Given the carnage in the banking sector overseas it seems pretty hard to justify the idea that people are too optimistic about any financial sector or group overall, but maybe markets still are? Let us forget the specific problems we have been discussing about European financials including them being even more leveraged than here in the US, the fact that they own a bunch of US mortgages, that they have financed their own housing bubbles, that they have much larger exposures to Emerging market debt, including Eastern European mortgage debt.
Instead let us look at what expectations for them are now. From Citigroup (pdf.)
What we see here is that expectations for profits and loan growth are far higher than past crises show are likely. The question we have to ask is whether it is as bad as those past events? I don’t know, but if it is as bad as it appears expectations are still too high.
Earnings (of course) collapse, driven in part by soaring bad debts. However, these periods also suffer massive shrinkage in loan books and (more modest) shrinkage in deposits and total balance sheets. Pre provision operating profit also tumbles, in part reflecting this balance sheet shrinkage. Applying even the least damaging of these episodes (Hong Kong 1997-2002) to the current sector would see loan books halve and earnings, equity and operating profit all fall c40% from current forecasts.
To be clear, none of our economists forecast depression or deflation in Europe, but as recent IMF analysis demonstrates, recessions preceded by financial crisis tend to be long and deep. We might find ourselves rereading this report in a few years time and thinking that we were way too bearish to even raise this spectre. Or we might not.
My suspicion is that the specific problems mentioned earlier make these outcomes far more likely than many people wish to admit.
Hat Tip: Alphaville