IU: How much have nonfinancial profits actually fallen?

Morris: Across global developed markets, nonfinancial prices have dropped about 15% off their peak levels. So broadly speaking, there's a huge gap between market pricing and actual corporate profits in those segments. More specifically, it appears that investors are punishing basic materials manufacturers especially hard.

IU: But you consider nonfinancial stocks to be priced fairly now, don't you?

Morris: Yes, and the 55% gap between how much prices have dropped for nonfinancials so far and the actual falloff in corporate profits signify the future for investors. In other words, that 55% gap represents the potential upside in nonfinancials going forward. But that's based on an assumption that no other significant material events will occur to cause a major contraction in corporate profits. But if that does happen, at this point, the downside seems limited because the market has already taken a 55% greater hit than actual earnings and cash flow measurements would justify.

IU: The majority of downside risk for investors globally will continue to come in financial sectors then, won't it?

Morris: Yes, going forward there could be some real nasty surprises. But that's likely to hurt financial balance sheets much more than nonfinancials, considering that financials have fallen by so much at this point. And the limit to that risk is the positive yield curve that is benefiting banks right now.

IU: How do you see bond yields impacting the profit picture for banks across the developed world?

Morris: With 90-day Treasuries yielding around 11 basis points today, and 30-year Treasuries yielding about 400 basis points, financial institutions can borrow at short-term rates—that is, take deposits—while lending at longer-term rates. So they've got a built-in profit margin right now in the lending business. 

IU: But banks are being criticized for not lending enough, aren't they?

Morris: We keep reading that. But the total assets in the world banking system are just under [U.S.] $60 trillion. So even if bank lending shrinks a little, that positive yield curve is still working with an enormous base of assets.

IU: So as long as yield curves remain positive, that will act as a floor to losses in the financial sector?

Morris: Yes, that would seem to be the case. Remember that when the credit crisis began in the summer of 2007, the yield curve was inverted almost everywhere in the world. You can debate the merits of Ben Bernanke's short reign as chairman of the U.S. Federal Reserve's board. But give him credit—he did manage to get the yield curve to turn positive in the span of a little more than 18 months. Consider that in June 2007, 90-day Treasury notes were yielding 480 basis points, and 30-Year Treasury notes were around 505 basis points. So that put a huge squeeze on bank profits. That situation has been turned around and will prove to be a significant factor in the performance of financials as a whole in coming quarters.

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