Market sell-off is both overdone and warranted
Fears of a global recession are stalking financial markets.
On Tuesday, European equities fell to their lowest level since October 2013 as investors rushed into the safe haven of government debt, with the yield on Japan’s 10-year government bonds dropping into negative territory for the first time.
Banking stocks have been on the sharp end of the deterioration in sentiment, with the shares of Credit Suisse and Deutsche Bank, two leading European banks, plummeting some 40 per cent since the beginning of this year, dragged down by weak earnings, weak profitability and the prospect of very low (and in some cases negative) interest rates for a considerable period of time.
A plethora of vulnerabilities that have been weighing on sentiment - persistent concerns about China’s economy and policy regime, the economic and financial fallout from the plunge in oil prices and mounting uncertainty regarding the outlook for US monetary policy - are now feeding on each other, fuelling a wave of bearishness centred around the financial sector.
The question is whether the pessimism is justified.
Clearly the severity of the deterioration in sentiment since the start of this year - a 15 per cent decline in eurozone stocks, a 55 basis point fall in the 10-year Treasury yield and rising bets of a US recession this year - is disproportionate to the catalysts for the sell-off - all of which were firmly in place well before the beginning of 2016.
Yet just because the sell-off is overdone does not mean that a deterioration in market conditions is not warranted.
The plunge in global bank stocks - on Monday the main equity index of European banks had its second worst day since the nadir of the eurozone crisis at the end of 2011 - has exposed a number of troubling vulnerabilities which stem partly from the policies of central banks, the very institutions whose ultra-accommodative monetary policies have been responsible for stabilising markets during periods of financial turbulence.
The Bank of Japan’s unexpected decision on January 29 to introduce negative interest rates (thereby joining a growing club of central banks that have lowered borrowing costs to below zero in the hope of igniting growth and inflation) has apparently convinced markets that other central banks, even the US Federal Reserve, will follow suit.
This is contributing to the dramatic fall in government bond yields - nearly 30 per cent of the world’s sovereign debt are offering yields below zero, according to an index compiled by Bloomberg - which is hitting banks’ profits by flattening yield curves, thus narrowing the spread between the long-term rates at which banks lend and the short-term ones at which they borrow.
Europe’s banks are most at risk as they are already suffering from weak profitability, high shares of non-performing loans (particularly in southern Europe) and are under significant pressure to raise more capital.
The credit default swaps – the cost of protecting against the risk of default - of Germany’s Deutsche Bank have risen to their highest level since the eurozone crisis.
A vicious circle is forming in which the unintended side effects of central banks’ ultra-loose monetary policies and the vulnerabilities of the banking sector are now inextricably linked, fuelling concerns about financial stability and the risks of a global recession.
Indeed, all of a sudden, fears about the health of European banks have supplanted worries about China and oil prices.
While these concerns may be exaggerated, they have been triggered by a loss of confidence in central banks’ policies.
If investors’ were to lose complete faith in central banks’ ability to stabilise markets, the scope for a much sharper and prolonged deterioration in market conditions would increase significantly.
The region to keep a close eye on is the eurozone which has enjoyed three-and-a-half years of relative calm in financial markets but whose banks - in particular Italian ones which are burdened with extremely high shares of non-performing loans (NPLs) - are now the focal point of investor nervousness.
Although there are no signs of a full-blown liquidity crisis similar to the one which erupted at the end of 2011, the debt of European banks - in particular some of the riskiest bonds, known as contingent convertible bonds (or cocos) - is under increasing strain.
That this is happening at a time when markets are questioning the policies of the European Central Bank (ECB) raises the stakes further.