Brexit, Bank Stocks, Currency Wars: The Usual Suspects by Rothschild Wealth Management
Foreword
Bank stocks are volatile at the best of times, and these are not the best of times. Recent losses and restructurings, untested capital structures, negative interest rates, flattening yield curves, and fears that senior bond holders and even depositors might be asked to bail them out, all combined in February to push some European bank share prices down to levels not seen in a generation. The big stock indices fell to two-year lows.
Market fears can be self-fulfilling. “Feedback loops” exist, and were very visible in 2008, for example. However, there are also precedents for markets loudly crying “wolf” mistakenly, namely in 1987 and 1998 (coincidentally, both associated with lowered oil prices). Aggregate bank solvency and liquidity are stronger than in 2008, and central banks still have room to act should they feel the need to do so. As yet, the interbank market remains well-behaved, even as credit has reportedly become harder to get.
February’s volatility follows an unhappy New Year for stocks. It is unclear exactly why the investment mood has darkened so suddenly in 2016. It probably reflects investors’ understandable sensitivity to “credit” concerns, and market dynamics, rather than an underlying problem we have collectively missed – but by definition, we can’t be sure of the latter.
Our view is unchanged, but this doesn’t mean we are complacent. If we were to change our view at this point we would be responding to market sentiment, not new facts. We doubt the longer-term outlook has altered, and our portfolio managers have been looking for opportunities unearthed by the turmoil. In separate essays below, we also review the intensifying Brexit debate, and argue that fears of a global currency war are premature.
Kevin Gardiner
Global Investment Strategist
Rothschild Wealth Management
The usual suspects
“Snakes. Why does it always have to be snakes?” – Indiana Jones
Still muddling through
Stocks have rallied since lurching into bear market territory on 11 February, but it is premature to proclaim stability. We have been spoiled by a seven-year US expansion and a relatively clear cut market call in that period: recent volatility is in fact not yet that unusual, and while economies, corporate profits and stocks all tend to move forward in the longer-term – for reasons that have little to do with central banks or interest rates, positive or otherwise – they don’t travel in a straight line.
We think the global economy can continue to muddle through for a while yet. On some of the markets’ specific concerns:
- Does the market “know something” we don’t? We can still remember being told by a corporate financier with a blue chip client list that the UK corporate sector was in difficulties in 1990 some weeks before official data showed the economy diving. We also remember that the credit market’s local difficulties in 2007/8 did indeed morph into a wider, dramatic threat to risk assets in general.
But our hunger for a plausible story – for a human metaphor that brings markets to life – can lead us astray. Sometimes markets move for reasons that have no macro logic, but which simply reflect the changing positioning of key players, and which can be unimportant in the longer-term context. The data at which we look most closely – covering economic activity, money supplies, financial tension – are not yet pointing to a change in the climate.
- Are EU banks in trouble again? The speed with which European bank stocks fell in February was alarming. In several instances, restructuring costs ate into capital, and the existence of new “contingent convertible” (or “CoCo”) bonds (with coupons payable at regulators’ discretion) makes this a more urgent risk. In the background, the new resolution framework makes it more likely that senior bondholders generally, and even larger depositors, may be more quickly at risk (or “bailed in”) in any shortfall. The treatment of Portugal’s “bad bank” bonds at end 2015; continuing uncertainty over Italian banks’ non-performing loans; and the impact of negative interest rates and flatter yield curves on net interest margins, have further sensitised the issue.
However, there are still few signs of an increase in systemic banking risk (figures 1 and 2). The ECB continues to offer potentially unlimited liquidity, and pressure on net interest margins would fall if banks passed negative rates on to private depositors (which has mostly not happened so far). Collectively, bank capital and liquidity are stronger than in 2007/8, and if markets stabilise we suspect that bank stocks will rebound strongly.
- Is the US entering recession? We’ve long argued that there haven’t yet been the excesses in US domestic spending to warrant a meaningful downturn, but the risk of a technical recession did rise at year-end: growth slowed to a near-standstill, and poor weather seemed to threaten a weak new year too. However, consumers in particular continued to spend robustly in January, buoyed partly by cheaper oil prices, and the effects of a stronger dollar and energy sector cutbacks may have peaked. A technical recession looks alittle less likely than it could have done.
- Is China melting down? Data still point to a slowing economy, not a collapsing one. Meanwhile, China’s importance, and its exchange rate policy, can be misinterpreted. It has contributed a lot to global GDP growth in recent years – more than the US – but is still some way from being the largest economy in current dollars (figures 3 and 4), and its growth is less relevant to capital markets than (say) US or European growth. As we note again below, it has not started a currency war (though the renminbi is not one of our favoured currencies).
Investment conclusion
There hasn’t been an economic accident yet, but one of the things worrying investors is the idea that if there were to be, the authorities are now powerless to help. We think this is mistaken: central banks can still improvise on monetary policy and act as lenders of last resort, and governments have plenty of levers still available to pull.
Central bank support is not a key part of our case for investing. We think the global economy can stand on its own two feet, and ideally should be left to do so (subject of course to having safety nets for those harmed by the business cycle). Fiscal deficits are (as Ronald Reagan said) big enough to look after themselves. Longterm prosperity is not driven by interest rates, bond purchases or public spending, but by the availability of resources and by ongoing innovation and learning by doing. Investors shouldn’t be so worried on this account (the issue of who exactly might be pulling the US levers in particular is another matter, perhaps).
Meanwhile, at end-2015, US corporate earnings were down modestly on the year. Excluding oil and materials companies, however, they were broadly unchanged, with few signs of a downward lurch ahead. Stock valuations across the developed bloc – and now in the US too – are firmly below trend, and while bonds are expensive, the absence of inflation (and the scale of current and previous central bank