As I discussed in my most recent newsletter (please email me to request a copy) and in my February 19, 2016 Forbes column (“Shares Of Global Banks Are Too Cheap To Ignore“), I remain constructive on shares of U.S. financial companies, despite (or even because of) their recent underperformance. More specifically, I asserted that much of the current fears (e.g. impact of rising energy-related defaults and ongoing litigation costs & financial penalties related to conduct leading up to the 2008-09 global financial crisis) surrounding U.S. and global financial stocks are overblown.
I also asserted that share prices of global financial companies in 2016 will mostly be driven by the Federal Reserve’s monetary policy, as a significant portion of U.S. banks’ revenues is driven by “net interest income,” i.e. the traditional role of banks’ borrowing short and lending long. In Wells Fargo’s case, net interest income makes up more than 50% of the firm’s revenue. If the Fed embarks on a renewed hiking campaign and the U.S. yield curve flattens, then U.S. banks’ margins will be hit, which in turn will depress their share prices.
Fortunately, the U.S. yield curve is still very far away from flattening. E.g. As of this writing, the spread between the 10- and the 1-year Treasury rate stands at 1.27%. Just as important, the CME Fed Watch indicator does not suggest a rate hike until the FOMC’s December 21, 2016 meeting at the earliest. Moreover–despite the recent underperformance of U.S./global financial stocks–credit risk for the global financial sector remains relatively and historically low; in fact, as computed by S&P Global Market Intelligence, the implied credit risk within the global financial sector is actually the lowest out of all ten major S&P global sectors.
As financial history and the experience of the 2008-09 global financial crisis have demonstrated, however, the global financial system is only as strong as its weakest links; and it is these “weakest links” that investors have recently focused on. More specifically, the slow pace of general and banking reforms within the Euro Zone, particularly the relatively high level of nonperforming loans in the Italian banking sector, is raising the specter of counter-party risks and resulting in a flight of capital away from Italian/European financial stocks (e.g. UniCredit is down 37% YTD, Intesa down 26%, and Banco Popolare down 38%), and to a lesser extent, U.S. financial stocks.
Figure 1: Italian Banks Have Relatively High NPL Ratios (as of June 2015)
The Italian banking system is saddled with about 360 billion euros of NPLs, making up about one-third of the Euro Zone’s total NPLs (although 50% of it has already been provisioned). With Italian banking stocks down nearly 20% YTD (and down 25% over the last 12 months), Italian policymakers are now being forced to act to shore up the country’s bank balance sheets through sales of NPLs, equity raises, and accelerating the write-off of NPLs. An effort in January to encourage sales of NPLs by providing government-backed guarantees gained little traction (and unfortunately attracted investors’ attention to Italian banks’ NPL problem), as Italian policymakers could not agree on how the plan would be implemented, especially in light of European rules that explicitly ban state aid to failing companies.
So far this week, Italian policymakers–working in conjunction with banks, pension funds, and insurers–have drawn up plans for a 5 billion euro bailout fund (dubbed “Atlante”) to purchase NPLs and/or to inject capital into ailing banks. Investors’ initial responses have ranged from skeptical to condescending, given the relatively small size of the fund and the lack of details surrounding its implementation. Bottom line: Italian/European policymakers, in conjunction with the private sector, will need to work harder to create a more comprehensive and workable solution to reduce NPLs in the Italian banking system. Until this happens, the current rally in U.S./global financial stocks from their early February lows will remain precarious.