Brexit, Bank Stocks, Currency Wars: The Usual Suspects by Rothschild Wealth Management
Foreword
Bank stocks are volatile at the best of times, and these are not the best of times. Recent losses and restructurings, untested capital structures, negative interest rates, flattening yield curves, and fears that senior bond holders and even depositors might be asked to bail them out, all combined in February to push some European bank share prices down to levels not seen in a generation. The big stock indices fell to two-year lows.
Market fears can be self-fulfilling. “Feedback loops” exist, and were very visible in 2008, for example. However, there are also precedents for markets loudly crying “wolf” mistakenly, namely in 1987 and 1998 (coincidentally, both associated with lowered oil prices). Aggregate bank solvency and liquidity are stronger than in 2008, and central banks still have room to act should they feel the need to do so. As yet, the interbank market remains well-behaved, even as credit has reportedly become harder to get.
February’s volatility follows an unhappy New Year for stocks. It is unclear exactly why the investment mood has darkened so suddenly in 2016. It probably reflects investors’ understandable sensitivity to “credit” concerns, and market dynamics, rather than an underlying problem we have collectively missed – but by definition, we can’t be sure of the latter.
Our view is unchanged, but this doesn’t mean we are complacent. If we were to change our view at this point we would be responding to market sentiment, not new facts. We doubt the longer-term outlook has altered, and our portfolio managers have been looking for opportunities unearthed by the turmoil. In separate essays below, we also review the intensifying Brexit debate, and argue that fears of a global currency war are premature.
Kevin Gardiner
Global Investment Strategist
Rothschild Wealth Management
The usual suspects
“Snakes. Why does it always have to be snakes?” – Indiana Jones
Still muddling through
Stocks have rallied since lurching into bear market territory on 11 February, but it is premature to proclaim stability. We have been spoiled by a seven-year US expansion and a relatively clear cut market call in that period: recent volatility is in fact not yet that unusual, and while economies, corporate profits and stocks all tend to move forward in the longer-term – for reasons that have little to do with central banks or interest rates, positive or otherwise – they don’t travel in a straight line.
We think the global economy can continue to muddle through for a while yet. On some of the markets’ specific concerns:
- Does the market “know something” we don’t? We can still remember being told by a corporate financier with a blue chip client list that the UK corporate sector was in difficulties in 1990 some weeks before official data showed the economy diving. We also remember that the credit market’s local difficulties in 2007/8 did indeed morph into a wider, dramatic threat to risk assets in general.
But our hunger for a plausible story – for a human metaphor that brings markets to life – can lead us astray. Sometimes markets move for reasons that have no macro logic, but which simply reflect the changing positioning of key players, and which can be unimportant in the longer-term context. The data at which we look most closely – covering economic activity, money supplies, financial tension – are not yet pointing to a change in the climate.
- Are EU banks in trouble again? The speed with which European bank stocks fell in February was alarming. In several instances, restructuring costs ate into capital, and the existence of new “contingent convertible” (or “CoCo”) bonds (with coupons payable at regulators’ discretion) makes this a more urgent risk. In the background, the new resolution framework makes it more likely that senior bondholders generally, and even larger depositors, may be more quickly at risk (or “bailed in”) in any shortfall. The treatment of Portugal’s “bad bank” bonds at end 2015; continuing uncertainty over Italian banks’ non-performing loans; and the impact of negative interest rates and flatter yield curves on net interest margins, have further sensitised the issue.
However, there are still few signs of an increase in systemic banking risk (figures 1 and 2). The ECB continues to offer potentially unlimited liquidity, and pressure on net interest margins would fall if banks passed negative rates on to private depositors (which has mostly not happened so far). Collectively, bank capital and liquidity are stronger than in 2007/8, and if markets stabilise we suspect that bank stocks will rebound strongly.
- Is the US entering recession? We’ve long argued that there haven’t yet been the excesses in US domestic spending to warrant a meaningful downturn, but the risk of a technical recession did rise at year-end: growth slowed to a near-standstill, and poor weather seemed to threaten a weak new year too. However, consumers in particular continued to spend robustly in January, buoyed partly by cheaper oil prices, and the effects of a stronger dollar and energy sector cutbacks may have peaked. A technical recession looks alittle less likely than it could have done.
- Is China melting down? Data still point to a slowing economy, not a collapsing one. Meanwhile, China’s importance, and its exchange rate policy, can be misinterpreted. It has contributed a lot to global GDP growth in recent years – more than the US – but is still some way from being the largest economy in current dollars (figures 3 and 4), and its growth is less relevant to capital markets than (say) US or European growth. As we note again below, it has not started a currency war (though the renminbi is not one of our favoured currencies).
Investment conclusion
There hasn’t been an economic accident yet, but one of the things worrying investors is the idea that if there were to be, the authorities are now powerless to help. We think this is mistaken: central banks can still improvise on monetary policy and act as lenders of last resort, and governments have plenty of levers still available to pull.
Central bank support is not a key part of our case for investing. We think the global economy can stand on its own two feet, and ideally should be left to do so (subject of course to having safety nets for those harmed by the business cycle). Fiscal deficits are (as Ronald Reagan said) big enough to look after themselves. Longterm prosperity is not driven by interest rates, bond purchases or public spending, but by the availability of resources and by ongoing innovation and learning by doing. Investors shouldn’t be so worried on this account (the issue of who exactly might be pulling the US levers in particular is another matter, perhaps).
Meanwhile, at end-2015, US corporate earnings were down modestly on the year. Excluding oil and materials companies, however, they were broadly unchanged, with few signs of a downward lurch ahead. Stock valuations across the developed bloc – and now in the US too – are firmly below trend, and while bonds are expensive, the absence of inflation (and the scale of current and previous central bank purchases) still means they may stay so, though they are not an investment we feel able to recommend currently.
The question we expect to be tackling in the spring and summer months is not whether the economic climate is moving into a new ice age, but whether instead it is about to become more temperate for the emerging markets, oil and mining companies and other investments – including UK and Australian stock markets, and US speculative grade bonds – all of which have now lagged appreciably during the last few years.
Never closer union: Brexit update
“Determined to lay the foundations of an ever closer union among the peoples of Europe…” Treaty of Rome, 1957
In early December (“Breaking bad? Brexit and UK markets”) we argued that Brexit would be bad news for UK business, but not on a game-changing or portfolio-restructuring scale: in or out of the EU, we felt the UK would likely remain the most dynamic big economy in Europe. We suggested that a mix of strongly partisan views with uncertainty was a recipe for financial volatility, but that UK capital markets are largely driven by wider global forces, not just narrowly European ones, and that long-term portfolios with healthy weightings in global franchises are implicitly protected against local economic risk and a weaker exchange rate. We hazarded a guess, though, that voters would choose the status quo. We stand by these views, but the referendum (confirmed for 23 June) now looks set to be – if that is possible – even closer than seemed likely.
The 18–19 February EU summit deal was dismissed as of little substance. But a public exemption from “ever closer union” addresses the heart of the matter for EU-sceptics, and will not have been granted lightly by the partners. The phrase features at the beginning of the 1957 Treaty of Rome, and a failure to acknowledge this political dimension – taken for granted by the founding partners – is responsible for much of the unhappiness that has characterised the UK–EU marriage to date.
The extent to which the partners really seek a formally federal outcome is debatable. But a public acceptance of the need to gradually give up some national sovereignty has always been part of the package for members. And now it isn’t.
Brexit itself is being analyzed more closely. In order to secure access to EU markets – particularly in services – an “outside” UK might have to contribute to the EU budget, and comply with many EU rules, but without being able to influence them (the so-called Norway model). The UK’s net contribution to the EU is small anyway (though routinely overstated by the Brexit lobby), at roughly 0.5% of GDP, but if leaving were to bring little financial or political advantage – taxation without representation in fact – then what would be the point? The reality is that no single country is really in control of its destiny: compromise rules, and a state’s formal “sovereignty” can be of little practical use.
The stability of an EU without the UK is also being questioned. The EU is the UK’s largest single export market, but the UK is probably the biggest single export market for the rest of the EU too (it is for the eurozone at least). The dependence is smaller, but markets are highly sensitised to risk, and it is possible that the UK might trigger a wider break-up. That may not affect the UK vote, but it could certainly affect wider financial stability afterwards.
The debate is putting some lobbyists on the spot. As we noted in December, the UK was widely regarded as “the sick man of Europe” in 1973, and joining the Common Market was seen as a way of making it more competitive and dynamic. Now, the UK is the (relatively) dynamic partner. This doesn’t necessarily mean that Brexiteers are liberals: immigration is a key strand in the public debate (the possible resumption of mass refugee movement in the spring may yet shape the outcome). But some are indeed free traders, which is why the “out” camp is divided.
What of the referendum itself? Opinion polls in the 2014 Scotland referendum and the 2015 General Election reportedly failed to capture properly the views of older voters, and so understated support for the status quo. Brexit, however, is more popular with older voters, and if the polls still suffer from this problem, they may be biased in favour of staying in.
Uncertainty is having an impact on markets. Sterling has weakened (a possibility noted in December), and versus the dollar is close to psychologically-significant levels (for traders, that is). It is not yet especially cheap in inflation-adjusted terms, however, and clearly could fall further in the months ahead.
A lower exchange rate need not be feared in an economy with negligible inflation and substantial exports and overseas assets. Long-term investment portfolios should routinely allocate a significant weight to global businesses, wherever domiciled. From a purely top-down viewpoint, the UK has long been one of our least favourite developed markets, and has now underperformed for several years. Possible Brexit notwithstanding, it may be time to revisit this call – particularly if commodity prices stabilise.
A phoney war?
“…an increase in the balance of trade of one country at best leaves the level of employment for the world as a whole unaffected” – Joan Robinson, “Beggar-thy-neighbour remedies for unemployment”, 1937
Investors have been worrying about a currency war, a “beggar-thy-neighbour” strategy of competitive exchange rate depreciation, since China loosened the renminbi’s link to the dollar in August.
For a country faced with slower growth, a cheaper exchange rate is seductive. Exports get a boost, overseas earnings are revalued and if there is little inflation to begin with the cost in terms of domestic instability is modest.
But if everyone chases a bigger slice of the global cake in this way, you end up where you started. The net effect is heightened tension and uncertainty all round – and perhaps a smaller cake, much in the same way that retaliatory protectionism deepened the depression of the 1930s.
This is not what is happening now (though this doesn’t mean markets have to stabilise!). Recent currency movements have not been extreme, and those currencies that look cheap have mostly been trending lower for a while, and not because they are seeking to undercut competitors.
The extent to which key currencies are at unusual levels is summarised in figure 9. Trade-weighted indices capture a country’s exchange rate against all its significant partners, and the chart shows divergences from 10-year trends. Currencies whose real trade-weighted exchange rates are at least two standard deviations below their trend are (with the biggest divergence first) the ruble, Canadian dollar, Norwegian krone, the rand and the Brazilian real. In percentage terms, the ruble and rand look particularly cheap, both being some 30% below trend. At the other end of the scale, the dollar is two standard deviations above its trend, though only 14% above it, while the renminbi is less than two standard deviations but 23% above its trend.
The countries with cheap currencies are commodity exporters. Their currencies have not become cheap suddenly, but have been falling with the value of their key commodity exports. In the jargon, their “terms of trade” – the price of their exports relative to that of their imports – have worsened sharply, and their lower exchange rates reflect that.
To view those lowered exchange rates as a competitive threat to the wider world is mistaken. Cheaper oil and metal prices do not make Western manufactured goods less competitive – if anything, Western producers benefit a little from cheaper inputs and a corresponding rise in their own terms of trade. Commodity demand is in any case very insensitive to price changes.
There is of course a transatlantic tussle underway. But while the dollar looks expensive relative to trend, and the euro cheap, the proportionate divergences are not dramatic, nor have they suddenly widened (figures 5 and 6). And as noted, China’s currency, the source of much of the “currency war” rhetoric, is still well above trend: the supposed aggressor has in reality not yet fired a shot (figure 8).
This could change. We do not make currency forecasts – such projections are even more fallible than point forecasts for GDP and interest rates – but the euro and renminbi are two of our least favourite exchange rates currently (the dollar remains our favourite, and sterling would be our second preferred were it not in the Brexit doghouse).
Dramatic change, however, may not happen. The euro has consistently been less fragile than expected, despite ECB easing. China still has capital controls: they are leaky, but still potent, and China is quite capable of putting liberalisation on hold – or even reversing it.
Intriguingly, while China’s currency is high relative to trend, it still looks undervalued in absolute terms (figure 9 again). The whole-economy equivalent of a “Big Mac” index is still low: calculations of China’s purchasing power parity (PPP) used by the IMF et al show the currency still to be below fair value. China’s currency is simply less undervalued than it was.
This subtle point is overlooked. If PPP matters, it does so in the very long term only. But a fundamentally undervalued currency is arguably less likely to collapse. And if PPP estimates don’t matter, then one of the arguments for treating China as more important of course disappears.
