This Side Of Brexit

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Douglas Adams


  • The biggest spillover from the Brexit vote has been the continuing rally in government debt across the developed world. $12 trillion in government debt now trades in negative territory.
  • Globally significant banks identified by the IMF now pose the greatest risk to the financial system with two of the three most significant posting negative returns on equity.
  • Italian banks pose the single biggest threat to the euro currency bloc.
  • As a result of the Brexit turmoil, an increase in the federal funds rate in 2016 is off the table.

Perhaps the biggest macro-economic spillover this side of the British referendum vote is the continuing rally in government debt with the concurrent plummet of yields across the developed world (see Figure 1, below). The mean basis point (b/p) drop for the top eight globally significant banks designated as such by International Monetary Fund (IMF) is 35 b/p over the course of a month. In the US, the 10-year benchmark blew through its previous low of 1.40% set in the wake of Spain's banking crisis in July 2012 to settle at 1.37% at yesterday's (5 July) market close, falling 38 b/p for the period. There is now little chance of a Fed move on interest rates for the remainder of the year. That said, the real point here is articulating just how inviting US bond yields have become to European and Asian investors over the past month. With an estimated $12 trillion of developed world debt already posting negative yields and the growing talk of further negative moves by the Bank of Japan (BOJ) and the European Central Bank (ECB) in the offing, US debt and dollar-based assets will remain in demand for the foreseeable future. This means the rally in US debt will surely continue and delineate a new string of historic lows moving forward.

Figure 1. Global Systematically Important Banks (as of 5 July)



Base Country




Yield %


1 month (b/p)

Market Return YTD

Deutsche Bank
















Credit Suisse








JP Morgan Chase








Goldman Sachs








Bank of America








BNP Paribas








Banco Santander








Falling yields have already wreaked havoc on bank balance sheets and share prices, especially those banks with outsized dependence on interest revenue from loan portfolios as Figure 1 aptly demonstrates. With any increase in the federal funds rate largely off the table for the balance of 2016, the US yield curve has flattened considerably. The spread between the highly interest rate sensitive 2-year and 10-year note came to 80 b/p at yesterday's market close (5 July) - the lowest spread in about eight years. JP Morgan Chase and Goldman Sachs are the only systemically significant banks that do not trade at a discount to book value. The toxic mix of slow GDP growth, a moratorium on further interest rate increases and a flattening yield curve will apply downward pressure on bank earnings and valuations for the foreseeable future. JP Morgan Chase has the best return performance of the list losing 9.81% through yesterday's market close. Meanwhile, Bank of America (BAC) trades at a 25% discount to its book value while at the same time the company's return on equity remains squeezed by current economic conditions. The result was a dismal 24% decline in market performance through the first half of the year-with little respite in the offing for the second half of play.

Unsurprisingly, the biggest move was in the UK with the 10-year gilt falling a full 52 b/p to 0.772% at yesterday's (5 July) market close for a new post-WWII record. The pound has followed a similar path, settling at $1.28 to the dollar at yesterday's market close-the lowest post since April of 1985. The Bank of England (BOE) is expected to cut interest rates by 25 b/p as early as next week, according to news reports, with another 25 b/p slated for August. This would bring interest rates to zero. There is also talk of dusting off its large-scale asset purchases (LSAP), a program the BOE shelved in late 2012 after purchasing an estimated £375 billion in government debt. The UK would then rejoin the Bank of Japan (BOJ) and the European Central Bank (ECB) in further loosening monetary policy, leaving the Federal Reserve the lone central bank in the developed world not actively pursuing some form of traditional or alternative policy options.

Eurozone banks continue to pose the weakest credentials on the IMF list of the world's most systemically important banks. Deutsche Bank, identified as presenting the biggest systemic risk of all, sports some of the weakest valuations of any bank on the list. Its return on equity, along with Switzerland based Credit Suisse, claim the only negative posts in the category. Deutsche Bank shares sell at a 50% discount to book, signaling a strong wariness by investors of the implied market value of its balance sheet assets. Deutsche Bank Trust Corporation, a US-based subsidiary, has failed the Federal Reserve's stress test for two consecutive years. Credit Suisse shares sell at a 5% discount. The pair's market value is down almost 46% and a whopping 54% respectively through half of the year. All of this leaves precious little room for capital replenishment from investors in the capital markets if and when the need should arise. A similar story arises with Banco Santander (SAN) of Spain and BNP Paribas (OTCQX:BNPQF) of France. Both trade at 25% discounts to book value while the return on equity ratio of the two banks fall well below the 10% threshold most investors hold for banks with sizable interest revenue dependencies. A US-based Santander subsidiary has failed the Fed's stress tests for three consecutive years.

While anemic rates of growth in the Eurozone, structural governance deficiencies at both the national and euro-level and ballooning debt-to-GDP ratios are constant companions, the negative interest rate environment of the region add a novel and largely unpredictable dimension to the equation. Not even during the darkest months and years of the Great Depression did interest rates fall negative. Plunging yields and interest rates have worked well in moving investor funds into riskier corners of the market as equity valuations continue to grow. In replace of organic growth in a constrained global market, US corporations have turned wholeheartedly toward shareholder enhancement programs like share buybacks and dividend payouts, fueled by almost unlimited access to dollar- and euro-based capital market debt at borrowing costs that hover about zero. The assumption of debt on US corporate balance sheets is likely an asset bubble in the making by most measures with the potential of outsized negative future consequences when interest rates do finally start down the path toward normalcy. In the meantime, actual corporate earnings by S&P 500 companies face a fourth consecutive quarter of decline. In Europe, the vast majority of economic growth remains captive not to the capital markets for ongoing and investment capital-but to banks and credit lines. These are the same banks with balance sheets in many cases already replete with non-performing loans still waiting to be unwound, making most loan originators even more wary of taking on risk-despite ECB programs that essentially pay them to lend to the greater economy if certain lending thresholds are met.

And then there is the debilitating issue of non-performing loans that blanket European banks' balance sheets-particularly in southern tier member states. Out of the total estimated €900 billion in non-performing loans outstanding in the Eurozone, Italian banks hold €360 billion of the total alone. Outside of Ireland and Spain whose banking sectors forced international bailouts and the formation of "bad banks" that offloaded foreclosed property and nonperforming loans from balance sheets, a Pan-European equivalent of the Troubled Asset Relief Program (TARP), the much maligned depositary for bad loans and highly depreciated assets the US set up in the immediate aftermath of the Great Recession of 2007, was never part the of the Eurozone response to its financial crisis. Until the launch of the ECB's Single Supervisory Mechanism in November 2014, banks dealt with non-performing loans within the confines of national banking rules. Many Eurozone member states, with Italy being the biggest example, never conducted an overhaul of their banking system in the crisis' wake as bad loans and questionable assets remained on balance sheets-often at original market valuations. Bloated staffs, too many branches, slow economic growth and an aversion to assume more loan risk depressed bank profitability. Given Italian banks' already rock bottom market valuations, raising private capital to replenish reserves in nigh near impossible.

Recent bail-in rules from the EU that took effect in January puts Italy between a rock and a hard place. The new EU rules are meant to force losses on investor by converting bank debt into equity which instantly absorbs losses due to equity positions carrying a dramatically reduced current market value in times of financial stress than original debt issues. The problem in the Italian case is the fact that these debt instruments are widely held by retail investors--in pension funds, savings certificates and other interest bearing securities. As debt instruments, the erstwhile shaky finances of the Italian national deposit guarantee fund would not even apply. The fear of losses could set off bank runs and capital flight across the country. A TARP-like government infusion to avoid the bail-in rules is not an option under current EU rules. While exceptions may eventually be negotiated, Italian banks are well along the way toward becoming the Achilles heel of the euro. The British vote on the EU has added new focus to those fears.

Of course, monetary policy in the US remains highly accommodative with an effective federal funds rate at 0.41% through the 1st of July. The trick for the Federal Reserve is whether the US economy, an oasis of measured growth, will be able to withstand the onslaught of safe harbor capital flows into the economy that appear destined to take yields on both government and corporate debt to historic lows, while strengthening the dollar in world currency markets. The Dollar Index (DXY) has gained 2.69% over the past month as the demand for dollar-based assets increases with the level of angst in global markets. A strengthening dollar undermines US competitiveness in world markets, pummeling earnings of US firms dependent on foreign sales revenue. Cheap imports in dollar terms carve out bigger shares for foreign producers of goods and services in US markets, subtracting from overall GDP growth. The US trade deficit grew to $41.1 billion through the end of May. The import of services hit an all-time record of $41.438 billion during the month with travel ($10.089 billion) and transport ($8.149 billion) both carving out new highs-suggesting a strong dollar increased domestic travel abroad. Interestingly, the CBOE VIX remains calm in the face of Brexit: The measure has fallen to 15.62 at mid-day (7 July), well below its long-term average reading of just under 20.

The market plays here are defensive and fear-based in scope, as momentum stocks will likely struggle in investment environs replete with uncertainty. While the cost/barrel of both Brent and Western Texas Intermediate crude have staged impressive gains since the latter part of January/early February time frame, the hedge fund trade of record during the period was shorting the dollar and long oil. The sustainability of either trade is arguably problematic moving forward in the aftermath of Brexit and with oil hovering on the south side of $50/barrel. The oil patch remains depressed as credit lines pull back to current market valuations of reserves in the ground. Defaults on past borrowings are on the rise while investment remains constrained-despite back-to-back reports of small weekly increases in rig counts about the Permian Basin and elsewhere. Beyond energy, utilities, consumer cyclicals and telecommunications were the three sectors that posted positive, unencumbered gains in the 2nd quarter. Gold and silver continues to play on the fear side of the equation, logging impressive year-to-date returns. Marketable real estate investment trusts and select alternative energy positions also come into play. The red ribbon running through these positions: annual yield. With the average annual yield of equity dividend positions well above the 1.37% yield of the 10-year Treasury note. In real terms, the yield on the 10-year note resides just south of the PCE deflator of 1.60% through the end of the 1st quarter. The demand for dividend plays should remain strong for the foreseeable future.

Gold and utility exchange traded funds include:

  • Powershares Utilities (PUI);
  • Vanguard Utilities (VPU);
  • SPDR Gold Shares (GLD)

Gold and utility stocks include:

  • Central Fund of Canada (CEF);
  • Public Services Enterprises (PEG). Yield 3.46%;
  • Ni-Source (NI). Yield 2.71%;
  • Consolidated Edison (ED). Yield 3.55%;
  • Portland Electric (POR). Yield 3.06%;
  • American Electric Power (AEP). Yield 3.45%;
  • American Water Works (AWK). Yield 1.77%

Alternative energy positions include:

  • Hannon Armstrong Sustainable Infrastructure (HASI). Yield 5.3%;
  • Pattern Energy Group (PEGI). Yield 7%.

Real Estate Investment Trust positions include:

  • Duke Realty (DRE). Yield 3.18%;
  • Realty Income (O). Yield 4.06%;
  • WP Carey (WPC). Yield 5.60%

Telecommunications positions include:

  • Telus (TU). Yield 4.42%
  • Verizon (VZ). Yield 4.22%
  • BCE (BCE). Yield 4.55%

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AEP, CEF, NI, O, PEG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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