The UK vote to leave the European Union has generated enormous volatility on the markets with significant underperformance by risk assets, particularly in the financial sector. We have taken a step back, and this is our first calm assessment of impacts and potential changes. This report also shows how we prepared for the possibility of the Brexit.
Consequences on the markets and the financial sector
The full impact of the Brexit vote is still hard to assess, but at this stage two consequences are clear:
- Political – uncertainty has risen in the UK and in Europe, too, as its very basis has been called into question. This has raised risk premiums across all asset classes;
- Macro-economic – growth is expected to slow (by 0.5% according to the ECB) and deflationary pressures will increase.
The immediate repercussions on the markets have been a rise in volatility and a drop in the price of risky assets, while rates have slid even lower. We believe rates will remain low under the combined impact of various monetary policies.
Banks have been the hardest hit sector on the equity markets. We believe this is more a reflection of their sliding profits in a weaker macro-economic environment when rates are dropping rather than another systemic crisis. Our systemic risk indicators remain stable (see Figures 1 and 2), which is very reassuring.
The excess liquidity in the system (see Figure 3) confirms that bank liquidity risk is low in both core Eurozone countries and those outside the EU. UK banks all have liquidity reserves of between GBP 100 and 200 Bn in the form either of cash deposited with the Bank of England (BoE) or securities that can be used as collateral. There is therefore little chance of any new liquidity crisis.
With respect to solvency, European banks are going into this new period of uncertainty with capital ratios at the highest they’ve been in eight years and, as such, high shock absorbing capacity.
Finally, Europe’s central banks (the ECB and the BoE) are providing unlimited liquidity and are buying securities on the markets under the ECB’s QE strategy. This rules out any risk of liquidity stress or higher debt valuations on related segments. The stable yields and spreads on periphery country debt and investment grade corporate debt is also reassuring.
Forecast bank profits for 2017 and 2018 have been revised down by 5% to 20% by sell-side analysts. The hardest hit banks, apart from UK domestic banks, are peripheral banks and those with significant Investment Banking activities. It is still too early to judge the soundness of these projections but the general direction seems clear. Falling profits will be impacted by lower revenues as growth slows and trade and new lending decrease as a result. Meanwhile, the cost of risk should increase slightly. We do not think that this will compromise the solvency of the main financial institutions but it will probably reduce their ability to generate organic capital unless they individually take compensatory action.
On the markets, risk premiums rose in the first two days after the result of the referendum: by 15 bps on senior bank debt, 55 bps on Tier 2 bank debt (see graph 4) and 65 bps on Additional Tier 1 (AT1) debt. Since 28 June all segments have seen a 10 bps fall in senior bank debt, 25 bps in Tier 2 and 40 bps in AT1.
OUTLOOK FOR THE NEXT FEW MONTHS
Political and macro-economic uncertainty will probably make the BoE drop its rates by 25 or 50 basis points this summer. We will also very probably see the launch of a new GBP 75 Bn QE plan aimed at both government debt and investment grade corporate debt (like that of the ECB). The Fed will certainly postpone all plans to raise rates. The ECB might introduce new measures in September, extending its current QE plan by nine months until end 2017 and/or increase purchases to 100 Bn a month. The market also expects deposit facility rates to fall again but we do not view this as the most likely scenario. Sterling should continue to sink dragged down by forecasts of lower interest rates. The dollar might continue to act as a safe haven. Long rates could keep sliding: -0.25% to -0.45% for the Bund, 1% to 1.4% on US 10-year rates and 0.8% on UK 10-year rates.
Credit spreads should remain within a range, increasing and reducing in response to political news and macro-economic data and to investors’ appetite for risk or liquidity. Over the next few months credit will basically remain a “carry” product.
Secondary market liquidity was generally quite good despite the wide trading spreads last week. We saw none of February’s panic selling. Indeed, the credit market was supported by four main factors:
1.“short” buybacks by hedge funds and banks;
2.daily buying by Asian investors;
3.extremely high investor liquidity;
4.ECB investment grade debt purchases.
In our view the credit market is technically enjoying significant support from investors looking for attractive risk/yield combinations at a time of low or negative rates, while central banks are stepping in to act as effective circuit-breakers when volatility peaks.
Glossary of terms
AT1 (Additional Tier 1): a Tier 1 subordinated debt instrument where holders are repaid before shareholders but after all other types of debt holders. These instruments are subject to specific risk of coupon non-payment as well as principal write-downs under certain circumstances.
Tier 2: a Tier 2 subordinated debt instrument where holders are repaid before shareholders and Tier 1 debt holders but after all other types of debt holders.
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