A fortnightly look at global financial markets
The following is a detailed commentary and analysis from deVere Group’s International Investment Strategist, Tom Elliot regarding the world’s financial markets and the concern over negative interest rates, the zombie banks of Europe and the uncertainties of coco bonds.
Q1 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income. Within equities overweight euro zone and Japan, underweight US, UK and emerging markets. Within fixed income, a preference for core government bonds over credit, no duration bias.
- The sell-off is no longer dominated by the energy and materials sectors, last week we saw financials dominate the headlines and falls in most risk sectors (such as tech) as investors fled to safe havens such as gold, the yen and core government bonds. While the MSCI World index is down 10.5% since the start of the year, the Barclays Global Treasury index is up 4.9% (both total return, in USD).
- As ever, investors are advised to sit still in a diversified multi-asset portfolio. Markets are caught up in a multiplicity of worries based around slower Chinese growth, collapsing commodity prices, and negative interest rates. All of which can be described as the fall-out of the unorthodox monetary policies pursued by central banks since 2008.
- Furthermore, the fear of a US economic downturn is in the air. Fourth quarter GDP came in at a miserable 0.7% annualised rate of growth and the US Treasury 2yr/10yr yield gap has compressed to below 1% for the first time since January 2008. This signifies intense investor preference for risk-free assets due to international factors, or a lack of belief in US growth and inflation, or –most likely- a mix of the two. The interest rate futures market now indicates no further rate hikes are expected this year.
- Intense unease is likely to persist in capital markets for weeks to come. Recent poor European bank results have highlighted the problems caused to the sector by European central banks using negative interest rates to stimulate economic growth. This would be less of a problem if so much of the sector wasn’t suffering from a significant non-performing loan problem, having never really recovered from the 2008 credit crunch.
- But importantly for investors, what we do not have is a convincing theme that suggests a global recession is around the corner. European, and global, banks are far better capitalised than they were in 2008. Meanwhile the sharp falls on global stock markets are each day reducing the key stock market bear argument of recent years, that equities are over-priced.
- Sit tight. The rest of this notes looks into how negative interest rates affect bank earnings and can be accused of harming – not stimulating- broader economic activity. I then look at how the colourfully named coco bonds fit into the current set of market worries over banks.
Concern over negative interest rates
- What would you do if you discovered that a treatment for your life-threatening illness actually made the problem worse, not better? You might try a new treatment. So it is with negative interest rates. Used by many central banks as a cure for weak demand, investors are asking if the policy actually damages the banking sector to a dangerous degree, inhibits consumer and business demand growth, and so hurts GDP growth and corporate profitability across the economy?
- If this criticism of negative interest rates is correct, should investors really be holding risk assets such as equities? Particularly given that last week the Swedish central bank announced still deeper negative interest rates and the Fed disclosed that they have asked US banks to prepare a range of business models that include factoring in a negative interest rate from the Fed. A much publicised report from JP Morgan last week suggested that central bank key rates could fall to -1.3% in the US, -2.5% in the UK, -3.45% in Japan and -4.5% in the euro zone.
- Yet it was only a fortnight ago that global stocks jumped on news that the arch-conservative Bank of Japan would follow the ECB and several smaller European central banks into negative territory. This, it was argued, would force banks that deposit money at the central bank to lend it into the real economy, so stimulating growth.
- But a series of poor bank results in Europe have given long-standing critics of quantitative easing and negative interest rates a voice. The policies are now being blamed by bank analysts for creating relatively flat yield curves, which are a disincentive for banks to borrow money short-term and lend it on into the real economy for long-term periods. This then limits bank profitability and hampers broader economic recovery. Meanwhile, negative interest rates have not spurred lending and a consumption booms where they do exist.
The zombie banks of Europe
- Continental European banks are particularly susceptible to the cost of negative interest rates and narrow spreads. Many never properly recovered from the 2008 credit crunch. The sheer length of the economic downturn ensured that non-performing loans (NPLs) continued to pile up long after those in US and UK banks, while weak bank balance sheets meant it was difficult for banks to write off NPLs while still remaining solvent. A policy of ‘extend and pretend’ led to debtors pretending that they would one day pay back what they owned, while the banks pretended that the loans were still a valuable asset on their balance sheet.
- Most European bank regulators have looked the other way as banks became zombies, helping to spread death into the euro zone economy. The banks were too full of NPLs to risk lending to new, energetic companies that needed credit to expand but at the same time they actively preventing insolvent debtor companies from declaring bankruptcy (which would mean writing off a bad loan) and so they did all they could to keep alive moribund companies.
- UK banks’ balance sheets are generally in a stronger condition because 1) the UK government injected sufficient amounts of tax payers’ money into the sector during the credit crunch, which allowed NPLs to be written off. 2) Many UK banks lend heavily into the residential mortgage market; their balance sheets are fine unless UK house prices start to weaken.
The uncertainties of coco bonds
- UK and continental European banks have been encouraged by regulators in recent years to strengthen their balance sheet, to help avoid the need for tax payer-funded bailouts. The response by banks has been to issue new equity, which fully absorbs losses, and to issue new types of debt that the bank can turn into equity during times of balance sheet stress. This is known as contingent convertible capital, or ‘cocos’. Cocos are very different from the more secure senior bank debt, that requires the bank to continue to pay a coupon in all circumstances except insolvency.
- Cocos sold well thanks to the high yields, though many old timers in the bond market argued that the risks were impossible to price due to their immaturity, illiquidity, and uncertain regulation.
- The uncertainties were highlighted in December when a key bank regulator, the European Banking Authority, issued a paper implying that banks could be made to stop paying coupons on cocos during a period of balance sheet stress, at an earlier point than had previously been the case. Last week Deutsche Bank announced its first loss since 2008 and had to deny that it would be forced to suspend the coupon on its cocos (more technically described as).
- Some coco holders fear that they are stuck in assets that give no upside potential (as with all bonds) but with increasing downside risk (of converting into equity at a time when bank shares will themselves be sliding, making it potentially worthless). Meanwhile, investors in banks’ shares fear that, should cocos convert too readily into equity in times of balance sheet stress, that they will be diluted exactly at a time when no one wants to hold bank equity, driving the share price down still further.
- A fear that central bank policies are driving down banks’ profitability, together with uncertainty over how a new but increasingly significant layer of bank capital will respond to a period of balance sheet stress (such as a sudden downturn in profitability), have conspired to weaken banks’ share prices.