- European stocks pushed global markets down after the German Chancellor said they will not help Deutsche Bank if it fails.
- Europe still offers too much risk for the expected return.
- In this article we’ll share two critical things you have to think about in order to weather all possible storms.
After a long and quiet summer, stocks are showing increased volatility. Last week’s FED decision not to increase interest rates has quickly been forgotten as markets try to digest news from Europe where increased fears over capital requirements for Deutsche Bank, which sent European markets down on Monday.
In this article, we’ll assess the depth of the issue and look for the real reasons behind the European 2% market move on Monday morning.
Deutsche Bank (NYSE: DB) shares have hit their lowest level since the mid-1980s. When an institution like this is in trouble, the markets can easily enter panic mode on contagion fears.
Figure 1: Deutsche Bank share price. Source: Yahoo Finance.
This is a perfect example of how risky big banks are and why they usually have low PE ratios. Due to the complexity of their business, you never know where a black swan might emerge from (black swan – an event that deviates from what is normally expected and is extremely difficult to predict). Shares of DB were trading above $100 per share prior to the financial crisis and strongly above $50 afterward until several black swans hit it.
Apart from the low interest rates seen in the last several years that have squeezed bank margins across the globe, DB has been involved in several scandals. In 2010, DB staff accused the bank of having omitted $12 billion of losses from the financial crisis. In 2012, the CEO went under investigation for tax omissions, soon after the LIBOR rigging scandal emerged, and in 2015, the bank’s mirror trades surfaced (mirror trade – buying and selling to yourself).
The latest bad news came from the Department of Justice and its proposed $14 billion settlement for DB’s trading activities in the financial crisis which DB’s CEO rejected. On top of such—and other scandals—in June 2016, the International Monetary Fund issued a warning that DB appears to be the most important net contributor to systemic risks. The same report states that the largest German banks and insurance companies are highly interconnected which explains why the complete European market moves in line with bad news for DB.
But all of the above was well known before this Monday when DB stock fell 7%. The most recent fall was influenced by the German Chancellor’s words that it will not bail out DB in case of trouble. DB quickly replied that it did not ask nor it will be needing government aid, but the damage was done.
Apart from the insight of how risky banks are, what can also be understood from the story above is how dependent markets are on government and financial institutions. Last Wednesday, the FED didn’t increase interest rates which pleased the markets but as soon as the weekend came, markets fell as the German government said that it will not bail out DB.
Investors will be better off avoiding such artificial markets as sooner or later those markets return to normalcy, or worse. As they are artificially inflated, when the strong government hand removes itself, panic will kick in and send asset prices to artificially low levels like they were in 2009.
Let’s take a look at what is going on in Europe in order to see if there are already bargains around.
Three months ago everyone was scared by the BREXIT vote only to forget about it in the next few days and continue on as if nothing had happened. But some important things have happened in the meantime.
As the Bank of England understands the short and long term implications of the BREXIT, it immediately lowered its interest rate to 0.25% and increased monetary stimulus to keep the economic environment as positive as possible. Many companies are rethinking their position in the UK and uncertainty has already lowered construction activity as much of the real estate in the UK was built for foreign investors.
Figure 2: UK construction activity index. Source: Bloomberg.
The Euro-area economy forecasted economic growth has been revised downwards and is expected to grow only 1.6% in 2017 and 2018. Given the high level of stimulus, this isn’t much. Elections in Germany are coming up in 2017 which, alongside some missed growth expectations, could quickly bring more turmoil to the markets.
Figure 3: European GDP. Source: Trading Economics.
Also, in Europe there is always the risk of a country like Greece, Italy, Spain or Portugal getting into trouble and dragging down the whole continent.
Are There Bargains in Europe?
Unfortunately, we are still far away from seeing bargains in Europe. PE ratios in the main stock markets are still extremely high, and therefore it is better to wait for a recession or a real financial crisis to look for good investments. Germany has a PE ratio of 20.8, the UK 39.5, France 20.9, Italy 34.1 and the Netherlands 27.5. A 50% market decline would create some bargains but until then, there is too much risk for the expected return.
Conclusion & Contamination Risks
On Monday, the DAX index (Germany) fell by 2.29%, and the S&P 500 also fell more than 0.8%. It’s clear that some contamination is unavoidable. But this has much larger implications than just a daily drop in stock prices. The economies are interconnected and trouble in one bank, like the Deutsche Bank, can be a trigger of systemic risks. Therefore, even if the U.S. economy does well and the FED does everything right, there is always the risk of contamination from Europe.
What should you do when the risks seem to be everywhere? The world will continue to spin even if there is a recession or a bankrupt financial institution. Demand for commodities will grow alongside global population growth, and the best companies will find a way to reach their customers. Two things are important: find good companies that will do well in any environment, and have some cash available that will give you the opportunity to buy when things get cheap.
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