From Citi’s Matt King:
- A rising tide of populism – The most obvious concern is that the vote fuels secessionist and protectionist tendencies outside the UK. This indeed seems quite likely – if nevertheless the sort of tail risk markets find it hard to price in advance.
- Beware the message from rates – More troubling and imminent is the rally in rates. This looks to us the most durable of today’s moves. Now that it is inflation breakevens falling – and not just a rally in real yields – it sends a much more negative signal for risk assets.
- Banks as the catalyst – The rates rally is wreaking havoc on bank equities in particular: SX7E is making new lows. Against this and given the negative convexity associated with potential bail-in, the relative strength in sub CDS and AT1 looks misplaced.
Beyond the important issue of just how messily the path to Brexit is now handled, we think the global fallout rests on two questions.
- First, to what extent does the UK result presage or encourage the rise to power of a wave of populist and secessionist movements elsewhere?
- And second, to what extent do today’s moves help to tip what was already a precarious balance in markets away from a reach for yield and back in the direction of risk-off?
On both counts, we think current market levels fail to fully reflect the risks; bank sub debt, in particular, seems vulnerable.
While the referendum result has a great many disturbing implications, perhaps the most troubling is the sheer extent of the gulf between what markets and most market participants deem to be desirable, and what it now turns out the majority of the public actually wants. The willingness to vote against the near-unanimous advice of experts must reflect either a gross underestimation of the economic consequences, or – worse – a public saying they simply don’t care.
…And since many of those voting for populist movements are doing so because they feel they are not benefiting from economic prosperity, they are unlikely to feel under much obligation to maintain it. While we are obviously still a very long way away from, say, an Italy or a France leaving the euro and defaulting on its debts in the process, the open espousal of such policies by leaders making significant gains at the polls – witness the new Five-Star-Movement mayors in Turin and Rome, for example – should arguably be accompanied by a risk premium in markets.
In addition, even if the political centre is able to fend off such movements, they seem likely to be able to do so only by themselves adopting policies with negative economic consequences. EU leaders are already making stern noises about being unable to let the UK simply cherry-pick which regulations it fancies and still enjoy access to the single market. Efforts to stem immigration will surely be stepped up.
Rather than inspiring a renewed push towards trade- and market-friendly policies, the gathering gloom about global growth prospects seems to be achieving exactly the opposite.
Ideally markets would simply reflect these fears with a risk premium – and perhaps, to some extent, they will. But we have seen time and again that markets struggle to price binary events efficiently. Worry too much about Brexit, or Grexit, or a new financial crisis ahead of time and you underperform versus those who are simply unhedged. Inevitably this creates the potential for tipping points, and a hunt for catalysts which might drive us over them.
…What seems much more troubling in the near term is the rally in rates and the associated sell-off in bank equities. These were at the heart of the markets’ disquiet in January and February, and seem dangerously close to becoming so again.
Even before Brexit concerns kicked off a couple of weeks ago, long-dated yields had begun rallying strongly. When the driver was thought to be falling real yields, and inflation expectations seemed reasonably stable, risk assets were able to turn a blind eye to this (Figure 2). Indeed, it seemed almost to fuel the reach for yield. But the more recent drop has come from a fall in inflation expectations, which are again approaching post-crisis lows.
This is something risk assets find far harder to shrug off (Figure 3). Explain the move in terms of real equilibrium neutral rates, as our rates strategists do, or in terms of secular stagnation, structurally declining business investment and credit exhaustion, as we would be inclined to, and it still points to an environment of challenged fundamentals in which risky asset valuations are worryingly dependent on a continued reach for yield.
In addition, it casts doubt on the efficacy of central banks’ past policies and, worse, raises significant question marks about what they might be able to do in the future. When the express aim of central bank easing – to boost inflation expectations – is failing so obviously, are markets really likely to be reassured by more of the same?
The driver of the yield rally seems to have been a partial capitulation by liability managers trying to cover their deficits. Today’s flight to quality and reduction in global growth expectations just exacerbates that. Even before the Brexit vote, the rally in global yields felt quite durable to us; indeed, our rates strategists are expecting yields to go lower still.
Such low rates put a strain on many financial sector business models. After a long period of resistance in recent years, presumably because yields were expected to rebound, insurance and especially bank equities seem finally to be focusing on this.
SX7E was already close to its lows prior to the UK vote, and is now making new ones – even with all the support the ECB is providing in terms of TLTROs.
If the rally in rates leads markets to worry once again about banks’ capital shortfalls, this could easily be just the sort of negative catalyst which tips global markets into a broader bout of risk aversion. Central banks can fix liquidity problems, but they can’t do much about solvency – and a largely untested bail-in regime creates ample scope for contagion.
This makes the relative strength of financial sector credit today decidedly puzzling. Both AT1 and sub CDS seem surprisingly well supported given their potential vulnerability. Even with equities making new lows, sub CDS retraced much of the day’s initial widening and trades around 40bp inside its wides from February. You might argue that they still seem relatively “in line” or even to have underperformed equities on recent betas, but we think this ignores the negative convexity that credit, as a par instrument, is always prone to.
In a similar vein, nor are we reassured by the fact that cash spreads in the periphery have widened in line with their sovereigns. The ECB is buying the sovereigns, and can do more if necessary; it seems unlikely any time soon to start buying the banks. And even then, this would be of limited assistance to sub and AT1 in instances where the market starts to fear a capital shortfall and subsequent bail-in.
In truth, we do not know how likely such a scenario is for now: we were surprised and impressed by the strength of the market today, in banks in particular. And as we have long commented, there is an unpleasant circularity, or herding, to market moves these days which makes identifying tipping points hard (I’ll buy (only) if you will). But at a minimum we would remain underweight banks and non-ECB-eligible bonds against ECB-eligible ones.
In Europe in particular, the dangerous nexus between banks and their governments remains unresolved. Regardless of whether you think the root of the problem is yesterday’s “reckless lending” or simply an inability to weather ever flatter yield curves, pressure on bank equities could easily prove a touchpoint for a much broader bout of risk-off. And with public disaffection at prolonged stagnation growing, appetite for a renewed round of bailouts is obviously zero.
This is the terrible irony behind the populist lurch away from the political centre, and the reason markets are probably under-reacting. It is not just that those voting for Brexit, and Trump, and Le Pen actually depend upon migrants, and trade, and banks far more than they realize. It is that the negative economic fallout from each successive step towards isolationism and protectionism will perversely add fuel to the political fire, leading to calls for still more extreme policies as a result. This is just the sort of toxic cocktail of bad economics and extreme politics which the 1930s were made of. It is hard to square it with such elevated valuations in risky assets.