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By: Costas Bocelli — May 31, 2018

A Sovereign Debt Crisis is Brewing (Here's What to Do)

It was six years ago when European Central Bank president Mario Draghi threw down the gauntlet.

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The eurozone was in the throes of yet another flare-up of the sovereign debt crisis.  Only this time the currency union was pushed to the brink of collapse.

At a speech in London in the summer of 2012, as bond yields of weak euro-member governments soared out of control, the ECB president made a profound statement.

“Within the mandate, the ECB is ready to do whatever it takes to preserve the euro.  And believe me, it will be enough.”

With just three simple words -- “Whatever it takes" --  Draghi literally changed the course of events.

Shortly after his speech, the ECB announced a program called Outright Monetary Transactions (OMT) to buy the bonds of its distressed countries.

Although the ECB technically never ended up using the program, its very existence, and the promise it would be used, was enough to reduce the stress in the debt markets and bring down bond yields across the euro zone.

It also saved Italy from losing complete control of its bond market and from needing a full blown bailout.

The Italian debt market is massive.

It’s the third-largest bond market in the world and ten times the size of the Greek bond market which has been ground zero since the European debt crisis began in 2010.

You see, had Italy succumbed back then, it might very well have been the end of the euro zone project, and the end of the euro.  Today, the eurozone debt crisis is still a very significant issue.

Italy’s debt load is $2.77 trillion dollars, which represents 138% of the country’s entire economic output as measured by gross domestic product (GDP).  Their banking system is a hot mess riddled with billions of euros of distressed assets and non–performing loans.

So what’s been keeping the country afloat?  Two things really.  Ultra-low interest rates and the political will to remain in the euro.

But earlier this week, ongoing Italian political uncertainty unhinged global markets.

Two populist political parties (each pushing an anti-austerity, anti-establishment platform) agreed to align to form a coalition government.  Since then, bond yields across the euro-periphery have been on the rise.

But over the Memorial Day holiday weekend, the Italian parliamentary president put the kibosh on those plans, and is attempting to block them.  This has put the entire political system in flux.

When normal trading resumed on Tuesday, Italian bond yields spiked to four-year highs.

The contagion also spread to the other weak euro members such as Portugal, Greece and Spain (the so-called PIGS).

(Click on any image to enlarge)

euro yields

The financials suffered the worst, having declined by more than 3%.

Large money center banks such as JP Morgan (JPM), Bank of America (BAC) and Citigroup (C) led the decline among U.S domestic equities.

Have a look at the KBW Bank Index (BKX) which represents 24 large U.S. national money center banks.

bkx

In previous bouts with the European debt crisis, the financials took the worst of it.  During the summer of 2010, 2011 and 2012, were some of the sweltering periods of the crisis.

Now that the Memorial Day holiday has brought the unofficial start to the summer season, is the market landscape ripe for a return of the eurozone to debt crisis?

It’s a good question.

I think the answer lies with watching the evolution in bond yields across the euro-periphery and the reaction from the ECB.

The next policy directive on monetary policy by the ECB is scheduled for Thursday, June 14th.

The ECB is “all in” in making sure the wheels don’t fall off.

And Mr. Draghi has backed up his words with actions too.  After his “whatever it takes” proclamation, the ECB began its own version of quantitative easing aggressively buying eurozone sovereign bonds.

The asset purchase program started in March 2015.

And as a result, the ECB balance sheet has ballooned to more than 3 trillion euros.  The ECB has committed to the asset purchase program by purchasing 30 billion euros per month until September 2018.

The committee has also signaled that it will maintain flexibility to the size and duration of the program should it become appropriate.  In other words, the ECB now has three trillion reasons to ensure that the eurozone bond complex stays relatively stable.

With that in mind, the recent volatility in the U.S. equities represents an opportunity to buy high quality securities in the financial sector.

The opportunity to find securities that can generate superior returns does not lie with the large money center banks (not saying that they can’t go higher).

Rather, look to small, regional banks.  This is the group that has zero exposure to what’s going on across the pond.

With the U.S. economy expanding, business and jobs being created at a steady clip and strong consumption, the U.S. centric regional banks are a compelling segment of the broad financial sector.

Have a look at the KBW Regional Bank Index (KRX) which represents 50 U.S. based small to medium sized regional banks and thrifts.

krx

While the regional banks have also pulled back with the large money center banks and the overall market from the recent volatility, the sell-off has been relatively modest.

The relative performance between the large money center banks and the regional banks has also contrasted since the beginning of the year.

Have a look at the relative performance chart of BKX as compared to KRX.

bkx krx RS

As you can see, the trend has been lower since January 2018 which means that the BKX is underperforming the KRX.  In other words, the regional banks are demonstrating relative strength and the segment of the banks to focus on.

Within the regional banks, you can take a look at these five in particular:

  • Texas Capital Bancshares (TCBI)
  • Bancorp South Tupelo Miss (BXS)
  • East West Bancorp (EWBC)
  • Synovus Financial (SNV)
  • Wintrust Financial (WTFC)

You’ll find that all five of these stocks possess strong attributes of technical strength.  All five stocks are in a positive uptrend.

All five stocks are demonstrating positive relative strength versus the broad market and against their sector peers.

And all five stocks could care less out about the eurozone debt crisis.

See you soon,

Costas

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