I wanted to highlight a few interesting reads from the last couple days. I think these are fairly important for U.S. investors looking at the relative strength of U.S. stocks and the yield differential between our sovereign debt and that of Europe. And especially for those that think this dynamic will continue to be bullish for U.S. stocks.
First, 3 Things to Know About Record-Low U.S. Yields from Mohamed El-Erian, chief economic adviser at Allianz. El-Erian offers a succinct summation of the current interest rate environment globally, and the potential challenges for the U.S. Fed in a world where negative interest rates are becoming the norm. In my mind, the most important take-away for U.S. investors was this point:
The lower yields will also amplify worries about excessive risk taking by non-banks. As they try to meet unchanged — and increasingly unrealistic — objectives, investors are likely to stretch even further for financial returns, increasing the risk of financial instability down the road.
While many market participants worry about the ever-inflating bubble in fixed income assets as a result of global quantitative easing, El-Erian highlights the potential for adjacent risk asset bubbles. The fear is we see a redux of what we saw in the late 1990s in stocks and in the aughts in housing. We know how those periods ended.
Now on to a read on the causes of the current interest rate environment, which is also hastening their demise, European banks. This morning, SocGen’s Chairman wrote for Bloomberg “Italy Could Spark European Bank Crisis“. The concern centers around the Italian governments inability to backstop nearly $400 billion in non-performing loans on their banks balance sheets (about 25% of Italy’s GDP), given their own indebtedness at 135% of their GDP. We have seen this movie before, we know how it ends with ECB head Mario Draghi “doing whatever it takes”. But given the recent events in the UK growth prospects for the region are heading the wrong way, just as many had hoped a bottom was finally in, years after the sovereign debt crisis. European banks are now in a vicious cycle where negative rates are pressuring their profitability with equity values that are a now a rounding error on their liabilities.
And the final read I wanted to highlight, on Monday, the WSJ summed up one of the main issues for the EU in a post Brexit world in an article titled, Brexit Exposes Eurozone’s Weak Spot: Italy’s Banks:
The stakes for Europe could hardly be higher. The EU’s legitimacy largely rests on its claim to provide common solutions to common problems. In Italy that legitimacy was already in question amid accusations that the eurozone has failed to find a solution to the common problem of growth and that it treated the common problem of irregular migration as a purely Italian problem for years until refugees started arriving in Germany.
If Italian savers in due course conclude that they are being forced to bear substantial losses as a result of the EU’s failure to recognize the common challenges posed by Brexit, the damage to the EU’s legitimacy may be irreparable. And Italy’s banking crisis could yet become a financial, economic and political crisis for the whole of Europe.
While all of this together speaks little to the current state of the U.S. economy, what’s clear to me is that U.S. stocks and Treasuries are obviously being viewed by global investors as a safe haven. But while I can see a path for high highs for Treasuries if things continue to heat up in Europe, I am hard pressed to see the same path forward for U.S. stocks. In July of last Summer I viewed the downward volatility in commodities, most major currencies, global equities (ex U.S.) and credit as a sort of warning bell that was screaming in silence for U.S. stocks. Since then we’ve seen two massive volatility shocks for U.S. stocks but are still in the same spot as a year ago in the SPX. This Summer I see a very similar set up. Committing new cash to U.S. stocks right here, right now seems ill advised. At the very least a 10% sell off in the SPX, similar to last August or Jan/Feb seems far more likely than a 5% blast to new highs. Obviously sell-offs happen all at once, and a rise to new highs could be a grind, but I think it is important to remember we have been in a one step forward two to three steps back stock market here.
One last thing, not too different than Summer/Fall of 2008 here in the U.S., or back in summer of 2011 into 2012 during the European sovereign debt crisis, I suspect the price action in Euro banks will lead to some sort of coordinated action by central banks to attempt to backstop troubled banks and avoid some sort of contagion. If this does occur the snap-back off of such an oversold and pessimistic investor positioning can last longer than it should, but it will be a great short entry or a place to sell some profitable longs. History has shown us that these sort of crises don’t end without damage, and that is usually in the form of shareholder equity.