The British vote for a so-called “Brexit” from the EU has resulted in some big market moves. Most notably, bank stocks across the EU have plummeted by a quarter in the past couple of days. But the falls over the past year have been even more extreme – up to 70%. Is this a new banking crisis, and could it spread to the US and the rest of the world? Is it time to panic once again?
British politics is in turmoil. The Conservative party prime minister, David Cameron, has resigned and a replacement has to be chosen. The main opposition Labour party has imploded and a leadership challenge seems almost certain.
Across Europe, those who seek to leave the EU have been emboldened. There are calls for referendums in many countries. Sooner or later some of them may come to fruition.
Within the EU political establishment, there is a clear split between those who want to punish Britain for the temerity of acting democratically, and those who urge restraint, since their countries export huge amounts of goods to Britain. It will take time to see how the chips finally fall.
The British currency, the pound sterling, has lost about 10% in recent days. That takes it to levels against the US dollar last seen in the 1980s. Friday’s drop of 7.6% against the dollar was the 8th largest one day move since 1862, according to analysts at Deutsche Bank. It was also the biggest drop since November 1967, or 49 years ago.
Investors that owned both stocks and gold have been hedged against the turmoil. In particular in Britain, where gold is up 41% since December when priced in British pounds.
Gold has fulfilled its safe haven status admirably. At $1,312 an ounce, at the time of writing, it’s now up 24% since the low on 3rd December. Investors that owned both stocks and gold have been hedged against the turmoil. In particular in Britain, where gold is up 41% since December when priced in British pounds.
Many stocks have suffered in recent days, not always for obvious reasons. But markets hate uncertainty, and Britain and the rest of Europe now have plenty of it in spades – of both the political and economic kinds. After months of little excitement, fear has come back to the fore.
Specifically, bank stocks have collapsed. The main British banks have seen their prices plunge around 30% in recent days, and even more when measured in US dollars.
But it’s not just in Britain where bank stocks have collapsed. I took a look at 12 of the largest banks across Europe, including four British ones. The average combined price fall on Friday and Monday was 27%, measured in US dollars for comparability (and because all of them are traded in New York).
And it’s not just in the “post-Brexit” past few days that banks stocks have taken a battering. Over the past year that same group is down 50% on average, again measured in US dollars.
Here’s a chart comparing the price moves of this selection of big European banks in the aftermath of Brexit, but also over the past year.
The biggest loser over the year has been Unicredit, the largest bank in Italy, down a whopping 70%. But from this selection you can see that prices have been slammed across the board.
The largest banks in Italy, Switzerland (note: not in the EU), the UK, France, Germany, the Netherlands and Spain are all included. In other words, all of the biggest economies in Europe, plus the Swiss banking centre.
Big US banks have taken a hit as well, although for now it’s not nearly so bad as in Europe. In the two days after the Brexit result a selection of six major US financial institutions were down 11% on average. (They were Bank of America, Wells Fargo, Citigroup, JPMorgan Chase, Goldman Sachs and Morgan Stanley).
A big question here is whether there is genuine distress in the financial system. Is it time to get scared? Or is this is just a market overreaction to political events?
The global financial crisis of 2007 to 2009 was, at its root, a solvency crisis. Banks in the USA and elsewhere had indulged in an orgy of lending, leverage and financial engineering. That left them highly exposed when sub-prime mortgage borrowers started to default in late 2006.
That meant big asset write offs, and the risk of widespread bankruptcies in the banking sector. In turn, as global banks lost confidence in lending to each other, it turned into a liquidity crisis. Funds stopped flowing. More and more assets started to implode, hitting bank solvency further. That’s why governments and central banks stepped in on a huge scale.
Governments bailed out the bankrupt players (well, except Lehman Brothers…they must have had some serious enemies), and central banks lent huge amounts of cash to banks, to ensure that they had day to day funding.
Since then the banks are supposed to have been fixed, or at least mainly fixed. They are required by law to be much less leveraged than before. That means they can write down a bigger portion of their assets without going bust.
If a bank is 50 times leveraged, it only has to write down 2% of its assets before its equity capital is wiped out. If it’s 20 times leveraged then it can survive a 5% loss (although it would be left undercapitalised well before that).
Across the board, leverage has fallen at the big banks. Also they’re expected to hold much bigger “liquidity reserves” than before. These consist of cash and things that can be quickly sold for cash (such as government bonds). That’s important in case of emergencies such as a bank run, when “depositors” suddenly call in their loans to the bank and withdraw cash.
Obviously the huge bank losses of the 2007 to 2009 period, which ran to hundreds of billions of dollars…plus the need for bailouts and the general market panic…caused stock prices to collapse. In the case of my ex-employer, UBS Group, the stock price was close to 80 Swiss Francs in early 2007, but plunged by over 90% at one point. After the latest falls it’s still down around 85% from that 2007 high.
But this time things are happening in reverse. Bank profitability has been weak for years.
But this time things are happening in reverse. Bank profitability has been weak for years. They’ve been pulling out of trading businesses as they try to adjust to the higher capital requirements. Interest rates have been ultra low, which hits interest income. And many have paid billions of dollars, euros or pounds in fines, as more and more misdemeanours have come to light.
However, it seemed that most of that had now been put behind them. Things were supposed to have stabilised, even if profitability has settled at a much lower level than before.
A return on equity capital of 10% a year is now considered to be an aspirational target in bank board rooms…something to aim for. Actual returns are still much lower in a great many cases. Long gone are the pre-2007 days of 20% or 30% returns that many big banks enjoyed.
Ongoing bank profitability is certainly weaker these days. But we haven’t seen huge numbers of banks announcing massive losses that put their solvency at risk. And they’re supposed to be much safer these days in any case.
Yet banking stocks are getting hammered, especially in Europe – both before the Brexit shock, and after it in recent days. Even UniCredit SpA – the largest Italian bank, and worst performer in the chart above – made a profit both last year and in the first quarter of this year.
Banks with big investment banking divisions, like Credit Suisse and Deutsche Bank, have been doing worse from a profit perspective. But they are far, far better capitalised than before the global financial crisis.
This leads to two or three broad conclusions about what’s going on.
Perhaps investors have realised that there is no way back to high profitability for these businesses, and are finally marking their stocks down to levels where investors can get a decent return for the (rising) risk…
…Or maybe the price falls are overdone, and there are some real bargains to be had out there. I’ll be doing some more digging on this front…
…Or there’s something new and malevolent stalking the banking sector, and we’re about to be plunged into a genuine new banking crisis. Are we just a few weeks or months away from banks starting to announce huge new losses from bad debts? Do the market insiders know something that we don’t? Could it spread to the US? Only time will tell.
The house of cards that is the massive amount of financial derivatives swilling around the financial system has never gone away (Warren Buffett’s “weapons of financial mass destruction”)…developed country government debts have gone through the roof in the past nine years, with countries such as Greece, Japan and even maybe Italy too deep in the debt hole to ever climb out…economic growth has been poor, even during the supposed “recovery” phase.
Brexit may have concentrated traders’ minds, but given the pre-Brexit price moves in bank stocks over the past year it looks like there’s a lot more going on. It’s all uncertain, and I’ll be keeping an eye on developments. But for now it seems clear that a large allocation to gold remains a good idea.
The price of gold may or may not keep going up in the short term – in fact it may go down again once the current panic subsides. But short term losses could be a price well worth paying for peace of mind, as uncertainty comes back to the fore and bank stocks implode.
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Stay tuned OfWealthers,