As a macro observer, I am quite accustomed to market turmoil created by Federal Reserve (Fed) policy, foreign exchange volatility, and global capital flows. Those are all par for the course. Typically, it is this type of turmoil that creates fantastic market opportunities.
However, from a macro perspective, when bank stocks and credit spreads start underperforming in a big way, it is a totally different ball game. That volatility usually foretells major problems in the economy and credit creation a few quarters or a year down the road. In that sense, banks are the proverbial canaries in the coal mine.
The questions in the current context of weakness in both bank stocks and credit spreads then become: Are the canaries dying? Is that telling us something about the state of the global economy in coming quarters? And is it time for the miners, i.e., investors, to get out of the mineshaft?
This is especially important because unlike Internet stocks, consumer staples and biotech, valuations in banks never got too high to begin with. Investors never expected them to be high flyers and were happy to leave them for dead.
So then what could possibly be driving the selloff in bank stocks?
Potential Credit Losses
One explanation could be that the selloff in banks is primarily driven by the possibility of coming credit losses. The credit markets have been in a tizzy for 18 months and implied default rates are shooting higher.
While it all fits, I have a difficult time accepting this thesis. If you look at the credit growth data economy-wide, private credit overall did not grow much in the developed markets during the current cycle. In the U.S., for example, while the corporate credit growth rate was decent, household credit growth barely turned positive. Even in energy, the world epicenter of credit problems, most of the credit growth was funded by the capital markets and emerging market banks rather than developed market banks.
Furthermore, the underperformance in banks is focused in Japan and Europe. That is especially galling because corporate credit growth in those regions was far more subdued than it was in the U.S. While potential credit losses clearly are a possible source of the contagion, they aren’t the probable source.
Another explanation could be the interconnectedness of the large global banks and the contagion coming from a large systematically important bank—in this case, Deutsche Bank—running into trouble and taking down the sector altogether. Recall that during the Great Financial Crisis, large banks came under pressure due to the systemic nature of the crisis.
Today, Deutsche Bank is under profitability and capital pressures due to recent large losses. Could Deutsche Bank be the source of contagion? Again, I find this explanation hard to accept.
While Deutsche Bank’s losses have implications for its ability to pay the coupons on some of its lower capitalization level securities, it insists it has the capability to pay those coupons. Given that most of its recent losses are restructuring related and entirely under Deutsche Bank’s control from a timing standpoint, I see no reason not to believe its assertions. While Deutsche Bank has a lot of work to do to get to a much better level of profitability, given its disclosures and the very high level of scrutiny from regulators, I believe it is a victim rather than the source of the contagion.
Selling by Sovereign Wealth Funds (SWFs) is also offered as an explanation. After the financial crisis, SWFs were one of the largest sources of capital for European banks as those banks went about rebuilding their capital bases. As SWFs start selling assets to plug the spending holes created by lower oil prices, clearly they could be expected to unload some bank capital stock on the markets.
That certainly would have been a plausible explanation a year ago, given the bank equity sell-off at that time. Today, however, I am assuming SWFs would sell off a whole lot of other assets before they get to Credit Suisse stock, for example, which currently is trading at a multi-decade low.
Central Banks and Negative Rates
The last and probably best explanation I can find is the advent of negative rates in an environment of large reserves piling up at the various central banks.
At the moment, the European Central Bank (ECB) and Bank of Japan (BOJ) have negative deposit rates in effect. In other words, banks that leave reserves on deposit at the ECB and BOJ must pay them to hold some of those deposits. While negative rates may make sense from a monetary policy standpoint, negative rates, large surplus reserves and flatter risk-free rates are effectively the end of banking and the banking world as we have known it for centuries. Banks were unlikely to get to very high levels of profitability due to low rates and high capital requirements, and negative rates simply add to their list of woes.
If that is the primary driver behind the sell-off in bank shares, I believe there is reason to be hopeful on bank equities and risky asset prices:
- First, the sell-off has gotten bank equities to very cheap levels relative to their book values and overly discounted their lowered profitability picture.
- Second, the Fed is still far away from implementing negative rates, so U.S. bank stocks like Bank of America may be the proverbial baby being tossed out with the bath water.
- Third, even for European banks like UBS and Credit Suisse, the value of their wealth management franchises may be more than their current market value.
- Finally, if it is bank profitability rather than credit losses that are driving the selloff in their equities, there is hope for the credit markets after all. Credit markets have been on a one way sell-off since the middle of 2014 and are now discounting very high levels of losses even in investment-grade companies.
In this framework, the canaries are not dying in the coal mine. They are just depressed and exhausted.
And we miners don’t have to clear out the mineshaft just yet.
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