Image: iStock.com/franz12
As German 10-year bunds were headed towards their first dive into negative territory in 2016, courtesy of the epic Brexit disaster and the overall deflationary environment in the eurozone, the stock of the largest bank in Germany – and one of the largest in the world – was trading with a truly bizarre correlation to the 10-year U.S. Treasury yield. If you think about it, the risk-free interest rate in United States Treasury bonds should have very little to do with the clobbered equity of a large European bank, but the explanation is surprisingly simple. The deflationary black hole that German bund yields sank into is what is ailing Germany’s Deutsche Bank (DB), and that very same black hole is pulling Treasury yields lower.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
On the chart above, you can see that this correlation “broke” in early 2018, courtesy of the Trump tax cuts that pushed U.S. economic performance into overdrive last year. This is the same overdrive phenomenon that caused the Federal Reserve to accelerate the pace of its quantitative tightening, resulting in upward pressure in short-term U.S. interest rates and regrettably sharply rising volatility in the U.S. stock market. The only other time we have had such a sharp contrast between fiscal and monetary policy was in 1987, during the Reagan administration, when the stock market crashed, but without an economic recession.
Last year’s “tax-cut sugar high” in the U.S. economy seems to be abating this year, so the Deutsche Bank 10-year Treasury correlation is being re-established, particularly with the Federal Reserve’s dovish pivot, in which the central bank has moved to the sidelines when it comes to any fed rate hikes and has declared its plans to stop the runoff of bonds from its balance sheet later in 2019.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
The question now is: Will German bunds keep pressuring Treasury yields lower and hence maintain that Deutsche bank correlation? The lowest German bund yields have been -0.19% in July 2016, when they pulled the 10-year Treasury yield down to 1.31%. Since 2016, the Treasury-bund spread has kept expanding with better economic performance in the United States and a continued deflationary trend in the eurozone. I suppose with a hard Brexit and continued good economy in the U.S., the German 10-year bund yields can go to a fresh all-time low and the Treasury/bund spread can go over 3%, despite being at multi-decade highs. The way these spreads work is that they tend to revert to the mean in a more normal economic environment, although the situation in the eurozone is anything but normal at the moment.
Deutsche Bank for 22-Cents on the Dollar
Deutsche Bank has a book value per share of 0.22 at present. What that means is that, under a theoretical liquidation, you are paying 22 cents for what would be one dollar of book value in return. In reality, book values are a significantly more nebulous metric for large banks than they are for operating companies.
Comparisons with Lehman Brothers are easy to make, due to the performance of the share price, but Deutsche Bank has been in “Lehman territory” for quite a while. Plus, DB is at least three times larger than Lehman when it comes to the size of its balance sheet and it is literally “too big to fail” when it comes to the German economy. It is no wonder that German regulators have urged Deutsche Bank and Commerzbank to start merger talks. I suppose that the Commerzbank valuation, at 0.33 in book value per dollar, is 50% higher than Deutsche Bank, but that is because it is a more “pure” bank, with a smaller international presence as well as investment banking and capital markets businesses.
(Navellier & Associates does not own Deutsche Bank or Commerzbank in managed accounts or our sub-advised mutual fund. Ivan Martchev does not own Deutsche Bank or Commerzbank personally.)
I am not sure how merging two sick banks will make one healthy bank. In Japan, the Bank of Tokyo-Mitsubishi did merge with UFJ and not much changed for the profitability of the overall operation. The “Japanification” of European financials is rather obvious and with the deflationary backdrop in the eurozone, which is likely to get worse in the case of a hard Brexit, one can expect the combined Deutsche-Commerzbank entity to perform no differently than the Mitsubishi-UFJ Financial group.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
I don’t know what will happen with Brexit, but I am by now tired of the soap opera that is playing out in the House of Commons. There is no doubt in my mind that the British shot themselves in the foot by voting to leave the European Union (EU) for fear that Germany was using the EU for its own political and economic interests and was growing too dominant. Didn’t Britons understand that leaving the EU makes Germany even stronger within the EU? Those City of London jobs already leaving for Frankfurt may get more numerous if a hard Brexit end ups being the ultimate result.
In the end, the EU without Britain is a weaker institution. Both Britain and the EU are worse off after this acrimonious divorce and the risk of a breakup of the EU has notably increased, which means a breakup of the euro is no longer a low-probability event. In that regard, financial companies in Europe will trade at depressed valuations for as long as the EU is a malfunctioning confederation – which could be a while.
