by Ivan Martchev | March 21, 2012 11:41 am
The massive rebound in European equities — particularly eurozone financial stocks like Deutsche Bank (NYSE:DB) and BBVA (NYSE:BBVA) — is due to the aggressive monetary and fiscal actions taken to stabilize the eurozone sovereign debt markets. Many indicators of eurozone financial stress are improving, so the above stock market reaction is normal and likely will continue should formerly problematic sovereign bond markets continue to stabilize.
When I was asked to comment on the European multi-asset rally this week, I almost called up a familiar bond expert, as this eurozone rebound is as much about stocks as it is about sovereign bonds. But at the risk of sounding like a Spaniard trying to speak Portuguese, I decided to take a crack at the sovereign bond side of this massive European rally, as I had been following the issue for some time.
The eurozone sovereign bond markets look like the mirror image of last summer. At the time, most spreads to the German benchmark bunds were expanding; now, most — save for Portugal — are contracting. Bigger sovereign PIIGS markets like Spain and Italy are well off the yield highs seen last November and presently are allowing those governments to borrow at much more affordable rates.
The same banks that seemed like pretty decent short candidates in an environment of rising financial stress during the summer of 2011 seem to have survived the storm and now are seeing their shares rally and re-price for the new more benign market environment.
I think this is the stock market reacting to the normal resolution — if there is such a thing — to the Greek default and the subsequent orderly CDS Greek bond auction. The Greek default did not drag Europe down into a black hole, so the current 66% likelihood that Portugal will do the same is not bothering investors — so the much larger sovereign debt markets in Spain and Italy indicate. They show sovereign 10-year yields of 4.84% and 5.20%, respectively, which are very close to 52-week lows.
I had seen some interpret the rising ECB borrowing from Spanish (and other) banks as an indicator of financial stress, but the simple explanation I received from an accomplished institutional investor seems a lot more plausible:
“I would just add that the banks in Europe are making a lot of money borrowing at 1% (3-year loans) from the ECB and then buying Italian and Spanish bonds! So the next couple years look pretty good for this interest rate arbitrage that the ECB is encouraging.”
Think of it like Deutsche Bank and BBVA doing the same wildly profitable carry trade — buying higher-yielding assets with cheap financing — that got MF Global in trouble, without ever having the chance to end up like MF Global! The key, of course, is the guaranteed 1% cost of ECB funds that was not available to the less fortunate and much smaller American futures broker that tried to mimic an investment bank under Jon Corzine’s brief leadership.
European financial stocks are cheap. Based on book value — a slightly more reliable metric that takes into consideration the banks’ earnings power over time — BBVA trades at 0.86 (discount!) to book while Deutsche Bank trades at even cheaper 0.68 times book. Given the contraction in certain PIIGS’ spreads to bunds, it appears that market participants now are willing to differentiate between “good” PIIGS — Spain, Italy and Ireland — and the dirty kind like Portugal and Greece. So even a Portuguese default no longer seems as scary at this juncture.
Still, the above are shorter-term tactical considerations for traders trying to make a quick buck. From a longer-term perspective, the problem of the eurozone having one monetary policy and one exchange rate with 17 different finance ministers and 17 different fiscal policies, sometimes in outright friction with the ECB, has not been fixed. A complete fiscal eurozone integration is difficult to imagine, recent statements from eurozone political leaders to the contrary notwithstanding.
Buy-and-hold investors should not overstay their welcome in the current rally in European financials, the length of which will be decided by the direction of the PIIGS’ sovereign bond markets. If you are looking for “bombed-out” banks without the macro problems of Europe, consider Argentine financials like BBVA Banco Frances (NYSE:BFR) and Banco Marco (NYSE:BMA) that trade at similar book value multiples of 1.22 and 1.17, respectively. Sure, they have different problems in Argentina, but the actions taken recently by the authorities to reign in inflation are a long-term positive, and the declines of both stocks already reflect many of the risks.
Much has been said about the strong-arm tactics of the Argentine government toward oil giant YPF (NYSE:YPF) and the directive to cut dividend payments to 57% owner Repsol (PINK:REPYY) in order to invest more heavily in oil production (there are plenty of oil deposits in Argentina but not enough investment to extract them). I am not sure this is the approach that will raise oil production in the country. Tax breaks to multinationals and a business-friendly environment, of which the latest governmental actions are anything but, seem like better options.
The above drama has rubbed off negatively on BBVA Banco Frances and Banco Marco, which despite good operational performance in 2011 saw their shares decline and now yield in the high single digits. Neither BFR nor BMA are likely to repeat their respective 2011 annual dividends of $1.11 and $2.08 per share in 2012, but given what they have historically paid out on average as dividends, the amount is likely to be high by developed-world standards.
Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own. This is neither a recommendation to buy nor sell the investments mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell any above mentioned securities.
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