For all the talk of market turbulence and volatility ahead of the Brexit vote, the reality is that after the selloff scare in late January and February, the S&P500 has barely registered any of the global fears that have roiled virtually all other foreign markets, and just two weeks ago the S&P500 trading less than a percent away from all time highs.
And yet, there is one chart that shows that underneath the placid surface of the S&P not all is well. The chart is the following, and demonstrates the substantial recent selloff in US bank stocks, which have been a near-flawless ‘canary in the coalmine’ ahead of major market inflection points, and which have successfully predicted most major crashes in the past several decades.
As Deutsche Bank explains, the chart above shows a rolling pct change from 52wk high of US bank index (S5BANKX) against SPX. The key point here is that there were a couple of instances in the past where banks’ underperformance of SPX bottomed out near -15% range, namely in 1994 rate hiking campaign and in 2011/2012 around the peak in EU breakup fears. And then there are three instances where this metric went to -20% and over that level, and all those three were associated with turning credit cycles (highlighted in red in Figure 4).
So is it time for another steep, “red” drop indicative of an imminent market crash? Read on for the reason why Deutsche Bank is certainly not optimistic.
From DB’s Oleg Melentyev
With volatility back across most screens, the market is giving back what it has gained while flying high on QE hopes earlier this year. And it appears that those hopes are failing to deliver any tangible results, just like they did last year. Just roll the tape back 12 months and recall what has happened. The ECB was in early stages of launching an €80bn/month QE program, having just established a negative 20bps deposit rate. The markets rallied on those announcements taking place between late fall 2014 and March 2015, peaking in June. As other factors took shape, including growth concerns in China and more broadly in EM, credit spreads widened in second half of the year here and in Europe, and technicals underpinned by QE failed to prevent that from happening.
Now fast forward to earlier this year, and the market was once again moving higher on expectations of QE delivering a sustainable change in risk appetite. But are €90bn/mo of QE, with a sprinkle of corporates in it, and another 20bps to negative deposit rates are really all that different from what was in place last year? And if last year’s attempts failed to prevent fundamentals from overwhelming technicals, is it prudent to expect a materially different outcome this time?
Taking a step back to renewed pressures in financials, regular readers of these pages would not need a reminder on how important this factor is in our framework of the default cycle evolution. With US banks now being 17.3% behind the S&P500, close to the lows of this relationship so far YTD, it is important to recall the significance of this level. Figure 4 below shows a rolling pct change from 52wk high of US bank index (S5BANKX) against SPX. Naturally, this measure is almost always at zero or negative, as it is calculated off of 52wk highs. The key point here is that there were a couple of instances in the past where banks’ underperformance of SPX bottomed out near -15% range, namely in 1994 rate hiking campaign and in 2011/2012 around the peak in EU breakup fears. And then there are three instances where this metric went to -20% and over that level, and all those three were associated with turning credit cycles (highlighted in red in Figure 4).
Undoubtedly, part of this underperformance is related to low rates standing in the way of expanding net interest margins. Figure 5 goes on to put the US bank index against those in EU (MXEU0BK) and Japan (N5BANK) in absolute terms, all normalized at 100 exactly one year ago. It provides a pretty convincing argument, in our view, of a substantial extent of negative rate impact on financial equities.
But that is not the whole story. In early Jan 2016, all three lines were down by 20% well before the BOJ negative rate announcement on Jan 29, or the ECB decision to expand QE in March. Both of these events have contributed to European and Japanese banks losing another 15-20% from early January levels, but they arguably have much less to do with the US bank index still sitting at its early January levels. We believe that a solid share of poor US bank equity performance is attributable to expectations of rising credit losses outside of the commodity sectors.
What kind of evidence makes us maintain such a view? First, it is willingness of credit investors themselves to finance the riskiest names. Figure 6 shows how lending volumes in CCCs, while having thawed a bit from a completely frozen state in Jan-Feb, remain at some of the lowest levels seen in the past 15 years. Investors are not exactly going after all the 13% yield opportunities in the ex-commodity HY CCC segment, and there could only be one explanation for such a behavior in a yield-starving world.
Such a behavior also naturally translated into higher realized credit losses in the ex-commodity sectors, with our default rate calculations showing an annualized 3mo issuer-weighted rate reaching 4.6% in May. Overall HY defaults, including energy and other commodities, were trending at a 9.8% issuer-weighted rate over the past three months! Trailing 12mo rates for both market segments currently stand at 2.7% and 5.8% respectively.
So, if investors are skittish about credit risk, do extreme steps taken by central banks help in reopening the credit channel? The evidence we see provides little support to that claim. Figure 7 shows overall corporate bond issuance volumes (IG+HY) in the US and EU over the past five years, presented here as a percent of respective market sizes. Of a particular interest is the reaction function in EU credit, where new issue volumes have peaked in Apr 2015, or a month after that ECB engaged in the original QE last year. Since then volumes have dropped precipitously, currently sitting near their lows over the past four years. You can lead a horse to water, but you can’t make it drink.
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As the events of last week showed, including not only the dramatic FOMC statement but Bullard historic “trial balloon” U-turn on years of monetary orthodoxy, central banks are finally getting it too. DB’s take:
And if the central banks behind extreme policy measures have little to show for the risk they have taken on their balance sheet to this point, and the pressures they have subjected their savers and financial institutions to, why should we expect such actions to be extended much further into the future? Any benefit of additional central bank accommodation appears to have been largely exhausted at this point in the cycle.
DB’s conclusion:
“If that is indeed the case, it is much more likely that a year from now we would see those programs on their way to curtailment rather than further expansion. Fundamentals would once again prevail over technicals, just as they always do over time. Recent market moves suggest investors are beginning to position themselves accordingly in anticipation of such an outcome.“
The outcome in question, which the chart up top implies: A crash. We, however, disagree with DB: while the next move in stocks is indeed likely lower, and much lower at that, this will only serve as the precursor to the final all-in central banking gamble to stimulate not just inflation, but hyperinflation: helicopter money. Which is precisely what we explained early this week in “Wanted: Policy Panic” – Why The Biggest Investors Are Praying For A Market Crash.“
They may get it very soon, and Brexit would be just the right catalyst…
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