Notes From Underground

The pundits have been pontificating about the low valuations of European financial stocks–based on correlations to other developed-market financials–and proclaiming it’s time to purchase the “undervalued.” Why, this is the greatest no-brainer since sub-prime debt and Orange County Treasurer Robert Citron buying very risky inverse floaters prior to 1994 (sarcasm intended). The only problem with the pundits pushing European bank stocks is the following chart of Deutsche Bank. There is a great disconnect between the huge U.S. banks and Deutsche Bank. Even more significant is that the massive Swiss Banks (UBS and Credit Suisse) are holding their rallies despite settling with financial regulators in many different markets. What is wrong with the crown  jewel of Europe and Germany?

It is a similar problem for the large Japanese banks, which have been underperforming the Nikkei rally and the euphoria about the success of ABENOMICS. If Japan is on the road to some inflation and increased economic activity, the banks are supremely undervalued and efficient market theory maintains that it can’t be so. It appears that there is a major disconnect between reality and perception. The Japanese banks OUGHT TO BE outperforming all the global financials because of the aggressive action they have taken to offload their hoard of JGBs. Japanese banks are acting rationally by selling off a potential depreciating asset to the market’s largest buyer: the BOJ. According to a Bloomberg article by Finbarr Flynn and Monami Yui  from January 31, Sumitomo Mitsui cut its JGB holdings by 56 percent.

If Abenomics is ultimately successful, why would any investor want to hold bonds that will be a negative yield as inflation levels rise? BUT IF BANKS LIKE SUMITOMO are raising cash by selling JGBs what are they doing with the cash? If the Japanese economy was indeed growing, domestic loans should be rising. Flynn and Yui report that domestic loans increased by only 4.3 percent last year. Also, Tokyo-based Moody’s analyst Graem Knowd notes: “Banks need to rebalance their portfolios away from JGBs. It it turns out that Abenomics hasn’t worked and only ended up leaving Japan with a bigger pile of debt” and a “doomsday scenario for JGBs isn’t a zero probability scenario.” Again, if the banks are invoking the correct policy, why has the market failed to raise their equity valuations. (I am buying some of the banks on a very slow and correction only basis–in my opinion this is a low risk valuation relative to the pricing of other global equities.)

Bringing more focus to the efforts of the Japanese banks to rebalance their assets away from JGBs is the recent discussions taking place in Japan over the issue of the Government Pension Investment Fund (GPIF). The Japanese public pension fund has 1.26 TRILLION DOLLARS in assets and targets a very conservative style of investment. Currently, the GPIF invests 60 percent in JGBs and 12 percent in Japanese equities, according to a March 5 Reuters article. Prime Minister Abe’s government is “… pressing the GPIF to buy more stocks and invest relatively less in bonds to generate higher returns for Japan’s fast-greying population.” The issue of maintaining a decent rate of return on its national pension will be a challenge for the administrators of the fund. If not JGBs, what will be the most efficient mix of assets? Regardless, the Japanese banks are pressing ahead and dumping questionable assets on the major buyer of last resort, the BOJ.

The theme of banks continues through an article from March 7 piece in the International Financing Review by Gore and Whittall, “Eurozone Banks’ Sovereign Exposure Hits New High.” This is a very serious issue for it creates the potential for an adverse feedback loop that can bring the European economy to a depression. “Banks in the region now hold about 1.75 trillion euros in government debt, equivalent to 5.7 percent of their assets, and the highest relative exposure since 2006, according to ECB data. In Italy and Spain, roughly one in every 10 euros in the entire banking system is now on loan to governments.” The Eurozone banks are loading up with sovereign bonds because under the Basel rules sovereign debt is deemed a “riskless” asset and therefore banks need not to hold reserves to protect sovereigns in case of a stress event.

Let’s remember that it was only 18 months ago that the European bond markets were under great strain and President Draghi announced that the ECB would do “whatever it takes” to secure the European sovereign debt market as well as the Euro currency itself. As the article goes on to say, “Banks’ holdings of government bonds have risen by 355 billion euros–or about 25 percent–since the liquidity injections in 2011 and early 2012. Banks in fiscally weak countries have increased their purchases the most, with Italian, Portuguese and Spanish banks increasing their holdings by 62%, 52% and 45%, respectively.” Look at the chart of Deutsche Bank again and one gets the sense of a negative feedback loop in full development, which should raise a yellow caution flag. Now, how about those sanctions on Russia?