Stocks May Sink 35% in Worsening Sovereign-Debt Crisis, Deutsche Bank Says

Stocks worldwide may tumble 35 percent if Europe’s sovereign-debt crisis deepens as investors flee risky assets and earnings drop, according to an analyst team at Deutsche Bank AG (DBK) in London.

“While consensus is that equities are not overvalued at current levels, we believe that investors and politicians underestimate the impact that a full-blown financial crisis would have,” the bank’s valuation and accounting team, led by Francesco Curto, wrote in a report today. “On a milder scenario, under which the crisis is contained and does not spill over to the real economy, we would still expect the MSCI World to fall by around 12 percent,” they added.

The MSCI World Index is headed for its worst week since August 2010, having dropped 2.5 percent so far, after bond yields for Italy and Spain rose to their highest since the euro was introduced in 1999 amid the escalating debt crisis in Europe. Standard & Poor’s yesterday became the second company this week to say it may cut the U.S.’s top credit rating.

In a “worst-case” scenario, the debt crisis would evolve to a “full-blown financial crisis” like the one caused by the collapse of Lehman Brothers Holdings Inc. in 2008, they wrote. The cost of equity capital would rise to levels last seen at the market bottom of March 2009 and companies’ net income would fall, they wrote.

In such a scenario, banks would trade at 0.32 times the value of their assets, down from about 0.85 now, the report said.

Equity Risk Premium

The extra return investors demand from European equities in the form of earnings as a percentage of share prices has risen to the highest relative to yields on German government bonds since the end of 2008, according to Bloomberg data.

In the U.S., the so-called equity risk premium reached a monthly record high in February 2009 as the credit crisis roiled markets. The earnings yield on the Standard & Poor’s 500 Index that month topped the yield on 10-year Treasuries by 6.13 percentage points.

The team’s main scenario is that the MSCI World (MXWO) ends 2011 at 1,359, climbing 3.7 percent from yesterday’s close of 1,310.83.

“Prompt action from European authorities could avert this worst-case outcome, however,” the analysts wrote. “But the downside risks to our relatively mild scenario have undoubtedly increased recently.”

The valuation and accounting team’s view differs from forecasts by Deutsche Bank’s equity strategists. Gareth Evans, a London-based European strategist, predicts that the Stoxx 600 Europe Index will climb 18 percent from yesterday’s close through year-end. Binky Chadha in New York, the bank’s U.S. strategist, predicts the Standard & Poor’s 500 Index will end 2011 at 1,550, an 18 percent advance from yesterday’s close.

To contact the reporter on this story: Alexis Xydias in London at axydias@bloomberg.net.

To contact the editor responsible for this story: Andrew Rummer at arummer@bloomberg.net.

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