The last week or so has been a rollercoaster ride for asset markets: the Brexit victory triggered a sell-off with some of the most pronounced moves coming from equity and currency markets, particularly sterling and the banking sector. In some cases the British banks lost up to a third of their share price value at the lows and riskier instruments such as CoCos were hit aggressively too. But even with the bounce in markets, the share-prices of Lloyds, Barclays and RBS are still at least 25% below their pre-Brexit levels with Lloyds a better performer. On announcing the Brexit result the Merrill Lynch sterling financials bond index saw its spread widen 31 basis points (currently around 38 basis points wider).
Brexit is expected to be negative for growth and investment. For example, Fitch ratings cut the UK’s credit rating to AA (negative outlook) from AA+ earlier in the week has cut its UK GDP growth estimates to 1.6% in 2016 (from 1.9%) and to 0.9% for 2017 and 2018 from 2%. Mark Carney, the Governor of the Bank of England, has also warned that monetary easing may now be necessary over the summer.
For the UK commercial banks this means loan growth will slow, net interest margins will be pressured and loan losses are likely to increase even without assuming a recession. This scenario is negative for profits and return on equity and pressures dividends. For banks wanting to operate in Europe, Brexit risks losing ‘passporting’ rights which allows the banks to offer services across Europe from the UK. This fear has not been helped by Francois Hollande announcing “The City, which could handle clearing operations in euros thanks to the UK’s presence in the EU won’t be able to do them anymore.” While some dispute whether this can happen in practice, it does serve as a warning that the UK is going to struggle to be allowed the same freedom under a diluted ‘associate status’ as it now enjoys, particularly, if it is not prepared to sign up to the core EU principle of the freedom of movement of people in some form. As Donald Tusk put it “there will be no single market a la carte.”
Following on from the downgrade of the UK sovereign rating, the ratings agencies are now turning their attention to the banks: Moody’s have cut the UK bank sector outlook to negative citing the negative impact of weaker growth on their key credit fundamentals. But the change is more a change in the outlook than changes to overall ratings. Banks are in a stronger position than before the global financial crisis and as Fitch notes: “Banks have an aggregate Tier 1 capital ratio of 13.8%, higher than the Bank of England’s view on steady state capital requirements of around 11%.”
European banks have also been buffeted by the Brexit result. Italian banks are thought to be some of the most vulnerable and the Italian government has stepped up its efforts in talks with the EU to bolster the capital levels of some of the weaker players. Reports say the Government is looking at measures to inject as much as €40bn of capital and are trying to use Brexit as an “exceptional circumstance” and “systematic risk” as justification for providing state aid without following the current EU rules which would impose losses on shareholders and junior creditors first.
While comments from Angela Merkel appear to rule this out an initiative to allow €150 bn in liquidity support guarantees has been approved. The sums being talked about now are certainly larger than previous measures announced; As we wrote a couple of weeks ago the Atlante fund was estimated to be around €5bn in size and is aiming to help small lenders raise capital and offload bad loans. Italy also reached an agreement with the EU earlier this year whereby Italian banks can securitise non-performing loans into special purpose vehicles but this initiative will at best only see a portion of bad debts securitised. Estimates put Italian non-performing loans (NPLs) at €360bn or ~18 percent of total loans and ~22% of GDP although ‘sofferenze’ or the severely delinquent bad loans are closer to €200bn. Net of provisioning estimates put the figure closer to €85bn. Basically, there is still a lot of ‘cleaning up’ that needs to be done.
Brexit is negative for growth and comes at a time when global growth is struggling thus it is little surprise that the value of global sovereign debt trading on negative yields has now increased to over USD 11.7tn: for us bonds from creditor nations with positive yields remain an attractive investment.