What next for Wall Street bank shares?
There is no reason to believe the US economy, 25 per cent of global GDP, will fall victim to a "Made in China" recession.
US bank shares were outperformers in the first six months of 2015 as Wall Street assumed the Federal Reserve rate hikes would lead to a steeper US Treasury yield curve and higher net interest rate margins (fatter profits) for banks. Yet the Peoples Bank of China killed the rally in bank stocks when it devalued the yuan. The Chicago Volatility Index more than doubled to 28. Global equities markets tanked in unison. Corporate/high-yield bond spreads, already under pressure from the crude oil shock, widened sharply. US Treasury note yields fell as global capital flows fled in panic to the largest, most liquid bond market in the world. Emerging markets from Brazil to India to Russia crashed. The shares of international banks Citigroup, JPMorgan, HSBC, Bank of America, Goldman Sachs, Barclays and Standard Chartered Bank all fell 12-20 per cent. August and early September 2015 saw a swift, savage bear market in the Western world's money centre bank shares.
China, the Uncle Sam debt yield curve, recession risk in Russia and Brazil, the shrinkage in world trade, trading losses in volatile assets and loan exposure to distressed oil/metal producers all have the potential to hit bank earnings. China could well trigger a slowdown in global growth, if not outright recession. Investors yanked $300 million from the S&P Bank ETF in August, its worst outflow since the June 2013 "taper tantrum". Wall Street has downgraded its outlook for Fed monetary tightening, loan growth and bank profits.
There is no reason to believe the US economy, 25 per cent of global GDP, will fall victim to a "Made in China" recession. Second-quarter GDP growth was 3.7 per cent, the unemployment rate has fallen to 5.1 per cent, the plunge in gasoline is a de facto tax cut for the US consumer, US vehicle sales are even higher than pre-Lehman credit bubble era levels at 17 million units and housing starts are a robust 1.1 million. The American consumer, 70 per cent of US GDP, is in extremely good shape.
The Fed's dual mandate means the "data dependent" US central bank cannot ignore the rise in US economic data momentum and wage growth in excess of its two per cent inflation target. So the flattening of the US Treasury note market yield curve is only temporary. Moreover, Chinese state reserves are still $3.4 trillion and Beijing's central bank has intervened after August 11 to prevent a steep yuan sell off.
The US money centre banks litigation cycle has peaked (Bank of America alone paid $70 billion in more than Citi, Wells Fargo and JP Morgan combined), though further fines related to Libor, credit derivatives or foreign exchange rate rigging scandals are possible. While loan growth in the US is a solid six per cent and all the New York money center banks passed the Federal Reserve's "stress tests", they could face rising losses on syndicated loans to US shale oil producers and Asian/emerging markets corporate borrowers.
With such great systemic uncertainty, it is no longer possible for bank stock valuations to rerate on Wall Street - for now. The KBW Bank Index has fallen even more than the fall in the S&P 500 index since the Chinese yuan shock on August 11. This will continue even if the Fed leaves rates unchanged on September 17. Even if there is no rate hike in September, US economic data will continue to strengthen, making the case for a winter Fed rate hike irrefutable. I am certain - yes, certain that Dr Draghi will announce a "shock and awe" ECB rate cut in October, as the Bank of Japan did last October. A "shock and awe" ECB QE means the Euro could well fall below 1.02 or even parity by Christmas. (King Dollar should then be called King of Kings Dollar!). Yet, a ECB move will also be a steroid shot for interest rate sensitive and emerging markets exposed money centre banks. This means Bank of America, Citigroup, JPMorgan and Goldman Sachs could surge and make me relive la vida loca. There are two key ECB conclaves this autumn. It is time to drill for real gold (not that Auric trash that is a phony store of value, down 40 per cent since its $1930 peak) in bank calls and puts on the Chicago Board Options Exchange now that implied vols have tripled.
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