Markets wobble again, with European banks leading the way
By Buttonwood
ANOTHER worry has been added to the long list plaguing equity markets this year. Bank shares have been falling fast, particularly those in Europe, which in morning trading, were down 22% so far this year. The collapse of 2007 and 2008 was all about the banking sector. If European banks are in trouble, then comparisons with that period are bound to mount; earlier worries, notably the slowdown in Chinese growth and the fall in commodity prices, had more parallels with the Asian crisis of 1997-98.
A number of factors are hurting bank shares. First, the sluggish performance of European economies over several years means there are worries about bad debts on bank balance sheets; Heartwood Investment Management reckons that 16.7% of Italian bank loans are non-performing, against a European average of 5.6%. Italian banks have been amongst the hardest hit. More generally, however, the recent results season for Europe's banks was disappointing with the CreditSights research team describing them as
weakened by a mix of restructuring charges, goodwill writedowns, lower trading revenues and impairments
Second, there are specific worries elsewhere. Deustche Bank's shares and bonds have been hit by worries about its ability to pay coupons on its $5 billion or so in convertible capital bonds (cocos). Such securities were issued as part of new bail-in rules designed to make the private sector, rather than the government, bear the cost of bank rescues; the problem is that investors don't want to be bailed in. Greek banks have been hit by renewed worries about the country's bailout agreement with the rest of the EU, in the wake of continued protests about the required economic reforms, including cuts to pensions. Greece's stockmarket is at its lowest level since 1990. Finally, the prospect of a long period of negative interest rates in the euro zone may weigh on bank profits. Negative rates are imposed by central banks on reserves held with them by the commercial banking sector. But the commercial banks are unwilling to pass these on to customers. So negative rates act as a tax on bank profits.
Europe is not the only place where there is a problem. Bank of America Merrill Lynch calculates that, so far, US financial companies have reported a 4.2% decline in quarterly profits. Indeed, that is part of a general decline; fourth quarter profits for S&P 500 companies are down 2.3% quarter-on-quarter and 4.3% year-on-year. Even if energy stocks are excluded, companies managed only a 0.4% quarterly, and 1.7% annual, earnings increase. The latest research from BCA shows concern about the financial health of the US corporate sector arguing that
leverage has soared in the past couple of years on the back of a merger and acquisitions wave and rampant equity buyback activity. Profit margins also appear to have peaked.
Weak US profits are part of a bigger debate about the health of the American economy; strategists are busy calculating the probability that the US will enter a recession this year. Friday's non-farm payrolls numbers were mixed; while the headline jobs increase was lower than expected, there was better news on wages and the unemployment rate (calculated on a different basis from the payroll numbers). The Atlanta Fed's GDPNow model used the data to point to a very decent 2.2% annualised growth rate in the first quarter, up from the fourth quarter's weak 0.7% annualised rate.
Ethan Harris of Bank of America Merrill Lynch says that investors seem mostly to worry that the US will be dragged down by slower growth in the rest of the world. But he says that least five global shocks - the 1982 Third Word debt crisis, the European exchange rate crisis of 1992, the Mexican or tequila crisis of 1994, the Asian crisis of 1998, and the euro zone debt crisis of 2012 - have not pushed America into recession.
Popping US perceived asset bubbles and tight US monetary policy often trigger global downturns but, as we have seen, some fairly ugly stuff outside the US seems to blow over the US with little impact
adding that
the dollar is by far the most pre-eminent reserve currency and the US Treasury market is the centre of global capital markets. Hence during periods of "risk-off", capital tends to flow into the US even if the global shock originates there
Nevertheless, the markets may still be right to worry even if the US is not headed for outright recession. Slower global growth - the secular stagnation scenario - could still be a worry, particularly for corporate profits. There may also be a sense that asset prices have been held up by monetary policy, and that the effectiveness of this support may now be declining. That is the thesis of Rabobank which argues that
1) A principal aim of QE is to boost asset valuations such that positive wealth effects trigger a recovery in demand; 2) This, though, is self-defeating as QE also furthers the “financialisation” of the economy which, as in the run up to the crisis, sees profits diverted away from investment and wages (via an incentive to invest in financial securities which are being underpinned by the central bank rather than undertake “real world” investments or, on the back of low borrowing costs, to engage in share buybacks or M&A activity); 3) As a result, labour’s share of national income continues to decline as evidenced in the conspicuous lack of a recovery in advanced economy wages even as jobless rates plumb historical lows; 4) In marked contrast to the pre-crisis period, however, “financialisation” now no longer has a flip-side – i.e. previously labour’s declining share of national output was compensated for by easy access to credit. Now, though, with private sector debt levels still high, some distrust of these higher asset valuations likely at play given memories of the crisis are still fresh and, most importantly, the fact that QE has gone hand in hand with tighter regulation means the willingness and ability to borrow is limited. As a result, policy stimulus succeeds in boosting asset valuations but arguably simultaneously stymies the recovery it seeks to engender.
In a sense, the market is divided between bears who think that these big issues are now coming to the fore and bulls who think these worries are overdone and that the global economy will muddle through once more, with low oil prices as a key driver. Falling bank shares are another piece of evidence for the bears. But the bulls are a long way from giving up.
Perhaps the bulls will be rescued by a dramatic central bank move; that thought caused Martin Taylor of Nevsky Capital to close down his fund, rather than to go bearish. Or perhaps the bears will be proved right by a "1992 moment" when the central banks attempt something so outlandish that the markets assume they will fail. Back then, the Bank of England raised rates by five percentage points in a day to support sterling. It was a move that smacked of desperation and the pound was devalued by the evening. One day, a central bank may unveil more QE or even more negative rates, and the markets will laugh.
