The falls in Euro-area share prices over the last year have been led by big falls in commercial bank shares. In part, this reflects slow progress in dealing with the bad debts and poor conduct of the pre-crash period, leaving many of them with low levels of cash and capital to absorb past losses. It reflects the difficulties many of these banks face in finding new profitable businesses and earning better returns against a backdrop of slow growth and ultra-low interest rates. The very monetary experiments designed to boost the Euro area economy are serving to highlight the structural weaknesses of a banking system dogged by low returns and insufficient retained profit.
Maybe the events of this summer will start to produce better results for shareholders. Bank shares are now a lot cheaper. Meanwhile the European Central Bank is firmly demanding that all the main banks do raise or retain more capital and demonstrate better balance sheet strength. This dilutes returns as the capital is raised, but allows better trading thereafter by permitting more loan growth. It is true that the new EU system of dealing with banks in trouble is much tougher, placing the emphasis on shareholders and bondholders paying for the losses whilst trying to stop taxpayer subsidy or capital riding to the rescue. The big fall in share prices in part reflects that new reality sinking in to markets.
The decision of UK voters to leave the EU may also be helpful in the longer term
The decision of UK voters to leave the EU may also be helpful in the longer term, assuming it is implemented properly and results in the UK no longer being part of the budget process and decision making of the EU and its single market. Freed of UK participation the rest of the EU can move more swiftly to full banking union, with more direct control of the EU institutions over all main banks in their system. The gap between non-Euro members and Euro members of the EU will look very different without the UK. Only the UK and Denmark have permanent opt outs from the Euro. Only the UK has fought hard to avoid the EU being identical to the Euro area for budget-making and decision-making purposes. This has slowed movement towards a properly unified Eurozone government at EU level doing whatever it takes on fiscal and budgetary policy as well as on regulations and controls to make a success of the currency.
It is true that once the UK is out there will still be a reluctant Germany. Germany is not keen to make the extensive money transfers to the poorer parts of the zone that a successful single currency requires. Germany is still trying to resist mutual deposit insurance as a system of bank guarantees around the zone. However, it seems more likely that Germany will move on these matters if the UK is not there helping resistance and seeking to keep these Euro-area decisions separate from the EU as a whole. The matter will change from being internal wrangles around the Council table in Brussels, to being important questions for public debate in German elections. The CDU and SPD main parties will need to be braver in explaining the consequences of currency sharing to the German electors, against the Eurosceptic challenge of the AFD.
I am less negative about Euro area shares today, as I think recent market falls, Brexit and the further discussion of how to strengthen banks are all making them better value. It will take stronger stimulus packages and improving news form the real economy to lift the markets more convincingly. Attention will shift to what the European central Bank does in September to provide a further boost.
The above article by John Redwood, Charles Stanley’s Chief Global Strategist, was first published by Charles Stanley on 29th July 2016.