The tentative global expansion that started in the fall now appears to be turning into a slowdown and threatens to become an outright contraction, thus worsening the equity market’s already unattractive risk/reward profile. We think near-term rallies cannot be ruled out, but these are likely to serve as opportunities to further de-risk. We see five major categories of concern. By Roubini EconoTeam
1. Central Banks: Out of Ammo in a Negative Rate Environment?
Initial central bank actions during the recent “risk-off” episode have not provided much comfort, though a belated recognition of the potential negative impact on banks’ balance sheets from negative rates have helped ease sentiment. The Bank of Japan’s move to adopt negative interest rates barely made a dent, with the yen strengthening and bank stocks sharply underperforming the broader market.
In Europe, mounting concern over banks’ capital adequacy and a raft of selective bail-ins for Portuguese banks may have undermined ECB head Mario Draghi’s perceived ability to “do whatever it takes.”
In the U.S., policy makers now face the task of addressing oil-related credit risks to banks—potentially a much greater challenge than containing housing-related risk, as targeting energy-related debt is more politically difficult than intervening to prop up the housing market.
2. U.S. Recession Risk: Higher Probability
At the outset, the equity-market rout appeared to be a China-led slump, with falling oil prices taking a toll on sentiment as well. But rising concerns over the U.S. growth picture gave rise to a more indiscriminate risk-off episode.
High-yield credit spreads have widened toward a level that would trigger a recession, with banks a possible channel for the contamination of investment-grade credit due to their energy-sector exposure. Meanwhile, the economy’s tentative recovery appears to be morphing into a slowdown.
3. Credit Conditions: Contagion Broadening
Banking-sector stress is adding fuel to the fire in non-financial credit. Indeed, the broad U.S. high-yield market continues to deteriorate, with pressure now leaking into investment grade.
4. Banks: The New Front Line
A number of recent developments have made eurozone banks a major area of concern: selective bail-ins of Portuguese banks, worries over capital adequacy and disappointing earnings releases on the back of litigation and restructuring charges.
Signs of weakness have triggered a re-evaluation of banks’ Tier 1 capital securities—primarily their contingent convertible bonds. Deutsche Bank has been the focus of these jitters, with its credit-default swaps widening sharply, but investors are increasingly uneasy about the entire banking system.
Beyond capital adequacy issues, a more serious threat to the eurozone’s efforts to create a banking union stems from Portugal’s selective bail-ins of large institutional debt holders, which runs counter to the push to establish a clear resolution mechanism.
Furthermore, the continued balkanization of the eurozone—with the migrant crisis weakening the Schengen agreement and exposing the limits of the region’s institutional unity—points to a negative step change in eurozone banks’ profitability outlook. This weaker outlook, in turn, is raising banks’ funding costs and threatening the region’s nascent credit recovery.
U.S. banks have had better capital ratios than their eurozone peers, but their exposure to energy-sector credit has made loan loss provisions a major concern—a topic analysts grilled companies on during the Q4 earnings season. The fact that the U.S. Federal Reserve’s latest stress-test scenario factored in negative rates has reinforced concerns that U.S. banks could one day face the same kind of profitability squeeze as their counterparts in eurozone and Japan.
5. Earnings Cycle: Further Challenges Ahead
The corporate earnings outlook generally remains challenging, with energy-related losses rippling through the banking sector and a shift in currency market trends exerting pressure on Japanese and European earnings.
Japan’s earnings momentum has been one of the few bright spots in the global equity market in recent years, but conditions no longer look so rosy there. The strengthening of the yen, if sustained, will pressure profit margins and take a toll on earnings. China’s slowdown also bodes poorly for sales growth.
In the eurozone, the reversal of the euro’s depreciation trend and the array of factors weighing on banking-sector profits (negative interest rates, litigation, restructuring, emerging-market exposure) constitute major obstacles to a rebound in earnings.
Finally, in the U.S., continued weakness in manufacturing, capex and the energy sector, coupled with the strong dollar and a surge in wages pose serious threats to an already weak earnings trend. With the energy sector now accounting for only 4% of total earnings, the primary threat to earnings performance stems from the potential for second-order effects. Should the banking sector’s credit-related losses rise, driving up financing costs for firms outside of the energy and financial sectors, the cumulative impact on earnings could be at least as damaging as that owing to the direct hit on the oil sector.