What is the impact of rising political risk on financial securities?
Major elections will be taking place in late 2016 and 2017 in several major eurozone countries. To what extent could the return of political risk drag down performance of financial securities?
The market doesn’t (usually) like political risk. However, in light of recent events, we must admit that investors are becoming relatively insensitive to this risk. Wall Street hit new record highs after Donald Trump was elected. The wide margin of victory by the “No” camp in the Italian referendum triggered only a moderate reaction on the markets. However, the story may move in a different direction in the event that doubt is cast on the cohesion of the eurozone in the wake of a populist party being elected. In this scenario (which is not very likely to happen), financial securities would be hit hard by rising risk aversion.
The ECB could react to rising political risk by increasing the size of its QE programme. Mario Draghi specified that if the outlook were to become less favourable, the Governing Council would look to further increase the size of the programme. However, a very (or too) accommodative monetary policy would, to a certain extent, be counterproductive, because it would drag down banks’ profitability. As a reminder, the Euro Stoxx Banks index lost more than 25% over the first nine months of the year. This poor performance can be partly explained by the ultra-low-rate environment. The portion of the euro fixed-income
The German banking sector’s return on equity was only 2.6% during the first three months of the year, according to the EBA. This made it the third-worst performing country in the EU, ahead of only Greece and Portugal.
However, low profitability was a problem well before the financial crisis. The source of German banks’ low profitability lies in the sector’s structure. The abundance of savings banks and cooperative banks means that Germany has the most fragmented banking system within the eurozone. In 2014, the five largest banks held only 32% of the system’s total assets. As a result:
1. The environment is highly competitive and drags down margins on consumer and business loans.
2. There is a high cost structure. According to the ECB, there was one bank employee per 166 people in the eurozone in 2014, compared to one per 127 people in Germany.
Negative rates have exacerbated the situation. According to analysts at Deutsche Bank, the ECB’s 0.4% deduction on surplus deposits will cost the German banking sector €787 million this year.
Global Head of Research, Strategy and Analysis