The Selloff: Europe And Japan Scare Investors - Bezek's Daily Briefing

|
Includes: CS, DB, EWJ, FEU, FXY, SAN, USO
by: Ian Bezek

Summary

Markets suffered their biggest decline since February.

The Japanese Yen continues to soar, and it's having an impact on markets.

An update on the developing situation with the European banking and political scenes.

Yesterday, stocks suffered their worst one-day drop since early February. There was no clear catalyst for the decline; there's no easy explanation such as oil. Oil (NYSEARCA:USO) was only modestly lower on the day, and the market ignored oil's move higher in the afternoon.

Many people were surprised by the selling including journalists writing market recaps. Look at Reuters' take on the day:

This sort of explanation almost always indicates confusion. Worries don't just "resurface" out of the blue. The global economy has had plenty of things to worry about throughout 2016. I've turned increasingly negative; from strongly bullish in January to mildly bearish now - as the rally continued despite bad economic data continuing to mount.

Now, at least as far as Reuters is concerned, investors have had an epiphany. Suddenly global issues matter again, just one day after the Fed's move had reassured market participants into thinking there were blue skies ahead.

I'll suggest a few possibilities for why stocks fell so sharply. First is the carry trade discussed in yesterday's Briefing. In case you missed it, I recommend going back and understanding the concept. To avoid repeating myself, I'll just say that a rising Yen (NYSEARCA:FXY) causes margin issues and forces leveraged speculators to sell stuff. Oftentimes, US stocks are among the things on the chopping block when the Yen rises.

And the Yen sure did rise on Thursday (lower position on the chart is stronger Yen/weaker dollar):

Click to enlarge

The Yen has been a one-way trade all week, but the move greatly accelerated late Wednesday evening and on into Thursday morning. The Yen was up 2% in a 24-hour span, and with the amount of leverage involved in the carry trade, that sort of sudden move causes a tremendous amount of feedback.

Europe: Banks Still Dropping

Europe provided markets with more reasons for concern. One of these is political, and the other is the banking system.

The continuing decline of Deutsche Bank (NYSE:DB) is causing many people to feel unwanted flashbacks to Lehman. Deutsche is now trading below the 2008-09 low, and is just pennies away from new multi-decade closing lows:

Click to enlarge

Incredibly, Deutsche is now down 80% from the post-financial crisis highs. The chart looks truly ominous. Other leading large EU banks such as Credit Suisse (NYSE:CS) and Santander (NYSE:SAN) also trade below the 2008 lows.

Is there contagion risk to the international financial system? Yes. Is it a huge risk? At least so far, probably not. The banks' problems are as much a profit issue as a loan quality concern. Negative interest rates may sound appealing for a bank - free capital - but there's very little in which it can be safely invested. 15 and 30 year mortgages are available in Germany for 1.45% and 2.34%.

A bank's net interest margin (NIM) on that is going to be lousy, regardless of how cheap their cost of capital is. For my banking investments, I much prefer Latin America, where banks can and still do earn NIMs in the mid-5% range. That's a nice business. 15-year mortgages at 1.5%? Not so much.

I don't think Europe's banking system is about to implode and kick off a major crisis. If the market is concerned about that, its fears are probably misplaced. But persistently weak banking shares will be a drag on global equities; with no finance sector participation, it's hard to have sustained rallies.

Europe Continued: Political Risk In The Spotlight

The Dutch referendum on the EU's association with Ukraine ended in failure for those in favor of a united Europe. The Dutch referendum largely flew under the radar in the western hemisphere, given that it was non-binding and won't directly change anything.

Even with the Dutch people voting against partnership with Ukraine, the trade agreement came into effect earlier this year. And to suspend it, all 28 member states would have to agree to the move.

So the Dutch vote was a show, rather than an action with tangible power. However, the Dutch vote is a most effective demonstration of the growing strain in European unity as the migrant crisis drags on and the economic situation remains unfavorable.

The Dutch vote and the pending Brexit vote in the UK are fueled by the same general frustration. Across the continent, centrist parties are losing ground to more fringe elements. With each success against the European status quo, the anti-EU forces gain additional perceived authority and momentum.

The upcoming British vote on the EU is taking on more and more importance. And on that front, the Panama Papers scandal threatens to tilt the vote. Prime Minister David Cameron's father used offshore accounts, and the media is asking increasingly pointed questions as the story unfolds. Cameron admitted Thursday that he profited from his father's offshore fund. If Cameron's popularity wanes, it will give substantial aid to those who want to leave the European community.

For investors, it's a bit early to deduce what the broader fallout of these European tensions will be. Like in 2011-12, there's a good chance we're going to enjoy (that may be the wrong word) a summer full of European-news driven trading. Prepare for volatility.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.