In the wake of the coronavirus pandemic, the world’s largest commercial lenders have seen their share prices plunge by more than 80%. BNP Paribas, one of the largest banks in the world, saw its stock price fall by 78% in March 2020. The price of their stock hit a 52-week low. Similarly, Credit Suisse shares have dropped by 77% since the start of 2020 and Morgan Stanley’s stock shares have decreased by 73% in the same time period. All three banks have seen the prices of their stocks decline in March alone by at least 40%.
Investors seem to have piled into safety. The iShares MSCI Canada Index ETF, which tracks the S&P/TSX Canadian Stock Market Index, saw its price rise by 9.2% in 2020 while the S&P 500 increased by 3.3% and the Nasdaq Composite rose by 22.5%.
One reason for the market’s flight to safety could be the growing conviction that central banks around the world will have to resort to more aggressive measures to stimulate global economic activity. The world’s largest banks have suffered heavily because of the pandemic and many investors have lost faith in the traditional economic tools favoured by central banks in the post-crisis world.
Less Volatile, More Predictable
We could see more central banks resort to unconventional measures to fight the pandemic, including cutting rates and providing more liquidity to markets. For instance, the European Central Bank’s (ECB’s) interest rate on overnight cash loans is now minus 0.5%, down from 0.75% previously, while the Bank of Japan has decreased its benchmark interest rate for the tenth time since the global financial crisis of 2008.
At the same time, central banks have had to contend with volatile capital markets that are much more unpredictable. Even before the pandemic, traditional safe havens such as government bonds and the equity market of large firms had become less attractive as economic uncertainty grew. The perceived safety of Japanese yen, Swiss francs, and US dollars, for example, have all decreased in recent years as the market’s volatility increased.
Lower Valuations
The world’s largest banks are valued much less than their earnings would suggest. The price-to-earnings (P/E) ratio for the S&P/TSX Canadian Stock Market Index is currently just 19.7, compared to a historical average of approximately 27, and valuations are even lower for the three largest banks in Canada, Citi, RBC, and the Bank of Canada.
In fact, the P/E ratio for the S&P 500 is only 16.3, a 17% decline from its pre-pandemic level. The price/earnings (P/E) ratio is a key valuation metric that indicates the multiple investors are paying for the company’s earnings. A decreasing P/E ratio suggests investors are becoming more confident that the stock price will rise over time as earnings grow.
The steep decline in the share prices of the largest Canadian banks is not a unique case. Look at other industrial and pharmaceutical company stocks that are down over 80% since the start of this year. The price-to-earnings ratio (P/E) for these other firms is also below their long-term averages, further suggesting that investors believe value has sharply decreased.
Smaller & Shorter Risks
While central banks will remain at the forefront of policymakers’ minds, as an increasing number of companies struggle to earn a profit in the post-pandemic world, individual investors will look to cheaper and more accessible investment opportunities. After years of cheap money and low interest rates that made traditional investment vehicles appear appealing, reduced market volatility will make even lower-risk investments a more attractive proposition.
The risk-return profile of the stock market will change as investors seek higher rates of return in a world where higher risk investments yield greater returns. Smaller capitalization companies will be cheaper to purchase, resulting in an opportunity cost that will impact how much investors are willing to commit to a project or business. The lower the cost, the greater the perceived appeal, even if the risks are higher. One of the biggest losers in this scenario is the venture capital industry, which has seen a major shift to more risky investments and increased competition, which has in turn driven down valuations and investment opportunities for firms.
The bottom line is that while the economic tools central banks have at their disposal will be essential to stave off a global recession, individual investors are now assessing the risks they are willing to take on themselves and what opportunities they can access that are less exposed to the financial markets’ inherent risks.