How Brexit will hit Europe hard

From Citi:

Like most boys, my three-year old loves see-saws. From his perspective, it has two steady states. ‘Down’ when he sits on it – and ‘Up’ when daddy sits at the other end. The transition between the two states is all too swift. And unfortunately, every time we end up in an equilibrium, it’s pretty hard to shift – at least until he’s eaten a lot more broccoli (or so I tell him).

The situation in markets is not dissimilar – albeit rather more joyless. Faced with disinflation, lower growth prospects, record high levels of indebtedness, low profit growth, and structural policy paralysis there is a fundamental equilibrium which is distinctly ‘down’. Yet the tightening in financial conditions and the hysteresis effects such an outcome would bring are the last things policymakers already faced with the breakdown of faith in the centre-driven – or call it ‘establishment’ – politics want to contemplate here and now. And so central banks are weighing more heavily on markets than ever, keeping valuations on most assets firmly ‘up’. Past attempts at getting off have led to precipitous descents in those valuations every time. So there we hang.

What’s new about the current situation is that the question has morphed from previous concerns about one central bank or another being about to bail, to one of whether they really have enough mass to offset the weight of negative fundamental impulses.

Faced with €400-500mn of ECB buying per day, the immediate answer in credit in the aftermath of ‘Brexit’ was a resounding ‘yes, they do’. But some other asset classes seem to be drawing a different conclusion.

…the two things that worry us at the moment are falling yields and European banks – and, indeed, their interaction. The negative signal that falling yields and inflation expectations send for credit is something that we’ve flagged repeatedly over the last month.

But this week we want to focus on the ongoing de-rating of European bank equities, which for a growing number of banks is greatly inhibiting the ability to raise new capital. Over the last year, the market cap of the SX7P (banks in STOXX Europe 600) is down by more than 40%, in what has become an almost perfectly correlated move with falling yields (Figure 1). Within that, of the 48 banks in the index, 25 have seen their market cap more than halve.


Granted, valuations remain considerably better than at the depths of the GFC and the sovereign crisis in aggregate (Figure 2). However, that masks considerable divergence. Nearly half the banks in the index have a market cap that is at or below the level from June 2012 – just before Draghi promised the ECB would ‘do whatever it takes’. Indeed, on a price-to-book basis the whole index is now right back to the GFC and sovereign crisis lows.

…the lower the equity valuation, the greater the proportion of any capital shortfall that will have to be filled by means other than the equity market. And that surely raises the probability that policymakers, willingly or having run out of other options, end up writing down or converting the debt. Although this might be more of an issue for mid-tier banks than the larger banks that make up the bulk of the indices, the precedent it would set should surely be reflected in risk premia.

But there is a much broader point, which surely impinges on non-financial credit too. Capital-constrained banks just don’t lend very much. The ECB can inject all the liquidity it wants, but if the cost of equity is higher than the return on equity then it is more efficient for banks to reduce balance sheet than to provide new lending.

Figure 6 shows very clearly how strong the link is between the excess return on equity and private sector credit growth in the Eurozone with a lead of one year. Currently, the high cost of equity suggests credit growth will turn negative over the coming months. Private credit growth, or rather the incremental change in it, has a very strong link with broader economic growth (Figure 7).


And to complete the loop back to credit, spreads in € IG are normally very well correlated with nominal GDP growth in the Eurozone (Figure 8).


So basically, when the market doesn’t believe in the ability of banks to deliver adequate returns it has a direct economic impact over time. That, in turn, should impact credit spreads down the road.

As long as the ECB is sitting so firmly on credit, you could choose to ignore that. But as we have pointed out previously, the experience last year from covered bonds strongly suggests that if the broader backdrop becomes negative, then it can outweigh ECB purchases and lead to wider spreads.

What’s apparent to us is that the tension between the technical created by the CSPP and the bearish undertones is increasing. The exact tipping point on the seesaw is extremely difficult to identify ex ante, because as much as anything it is a function of market psychology. We may never reach it, or we may already have crossed it. The balance of probabilities is probably with the ECB, but factoring the asymmetry in up- versus downside, risk/reward feels very finely poised here. Hence, as we outlined last week, our preference remains to emphasise relative value over direction.

And in case you are wondering, yes, we think the European bank sector will need a whole lot more broccoli, before we are prepared to recommend it from a credit perspective again.

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  1. Stephen Morris

    “And unfortunately, every time we end up in an equilibrium, it’s pretty hard to shift – at least until he’s eaten a lot more broccoli (or so I tell him).”

    This guy has obviously never heard of Archimedes. I always viewed the see-saw as an opportunity to explain the principles of “moment” to my daughters by moving in towards the fulcrum until equilibrium was achieved.

    • You mean you didn’t tell your offspring to load up with more weight on their end to make sure they got to settle down gently after they did? Never mind that the plank might snap, more (of what doesn’t work) is the only answer….

      • It is led by fools, not because of foolish CB policy, it is led by fools, because they allow the USA to do whatever they like and then they have to live with the consequences – i.e. a migrant crisis. Western Europe is getting exactly what it deserves.

      • Sorry JC if I didn´t understand your first post. However, you can´t blame the EU for the Middle East mess (OK, not entirely, just talking about the last 15y). The US has and is doing whatever it likes simply because it has the bigger muscle and, unless you are willing to go to war against them, there is very little you can do but wag the finger at them (remember Freedom Fries?). In this regard it is not very different to China laying claim to the S China sea. The IT at the Hague may be right in its verdict, but there is little to do other than calling China what it is, a bully. Maybe now that we have a new bully in the yard the US will learn to play nicer.

  2. Every time we speak of new financial stimulus, we remember that the “money” is created as debt.
    Certainly this debt is easier to handle because governments are getting close to paying no interest on it but while ever interest rates are this low, more capital is being destroyed and growth doesn’t occur to repay the sovereign debt.
    There are still the same three choices:
    3)revalue gold
    When gold is revalued there is no new debt-backed fiat created.
    Only gold can extinguish the debt.
    Germany, Italy and France still have large amounts of gold.
    The longer the current debt-backed fiat system exists the greater likelihood there is of turning to gold.
    Don’t forget that this sham has been an experiment since 15 August 1971.

    • Athalone, option 3 is a no option from the get go, if nothing else bc the US (who would suffer the most) will never go for it. Option 2 is the current strategy but, in a world of dropping fertility rates and fast approaching the singularity, unlikely to happen. That leaves option 1, which will be done in stealth (and judging by the bond markets, even Mr Market prefers it).

      • The US supposedly has the most gold(China being cagey) so the US has the most to gain.
        Whoever has the most gold makes the rules throughout history.

      • Not really. EU and US economies are roughly the same size as is external debt. Gold reserves though are (low ball park figure) 11K mTn whereas US is c8.1K. Even accounting for population size a reset based on a return to gold would see the US lose economic weight on a per capita basis. I suspect default and reset will be more to their liking. That still means that a portion of savings in gold is a good long term hedge.

  3. The EU problems is the same as most… private banks created poorly underwritten credit w/ tight ties to the shadow sector – see Deutsche bank and Société Générale and the elites have used central banks as confidence fairy dust distributors than screw with entrenched ideology…

    But then… with a “tax payer” financed bailout, as opposed to the lunatic Rube Goldberg bail-in scheme the Eurocrats have devised. The thing is that injecting public funds amounts to a public receivership, i.e. nationalization, if properly done, with the CEOs and boards fired, shareholders wiped out, together with most bonds and any residual ownership claims only attaching to the bad bank of non-performing assets. That is by far the most efficient and equitable way to resolve insolvent banks. But that would be “socialism”, acting in the public interest against neo-liberal dogma, which would make Mr. Market sad. So are these banksters really asking for someone to please shoot them, to put them out of their misery?

    Disheveled Marsupial… thank you economic libertarians – !!!!! – take a bow…

    • Most of us would love to see the banks nationalised and hopefully Labor’s Royal Commission may come to that conclusion…if it is allowed to run.

    • Skip, yes and no. Maybe globally this is true but in Spain the “Cajas” were the epicenter of the mortgage-driven bad debt crisis. As much as I dislike the idea, I agree with some of our resident permabears that credit has to be tightly linked to deposits and money creation put on a leash and centralised.

      • JasonMNan…

        Sorry but… linking credit to deposits or stuff and centralized is just a knee jerk which would be just as bad as a disorderly unwind of trade – see history…

        The drama was the metaphysical approach some thought was coherent or applicable in real world application, wrt rules and regulation i.e. Austrians supplied the philosophical smokescreen whilst the neoclassical’s gave it a patina of empiricism w/ a case of bad math and physics…

        Disheveled Marsupial… bad enough that it became dominate in the market but… taking over the government [too include international agencies] via ideological capture meant solutions or remedies outside the dogma were off the table… its only starting to change tides…