Is it Time for European Banks to Shine? w/ Seamus Murphy

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1:20Welcome to the next big trade and thanks for joining us. This week, I'm talking to Seamus Murphy, founder of Carrick Hill, an independent research boutique focused on the financial sector in Europe. UK and select emerging markets including Brazil and Mexico some of my favorite emerging markets as it happens. Seamus how are you doing? I'm excellent even though the weather isn't great in Dublin right now. I wouldn't worry I'm in Boston it's been pissing down the whole summer it's astonishing it's like a tropical rainforest. Yes. So Seamus can you improve on my crap introduction can you tell us more about carrick hill well i i suppose i used to i've been working in with financials for nearly 25 years and i suppose i was lucky enough to have worked through the the 2000 nasdaq bubble the gfc and i suppose after the gfc i suppose it became very obvious that um a lot of we were a research firm i worked for a research firm and uh but they were very focused basically on just a lot of the micro about the companies without miss would and missed basically the bigger picture as we would call it in terms of the factors that kind of influence the environment in which companies operate so that's what we try to do here is just have an exceptionally deep understanding of the data and what influences the environment in which financials operate so obviously for financials for example interest rates are obviously a key component you know the expected evolution of you know cost of credit cost of risk all these kind of factors and then obviously within individually we kind of mirror that with the individual companies where we speak with the companies and they either verify or refute our thoughts but I suppose a lot of firms as well focus a lot on the very short-term data we try to be quite long-term in our thought process to take it back through cycles which helps us which helps us try to understand but then more recently we've obviously been doing the shorter term data it's kind of so it's kind of a bit of a unique approach in the context how we think about financials Yeah, I read you were kind enough to send me a lot of material to take a look at, and I found it fascinating.

3:30I think this is going to be quite a stimulating discussion. Probably, let's waste time with me blurring on. Let's go into your next big trade. What should people be focused on? Well, I suppose the big thing for us, there's two big things. one is we've obviously had a period of exceptionally low interest rates for um well over well let's call it a decade in europe and globally and during that period we've had you know a kind of dysfunction as was uh come into play across the financial markets um especially within the individual sectors within financial so you know a couple of things are important for us we think we're entering a period of higher rates for longer um we don't think we're finished this cycle is over yet um there's a couple of key reasons for that um and then so european banks for us still look exceptionally interesting they have been you know a terrible trade investor or converticommas are a terrible investment for well over a decade uh but european banks in our opinion are still very interesting i think the narrative has changed in europe the political narrative has changed in europe economic narrative has changed in europe um and also the consequence the byproduct of that is that we're now entering we think an exceptionally difficult period for private equity asset management um and a more difficult period for household savings um but this these all these things take time to play out um and um you know i suppose if you don't mind harry like even if we think about what's happening today you know i mean you know obviously everybody has been trying to call peak interest rates in europe and in the us for quite a while our view for kind of six to nine months is that like even if money supply is falling it's actually you're kind of missing the picture and to some extent because the productivity of debt has been picking up for you know sequentially quarter and quarter for the last five to six quarters and therefore the velocity of money has actually been picking up and so therefore when you look at real gdp expectations we're still not in recession territory anywhere near it um and so therefore i think the question is we have to kind of ask ourselves when we think about financials in the broader sense in in europe and uk and in these emerging markets is you know why monetary policy has been completely ineffective today because i think if we sat here harry this time last year and we are i think anybody would have said and we we expected us rates to be where they are european rates to be at four and you know no issues uk rates to be people talking peak rates in the uk now six um i think most people would have said you know equity markets would have been it's substantially lower and you know we would be uh have a very difficult backdrop for banks cost of risk for banks would be through the roof and i suppose it's important to understand why why that hasn't happened so far totally agree for me it's the question i've got a working hypothesis but i'm very curious about your thinking on this yeah what is the mechanism and i suppose look for us for us in terms of how we think about the data um i don't know if gabrielle can put up the data just in terms of the household net worth growth between 19 and 21.

6:36There's kind of five key reasons basically in terms of why we haven't had, monetary policy has been relatively ineffective today, let's call it that. The first one was we had excessive wealth creation during the pandemic. You know if you look at the US, you know normally in the US you get kind of you know wealth grows at nominal GDP plus a little which is you know seven to eight percent but during the two period between the period 19 to 21 we had over 100 growth and and as a share of gdp basically um i'm sorry 107 growth in over two years which is really excessive we had like obviously europe is slightly lower because we just have less financial wealth but nonetheless we still had excessive oil creation in these countries um the other thing that happened obviously then when we move forward is that we just had an exceptionally strong period of household cash flow generation um you know gross savings rose really really substantially um but i suppose this is true to the fiscal intervention of the of the of the of the governments but also it wasn't only related to the fact that the governments intervened on the fiscal side in terms of supporting jobs and paying people actual money but they also intervened in in guaranteeing loans and i think that's really important because therefore we had a very fluid system where everything was guaranteed i mean we were speaking with a local italian bank recently and we think some they were telling us something like 30 of their loan book is still guaranteed by the state on the corporate side um which is pretty astonishing and so therefore we still have that adjustment back to normality to come or is still ongoing basically in in these regions and that's what a lot of people are saying when we read them the typical narrative is that you know this adjustment has already happened this already has already happened but what's actually equally as important harry is that what makes it more complicated now is that the adjustment that has happened isn't as actually as simple as one thinks because what we try to do here is we dissect basically consumption into what we call essential and discretionary items and one of the characteristics of this cycle and the third reason why it's different this cycle is that discretion what we call discretionary spending power is actually going up sequentially month on month in most regions.

8:54And why is that happening? I mean, you have exceptionally strong wage growth in most regions, but then you have essential item inflation now negative. So therefore, if you have wage growth, and for example, we look at Belgium, you know, where you have, you know, if Gabrielle put up the chart on Belgium employee compensation, you'll see uh belgium compensation growing at nine and five and 23 and 24 but on the following graph you'll see that you know um essential item inflation basically in some regions for example we pick out spain but it's happening everywhere is falling and so therefore when you look at germany if you look at house of discretionary spending power which is an earlier graph you'll see that that's actually sequentially rising time on time and what does that what does that what does that actually mean what that means basically is that if discretionary spending or spending power is growing is growing it means that people have more money to spend not less money to spend and so therefore the central banks have to eliminate that excess demand or have to fight harder to eliminate that excess demand so if gabrielle can put up the chart of germany for example which is of discretionary spending power in germany um household discussion spending power you'll see that that is sequentially still rising year on year um the most recent data point for example in to may shows that discretionary spending point in real terms up 15 percent in belgium you know five percent in the netherlands eight percent in ireland germany at seven i mean these are astonishing numbers and so therefore the demand still exists in the economy and central banks are now going to have to fight even harder to eliminate that demand so that's kind of sorry harry go ahead i was just going to say that's that's driven is it entirely real wages driving that increase in disposable incomes or are there other factors as well well i suppose you do get that you get the wage growth basically in terms of let's call it let's deal in nominal terms to start you have wages obviously growing in nominal terms yeah and if we if we think about what is an essential item basically so what we do we don't we it's not like we ignore core cpi and this what we did is we basically took uh there's a data set in in that's common across all the euro area in the uk we took to 120 items in that data set and basically put it into you know essential or non-essential items um you know essential items obviously your food travel you know travel to work all these kind of things i mean like for example a service for the car an essential item but the purchase of the car is a discretionary item.

11:28And we can match that to the CPI month on month. And what it showed us basically is that so last year when we were looking at the numbers there in the middle of last year, we were expecting basically. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus 500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? You can move to real money with as little as$100 once your account is approved.

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12:39The fact that because essential items are rising so quickly, we were expecting discretionary spending to fall. And there's a lot of payment companies in Europe, a lot of discretionary companies in Europe, a lot of clothing companies in Europe, where we expected profit warnings from some of these firms, but it just wasn't happening. And so what the companies were telling us was that things were exceptionally good. All the banks telling us there's no issues on cost of risk. And we were saying, oh, my God, what really is going on here? And then when we dug into the data, we started developing this House of Discretionary Spending Power Index.

13:12And when we looked at it across all of Europe, it became very obvious that nominal wages are growing quite quickly. And essential item inflation was growing, but not as quickly as wages and so therefore discretionary spending power was actually increasing and what's happening now is the ECB has raised into this the Bank of England has raised into this but what the most complicated thing for these guys now is the fact that you still have this wage growth expectations which is a lag effect because it's an averaging effect into an environment where essential items are now negative and most in some European countries are falling really really aggressively and so therefore you do have this excess demand that still persists but the problem with excess demand it's not a supply side issue anymore in one sense in terms of the red curve because supply chain indexes all the all the indices are basically telling us that we're back close to normality it really is just a demand issue um and so we do have to equalize this demand the other thing harry just moving off that for a second is the other really important thing to understand is that we also entered into 2023 in a very different period or different very different kind of era relative to prior cycles so if if if gabrielle wouldn't mind just putting up the chart of of the coverage ratio and let's suppose corporate coverage ratios in germany um and what what's basically i suppose what's what it is is we we become increasingly insensitive in some senses Harry to to interest paid and so if you think back this is a chart going back for 20 years this is just Germany but this is this is similar across most of Europe whereby if you think about coming into the last session basically back in 2008 the German interest coverage ratio corporate interest coverage ratio was running kind of eight to nine it fell 10, 15, 20 percentage points or 2 to 3 percentage points during the GFC.

15:17But since the GFC, since we've had exceptionally loose policy, interest paid by the corporate sector in Germany has fallen significantly. Profits have increased rapidly, or EBITDA has increased rapidly to such an extent, especially when you see the move, especially as was the last move the big move happened to ability surged rates fell and so in q1 2022 we had a coverage ratio of interest of 29 times in germany um you know you see something similar on the household on the household side um which um i don't know if gabrielle as well we just use germany as something it's a similar a similar um a similar this is the hdsp to interest paid shark gabriel if you don't mind um you'll see a similar revolution basically where you see that the interest coverage ratio has gone from kind of like in the prior cycle 10 times up to about 25 times discretionary spending or available discretionary spending and so therefore we come into a period where consumers and corporates were basically completely insensitive or relatively insensitive to the next rate move because interest is such a low component of their EBITDA or their disposable income.

16:35And what was the mechanism that achieved that? Is that because fiscal policy was so accommodative that you have a flow of funds type shift, allowing companies to pay down huge amounts of debt? It's not like rates have collapsed. No, well, I suppose really, we think it's quite unusual so for example the household interest bill in spain in 2008 uh when you think about it was roughly around i think around 54 billion in 2022 just the amount of interest paid by households alone by by 2022 that had fallen to 15. so the rate charge from the debt basically had moved from about 6.4 percent or about six percent back in 2007 2008 to basically around 1.5 percent in q1 2022 um and over that time incomes grew number of people employed grew incomes grew discretionary spending power grew um and so therefore we have had you know this rise in the interest coverage ratio so i mean if interest bill if the interest bill is basically you know one three percent of your ebitda um you know you're going to be relatively insensitive even if rates double then it becomes relatively insensitive so when you put all those things together and you kind of say why are rates we've been very very bearish on rates we think rates have had a lot of work to do on the upside for the last 69 months which is one of the reasons why we are exceptionally bullish on European banks and if you put those reasons together the excess the fall in essential item inflation growing wages, high levels of discretionary spending power that still exists in the economy, high levels of interest coverage or insensitive to interest rates, basically because of high coverage ratios in the household and the corporate sector, then you begin to form a picture of why rates have had no effect and why people still expect 1 % real GDP growth in the US.

18:42We're only now more recently talking about recessionary type characteristics in Germany. and so therefore it's quite difficult and I think the central banks actually have more work to do on the upside not on the downside and rates actually are still biased on the upward because I think everybody is trying to call the peak in rates but as long as this data persists and we see this monthly it becomes very, very difficult for central banks to take the foot off the pedal Yeah, so recent rate moves must have been quite gratifying for you Because the rate markets have been absolutely whacked in the last month or so.

19:17Yeah, look, we still think it's actually still biased upwards. I still think it's biased upwards. And, you know, you still have to see. Now, obviously, Harry, it's going to work. Don't get me wrong. This is going to work at some point. I think, you know, we'll come back to it in a second. I mean, you know, when we expect what's going to happen to corporate coverage ratios over the next three to four years and what's going to happen to household coverage ratios, then we're obviously going to have some level of effect but it's going to take some time and we are still in this sweet spot for particularly for European banks whereby the rate curve is still biased upward and we're not getting we're not getting any anything on the cost of risk but I suppose that's really really important though for us just as a firm to try to understand why because we can always we don't want to be a reactionary try to think 6, 9, 12, 18 months forward and just say, look, actually, where do we think rates peak?

20:11And certainly we think they're still higher than where we are today. And the factors that influence that decision are still telling us that we're going higher. So where do you think rates peak? That's an exceptionally difficult question. We know it's going to work at some point. And I I suppose one of the things I should say actually, Harry, which is actually an important consideration as well, is that we're assuming that it works because central banks actually won't go down without a fight. And the reason why I mentioned that is because I know we might come on to it in a while. It's because obviously politics has become an increasingly important consideration when we think about where rates can peak, because once the rate curve begins to have an effect and we do start to get recessionary type characteristics, politics um once these discretionary spending parametrics start to slow down once coverage ratios start to come down then will politics become more important we hope not and we do think that the central banks won't go down without a fight but you know certainly we could still see you know in Europe is it impossible to see you know another 100 uh 200 basis points maybe even more of rates relative to where we are today and I think the market is basically expecting rates to fall into 2024.

21:28We think that's highly improbable, highly, highly improbable once central banks begin to understand the narrative of the fact that there is this excess demand still exists and we still haven't had an adjustment in coverage ratios. Let's not forget, Harry, I mean, even for interest to flow through the economy does take a long, long time because, you know, for example, you know, you have a fixed rate mortgage in Europe and Germany for 20 years. You only reset once every 20 years, you're still paying, you're still completely insensitive to the rate curve. So, I mean, this does take a while to flow through.

22:04One of the countries actually where we believe rates actually could be significant and have been quite bearish is actually the UK. We think the UK is actually a bit of a unique situation. We haven't been long. UK banks we feel are a bit of a value trap because we feel the UK actually has a lot more work to do than Europe and the US on the upside. I see, unique in a bad way, not in a good way. I don't want to call it, let's not call it a bad way. Let's just call it, if they want to sort it out, they have to go higher. And I suppose when I say sort it out, what do I mean by that? I mean, I suppose the UK, you know, in a post-Brexit world, without getting into the politics of that feels you know you know i suppose we've had four or five crisis over the last kind of like 30 40 years in the uk we've analyzed these in detail and every in each crisis to kind of solve the issue basically and get the uk back into a trajectory where we have real gdp per capita and a growth basis it has had to adjust its rates to such an extent to the trades at about a two to three hundred basis points premium to the us in real terms um if we were to do that today if we were to do that today that tells us the uk rates probably should be or somewhere in the order i mean i think last year when we back last summer we said uh you don't laugh um but when the bank of england was calling peak rates at four i think we were saying rates probably have to go to seven or eight at that time um and we couldn't understand the uk decision now if we put in a two percent premium to the us we're probably looking at somewhere between 10 and 11.

23:48I mean, the big issue for the UK is basically the UK has been going through an era of overspending on the consumer side for a significant period of time. And even if you look at the gross savings ratio in the UK, Harry, today, the gross savings ratio in the UK is probably double what it was pre-COVID. So therefore, the excess demand that exists in the UK is actually pretty phenomenal. Now, obviously, that kind of, that seems to contradict the traditional narrative that the UK is in terrible shape, but actually the UK actually is and UK economy is actually doing pretty okay. And that's why we're getting revisions up now.

24:24So that's, I suppose, when we think about the rate curve, that's how we think about it. And we kind of look, we look at this monthly data and it keeps telling us that actually rates have to keep going up. And I think this is what it helps us to do, Harry. It helps us to understand a narrative around what we hear every day about peak rates and when is it going to have an effect. but when you put all those factors together you can see very clearly actually it's pretty sensible why rates would be ineffective if you have this excess demand still existing in terms of discretionary spending and you have you know coverage ratios that have been exceptionally high coming into the cycle so does that for me politically the the place where it's politically most sensitive to raise interest rates in the g10 is probably the uk because of floating index basis for real estate and because you know everybody who's anybody is long up to the yin yangs of uk property in the in the uk so that if i were to be biased i'd take the under on where uk rates end up not be not relative to your to your estimate not because you're wrong but because if anywhere it's going to have political pressure to do more through fiscal and less through rates it's going to be the UK yeah I suppose look you could be right I mean ultimately how does it end up I mean it ends up either in the currency market or in the interest in the rate market yeah so I mean if we do undershoot if we do undershoot on rates then obviously we probably end up in the currency markets in terms of a weaker GBP I mean for us you know you still haven't had that adjustment in uk i mean i think if if gabrielle wouldn't mind put up there's a chart where we have of we make an estimate basically of salary to monthly mortgage repayment in the uk of where we are today over the last kind of like 30 years 25 30 years and you know i mean it's a little bit dated now but that number today is probably closer to 24 25 for a new buyer um you know so therefore that a new buyer is basically roughly spending 25 of their income today if they were going to buy a home in the UK.

26:39This is hard in the GFC but we haven't had that adjustment in house prices yet in the UK. Are we going to have that adjustment in house prices in the UK? We would think so, we would hope so and we actually think it would be an important thing that we do get that adjustment in the UK. If we don't get adjustment in the UK then we're you know entering into a different conversation and we have this phrase internally which is not meant to be funny, it's actually quite serious um is that hopefully we don't all end up going turkey um uh you mean erdogan policy policy mix exactly exactly where we just keep rates too low and i mean i like the worrying thing i suppose really when you see it and you know this is why i suppose we're quite you know we still think that obviously politics is going to interrupt but with the one of the key tenants of this is that we don't think central banks go down without a fight and so even though we have had intervention in the uk more recently with uh uh jeremy hunt saying basically that uh you know banks need to pass on you know more deposit rates to their customers they should limit repossessions of homes for 12 months i mean you know it's it's quite unhelpful i would think to the implementation of monetary policy and it would give greater credence to your argument basically that you know we could end up lower than what we should have end up but obviously if we end up lower than what we should end up, that's not a positive outcome for sterling, for, you know, the less well-paid elements of the workforce will obviously suffer significantly.

28:16And therefore, we have higher inflation for longer because you still will not eliminate that excess demand. And so, look, I mean, we obviously, there's always a choice to make. But I suppose one of the big things here is, look, central banks will not go down without a fight. And if central banks do not down without a fight then we're going higher harry we're going much much higher than what people think because again i keep reiterating discretionary spending power in the uk in europe in emerging markets in the us is much much higher than what the market appreciates with essential item inflation slowing wage growth strong and we enter into this with coverage ratios that are too high on terms of interest coverage ratios.

28:59So look, if we do get that adjustment in the UK, like, I mean, we run the scenarios for some of the, you know, there's some, you know, some listed REIT companies in the UK, Harry. If we were to, you know, housing office transactions in the UK are declining quite precipitously because just the bid offer spread is widening quite significantly. We see something similar happen in the residential market, to be honest. But if we were to kind of put through kind of like, you know, where relative to, you know 18 months ago 18 months ago and today how what is the bid offer what is the bid aspect differential that we should have in a in a in a commercial property in the uk and we think commercial property prices which are down probably 10 to 15 are probably should be down on today's rates probably should be down close to 50.

29:44which is a lot closer to the marks you see using closed end investment trust valuations yeah exactly exactly but that's that's today's rates harry right oh dear yeah yeah oh dear exactly exactly so you put that into the residential market now obviously if we do get that happen i mean i think you know obviously it's going to be pretty painful from a financial markets perspective but it's actually very positive for the uk over the medium to long term um and that's what generally happened it happened in the 70s it happened in the 80s it happened in the 90s okay what it actually took those tough policy decisions um and again we're back into this question today of whether we do have you know the the you know the um the gumption to actually do this this time around we we think that the central banks will won't go down without a fight that's the key thing i mean what happens after that fight is a different question maybe we'll come back to that another time um but we won't go down without a fight well a lot of it is about political burden sharing um sure whether it should be property owners who could take the whack whether it should be businesses whether it should be renters right now obviously i'm british i'm i've got i've got a lot of contacts in london my brothers and sister my brother and sister still live in london um and what they tell me is that rents are absolutely screaming um it's an it's a distress situation for renters and it's it's going to cause political problems because what you've got looks a little bit like an intergenerational transfer where younger, more indebted people are paying up through the nose and older, property-rich people are benefiting.

31:24This is going to cause longer-term political stress there. Same as in the US, frankly. In the US, you've got monetary policy being pushed by a Fed higher. And as you pointed out, not everybody pays those rates quite a few of us 30 i think roughly the u.s mortgage market is 30 year fixed um they haven't noticed they haven't noticed yeah so therefore we are relatively insensitive i suppose that's the big with discretionary spending with fiscal policy etc etc but then when we think about that harry then when we come on to it and we're like i mean we look at like there are going to be implications across this i mean we mentioned the uk um has been a little bit more vulnerable um you know the other country that looks quite vulnerable in terms of what we think but when we think about the banks and the investments that we would make or you know payment companies or the reits we would think you know france looks vulnerable why because you know french household debt over the last decade you know if gabrielle wouldn't mind putting up the percentage change in household debt for for france across europe um and also the the corporate debt numbers you'll see that french debt is up kind of like 80 90 percent over the last just over the last decade in the following chart you'd see corporate debt basically has gone from roughly 100 percent of gdp 20 years ago to about 160 percent of gdp today um and so you know even though i might have shown you germany coming in at 28 times coverage uh in terms of its corporate debt ratios france comes in at six um so therefore as we move forward you know the french numbers for example are going to have an effect so if you look there france comes in during the last crisis it is three times um you know we're now at six germany's at 29 profitability is roughly half in france corporate profitability rather than what it is in germany and on a on a total basis debt is double what it is in germany um and so therefore you put those things together and you get to go from six now if rates go plus 500 basis points from when they start to rise you know the the average interest coverage ratio is going to fall to 1.6.

33:29That's a pretty big number. That's a pretty big decline. I mean, that's lower than any period over the last 25 years. So is that going to cause some stress in the system? I suspect it is. Because let's not forget, as we've transgressed through this period of rising rates, we've had issues. We've obviously had issues in the US financial system, banking system. We've had issues with credit suites. We've had issues in the UK. is there going to be more issues? Yes, there are going to be more issues as we adjust. So, you know, that's the other thing we have to be careful on. But during, I suppose, coming back to the idea then, you know, is that actually one of the other countries actually that we feel is going to have a problem is Brazil, actually, if rates persist here as well.

34:11But we can come back to that another time. When you can, let's touch on the Brazil. It fascinates me. yeah so the narrative in Brazil basically is quite straightforward so again Brazil made the choice so we had you know we had right you know let's call it protest in the street in Brazil in 2014 ahead of the election and between 2014 and 2021 total economy debt in Brazil grew by roughly 50 to 60 percentage points of GDP interest rates at the time in 2015, peaked in 2015, and between 2015 and 2021, rates fell precipitously, you know, basically from about 15 all the way down to one to two in Brazil.

34:58I mean, it was an amazing time as debt grew. So therefore, you had a situation where interest coverage ratios, again, you know, you know, rose really, really sharply. And but what was really, really important about Brazil in that time is that if you look at you know real gdp per capita in brazil between 2000 last christ 2000 and 2014 that it rose every single year um but since they entered into this policy of aggressive debt creation um then we have had no real gdp per capita growth into brazil um in fact it's actually declined so therefore you had this excessive debt creation with no productivity growth and that is really a recipe um that is a recipe for a disaster basically uh once it comes um if gabrielle can put up the chart we have a just a brief and how does this actually flow through it's just a debt analysis by sector in brazil so you'd see the total economy debt is roughly around 172 of gdp today but front book rates are well above the back book rates across all the various segments and the debt one of the things about brazil actually that makes it quite interesting is the duration of the debt is quite short so unlike the uk where government debt has a duration of let's say 12 to 15 years or in france at seven years most of europe about seven to eight years brazil is actually four yeah so that's lengthened since i last checked it was free last time i checked yeah but like a short duration this is short duration at 171 of gdp in terms of total economy government at 84 and so therefore when the front book as we call it the front book rate i what their funding at today flows into the back book rate which will happen over time because the governments will have to fund at a higher rate then you kind of get over the next three to four years you get basically you know you're kind of you know the extra funding required as a share of gdp is roughly two and a half percent um you know in one year and over four years you need to knock basically 9.6 off your gdp in terms of the higher interest bill and that's actually quite a big number and actually i didn't put it here today harry i didn't show the chart but if you were to look at the household debt service ratios in brazil i mean they're um they're going through the roof now we haven't had a cycle yet but again we're having a similar narrative in brazil as we are in other countries in terms of now governments are becoming increasingly involved trying to preserve household cash flow so they're talking about cap on credit card rates they're talking about credit card rates are punitive in brazil yes it's such a amazing way of making money yes if you're a brazilian credit card companies is my favorite if i come back i'll come back as a brazilian credit card company yeah they have they have been pretty terrible now in terms of in terms of investments over the last little period um but uh you know we think this is the reason actually that we are going to have and are we going to have an NPL cycle in Brazil a significant NPL cycle in Brazil not performing loan cycle um you know the risk is yes we are but obviously if the government intervenes and caps credit card rates or caps other kind of rates or decides to give more money to households um you know then we probably won't be having a credit card cycle uh that we would expect that we should have but again you know what actually how does this flow through we can't not everybody can be a winner yes it's the burden sharing question again rears its head yes and the government can intervene putting a finger on the scale to decide who it is that pays that bill yeah so therefore i mean you know some of the interesting events what what what should you do with brazilian with brazilian banks in usd um you know are we going to have a credit card cycle or credit cycle or not or if we don't have a credit cycle are we going to have an issue in relation to the USDBRL rate.

38:48But that, this flows through, I suppose, this narrative is something similar that we see in the UK. Again, we think rates should be biased upward, not downward, even though they're talking about cutting rates in the next cycle. But when we come up with, I know we've skirted around a lot about rates over the last little while, Harry, but when we come on to it, then we kind of say, okay, how do we make money? Yeah. How do we make money here? Always. It's obviously not easy, but what we try to do is, look, try to understand, I suppose, what we try to do is try to understand like what is the environment in which these companies operate yeah what are the factors that influence the outcomes and so therefore then when we speak with the banks or the payment companies or the REITs or you know the diversified financials the asset management firms in Europe we have some understanding of how we think if we can mirror what they tell us versus what we see from our data then we can kind of have a you know an interesting conversation about you potential investments and look we've been exceptionally bullish on european banks for the last 12 months i mean the stocks stocks have done well but they haven't actually re-rated from an earnings perspective i mean they've really gone up because the earnings have gone up um and really you know interest rates in europe as i said have been low so if we think about the factors that are going to influence the banks um and we you know you're going to say well obviously interest rates going up is a positive i mean as we mentioned the amount of interest paid in spain was 55 billion in 2008 it's 15 billion today i mean banks are in the process what do banks do banks basically earn money on a customer spread where they charge you for your loan if the loan rate is higher they have a greater opportunity to make more money on that loan so obviously that's that's one thing i mean we look at german front book corporate rates are up 350 basis points so if you want a loan in Germany today you're paying 350 basis points more so that's more positive for the banks assuming they can manage their risk one of the but a couple of other things are really really important actually as well for the European bank narrative is that it's not only a rate call here I mean that's the easy thing to do the thing that's really really important I feel is actually that people are misunderstanding the fact that banks have been disintermediated for a decade and what do i mean by that i mean look i mean we use spain quite often in our analysis here in terms of we look at spain i mean corporate debt in spain is roughly flat over the last 12 to 14 years since 2008 it peaked at about 1.3 trillion it's 1.3 trillion today but over that period over that period the bank's share of that credit has gone from roughly 65 to 70 percent share to about 30 to 40 percent share so the banks have actually lost an enormous amount of market share to the bond market the private credit markets and you know other players um over that period and so you know that's really really important when we think about the other element that influence the bank basically which is are they going to have an issue as as corporate coverage ratios converge to normality over the next three to four years and as we do get this push on rates and we do get the coverage ratios converge, how bad will it be for the corporate credit cycle?

42:00And on the basis of the banks have lost market share for a decade, we just wonder, you know, who has these loans now? Because it's not only the banks. It's not only the banks. It's actually other players who may not have been as good underwriters as the banks have been over the last couple of decades. The other thing that's really important, Harry, as well... Sorry, go ahead. no no I was just thinking about for some reason private equity popped into my head but you already said you didn't like private equity well I think when we think about private equity is actually let's just focus on private credit I mean watching some watching some of the proponents for private credit I mean obviously the proponent of the proposition is that this has never been a better time to write a loan because now I can get a loan for 6%, 7%, 8 % basically on what we call the front book, i.e.

42:57on a new loan. The problem is, what about your back book? So what about the firms who are refinancing? So we actually use the narrative. If we can split the German data basically into what the banks funded at and what the non-banks funded at. So the banks funded at the trough, sorry, at peak coverage, the banks basically gave um gave loans at roughly around two percent to a corporate uh 28 times interest coverage um the non-bank sector private credit bond market funded at one at 28 times interest coverage if we're right and rates have well even if rates that interest coverage ratio today or somewhere in two years time is when these guys come to refinance is going to be somewhere between four and six times so will they be able to refinance at one percent highly unlikely highly highly unlikely that's cool yeah we're hearing some interesting anecdotes out of germany for example on real estate lending and there is a fair amount of i'd call it pseudo distress where people need to finance uh find bridge loans can't find out find it out on normal terms so they go to uh specialist lenders who offer them rates of 15 to 20 percent and they balk at those shop around and come back and it's the coming back that i find fascinating i can understand rejecting 15 i can't understand paying it but again i suppose the thing is look obviously we have to stress into commercial real estate market in europe that's obviously pretty absolutely that's evident but look i suppose it reminds me of what happened in 07 in terms of when we did have the the bear stearns hedge fund issue in march 07 it really was about 12 to 18 months before the full effects flow through great point such a such a good point absolutely and like and so i also we always focus again on the most vulnerable but this is going to affect everybody this is just not unique to um to the commercial real estate sector this will be all corporates will have much much higher refinancings in terms of what they have to pay um and the issue from from the bank's perspective obviously the bank that's an opportunity for the banks to some extent in terms of regaining market share where they've lost market share for a decade but the second thing actually um if gabrielle wouldn't mind putting up um there's a chart where we use where we you know the the funding spread between the domestic banks and other and i think this is really really interesting in terms of the bullish case for the banks because you know we obviously the rates are important but the banks have actually also lost their pricing power over the last decade and what does this chart show this chart basically shows us so banks you have if you want to go to a bank harry um you generally have stability in your funding i mean they're there for you generally there for you they're not you know they won't default on you unless it's absolutely you know uh generally it's it's you know there's a process you go through the bond market is obviously more volatile in terms of it's a willingness to fund at a specific rate um the banks so the banks basically have lost their their pricing power over the last decade and so if you think back back pre-gfc banks used premium for bank funding was running at around let's call it 200 to 250 basis points the corporates were willing to pay so not only have corporates lost have banks lost market share but also their pricing power was eliminated over a decade and so are we entering an environment today we think we are um that people will know where bank for stability of funding will become increasingly important in terms of its ability to access funding and we think yes the banks are going to be able to have that funding and will corporates be willing to access the banks back to the banks and we think people will so therefore even though loan growth is obviously going to slow balance sheets by contract but the pricing power of the banks if you think about an industry what you want in an industry you want to be an industry involved in an industry with pricing power pricing power is much more important than volume to some extent and uh you know so if the banks can regain pricing power then this becomes a very very very very strong story and the other thing clearly which we should if if gabrielle also wouldn't mind just in terms of european banks is you know the loans the deposits ratio of the domestic private sector um and this is actually really really important as well because you know the banks do have significant amounts of excess liquidity so this is just this is italy for example this is a loans to deposit ratio in italy which has gone from so italy i mentioned you know italian corporate credit basically is again flat for over a decade deposits have grown quite strongly which means you know again households have a lot of excess net worth creation um but you know banks are very very liquid now um and you This is, apart from the French banks, this area is a theme across all of Europe where the loans to deposits ratio is basically very, very low.

48:16Can I interrupt you briefly? Sure. Just hold that thought. Why is France an outlier? What happened? It looks like they expanded credit provision significantly somehow. Well, I suppose, well, French corporate credit, as I mentioned earlier, has doubled in, you know, French corporate credit has, you know, gone from 100 % of GDP back in pre-GFC to 160 today. Corporate credit has doubled in a decade. Sorry, household credit has doubled in a decade and corporate credit has doubled in a decade. And that isn't obvious. German credit is up, but not as significantly. So therefore, the French have basically run a more levered model.

48:52and you can even see that somewhat a little bit in the differential. I mean, obviously, I'm sure you've had people on speaking quite significantly about the differential between German and Italian credit spreads, which is a key parameter for stressing the Eurozone. I mean, one of our worries to some extent is that we're now seeing a widening of the credit spread between France and Germany. And I mean, if you think about somebody, a country that's taken on a significant amount of debt, just as rates have accelerated higher, then probably, I don't want to say it yet, but is France potentially the weaker element of the eurozone?

49:32Potentially, is what's happening in France, these social issues that are happening in France today maybe symptomatic of a deeper issue that are related somewhat to the excessive debt creation over the last decade, then potentially. I mean, all these things kind of intertwine to some extent, but you know like i suppose france but all the other regions basically when we think about the banks in europe you know they're liquid they might have pricing power back they mightn't have all the credit losses this cycle because they've lost market share for a decade um they obviously will benefit from a widening customer spread um and so therefore you're entering into an environment where you know you know the they're much higher capital ratios and you're kind of saying well i mean you I didn't show you ratings in some of these stocks, but these stocks are trading at distressed valuations on a price-to-earnings or price-to-prepribution basis.

50:30Four times earnings with 10 % to 12 % dividend yields with earnings potentially biased upwards. It seems risk-to-report seems good. Which regions in Europe have the cheapest banks?

50:45We've tried to focus on banks, basically, that have a high level of sensitivity to net interest income where there has been limited credit creation over the last decade sure that's really really important because if you haven't created much credit then obviously you're going to be less sensitive to a rising rate cycle so the focus for us has actually been on the banks that were in the crisis in during the last gfc which is the Italian banks, the Spanish banks, the Irish banks, and maybe one or two select banks in the Benelux in Germany. But in general, we've tended to avoid banks in France, in the UK, Eastern Europe to some extent, because again, policy is a little bit more difficult there but just focus on banks where there are you know that have these characteristics low loans to deposits ratios no credit growth so therefore we just get the full benefit of the rate curve um and you know ideally banks that do buybacks so the other thing that's interesting harry is that you know even if rates do you know we don't expect rates to fall but even if they do banks still do okay in that cycle for a period so at this at these values i mean we're pricing in a very exceptionally bearish scenario and the way we think about that in terms of because the banks have lost market share for a decade you have these high coverage ratios you don't get cost of risk or you know poor provisions for a period um but the offset of that actually is you know just in terms of the you know the private equity asset management sectors are going to have a lot of challenges in the coming period and you know why is that um with a couple of reasons one is does a mix effect flowing through in terms of you know as bond yields keep pushing higher i mean ultimately you know bond funds are going to become more attractive um because they'll be paying five to six um versus an equity that's volatile um you know if bonds are paying five to six you know you know your equity could become more difficult so you have a mix effect whereby you know the the margins that these firms earn and their equity product is a significant premium to the margin there which is kind of like five to ten basis points basically on a bond product versus somewhere up to 60 to 70 on an equity product so you have a negative mix effect you have household cash flow normalizing eventually once we once this rate cycle progresses so therefore the flow into asset management will be weak um and then you have um i suppose you know many of these firms would have been overly aggressive in their cost basis over the last kind of like several years so you get potentially an environment where you have revenue falling and you know you have an inflexible cost base i mean asset management firms in general are not great at rationalization um um and so you know you it becomes a very very interesting period i mean like and one of the things we find about like even you can see it if gabrielle wouldn't mind just putting up the couple of charts that we have on on private equity towards the back end um of uh you know um we have basically where you know you know obviously private equity um i mean even in the uk they're talking about allocations to private equity but you know private equity allocations basically were gradually moving upward you know from 15 to 21 then we got this acceleration during covert where you know everybody had to get into private but i was just precisely at the time when the rate covers were low but all these things refinance in four years time from one percent rates at four to four to five percent rates or seven eight or ten percent rates we're not sure um so will will private equity give you the type of return that one expects over the next several years and we we suspect not and then the following charts will show you what's happening something similar to what's happening we mentioned earlier about the commercial real estate transactions in the uk if you look at private equity deal counts if you look at the European deal counts, like these things are falling precipitously.

54:53I mean, we're back to already, we're back at 2008 levels in terms of value. But these deals were all done. A lot of these deals were done at 28 times interest coverage at 1 % rates back in Q1 2022 and prior. Now we have to refinance at 10. And like I suppose, but then we know this is coming, Harry. Yeah, I suppose that's from our perspective. if we know this is coming and you ask the question when does it happen i mean obviously we all want to know when does this actually happen that's exceptionally difficult we just keep focusing on the data if we keep focusing on the data hopefully the data and we keep trying to look forward will tell us when we're beginning to see the stress we obviously talk to the companies they're not seeing it yet the data is telling us it's not yet and if those conditions still exist if those conditions still exist but the banks are telling us not yet our data is telling us not yet the discretionary spending is going up the coverage ratio is still too high we still have higher rates we still have work to do on the upside and in that environment not yet not yet we still got it so you know that's why we've been exceptionally bullish on european banks for a period we're still bullish on european banks ideally periphery um and uh you know we feel the asset management sector is going to be very very challenged we got a couple of quite interesting questions from the audience um so joseph um asks given demographics have not improved in the eu or the us and ai will take some time to improve productivity do you see financial repression returning after the excess savings burn off and base effects on wages stabilize or do you see an enduring wage you know upward weight pressure for years well i suppose the financial repression question is probably one of the most important questions one can one can ask i mean in terms of ultimately where did we end up because obviously if we do get financial oppression in terms of the government's choosing i mean there was a period um after world war ii in france whereby they directed where the banks lent yeah um so they determined policy basically determined monetary policy between 1945 and then about 1968 into the early 70s, whereby the government dictated policy.

57:16And that is what financial repression is. So will you be dictated? Will we be dictated to buy government bonds ultimately to preserve the nominal, the perception of,

57:35perception that everything is okay. And again, I suppose my answer to that is I come back to the fact that central banks won't go down without a fight. So I think financial repression comes after we have had that fight. And the only question then that's important is at what level of rates do we have that fight? We think it's higher. but it's coming and like once we get we'll know when the fight starts let me put it like that then obviously has different implications for gold and various other things because then we're you know we're uh we're in a different environment of financial repression um we don't see it yet i see some signs that the fight has already started but it's certainly not it's not a hot war yeah it's and i say that because feds their hiking rates for example but u.s uh the u.s fiscal deficit is eight percent so yeah if they had any control over the fiscal situation they wouldn't necessarily have to raise rates as much clearly they don't they're not the u.s government and the fed are pulling in different directions um paul also has a question um it's a good one What is the most important difference between European and US banks that leads, that will give you European bank outperformance?

58:56Why do you get European bank outperformance? I suppose there's a couple of questions. One is Europe had a crisis in between 2009 and 2012, 2013, whereby in particular exposure to certain sectors fell. So commercial real estate exposure, for example, in the U.S. regionals is roughly 30 % to 35 % of total loans. In Europe, 5 % to 8%. 5 % to 8 % significantly lower. Second thing is the European banks. So that's on the cost of, let's call that a cost of risk issue. Secondly is the credit growth in Europe has been an awful lot lower, similarly related to the cost of risk issue. the other issue that's really really important is around uh deposit betas what we call deposit betas in europe versus the u.s so um like the u.s saver seems to be a lot more sensitive to the rate curve in terms of their willingness to move so obviously we have yes yes i am i'm already in t-bills i'm it's a ridiculous thing to receive the deposit rates they offer you and have their default the risk on deposits so yeah and so so like that that is less of an issue in europe now not that's not to say it isn't an issue in europe it is an issue for example more recently we're seeing i think there's been roughly year to date roughly about 50 to 60 billion flow into btps in italy for example which are yielding four to five versus the depositors and the uni you know unicron and taser paying basically close to you know limited limited limited let's just call it limited um so but because we don't have the same level of uh i suppose homogeneity you know this this easy transferability from deposits into t-bills and i suppose maybe it's because we're less financially astute in europe um versus the us wouldn't not as deep uh kind of a money market uh money market funds then you don't get the same level of of deposit pressure as you do in the us and so therefore deposit meters in the us have actually been really really high deposit meters in europe have actually been really really low so you know like we can look at you know somewhere like ireland slovenia you know portugal where you know even though the ecb has moved by close to 400 basis points already um you know they have passed through probably you know 20 30 basis points of that move um even though you know so you you get you get that issue the other big thing about the european banks basically is that you know over the last decade they've been subject to significant regulations such that capital ratios have improved significantly and the us banks even though they obviously they had good stress tests the european banks are now entering a period where you know on higher earnings that they are now doing significant buybacks they're buying back their stocks they're just talk basically at four times earnings so i can i can buy some banks in europe with you know 10 to 12 yields i'm happy in terms of my earnings outlook for the next several years um but they're buying back stock at four times i mean i mean it's just it's just very it's it looks like it's a strong tailwind it's a strong tailwind basically so if you have more buyers and sellers so we're running really short time but i really wanted to touch on this point um which is you know the environment what you've described with upward pressure on rights sounds like a dreadful environment for US regionals because they haven't really been rescued by the Fed.

1:02:27They've just had this problem pushed back into the future. So it seems to me that US money centers have the advantage of being able to feast on the carcasses of US regionals, buying their assets up cheap when they get put to sleep. Am I wrong to look at it that way? Is that not? Yeah, well, we don't cover the US. We obviously keep an eye on the US because it's obviously an important mark we don't cover the u.s specifically but clearly um you know i i think you know it's a bit like you know we're going to get issues occurring as we push as we push on that you know we've been pushing on a string sometime that string some point that string will will bounce back rates can go high enough to hurt somebody we're just trying to figure out we're just trying who it is yeah exactly exactly and like and that's why i think we can't we can't you know we can't be complacent enough to suggest and we're certainly not complacent enough to suggest that this isn't going to have an issue for Europe I mean it is clearly going to have an issue for Europe in terms of the cost of risk for European banks is going up is there going to be differences between the UK France and Ireland for example yes there will be what I prefer to belong you know are you know certain certain regions and the banks in those regions yes um but you know we're we're We're going to have kickbacks, Harry.