Much of the talk during this month’s pull back in equity markets is that we would see a rotation out of growth and into value stocks. But after the initial tech led pull back, banks have once again been at the heart of this recent roll over, reminding us that, outside of a handful of US stocks, the global recovery in risk assets has been poor with many regions struggling to recover. That’s The Big Conversation.

By now everyone knows the narrative about mega cap tech stocks driving the main US indices higher during the recovery, buoyed by an influx of retail traders who also piled into the single stock options on their favourite names. Even accounting for the recent pullback, the ratio of US growth versus value is still near the all time highs. While most have been focused on the out performance of the tech names, it’s now becoming increasingly hard to ignore the underperformance of the financial sector, particularly the banks. The banks used to be considered the beating heart of an economy and although technology is starting to replace some of the functions that banks perform, this is a sector where customers aren’t quick to switch providers. The role of banks may be diminishing over time, but they are still a key part of the economic framework. And the underperformance of banks is a global phenomenon. The ratio of the Nasdaq versus the US large cap banking index, the BKX, is still close to the all-time highs, with the BKX losing over 6% in the first 2 days of this week alone. In Europe, the eurozone banks index has just broken down through its own three-month support, having barely recovered off the all-time lows. The ratio of the banks sector versus the wider European equity market is about to retest its all-time lows again. Both the absolute performance and the relative performance have been poor.

The UK’s banks have even been underperforming their European peers – something of a rarity until recent times, but year to date, the UK lags both the US and Europe. The UK economy has been particularly badly hit during the COVID crisis and uncertainty around Brexit is still to be resolved. A deal needs to be agreed by October 15th, though we’ve seen on many previous occasions that these dates are not set in stone. The UK’s banking giant HSBC will soon be testing the 30-year support. It accounts for over 50% of the UK’s banking index and a break of these key levels will drag the whole index down further. The Bank of England recently announced that it was looking at the possibility of negative rates. As with many central banks, this had been dismissed from the realms of possibility for many years. But on the announcement, UK bond yields fell dramatically, especially on the shorter dated maturities which are in negative territory out to the 6-year mark. This was another factor weighing on banks in recent days. Many people feel it is only a matter of time before the US federal Reserve start to embrace negative interest rates as well. In Japan, the story is the same. The ratio of the TOPIX banks index versus the broad based TOPIX index has been grinding along at the all-time lows for the last couple of months. US banks are doing marginally better than other geographical regions.  Although that is in line with the outperformance of the broader US equity market, the BKX consists primarily OF THE LARGE CAP NAMES WHICH HAVE OUTPERFORMED THE US REGIONAL BANKS. The large cap banks are more closely aligned with the capital markets through which they act as facilitators, helping large corporates to raise capital via bonds or through syndicated loans. Many of these banks also benefit from the higher volatility and the higher trading volumes during the peak crisis period.

Regional banks are not involved in capital markets to the same extent and their underlying client base don’t have the same access to capital that the larger listed names have. Banks will be less willing to lend in this environment and businesses might want to borrow, but many of the costs will be too onerous. Businesses in Europe are more dependent on corporate loans than are their US counterparts. Traditional bank lending has not rebounded as quickly as capital markets. Emergency loans have been made available, but these were stop gap measures. The willingness to lend and the willingness to borrow have been limited by the lack of opportunities and the ongoing uncertainty that has seen Europe impacted by the great financial crisis 12 years ago, then the Euro Zone debt crisis 9 years ago and now the COVID crisis today. This has been a long game of catch up and the current performance of European bank shares suggest that this is still an uphill struggle.

Banks globally are unable to generate decent margins from simple loan operations.  

And part of the reason is because yield curves are still incredibly flat, even though they have bounced off their lows. The spread between the US 2 year and the US 10-year government bond is around 50bps – its been here for around 5 months and is still very much at the bottom of the 30 year range. A steeper curve allows banks to generate higher margins. When it comes to yields, the eurozone is stuck between a rock and a hard place. Low yields across the curve means low margins for the banking sector. If yields rise at the longer end of the curve, then it starts to put pressure on the heavily indebted nations such as Italy. Euro Zone countries have no sovereignty over their currency. In pre Euro days, Italy’s currency would have been the adjustment mechanism, but this is not possible with the euro. Many European banks are therefore saddled with excessive levels of debt and no way for the local economy to grow out of them, unless the offset is made via a decline in wages relative to their eurozone peer group. The regulatory probe that has weighed on bank share prices at the beginning of this week in many ways reflects the difficulty of generating an honest revenue. If yields curves were steeper and business was booming, generating revenues would have been relatively easy. But in an environment where central bank policies help to destroy revenues in order to protect balance sheets, then alternative revenues streams need to be found and this may see corners being cut. 

This is the same as investors moving along the risk curve in the hunt for yield. Individual investors have taken on more and more risk and sometimes more and more leverage in order to eke out a better investment return. Banks have been cutting corners in order to offset the lack of revenues being generated via their mainstream banking operations. Banks are also facing competition from fintech and digital alternatives, although the changes on that front are relatively glacial when compared to how consumers have adjusted their shopping habits to an online environment. And this is partly because of barriers. Banks have been ring fenced by regulation. This has driven up the costs of borrowing and doing business – regulatory charges have increased and eaten into profits. But, at the same time, many of these regulations are barriers to new entries for new players, making it harder to encourage bank customers to switch their provider. Individual customers in the banking sector, particularly in Europe, remain attached to banks. I’ve been with the same bank for 30 years. But despite these barriers to entry, banks are still struggling to perform, and it probably reflects the rising risk of INSOLVENCY AMONG THE SMALLER ENTERPRISES who have been hit hardest and are also shut out of capital markets. Now we’ve discussed zombie corporations before – these are the ones that should have gone out of business, allowing new and efficient entrants to take their place. But they have been kept on life support by access to cheap capital, especially where markets have been supported by central banks such as the ECB and the US Federal reserve. Now this can be considered a misallocation of capital that drives down future productivity and growth opportunities.

At the other end of the scale are the small businesses that are being kept on life support by furlough schemes. In some cases, these schemes are being rolled forward as we have seen in Germany. In the UK, they are expected to roll off in October, though many MPs are calling for an extension. The problem for all countries are facing is whether they should let these schemes roll off now, and then deal with the aftermath by introducing alternative spending programs that encourage growth in new areas, OR keep alive many of the old businesses including the ones that have been radically changed by COVID. If they choose to maintain the support, many of the underlying issues with regard declining or non-existent demand will remain. And future cash flows will still be impaired even if the businesses are kept afloat for a little while longer.

We can see how some of the non-US equity markets have continued to follow a classic bear market pattern, even whilst the US has made new highs. By June of this year, the Spanish Ibex retraced exactly 50% of the initial decline, but is now making a new four month low. It looks like it could be heading back to retest the 20 year support level. The UK’s FTSE 100 rallied from the March lows into Jun was halted between the 50% and 62% retracement, in line with a typical bear market rally. The Eurostoxx 50 did manage to reach and exceed the 62% retracement level, but never really made any more gains after that. The DAX fared much better, almost returning to the all time highs (though the index calculation for the DAX is different to that of the FTSE and Eurostoxx). But overall, Europe’s markets have remained within a classic bear market pattern. With Europe rolling over, it may be no surprise that the euro has been on the back foot for a few sessions as well. 

The euro makes up about 60% of the dollar index, the DXY, so we need to watch this carefully. The DXY is CURRENTLY BREAKING UP OUT OF A REVERSAL PATTERN……… for a potential rebound to around the 96 level that also targets below 1.15 on the Euro. The dollar index gained 90 basis points on Monday when it had its second leg higher that day, and this saw oil prices move emphatically lower on an intra day basis. Throughout the preceding period of US dollar weakness, we’ve noted how G10 currencies and in particular the euro, were leading the way. Emerging Market currencies had failed to join the party, suggesting this move was more about euro strength, than out right dollar weakness. This may be reversing from an overstretched position. The euros gains through July were extremely rapid and even if it only gives back half of these, then we can expect emerging market currencies, equities and the commodity complex to remain under pressure. 

European policy makers will, however, be relieved. They had been openly concerned about too much euro strength. Japan’s new leadership will also be keeping an eye on the Yen. It has recently been testing the key 105 level. There maybe some tolerance down to 100, but it’s unlikely that they will stand back and let US Dollar/Yen drop through that level. To hit their inflation targets, they need dollar Yen heading toward 120 and beyond, not towards 80. One of the key questions for the market is whether this remains just an airpocket on the back of US equities giving back some of the excessive exuberance of the summer months, or if this is the beginning of the insolvency phase. Volatility of volatility remains well behaved. I would only expect this to spike higher if there was a disturbance in the fabric of the market. The US High Yield and Investment Grade ETFs have held up relatively well, though the insolvencies will arguably only show up at the small business level. Some large cap companies are clearly struggling with insolvency issues, but most of these were well known before the COVID crisis.

Meanwhile bond markets have hardly moved. In the US, 2 year and 5-year bond yields have been flatlining, BUT if these yields start to roll over then they will be pricing in the low growth environment in which cash flows remain strained and insolvencies would pick up. Banks, bonds and the US dollar will give us good clues about the growth outlook. Banks are already implying weaker growth, even if we factor in some of the most recent regulatory issues. Bonds, particularly the US, are still in undecided territory. Yields rolling over would re-enforce the move in the banks. US dollar strength would then be an accelerant on the trend because it would push that weakness into emerging market and commodities. So far only one, the banks, is flashing a real warning, but we need to watch the other two for confirmation.

In the last section, we looked at rangebound US government bond yields. This is especially true of the front end, where yields are generally tied to interest rates. At the latest FOMC meeting, the committee members appeared to be committed to interest rates staying at zero again for the next couple of years. In many ways, this signaling from the central bank is sucking the lifeforce out of the fixed income markets. There has been a lot of coverage about the rising level of implied volatility in the equity market, where retail investors have inundated the options market with call buying and the VIX forward curve is being pushed higher as we approach the US election bump.

There has been far less coverage about the bond market’s VIX equivalent, the MOVE index. In the last few days, this index has made a new all time low, even whilst many other assets have been zipping around. The combination of interest rates anchored at the zero bound, ongoing QE infinity and the potential for yield curve control (although this threat has been denied) is leading to the Japanification of the US bond market in which price discovery disappears.

Now there are also signs that the hedging qualities of long bonds combined with long equities appear to be reaching its limits. Balanced portfolios which combine long bonds and long equities have, over the last 20 years, generally seen bond prices rise (and yields fall) when equity markets are in severe trouble. The Gains on the bonds might not fully offset the losses on the equity part of the portfolio, BUT IT WOULD GO SOME WAY TO MITIGATING them. 

Over the last four decades, bonds and equities have both been in an uptrend. For bonds, that uptrend may well still be in place, BUT THE GAINS THEY HAVE MADE IN RECENT SESSIONS WHEN EQUITIES HAVE BEEN WEAK, have been very much well below par.The yield on the German 10-year bond, called the ‘bund’ had a relatively aggressive round trip in March, but overall there was little change in the yield level between February and May. IT LOOKS LIKE BONDS THAT YIELD CLOSE TO OR BELOW ZERO, are not offering much protection.  Although the German equity index has recouped most of its losses, at one point the index had dropped 40%, whilst German Bund futures fell by nearly 7% in mid-March after initially rallying, which equated to a decline and then rise of 70bps in yield. This was not a good hedge to long equity position. Now does this mean that bonds are now dead in their portfolios? Bonds can still have a key role in signaling the outlook for growth, especially if yields fall further. If government bond markets ARE severely distorted by central banks intervention and yet yields roll OVER AGAIN AND HEAD LOWER, then clearly the outlook for growth would be deteriorating. They could also be a lead indicator for interest rates. German 2-year yields briefly went negative in 2012. Yields had crossed the Rubicon, allowing the ECB, a couple of years later, to take interest rates into negative territory. Yields at the front end of the US curve could also pave the way for the US Federal Reserve to look at negative rates. Now so far this has been denied, but then again the Bank of England denied they would take rates into negative territory. Now this option is being openly discussed.

So can bond volatility head higher? From these levels, obviously it can and that might be a lead indicator for signs of contagion. I would have the move index on my dashboard to monitor for any signs that volatility is not just an equity market phenomenon. Currency volatility would be another indicator to watch. Volatility in G3 currencies has been relatively well behaved, though much higher than pre COVID levels. Positioning against the dollar is still significantly short, though as discussed before, this has primarily been amongst G10 currencies. Even when currencies have been weakening, as we have seen with the Turkish Lira, it has been without a significant uptick in volatility. But currencies remain one of the few mechanisms through which stresses can be released, at least it can for those that are freely floating. Given that equity volatility is already stretched, and bond volatility is being suppressed, currency volatility maybe the better volatility to pick up as a hedge against the risks into the end of the year, such as increased solvency and US election uncertainty. In recent sessions we have seen a renewed bout of volatility in the oil market. In the second quarter, oil prices had recovered off their lows to close the gap that had opened up after the price war escalated in early March. Since closing this gap, oil prices were remarkably steady. Their first major wobble over the last few months appears to have been a VAR adjustment across multi asset portfolios when equities took a dive at the beginning of September. But what is the outlook for oil now? I asked Refinitiv’s Wayne Bryan about the current trends in the oil sector.

[00:16:30] Yeah what we've seen so far in 2020 has been a real surprise. I mean, no one expected the Covid- 19 pandemic to cause such a real wide range of damage across the whole of the oil infrastructure pricing, demand, supply, the whole area really. I mean, firstly, if we look at the price, which is the most important thing, we've fallen 40 percent from where we were at the start of the year. Bear in mind though we had, did have a recovery with around twenty dollars a barrel sort of Mid Feb, since then we staged a bit of a recovery as the actual economy started to reopen, et cetera. And we're now trading at around the forty two dollar barrel. But now, of course, we've got a lot more concerns about second waves of lockdown's happening not just in the UK, but globally. So that's also now we've got prospects for prices falling further. But if you look at some of the underlying numbers there in terms of production demand, you can see some really interesting statistics. So looking at the rig count, that's down 73 percent year to date. We're now at 179 rigs. Last time we saw this level was post 2012, so that's also a big surprise. No one expected the rig counts to fall so low. And the actual rebound we've seen the last couple of days isn't really in line with the sort of rebound in price. Looking at U.S supply as well, that's down about 20 percent this year. U.S supply actually had risen to around 13 million barrels at one point was the world's largest supplier, but the subsequent developments around the Covid-19 pandemic have seen that fall as well. OPEC supply, we've had the OPEC cuts, of course, but they've fallen by around 10 percent year on year. So that, again, we didn't expect such falls in OPEC supply. And now they're talking about perhaps even cutting supply further or having stricter compliance on existing production cuts. Then we look at demand, demand this year now is forecast to fall by nine million barrels a day from last year. And that was the most recent forecast, but I think now what's happening over the recent few days and what we might see moving forward, we're going to see further falls in demand over the coming months. We're seeing changes in the way we live. There's less people now going into the office, less people using public transport, so that's having a profound effect. And I think what we're going to see as we head into the winter is an even more profound effect, and fast-forward, six months or seven months it would be interesting to see where we are then and maybe revisit some of these numbers. But judging by what we're looking at, looking internally at our forecasts and looking at production supply and the whole global picture, the outlook is quite dismal at the moment. Chinese demand is also going to be very important. Now, if you look at China, everyone was expecting their economy to recover the quickest. They came out of the pandemic early, so you would expect economically they're going to be on a faster track of recovery. However, recent numbers, however promising, they're also worrying now about overseas demand. With overseas demand falling, then Chinese internal production etc will also start to fall. Let's not forget as well, we've got the U.S elections coming. We've also still got some concerns around trade wars. And I think volatility around these, again, could have a profound effect. And if we do see Chinese demand start to slip, then we're really going to start to worry because I think the oversupply will deepen and we may need to cut supply from other sources, perhaps even OPEC might even look to cut even further. So that is the big concern is around these U.S. elections and any or any escalation in these trade wars. 

So it looks like the real economy could once again start asserting itself on risk assets. Oil prices, in fact actually commodities in general, had been supported by expectation of a rapid economic recovery. That economic recovery is taking longer than expected and has only been possible because of the huge levels of global fiscal and monetary stimulus. Headwinds are again building and even China is struggling to find solid demand for its goods in overseas markets. Oil is a real economy asset to watch for signs that the initial recovery maybe running out of steam, and that the global economy still remains starved of cash flow outside of government support.