FINANCIAL SECTOR THINKS IT'S ABOUT READY TO RUIN WORLD AGAIN
Look at some of the current market price signals and it looks like we are headed for some difficult times:
- Deutsche Bank and financial sector CDS spreads have exploded higher to levels similar to Financial Crisis;
- COCO contingency bonds have significantly fallen in price based on the belief that banks will not be able to refinance;
- Equity sell-off moving to bear market and is global in nature;
- Rates signal economic slowdown around globe albeit not with inverted yield curves;
- Gold has moved significantly higher against central bank negative rate policies;
These market signals seem at odds or at least an exaggeration versus the macroeconomic data. While the global macro data suggests slow growth and continued weak inflation, it is not signaling recessions in the developed world. We can look at probability models which show increased risk of recession, but the numbers are still at relatively low levels.
This leaves us with three choices or views based on different models of the world:
- Forward looking view - Market prices are forward expectations of the real economy and it is sending a signal of a major slowdown with banks being in trouble.
- Over-reaction to past prices view - Market prices are in a negative feedback loop which is over-reacting to some slower macro data. Selling has begot more selling but the macro data suggests this is an over-reaction. Look for a reversal in price data.
- Combination story or RO/RO view - The world is focused on changing risk-taking and right now we are in risk-off mode. There is heightened risk in the markets and economy. The markets have reacted to this risk or uncertainty information. Current monetary policies are confusing. Macro data are mixed.The central bank policy of negative rates is negative for banks and not as effective as previously thought a few years ago. Hence, there has been a sell-off which has changed risk perceptions. We are in a risk-off environment and policy cannot change this view.
The most likely scenario is the RO/RO world where changing risk perceptions are forcing a repricing of assets. This will continue until there is a catalyst to change risk perceptions. It could be a policy statement or new data, but right now it will continue. It is not an over-reaction or herding but a new view that safety is more important than reaching for yield. If banks are also in risk-off mode, there will be less lending and more holding of cash which should reduce earnings and cut ROE. In this case, the price investors are willing to pay for banks should fall. The RO/RO environment with a focus on the Risk-off is consistent with the periods between the QE's post Financial Crisis.