It seems my travel schedule tends to coincide with outbreaks of economic tension. On that note, I've just finished getting myself set up here in Spain, in time for the latest European economic jitters. The Briefing is back to its regular posting schedule, and fittingly, let's kick things off with a look at the European situation.
European Banks: The Elephant In The Room
As 2008 demonstrated so clearly, a modern economy is only as good as its financial system. Judging by the stock prices of European banks, Europe is heading for a massive bust.
Consider Deutsche Bank (NYSE:DB), one of the continent's core banking franchises. It trades at levels below the darkest hours of 2008-09:
If you zoom in on the chart, you can see that the bank has already taken out the January-February lows; we're marking new multi-decade lows now. Others, such as Lloyd's (NYSE:LYG) and Santander (NYSE:SAN), have only marginally better-looking charts.
But let's focus on Deutsche Bank. As Germany's most important bank - and thus, the most important bank in Europe's barometer economy - it is among the single-best equity risk indicators for the continent. Trading at multi-decade lows, all signs are saying there's much cause for concern.
Consider the company's 0.3 price/book ratio (and equally eyebrow-raising 0.33 price/tangible book ratio). If the balance sheet is accurate, this is literally a dollar selling for 30 cents. Even if you cut book value in half to be conservative, you still have a stock selling way under its liquidation value. So what's going on?
There are several big possibilities. One, the market doesn't believe book value. In this view of the world, Deutsche Bank is loaded with junk assets that aren't worth nearly what they're marked at on the balance sheet. This could very well be the case; many of the "too-big-too-fail" banks in the US are plagued with similar investor concerns. Considering that Deutsche Bank has never once over the past 15 years posted an ROA of above 0.5%, there's good reason to doubt these assets. (A good bank earns ROAs of above 1%.)
There's also great concern that the bank has huge derivative liabilities that are poorly understood by the market. It's almost impossible to predict what sort of effect these would have on the company's overall balance sheet. Again, as 2008 demonstrated, a balance sheet is not that credible if you can load it up with off-the-books side bets that amount to the bank's equity several times over.
Finally, and probably most ominously actually, there is the idea that Deutsche Bank won't be able to return to normal profitability in the intermediate term. Interest rates continue heading ever lower. If you chart DB stock against a chart of the US 10-year Treasury (NYSEARCA:TLT), they match almost exactly. As yields fall, money-center banks become ever less profitable.
After the head fake toward higher US interest rates, recent weeks have seen yields resume their run to never-before-seen depths. Europe is at a worse stage of this than the US. With significantly negative interest rates, it has gotten to the point where European banks are considering storing money in private vaults to avoid getting hit by negative rates for storing it at central banks.
This is, to put it bluntly, absurd. Banks are supposed to lend their reserves to support economic growth. Instead, we're one step removed from banks stuffing their cash in the mattress.
And there's good reason for this lack of new lending. Europe faces dreadful prospects. Populations are now declining due to low birthrates. Spain, from where I'm typing this, is estimated to have seen its population peak in 2012, and has lost roughly half a million people since then. This despite a life expectancy of 82 years - among the world's leaders in longevity. There simply aren't enough children to maintain, let alone grow, population. And with a shrinking population base, the economy is bound to contract as well.
European GDP growth, as a continent, hasn't consistently run above 1% at any point in the last decade, and at this time, even maintaining a positive figure is a challenge.
Against this backdrop of stagnant or dropping populations and stalled out GDP, what's the motivation for making large new capital investments if you're a leading European business? Returns are likely to be low - better to invest abroad or return capital to shareholders. And if you're a bank, suddenly sticking your cash in a private vault makes sense.
I'd like to buy Deutsche Bank or Santander as a contrarian play, but I simply don't see any catalyst for a turn at this point. You can try to get cute with a buy now and sell in the next week or two if the Brexit vote fails. There's a case for that. But as longer-term investments, things look bleak. Even without accounting for the political drama or migrant crisis, you face ever-contracting Net Interest Margins, or "NIMs," and falling demand for new credit.
Markets: What's Next?
The S&P 500 (NYSEARCA:SPY) had an exciting week. Despite a spirited rally on Thursday, the bears prevailed; it was the worst weekly sell-off since the beginning of February. Friday's sell-off really took the wind out of the market's sails.
From a technical standpoint, the S&P 500 is still a solid 20 points above critical support. If bulls can hold their ground early in the week, there's a good chance the market can firm up once the Brexit vote occurs. At this hour, betting markets still show a 65% chance of Brexit failing, and your author views that as a reasonable guess.
It will be interesting to see how stocks trade on Monday. Much of Friday's selling was driving by selling in shares of Apple (NASDAQ:AAPL) after reports suggesting the company has run into problems with its Chinese operations. As for Apple, it's an excellent reminder that stocks with significant Chinese exposure that look "cheap" can always get cheaper.
For the broader market, it's worth remembering that things might not be as bad as they looked, if you strip out that individual stock. Still, numerous leading risk-sensitive sectors, such as biotechs (NYSEARCA:XBI), got hit hard on Friday. We're are approaching a critical juncture for the market.
If support fails, we're in for a summer correction. The market could right itself, particularly if Brexit fails. However, there's a possibility that this sell-off is the market pricing in various mounting conditions it had been obstinately ignoring all spring. In that case, a "stay" vote from Brexit might lead to a quick rally, but renewed selling on poor earnings, Chinese fears, the renewed strong dollar, and mounting recession risk could easily lead to another round of selling.
For now, the market top has held, and momentum is pointing toward the downside. Don't be a hero here - if you want to buy stocks, don't do so aggressively. I'm nibbling on a name or two now, but this isn't the time for home run swings.
Disclosure: I am/we are short XBI.
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.