Weekly Update

February 12, 2016 Update

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Europe and the banks

The crisis du jour is found in European banks. The market has determined that nothing good and everything bad is knocking on the door of these large institutions. Remembering how unpleasant the fallout from the U.S. banking crisis was, markets have quickly piled into the worst case scenarios and extrapolated all manner of unhappiness from a few data points. Here are the datapoints of concern:

  1. The European Central Bank (ECB) offers negative interest rates for money on deposit with them.
  2. Debt/credit levels are already high in Europe as the economy has failed to generate enough growth to materially bring down the debt incurred during the 2008 financial crisis and 2011 crisis of confidence in the Euro. The European banks, generally, have not recognized these loans as bad, however. They have not, in other words, cleaned up their balance sheets to the same degree that U.S. banks did.
  3. Some banks have recently acknowledged that they are carrying more bad loans on their books than they realized. Thus, their balance sheets are not as good as they appear and need to write off more loans.
  4. More loans than expected turning sour would normally cause banks to become more conservative in their lending, which would cause them to put more funds with the central bank (as reserves). With the Central Bank now charging the banks to leave their money with them, and the risk of lending out more money looking higher, banks have to pursue a different path. They are looking to raise the interest rates they charge for loans as a way to offset the cost of the negative interest rates. So, perversely, the negative rates from the ECB are potentially going to push interest rates to consumers higher! Talk about unintended consequences!
  5. Further boxing in the banks are requirements that they increase their reserves in the next 2-3 years. They had hoped that increasing profits would fill up the piggy bank. With little economic growth and increasing bad loans, those expectations for higher profits are not materializing.
  6. The quickly diminishing profit outlook for the banks is being reflected in a substantial writedown of their stock prices sending them below their 2008 lows. That is yet another blow to the already damaged psyche of investors
Chart 1: Credit Suisse (CS) and Deutsche Bank (DB) plunge to new lows

Credit Suisse (CS) and Deutsche Bank (DB) plunge to new lows

Investors figure that the banks are boxed in and have no choice but to cut their dividends and/or sell new bonds at higher interest rates to have enough capital to keep the dividends going. Either way, investors view the European banking sector as bleak (and probably bleaker than the reality may turn out to be.)

Broadly speaking this development along with the continuing decline of high-yield “junk” bond prices reflects the latest boom-to-bust cycle in finance. There is a financial crisis roughly every decade. It follows the same script:

  1. confidence grows that the last crisis is over,
  2. the purse-strings are loosened and credit flows more freely,
  3. credit flows too freely to certain sectors where the fundamental business prospects cannot really support the funding (talking to the oil drillers out there!),
  4. the leverage in the system reaches an unsustainable point,
  5. the business prospects play out negatively leaving those who funded the worst players holding a load of bad loans,
  6. the fallout from those bad loans spreads … either a little bit or a whole lot depending on how solid the foundation of the financial system is compared to the leverage built upon it.

In the 2008 financial crisis, layers of ultimately bad debt were piled upon a relatively thin foundation of financial system reserves. The structure collapsed. Banks were forced to build a more robust foundation through higher capital requirements.

China and Europe appear to be now realizing some version of that crisis – e.g. a foundation too thin to support the debt piled on top. In China, you have a government with a mountain range of reserves to shore up the foundation and let the debt structure (hopefully) tumble in a measured way. In Europe, where the governmental system is fairly new and every crisis forces the countries to recommit to each other in their rather forced union, it’s easy for investors to fear the worst.

It’s better to be lucky than good?

Timing is everything they say. And being market timers, we certainly respect the importance of being at the right place at the right time. President Lula of Brazil was the most popular leader in the world during his tenure. Helping his natural charisma was a boom in China that carried the Brazilian economy (a key supplier of raw materials to China) to heights never before seen. Now, a decade removed, we see Brazil on the verge of an economic depression for many reasons, but perhaps many of which flow simply from a sharp slowdown in the growth of China and its ripple effect on Brazil.

Jack Welch was viewed as a legendary leader of the General Electric Corporation. His successor has had a much harder time of it. Perhaps it helped Mr. Welch that he was in charge during the economic boom of the 1990s?

By maybe a similar token, the following article posits that great investors are a thing of the past. Being an investor who experienced life-changing wealth was easier in the secular bull market of the 1980s and 1990s than in the stingy, flattish markets of the 2000s. It’s easier to become a legend when one is lucky enough to have a steady and strong wind at their back. Anyhow, next time someone is held out as having legendary performance, consider the larger environment in which they played, the factors that might have given them an advantage of their time. Doing so can make seemingly lessor accomplishments grow in stature such as the baseball pitcher who was dominant during the era of heavy (and juiced up) hitters or the hitter who stood alongside those heavies but without the benefit of the medicinal supplements.
Enjoy: Why we’ll never see another Warren Buffett or George Soros ever again

Market Update

The prior week’s rout in stocks showed no signs of letting up in Monday’s session with another -1.4% taken off the market index. The news was actually worse than that result would suggest. Oil prices continued their fall once again dropping below the $30 mark. China’s currency reserves continued their decline now reaching levels not seen in almost four years and leading observers to wonder how long China will continue using their reserves to prop up the Yuan. European banks were once more hammered to the extent that Deutsche Bank (DB) came out with a statement reiterating its “solid” capital position.
Those three items, taken together, could easily have lopped off twice what markets experienced in Monday’s trade. Indeed, stocks were down much further before recovering. Tuesday kept the pressure on before another late-day recovery pared losses to breakeven. Same script as Monday with investors looking to Wednesday’s Congressional testimony from Fed Chair Yellen. The testimony failed to excite investors with markets putting in another flat day. However, bulls had to be disheartened as a powerful opening rally completely faded by day’s end. Investors fled to safe havens Thursday as Chair Yellen continued her testimony while Sweden became yet another country to adopt negative interest rates. Markets have thus far seemed to find the increasing use of this tool as concerning rather than stimulative and have sold off risk assets such as stocks while preferring U.S. Treasury bonds and other perceived safe haven investments. Thursday ended -1.2% lower but again finished notably above its low point. Support for oil prices and European banks helped give investors a reprieve Friday as stocks zoomed upward almost +2% to recoup a good chunk of the week’s losses.

Warm wishes and until next week.