New York could be the big winner from Brexit, and China is getting killed on trade!

Deutsche Bank tried to send a reassuring message to markets this week, but it could end up backfiring.

Recent revelations about a looming fine from the U.S. Department of Justice (DoJ) added a level of urgency to Deutsche Bank’s current financial distress. After news of the mooted $14 billion levy became public, both parties hoped to reach a quick settlement, but were unsuccessful following negotiations this week. CEO John Cryan has moved swiftly to quell panic, insisting his firm has full access to capital markets. But rather than hoping investors take his word for it, Cryan set to prove it.

The bank reportedly raised $3 billion in a private sale of senior unsecured bonds last Friday, returning this Tuesday to raise an additional $1.5 billion. Great news, right? Not exactly. Deutsche Bank was forced to give an extra 300 basis points of yield above benchmark rates to entice investors, more than twice the premium required to sell similar notes in August 2015. Bloomberg estimated the price-to-yield at around 4.3%, which in the current record-low rate environment resembles the price of junk debt.

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The decision to aggressively raise capital was seen as a “power move” by Cryan, but the biggest takeaway from the deal was the high cost required to get a deal done. Instead of proving the bank is on firm financial footing, the bond sale reinforced just how far the German bank has fallen. In fact, Deutsche Bank now has the highest borrowing costs of any European bank, including troubled Italian lender Monte dei Paschi di Siena (MPS) and the National Bank of Greece (NBG). In a survey to determine the price of interbank borrowing for the European financial sector, Deutsche was the only bank reporting it was forced to pay to borrow over for a 9-to-12 month period. The bank paid 0.06% of interest for a one-year loan, while MPS and NBG borrowed at one-year rates of -0.06% and -0.04%, respectively.

To make optics worse, news also broke this week that Deutsche Bank received special treatment from the EU in recent stress tests. Rules state banks are not allowed to count capital raised from deals not completed by the end of the previous calendar year (in this case December 31, 2015). However, Deutsche’s lackluster results included $4 billion in proceeds from the sale of of its stake in Chinese lender Hua Xia, a deal that was agreed upon in principle last December but still has yet to be completed. Deutsche still would have passed the stress test without counting the divesture, but the news could further damage the credibility of European banking officials.

Deutsche Bank’s woes are just the most visible symptom of a disease sweeping the entire European banking system. In contrast, American banks appear headed in the right direction. 

Struggling to cope with negative interest rates and plummeting investment banking revenues, European banks have moved swiftly to cut costs. Deutsche Bank announced plans last October to cut 9,000 jobs, but the bank’s finance chief told staff this week those cuts could more than double to 19,000 (around 20% of the firm’s workforce). Deutsche also announced an across-the-board hiring freeze.

Deutsche Bank isn’t alone. Lloyds Banking Group, the U.K.’s largest mortgage lender, announced plans to eliminate another 1,340 jobs as part of a plan to reduce its workforce by 12,000 people by 2017. Commerzbank, a smaller German lender, recently announced it would cut one-fifth of its workforce, totaling almost 10,000 jobs.

European banking leaders struck an ominous tone at the annual Institute of International Finance (IIF) conference this week in Washington. “This new world of low interest rates and even negative interest rates is something that is very difficult. It is a game changer, not just for banks but for the whole financial industry,” said Frederic Oudea, CEO of French bank Societe Generale.

American banking executives expressed greater optimism. While U.S. banks are also struggling to get returns above the cost of capital, their balance sheets are healthier because they completed litigation and wrote off larger portions of bad loans sooner. Goldman Sachs President Gary Cohn said the U.S. banking system is in the "best shape it has ever, ever been by far."

Top global banking executives reiterated their warning about pulling jobs from the U.K. amid growing concern Britain will not retain access to the European single market when it leaves the EU. Banking centers in continental Europe are hoping to benefit from an influx of former U.K.-based banking jobs following Brexit, but it’s looking more likely many of those jobs could move to the United States. While Dublin and Frankfurt look most likely to absorb some European banking jobs, Morgan Stanley CEO James Gorman said, "The big winner for Brexit will be New York; you'll see more business moving to New York."

POUND'S SHARP DECLINE WREAKING HAVOC ON U.K. BUSINESS

Brexit fears continue to weigh on the pound, and the sell-off has gotten so extreme it’s starting to wreak havoc on business in the U.K. The currency depreciated nearly 7% over the past month, bringing its total slide versus the dollar since the referendum to around 18%. Accelerating the decline has been an increasingly nationalistic tone struck by British Prime Minister Theresa May. Also not helping the cause has been pointed rhetoric from European Council members including President Donald Tusk, who made it clear this week the U.K. has only two choices: "hard Brexit" or "no Brexit." The latter scenario looks increasingly unlikely unless the anti-Brexit parliament gets a say on when or if to trigger Article 50. PM May says British lawmakers shouldn't play a role in decide whether to initiate Brexit talks, but the issue will soon be decided in a U.K. courtroom.

[Read: The markets have taught Theresa May a hard lesson on sovereignty: The British government will learn about the limits of control in an open economy]

While a weakened currency can boost a country’s exports, benefits disappear when the adjustment is rapid and disorderly. The pound’s fast fall from grace has forced British corporations to slash profit forecasts amid fears over rapid inflation. Consumer products giant Unilever is in a standoff with supermarket chain Tesco over pricing on products ranging from Hellman’s mayonnaise to iconic British breakfast spread Marmite. In order to make up for the pound’s recent plunge, Unilever wants to raise prices by 10%. Hedging costs for U.K. firms have also skyrocketed.

The turmoil in Britain is reverberating through Europe. European bond funds lost $2.2 billion to withdrawals in the week ended Wednesday, the largest outflow since June 2015. The sell-off was in part a response to reports (which were later denied) last week the European Central Bank (ECB) may taper its purchases starting early next year. To allay those fears, the ECB this week upped the pace of its sovereign bond purchases. However, the ECB is starting to bump up against the limits of monetary policy by pricing itself out of the corporate-bond market as yields plummet so low many are no longer eligible for its purchase program.

CHINA IS GETTING KILLED ON TRADE

You’ve heard it on the campaign trail: China is devaluing its currency and killing us on trade. Back in the real world, however, the communist government is burning through foreign exchange reserves to prop up the yuan and Chinese exports have plunged for six straight months. The most recent trade data released this week showed Chinese exports plummeting 10% from the year-ago period, well worse than expectations for a 3.3% decline. Global equities declined on the worrying news but did rebound after China's inflation data eased concerns over the prior day’s weak trade report. However, anxiety over the Chinese economy is back on the rise.

Yes, the yuan hit six-year lows this week, erasing all of its appreciation since 2010, but that’s because China has decided the currency is becoming too expensive to support. The Chinese government is trying to transition the domestic economy from one reliant on manufacturing and exports to one based on consumption. In order for that to take place, domestic consumers need a strong currency. However, a strong currency makes it harder to service debt, so Beijing is attempting to split the baby by allowing a very gradual market-driven re-calibration of the exchange rate.

The problem with allowing a currency to depreciate gradually is it invites further capital flight. With the dollar (to which the yuan has a range-bound peg) strengthening, China’s mission to support the yuan is becoming increasingly costly. As a result, government officials are starting to get more serious about dealing with a massive debt overhang before the situation becomes unmanageable.

China laid out guidelines this week for controversial debt-for-equity swaps between banks and corporations that will help companies reduce runaway debt loads but leave financial institutions strapped for cash. Analysts estimate Chinese corporate debt now accounts for 160% of gross domestic product (GDP), up from less than 100% in 2008. Larry Hu, a China economist at Macquarie Securities, told the Wall Street Journal he’s worried “a poorly designed debt-for-equity swap could aggravate the problem and delay the exit of inefficient firms.”

The Chinese government is also trying to curtail frothy speculation in property markets by tightening control on funds flowing into real estate investments. Chinese financial markets fell sharply on the news because it threatens China’s economic growth ambitions.

Goldman Sachs believes capital outflows from China may be worse than they look. Late last week, the People’s Bank of China (PBOC) announced its foreign exchange reserves fell for the third straight month by more than expected. Chinese investors are also finding “creative” ways to get money out of the country. A Chinese consortium, Sino-Europe Sports, was caught forging fake bank records to demonstrate its ability to buy Italian soccer team AC Milan in a deal that, if completed, would be the largest-ever overseas soccer acquisition by a Chinese company. But unlike Anbang’s failed takeover of Starwood Hotels, the deal is still on track for completion. What’s a couple of fake bank documents among friends?

Deutsche Bank sees the yuan falling 17% over the next two years due to capital outflows, which could pick up when/if the U.S. Fed hikes rates this December. If the Chinese property bubble deflates as expected and the People’s Bank of China (PBOC) is forced to ease monetary policy to help banks cope with mounting sour loans, outflows could accelerate even further. 

EARNINGS RECESSION COULD BE COMING TO AN END

S&P 500 profits have declined for five straight quarters, but there is light at the end of the earnings recession tunnel. 

FactSet, based on analyst estimates, projects S&P 500 earnings this quarter to decline by 2.1%. However, earnings estimates are notorious for undershooting actual reported earnings. Over the past four years, actual S&P 500 earnings have exceeded estimates by an average of 2.9%. If that average holds, actual earnings this quarter would grow 0.8%. Materials companies are expected to lead the rebound, with S&P Global Intelligence projecting the sector’s earnings to grow by 8.8% this quarter. Financials (+5.7%), utilities (+4.4%) and consumer staples (+4.2%) are next in line. If earnings can’t get back into positive territory this quarter, FactSet projects 2017 full-year earnings to grow 12.9%.

JP Morgan (JPM), Citigroup (C) and Wells Fargo (WFC) kicked off earnings season this week. JPM beat on the top and bottom line thanks to better bond trading revenue. WFC topped estimates despite a year-over-year profit decline of 3%, while also announcing plans to widen its investigation into shady sales practices. Citi revenue and profit also fell, but beat estimates. All three stocks opened higher Friday morning before selling off during the session to close near the flat line.

QUOTE OF THE WEEK

"Based on the average change in earnings growth due to companies reporting actual earnings above estimated earnings, it is likely the index will not report a decline in earnings for the third quarter." 

- FactSet analyst John Butters in a note this week on the upcoming earnings season

FURTHER READING

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