We also see rising regulatory risks for STAN. Previously, the focus of the UK regulator has been on domestic economic and financial risk. On December 1st, the Bank of England is expected to release the results of a stress test which will specifically look at direct exposure to cyclical downturn in Asia, including Chinese economy growing at just 2%, Hong Kong GDP falling 6% and HK property prices back at 2010 levels (-40%) as well as a $38 trough in the oil price! In other words, a cynic might think it is a test which has been specifically designed for STAN to fail. As STAN admits “the focus of the BoE stress tests are external risks to the UK and accordingly, the stress parameters are more focused on emerging markets…..Consequently the stress parameters are more severe”. As such, management might be motivated to use the stress test as a catalyst to raise significant new equity from its shareholders, which in our opinion it needs anyhow to deal with the forthcoming downturn in asset quality for which it would currently appear insufficiently prepared.
We think that a benign outcome from STAN is that the bank is managed in the interests of debtholders and regulators for the next few years as management de-risk and de-lever the balance sheet whilst the balance sheet is rebuilt with materially higher P&L provision charges and current shareholders are diluted through the issuance of new equity. Pre-provision profit will also fall as costs cannot be cut fast enough to compensate for falling revenues. We cannot square even this benign scenario with consensus analyst forecasts that the balance sheet and revenues continue to grow, provision charges peak this year and the share count remains constant. So even in this benign outcome, current investors will need long time horizons and the belief that Asia, EM and commodities are facing short-term headwinds rather than a structural downturn. Our experience of the credit cycle in Europe would suggest it is more prudent to be cynical and to wonder about being “here for now”, rather than “here for good”.
Barry Norris and Greg Bennett (above) are co-portfolio managers of the Argonaut Absolute Return Fund