The Global Credit Cycle is Turning

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The commodity price bust — the one that began all the way back in 2011 — looks to have finally made its way into the global financial system.

Carnage returned to markets overnight. At one stage the Dow was down nearly 400 points. It recovered into the close though, down ‘just’ 180 points.

The S&P500 looks a little more fragile though. The benchmark index closed at a new long term low overnight, taking out the lows reached in January this year and during the panic sell-off in August 2015. You can see this in the chart below:

Source: BigCharts

Financials and oil stocks drove the sell-off. Shares in the number two natural gas producer Chesapeake Energy plunged on bankruptcy concerns. From Reuters:

Chesapeake Energy, the No. 2 U.S. natural gas producer, said on Monday it had no plans to file for bankruptcy, after sources told Reuters the company had asked its longtime counsel to look at restructuring options.

Chesapeake’s shares were halted after plunging more than 50 percent but later pared some losses, as it said advisers Kirkland & Ellis had been providing counsel since 2010 and will continue to help the company strengthen its balance sheet.

Chesapeake has a market value of $1.2 billion and $10 billion of debt outstanding. No wonder the rumours are flying. And no wonder the financial system is under scrutiny too. No one really knows who’s exposed to these highly indebted energy producers.

According to the Bank for International Settlements, debt issued by oil and gas firms in emerging markets alone climbed to $439 billion in 2015, up from just $31 billion in 2000.

While much of the debt wasn’t borrowed directly from banks, there is enough debt at risk to make investors nervous about banks’ exposure. Throw in a slowing global economy and concerns that the credit cycle is turning, and financials are decidedly unpopular right now.

None more so than Deutsche Bank, Germany’s banking giant. Its stock price is in the process of crashing, and recently broke through the lows of 2008. It’s shaping up to be a good old-fashioned bank run.

Overnight, Deutsche had to issue a statement to the stock exchange basically saying that it had enough liquidity to meet its repayment requirements.

You know a bank is in big trouble when it has to publically state that it is in fact just fine.

Deutsche’s woes are not specifically related to the oil price rout or exposure to oil related debt, although that is playing a part. But it is largely an investment bank, which means it must rely more on trading income and capital market ‘activity’ to generate profits. Plus, it reportedly has a massive exposure to derivatives so who knows where the problems lay?

One thing is certain, the market is saying something bad awaits Deutsche. But it’s not only the German giant in trouble. European banks are in free-fall. Check out the chart below. The European bank index fell to another new low overnight. It’s down 40% from the highs of July 2015!

Source: BigCharts

What is this chart telling you? It’s saying the credit cycle has turned. It’s saying that Mario Draghi’s policy of more and more quantitative easing is not working. At its most basic though, it’s saying Europe’s banking system is fundamentally weak. There is not enough capital supporting the mountain of debt on the banks’ balance sheets.

In short, it’s not good for Europe.

But what does this have to do with Australia?

On the surface, our banks are much stronger. Because of the country’s love affair with residential property, housing dominates the asset side of banks’ balance sheets. And as we all know, house prices never fall…

But on the liability side of the balance sheet, banks have a large reliance on offshore borrowing. The pressures on the global banking system mean that the cost of financing these liabilities will rise.

Not only that, the cost of equity is on the rise as well. Let me explain because it’s important to understand if you’re invested in the Aussie banking sector.

When share prices are high relative to earnings (meaning a high P/E ratio) the cost of raising equity is cheap. For example, if a bank trades on a P/E of 15 times, as a rough guide its cost of equity is 6.6% (derived by inverting the P/E, so 1/15).

But if investors see the outlook for banks as increasingly risky, and their share price falls to a P/E ratio of, say, 10 times, the rough cost of equity increases to 10%.

And there lies the problem for Aussie banks. They are under pressure from the regulator to raise more equity capital to strengthen their balance sheets. But as their share prices fall, the cost of raising this equity increases. This will suppress future returns from the sector. The good old days are over.

Let’s be clear, I’m not saying Aussie banks are in the same place as their northern counterparts…not yet anyway. But if the global credit cycle is in the process of turning down, our banks will get caught up in the sell-off…

More worryingly, there seems to be real confusion about whether central banks can actually help out here. The long run effects of QE are starting to show…and they’re none too beneficial for the banks.

Thank goodness China’s markets are closed for the week. It at least allows Australia to pretend that the world’s problems still emanate from the chilly northern hemisphere.

Be that as it may, slowly but surely those problems are creeping onto our shores too.

Greg Canavan,

For The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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