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Canadian investors learned during the summer of 2012 that when European debt fears pop their ugly heads up, domestic bank stocks get hit. Now, with the three-ring circus of Italy's federal elections roiling global markets, it's time to take another look at the ties between the European debt crisis and Canadian bank stock prices. Hint: they're not encouraging.
The European crisis is at heart a sovereign debt issue that has spread to the banking system. The public and private sectors are so intertwined at this point – governments borrow funds from the ECB to give to the banks so that the banks can buy government debt issues – there is little point in discussing the two separately.
Monday's federal elections in Italy ended as such a giant mess that drawing conclusions is dangerous. It is clear that voters are organizing against austerity plans and this represents a determined pushback against the country's Brussels-based overlords. A messy breakup for the Eurozone is nowhere near a foregone conclusion but political risks are rising, and Monday markets sold off accordingly.
This chart shows the price of credit default swaps (CDS) for Italy's two largest banks, Unicredit SpA and Intesa SanPaolo SpA (both bigger by assets than RBC, by the way) compared with the S&P/TSX Bank Index. The inverse correlation is approximately -0.75 for both Italian banks, indicating that when CDS prices – essentially the cost to insure the banks' debt against default – rise, Canadian bank stock prices fall.
It's inconvenient, but Canadian investors will have to begin paying close attention to political developments in Europe again. Further upheaval, particularly if more voting in Italy solidifies a "get us out of the euro" movement, will be negative for domestic bank stocks – no matter how good their quarterly earnings turn out.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow