DEUTSCHE BANK: Strap in, it is about to get bumpy

Wall Street has been having a bumpy ride of late.

Financial stocks and bonds have taken a pummelling, with European banks at the center of the storm.

In a note Monday, Deutsche Bank strategists Oleg Melentyev and Daniel Sorid said that that likely spells bad news.
Stress in the financial sector usually precedes a period of volatility.

“Their importance as a leading indicator stems not only from their vulnerability to systemic risks, but also to their direct exposure to troubled sectors,” the note said.

The pain has been broad-based. US financial stocks have underperformed the S&P 500 by 7.5% since August, despite a Fed rate hike which was supposed to help bank stocks. European banks have underperformed the Stoxx 600 by 10%, according to Deutsche Bank.

Risky bonds have taken a battering too, with bank contingent capital securities, or ‘Cocos,’ selling off.

These instruments have coupons like traditional debt but can be written down or converted into equity if a bank’s capital falls below a certain level, Deutsche Bank itself has seen the prices of its cocos fall to a record low.

That does not bode well. Financials have suffered one to 12 months ahead of a spike in corporate defaults in each of the last three periods of credit stress.

Here is Deutsche Bank (emphasis ours)

These developments in the pricing of bank securities suggest a risk of a more disorderly period ahead, given the critical role financials play both in the economy and in the historical experience with credit cycles. The resilience of US banks to date suggests that these issuers continue to be perceived as safe havens in the market, but their dissociation with European financials strikes us as unsustainable in the presence of credit stresses that are more global in nature.

Screen Shot 2016 02 08 at 4.43.21 PMDeutsche BankUS and European financial stock performance relative to the index

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