higher U.S. bank stock valuations might have reduced the number of investment opportunities, but PL Capital Group's Rich Lashley still sees a number of places to put dollars to work.

Bank stocks have risen close to 50% over the last 18 months on hopes of higher interest rates, stronger economic growth, and regulatory and tax reforms coming in the aftermath of the U.S. election in November 2016. The rally has left the bank group trading at roughly 2.0x tangible book value, compared to 1.5x a year and a half ago.

Lashley, a longtime bank investor and shareholder activist, sees fewer attractive investments today, but noted that the market has done a good job discerning between higher-performing banks and institutions with below-average returns. Strong performers might now trade at 250% of tangible book value versus 160% before the election, while weaker-performing banks trade at 160% of tangible book value, compared to 120% pre-election.

That spread still creates desirable entry points for the likes of PL Capital, which looks for its portfolio companies to improve their value independently or eventually partner with another institution at a favorable sale price.

"Even though the absolute values have risen, there is still a relative value spread between targets and acquirers," Lashley says on the latest Street Talk podcast. "Until that math doesn't work, we're going to continue investing."

In the episode, we spoke with Lashley, principal at PL Capital, about his firm's investment thesis and his outlook for M&A activity and bank fundamentals, including the prospect of rising deposit costs that he believes will separate the "haves" from the "have nots."

Lashley said it is hard to be bearish about bank fundamentals given that credit quality is "phenomenal" and seems unlikely to deteriorate soon: Efficiency ratios are improving, net interest margins are expanding with increases in interest rates, and proposed tax reforms would offer an even greater boost to earnings. However, he said higher rates will challenge banks' deposit bases and not every institution is prepared for the change. Lashley noted that in the last seven years, every bank benefited from low-cost deposits rushing in their doors. Now that short-term rates are rising and deposits are beginning to carry annual percentage yields in excess of 1%, customers are moving their money around.

"The 'haves' that have nice core deposits and good C&I customer and good deposit relationships, they're going to be fine," Lashley said. "But the 'have nots' who may have fooled themselves into thinking they have stable deposit bases, I think they're going to find that it's not only hard to grow those deposit bases, it may even be hard to keep what they have."

Some banks with stable deposit bases and large slugs of noninterest-bearing deposits such as Comerica Inc. and Zions Bancorp. have already outperformed the bank sector over the last year, he noted. 

Lashley believes bank investors will receive continued support from a healthy bank M&A environment, perhaps even buoyed by some institutions' desire to bolster their deposit franchises. He expects close to 4% to 5% of the U.S. banking industry to sell every year and noted that lower tax rates, should they come to pass, will create even greater cost savings from transactions, resulting in even stronger deal multiples.

No matter what the next year brings, Lashley remains confident that changes will create new investment opportunities.

"There's always an opportunity. There's always some bank that gets in trouble. There's always a bank that stumbles. There's always something that happens that is a temporary change in valuation. And we think we'll be able to invest our money for a long time to come," Lashley said.

Street Talk is a podcast hosted by S&P Global Market Intelligence.

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