Capital Markets Outlook | Q3 2016

No break from Brexit

Global allocation insights

Several events on the horizon could cause shocks like the U.K.’s June referendum.

Key takeaways

  • More volatility may be in store for markets as political risks combine with signs of economic slowing in several of the world’s largest economies.
  • The European Union faces a series of potential destabilizers, from a banking crisis in Italy to sovereignty issues across several member nations.
  • A subsiding rally in oil markets may slow the U.S. recovery and add to pessimism about Europe, China, and Japan.

Italy’s banks may feel the first Brexit aftershock

Clearly by this point, anyone curious about “Brexit” will find plenty to read on the topic. And while the title of our piece this quarter is somewhat tongue-in-cheek, it highlights our view that much of what has been written since June 23 misses the larger point — of much greater import — that the outcome to the referendum should not have been terribly surprising in the context of what has been happening to the politics of the European Union since the first hints of the European sovereign credit crisis began in 2010.

Indeed, long before the first euros were put into circulation in 2002, the struggle for the concept of the EU was always going to involve issues of sovereignty. The ebbs and flows of political currents within each individual member country will always create stress around issues such as border control, tax policy, and financial regulation. Such stresses and issues in focus evolve over time. The current political climate and the election cycle have aligned to create something of a perfect storm for the coming year. The anticipated negotiations between the U.K. and the EU around trade; Italy’s constitutional referendum in October; gains by Euro-sceptic parties in Austria, Italy, and France; and major elections in France and Germany all create a great deal of policy uncertainty. In turn, this uncertainty will create substantial headwinds for cross-border M&A activity and capital expenditures that would be positive for markets.

The topic of most immediate concern revolves around the potential bailout of Italy’s troubled banks, where non-performing loans (NPLs) currently account for at least 18% of the total loan book at more than 360 billion euros. Putnam research estimates that the market clearing price to offload these bad loans is below 20 cents on the dollar but that they are being carried on the balance sheet marked at 50 cents. Unlike the troubled loans held by Spanish and Irish banks, which were backed primarily by real estate, Italy’s loan books tend to be dominated by the assets of small and midsize businesses whose holdings and collateral are more difficult to value and less likely to find a buyer.

To make matters worse, the equity prices of Italy’s banks fell by between 20% and 30% in the aftermath of the Brexit vote, hitting the Core Tier 1 Capital Ratios, which makes it much more difficult for the banks to raise fresh external capital. In the beginning of this year, the European Commission’s BRRD (Bank Recovery and Resolution Directive) took full effect. The BRRD now requires any bank rescue to involve a hit to the bank’s creditors (including depositors) to help mitigate the cost to taxpayers. The fear, of course, is that when a particular bank is suspected of being in jeopardy, it could precipitate a run on the bank.

In the best outcome, the European Banking Authority will find some of Italy’s largest banks to have failed their next stress test at the end of July, which would trigger a loophole in the BRRD, called Article 32, that allows state aid for banks at risk of failure. This would surely, once again, call into question the issue of just how cohesive the EU really is, if the one single crowning achievement to quasi-federalization, a common banking system oversight, is unraveled for yet another “one-off” exception to the rules.

Signs that the oil rally may have peaked

Meanwhile, the rest of the world is not all sunshine, either. Despite a strong recovery in oil prices since the first quarter, which has taken some of the pressure off the strained balance sheets of commodity-sensitive companies, default rates in corporate America continue to rise. Crude oil’s descent toward $25/barrel was a key contributor to the double-digit correction in global equity prices in January. The near-doubling in prices between February 11 and June 9 contributed to the ability of U.S. equities to test the high end of their trading range over the past few months. Unfortunately, the energy complex has a number of receding tailwinds, including a reversal of the U.S. rig count decline since May, the prospect of some Nigerian production coming back on line, and the potential for diminished demand from China after it topped up its strategic petroleum reserve.

Recall that the event that sparked a risk-off period beginning last summer was when China unexpectedly changed the yuan’s value by just over 3% in early August 2015. What has gone largely unnoticed since then is that the yuan has continued a slow and steady decline against the U.S. dollar of an additional 4.5%. This “valuation adjustment” against the dollar and other major currencies continues to have the effect of exporting deflation from China to the rest of the world.

In the U.S., growing and slowing look the same

The United States has been a bastion of relative stability, but even here, two months of disappointing monthly employment reports have offset the relatively upbeat composite PMI (Purchasing Managers Index) reports of services and manufacturing. A particularly challenging problem for the Fed is that a general economic slowdown and an economy at full employment would look almost the same at this point in the cycle. An illustration of this was buried in the minutes of the June 2016 FOMC meeting: “…a few participants suggested that the weak employment growth may instead reflect supply constraints associated with a general tightening of labor market conditions. These participants saw the rising trend in wages, business reports of reduced worker availability, and high rate of job openings as supporting this interpretation.”

Unfortunately, the conditions of a tight labor market and a slowing economy, are not mutually exclusive, although they call for different policy prescriptions. There are almost certainly structural frictions in place, driven, for example, by skills mismatches. Silicon Valley needs people to write code, and, in the Permian Basin in Texas and New Mexico, they need people to drill for oil and natural gas — clearly not the same workforce. But it is also true that the “earnings recession” that has been in place in the United States for the past several quarters is also likely to weigh on employment growth.

If indeed the U.S. growth engine is slowing, then we can add it to Japan and the United Kingdom as large contributors to global growth that are downshifting. China, too, after a powerful dose of fiscal stimulus late last year, has taken its foot off the accelerator.

Central banks might try their last tool

Central banks around the world are down to one last tool after moving from zero-interest-rate policies to negative-interest-rate policies. That tool is helicopter money. This policy would involve central banks giving money to consumers, or dropping it from “helicopters,” as former Fed Chair Ben Bernanke described it in a theoretical discussion. Actual implementation would probably involve central banks creating automatic credits in consumers’ bank accounts. The emergence of a global recession will almost certainly bring forth at least a few central bankers willing to experiment with this tool. However, things will need to get worse before that happens. For now, we expect that the low-return, higher-volatility world that we have lived in for the past two years will continue.

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