June Review: Brexit’s Impact on Markets Overstated

Jonathan Rochford

Risk assets were mixed with commodities mostly higher, equities lower and credit flat. US equities eked out a gain of 0.1% but falls were seen in Japan (-9.6%), Europe (-6.5%), Australia (-2.7%) and China (-0.5%). US natural gas soared 27.5%, with iron ore (11.0%), gold (8.8%) and copper (5.3%) also strong whilst US oil (-1.5%) fell.

The big news for markets this month was the Brexit vote. The uncertainty of what happens now is real, as there are at least ten different ways Britain can leave the EU and they might not leave at all. However, blaming Brexit for the falls is superficial. Over-priced risk assets have been a bug in search of a windshield and Brexit is just a good excuse for a sell-off. Well before the vote the wave of predictions of tough times ahead continued with key US data continuing to signal a recession is possible. A Barclays report predicts net job losses in the US in the next year and LinkedIn is saying that jobs ads have been falling since February with May the worst month since February 2009.

Despite waves of dire commentary, in the long term the vote for Britain to leave the EU was a win for democracy and a win for sound economics. It’s a victory for democracy as a bad government (the European Parliament) has effectively been voted out by the British people. The 51.9% vote to leave is extraordinary and demonstrates that this is not a mere protest movement but a widespread feeling of discontent. A rag-tag bunch of campaigners with the better arguments defeated the big guns of British officialdom. It has been summarised as a scare campaign on economics (remain) versus a scare campaign on immigration (leave) but there is so much more to the anti-EU sentiment.

Relentless red tape, wasteful spending, atrocious monetary policies and the disastrous handling of refugees has shown how out of touch the European bureaucracy has become. The spectacle of a drunk EU Commission President slapping and giving military salutes to various heads of state at a function sums up how bad it has become. It is no surprise that other wealthy and independently minded countries are also considering whether they should leave as well.

In the long term, the vote raises the possibility that European nations will start to take seriously the many economic issues they face and return to rational economic policies. Whilst the uncertainty of change is negative in the short term, the future instability created by high debt and deficit levels, and inefficient economies is far worse. Change is inevitable for Europe; Britain may have just chosen to get off a sinking ship whilst there is still space in the lifeboats.

The Brexit vote is just one symptom of how disenfranchised many have become with the current political offerings. In Europe (far left and far right parties) and the US (the Tea Party, Bernie Sanders and Donald Trump) non-mainstream candidates are winning enough votes to take power or to be influential coalition partners. Faced with an awful choice between presidential candidates from the two major parties, support in the US for the Libertarian party is growing. As an economist, it’s tough not to like a party with a first priority to end wasteful spending and balance the budget.

The immediate impact on markets from the vote was for risk assets to fall with most equity indices down by 3-8%. Banks were amongst the hardest hit with the poorly capitalised Spanish, Italian and Europe’s largest bank by assets, Deutsche Bank, down 10-30%. The ECB handed out €400 billion of four-year funding at 0% as part of liquidity measures.

One short-term positive/long-term negative point this month for undercapitalised European banks was the deferral of risk weightings for sovereign debt. It was thought that banks would need another $195 billion in equity to meet potential changes as existing bank capitalisation ratios consider sovereign debt to be completely risk free. This means banks can get cheap funding from the ECB and load up on higher yielding Spanish and Portuguese government debt, artificially pushing down interest rates for those countries. In the short term the governments and banks both love it, but in the long term it means that if one gets in trouble the other is almost guaranteed to follow it down. Worse still, Greek debt is now considered suitable collateral for ECB funding after Greece cleared the hurdles for the latest round of bailout money.

Italy’s bank bailout fund, Atlas, is set to be drained of another €1 billion this time by Veneto Banca. Those thinking about asking Atlas for help better hurry up as more than half of its capital will be gone in the first three months. Just like the Chinese, Italian banks are exploring securitisation of non-performing loans. The ECB is said to be ready to help by allowing senior tranches as collateral for funding. There’s rumours that the Italian government will use the Brexit uncertainties as an excuse to push through a bank bailout of up to €40 billion. Germany is trying to kill off that idea insisting that investors must take some losses as part of any plan. Spain’s Banco Popular is offering low interest loans to buy shares in its capital raising.

In a case of trying to board after the ship has sailed, the ECB is investigating whether European banks need to increase their provisions on shipping loans. Korean banks may need a government bailout due to their outsized exposures to the shipping industry. The global glut of ships is expected to take years to clear with continued deliveries of very large ships making the situation much worse. The CEO of a Kazak bank is openly saying his country’s banks will need a bailout too. Vladimir Putin’s favourite bank needs a bailout after funding too many non-economic projects. India’s banks might need $18 billion to recapitalise, $140 billion to meet new Basel requirements and the restructuring firms setup to buy their non-performing loans only have enough capital to buy 13% of those loans.

Across the Atlantic there’s more examples of stupid lending involving governments with high risk mortgages being bought or insured by US government programs. Last time around subprime mortgages were sold in securitised tranches without government insurance, but now Ginnie Mae is insuring loans with 98% LTVs and minimal income coverage. Fannie Mae is buying similarly toxic mortgages and offers the same interest rate for borrowers regardless of the risk characteristics.

Non-government backed subprime might be a better risk/return option with Credit Suisse issuing a small subprime deal where borrowers had to document their ability to service the debt and the issuer kept 5% of the deal. US government backed student loans continue to see outsized growth in size and default rates. Credit cards arrears and losses are picking up. There’s concern about marketplace lenders not checking whether borrowers are taking out loans with multiple lenders at the same time. The Federal Reserve’s stress test had all 33 banks passing, but it was a conceded pass for Morgan Stanley, Deutsche Bank and Santander. An alternative model has the top six banks needing another $376 billion of capital in a scenario that involves a 40% fall in the stock market.

For Australian banks this month there was an excellent piece by Simon Fletcher at NAB that estimated $153 billion of additional subordinated capital will be required by the four major banks. Get ready for a wave of preference share and subordinated debt issuance in the next three years. Exactly how much and what types of capital is still being considered by APRA, but European regulators have shown that there are many different ways to address total loss absorbing capital (TLAC) requirements.

Chinese banks are still seeing exponential growth in their short terms loans. That sort of activity is worrying as $350 billion of Chinese debt comes due in second half of this year. The Shanxi government is asking banks to go soft on zombie coal miners in order to preserve jobs. Chinese mutual funds have been leveraging up, buying debt from banks in exchange for credit lines. This means they can expand their asset base and returns without having to raise more from ordinary investors. Online loan sharks are getting borrowers to submit pictures of themselves naked in order to blackmail them if they don’t make their loan repayments.

Chinese companies are following their US peers and borrowing for share buybacks. China’s stocks were rejected for the MSCI indices again with government restrictions on capital movements and share sales issues that still need to be overcome. Currency wobbles resurfaced with the Yuan hitting 5 year lows against the US dollar and bitcoin surged on Chinese purchases. Chinese investors are buying US dollar denominated local government debt as a strategy to avoid Yuan devaluation. In theory you’ve got a hedge, but it depends on the borrowers being able to repay the loans.

McKinsey is optimistic on productivity growth being a boost for China, but that requires dealing with zombie companies. The IMF joined the chorus in recommending that the government address exploding debt levels soon. The central government is estimated to be running a deficit of more than 10% of GDP in order to stimulate the economy. That might explain why business activity as measured in the China beige book was generally positive. Such enormous stimulus will inevitably result in overbuilding and malinvestment, with 10% of Chinese property thought to be vacant. An unofficial gauge shows underemployment in China is surging. Not everyone is bearish about Chinese debt though, there are some arguments why China won’t have a banking crisis. The Chinese foreign minister had a tantrum when a journalist asked a question about human rights.

Brazil is starting to see a wave of bankruptcies, with a deep recession and a devalued currency belting companies that have borrowed in US dollars. The telco company Oi has filed for bankruptcy with $19 billion of debt. Corporate farmers are set to default on billions of dollars of debt. The conglomerate Odebrecht is struggling to rollover some of its $32 billion of debt. The bankrupt airline Gol is attempting to swindle its international creditors whilst protecting its shareholders and local debtors. The government itself is facing a deficit far larger than expected and its debt to GDP ratio is rising fast. Months out from hosting the Olympic Games Rio has declared a “state of calamity” and is begging for additional funds.

Emerging markets are pushing for a new rating agency as they believe they aren’t treated fairly by the existing players.The problem is that rating agencies already routinely over-rate sovereigns so the right outcome would be for highly indebted developed nations to be downgraded not emerging markets to be upgraded. Alternatively, they could try the Chinese rating agencies, who routinely over-rate China’s government and its companies. It has a hint of the awards charade that industries often go through. If you don’t win the award you want sponsor a new set of awards and there’s a pretty good chance you will win. It’s a lot easier than actually doing the hard yards to win a rating or an award fair and square.

Puerto Rico has said it will default on general obligation debt on July 1 as it prioritises services to citizens over debt repayments. It is also saying it will void $4.4 billion of debt. Venezuela hasn’t defaulted yet, but Moody’s expects the nation and the state owned entity that produces its oil will both default this year. When security guards have to accompany trucks loaded with food to protect them from being ransacked by a starving population the end is nigh. The main communist newspaper in China wins the bull of the month award with its view that Venezuela won’t default on its debts. Perhaps they have inside information that the Chinese government will do a deal on its existing debt to Venezuela, in exchange for years of cheap oil. China is learning some hard lessons about lending to weak governments. Another oil dependent economy, Nigeria, saw a 30% fall in its currency when the peg to the US dollar was dropped.

Japan’s 75-year-old finance minister told elderly people to hurry up and die if they won’t spend their money. The problem for Japan in making necessary reforms is that old people have almost all the savings and a majority of the votes. In a desperate search for yield, Japanese banks are offering 60-year subordinated loans.

The city of Chicago is considering buying the debt of its nearly broke school system as an “investment”, strenuously denying it is a bailout. Its home state, Illinois comes in third on Truth in Accounting’s list of Zombie states, highlighting its debt and deficit position. The “winner” was New Jersey, followed by Connecticut. Hospitals in Mississippi skipped pension contributions for 5 years. President Obama wants to expand social security and he believes the rich can pay for it. One small problem is that social security has been on a pathway to insolvency for decades and needs a lot more funding just to meet its existing obligations.

A stream of articles this month highlighted the similarities between current economic conditions and those of the 1930’s. There’s an open revolt against ultra-easy monetary policy with Deutsche Bank saying that the ECB has lost the plot. Citibank wrote that we should remember the folly of Rudolf von Havenstein, the German central banker who printed money in the 1920’s, noting that economies are not a petri dish.

That’s the problem with having academic economists running monetary policy. They don’t recognise the damage they are doing as they don’t have the practical experience to understand how businesses and individuals respond to incentives. They are willing to experiment with untested policies or worse still, try policies that have failed in the past believing that this time is different. The ECB has tried to defend the indefensible, giving six reasons why negative rates are ok. One study found that old and young people both hate negative interest rates. European green parliamentarians are calling for helicopter money. The ECB started buying corporate bonds in June and its first purchases included a company that has a sub-investment grade rating.

Mutual fund liquidity was back in the news with the Financial Stability Board airing its concerns about illiquid assets being held by funds that offer regular liquidity. Australian investors may well remember the property funds that locked up the early 1990’s and again in the early stages of the financial crisis. Mortgage funds and high yield debt funds also locked up in the financial crisis. Unwinding these vehicles typically takes years, arguably due to the managers who continue to harvest management fees whilst investors are restricted from getting out. If you think I’m cynical about some of my fellow fund managers without cause, this article notes that hedge funds take 80% of the alpha they create. I’m on record as saying that managers should only get 10% of alpha.

Fund lock-ups push asset prices down, as either assets are cleared quickly in a fire sale or are delayed from sale and create the perception of an overhang. This is why many well regarded investors have been selling down recently, it is a lot easier to buy assets cheaply when you are one of the few cash bidders left. I’m not sure that US investors have yet grasped the gravity of the situation faced with high yield bonds and leveraged loans held by mutual funds.

I’m careful to separate unlisted mutual funds from exchange traded funds, as they will act very differently in a time of crisis. A run on a mutual fund will result in lock-up unless the assets are truly liquid. All remaining investors will get stuck if too many try to exit. A run on an ETF will trash the market price, but holders have the choice of selling at the available price or sticking it out. ETFs are not a perfect solution, the large drops in several equity ETFs in the flash crash of August 2015 showed that the floor can fall away when markets are illiquid. The concept of market makers taking possession of the underlying assets and selling those for an arbitrage profit if an ETF falls too much relies on liquidity existing for the underlying assets. That liquidity and the arbitrage possibilities won’t always be there.

Whilst tech start-ups have been a source of much financial chicanery a couple of events give some hope that not everyone is drunk on unicorn juice. The Dropbox CEO stated his firm is cashflow positive noting “cash is oxygen, and if you keep having to go to investors to fill up your scuba tank, you can run out”. Another tech start-up actually paid a dividend.

The referendum on universal basic income (UBI) in Switzerland was soundly rejected, but votes in other countries are likely to follow. For those who haven’t been following the debate UBI is the idea that rather than having welfare come with strings attached, every adult should receive a basic regular payment from the government. Generally simpler is better when it comes to government programs and UBI certainly meets this by ignoring whether people are trying to get work or are earning enough already not to need government support. However, the simplicity comes by killing off the incentive to work particularly in low skill jobs.

Many proponents of UBI are profoundly socialist in their outlook. One often cited reason for its introduction is that it will save people from working in really boring jobs and allow them to pursue their interests elsewhere. Often examples are given of people who would concentrate on artist pursuits if they didn’t have to work in boring, low paid jobs. The argument runs that these jobs might even disappear as a result making society better.

When UBI meets basic economics it quickly runs into a brick wall. In countries like Switzerland or Australia with a high cost of living, the increase in taxes required to give every adult a basic income is enormous. Marginal tax rates would have to increase and cut in from the first dollar earned. You can see how this becomes a socialist versus capitalist debate, as those working and earning income are heavily taxed to fund payments to those who aren’t willing to work.

If UBI was introduced you could expect to see a large increase in the number of people who are trying to be professional sports people, models, writers, actors, musicians and artists. Many young people will spend years hopelessly trying to gain employment doing these things before figuring out there are very few people who earn good money in these glamourous areas. An even larger group will play computer games and watch television all day. The number of people gainfully employed will drop. This creates spill-over costs in mental health, crime and drug use.

Those boring jobs that people should apparently be saved from will become more expensive and difficult for businesses to fill. With their basic income need satisfied, some people will be unwilling to take on boring jobs without a substantial increase in their income. The effective minimum wage could rise to $30-40 per hour, as after tax pay would decrease due to the higher tax rates. Substantially higher wages for low skill work would create the twin effects of skyrocketing inflation and offshoring of jobs. At this point the socialist dream breaks down just as it has in Venezuela. UBI isn’t the solution, productivity, taxation and government spending reforms are.

Written by Jonathan Rochford for Narrow Road Capital on June 30, 2016. Comments and criticisms are welcomed and can be sent to info@narrowroadcapital.com


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