Larry Berman

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ANALYSIS: Italian banks are saddled with 360-billion euros in non-performing loans (NPL); this is about 20 per cent of GDP. As a comparison, the NPL in the U.S. as a per cent of GDP is about 1.2 per cent.

Last week, in the wake of the Brexit vote, the European Commission (EC) and European Central Bank (ECB) were working hard to stabilize markets. Their biggest concern is that other weaker nations may want to leave the EU too.

Italy is particularly vulnerable because the banking sector is a recession away from collapse that would make Greece’s debt problems look like a rounding error.

Over the weekend, the ECB asked some of the weaker banks in Italy to raise capital by selling off some of their bad loans.

Italian Prime Minister Renzi is considering putting capital into the banks like the Fed did in late 2008, which is against EU banking rules and is bothering the Germans because at the end of the day they write most of the checks. Recall that when Cyprus’ banking sector collapsed in 2012 we saw large unsecured depositors bailed-in (meaning the bank took their savings) to recapitalize.  

We look at the Italian bank index versus the pan-Europe bank index in percentage terms. As you can see it is not just Italian banks that are the problem, the entire European bank index is significantly stressed. It is very difficult to grow your economy when the banking sector is not performing well. This is one of the major reasons why Europe has lagged global markets in recent years.

In 2012 when Draghi said he was all-in and would do everything he could to stimulate growth the euro weakened and we saw banks double from their 2012 lows. But from March 2015 when they actually started QE and then moved to negative rates, banks have tanked and so has economic performance.

Around the same time, Spain nationalized four banks and markets recovered, but the remaining banks are now making lower lows than in 2012. Part of the answer for Italy is to establish a bad bank too, but so far it seems like that is not in the plans. 

The bottom line is that every cycle needs a cleansing of bad debt and we simply have not had it. There is over 50 per cent more debt in the world today than there was before the Lehman moment. More borrowing and spending stimulus will not likely work and all the debt in the world is a massive headwind to growth.

As long as the governments of the world continue to pile on debt as the solution with low interest rates global growth will likely continue to slow. Odds of a credit crisis in Europe or China over the next few years is extremely high. The European banking index is telling us not to trust the post Brexit rally in equities. Don’t even get us started on the trouble with bad bank loans in China.

The U.S. market remains the best dirty shirt in the laundry and there is a lot of money looking for yield, but the next global recession (and there will be one because there is always one), would see earnings fall 10-15 per cent and the market multiple fall to something less than average than the long-term 16.5x.

The argument that equities should trade at a higher multiple because bond yields are low simply does not hold water.

Bond yields are where they are because the global economy is weak and a weak global economy is not bullish for equities.

I suspect the U.S. (and Canada) may contemplate negative rates in the next recession as the fiscal path is challenge. But I will leave that missive for another day. 

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