Financial investors were hopeful that, given the weekend to comprehend the UK’s decision to leave the EU, rational heads may have worked out some of the issues – resulting in much calmer European financial markets on Monday
Understanding the consequences
However that was not the case. Like most of UK voters, the English football team while losing 2 to 1 against Iceland completely misunderstood what the concept of Brexit actually means.
Former Prime Minister David Cameron understood exactly what he was doing when he resigned on Friday morning. He has effectively delayed the pushing of the so called Article 50 button that would formally signal the start to the ‘leave’ process. For a comprehensive read of this legally intricate subject, David Green (a legal correspondent with the FT.com) has written a great article. There was also another interesting read on The Guardian website.
I’m not convinced that Article 50 will ever be triggered; the UK has every incentive to delay the commencement of this formal process. In this regard, Germany, France and Italy rejected the notion that informal talks would take place with the UK. These countries urged the UK to push the Article 50 button as soon as possible. The UK will not listen and will take its time.
This will lead to further uncertainty within a policy and leadership void.
Australian corporate bonds
For Australian investors in some of FIIG originated bonds there is likely to be little in the way of a direct impact. There may be some softness in prices on a relative basis, as market pricing moves broader credit spreads wider but most FIIG deals have a very low exposure to the UK and Europe. As for bonds denominated in either sterling or euros, I think that they may be further weakness in both currencies as the markets become aware and better understand additional risks.
UK’s credit rating cut
Against this backdrop, S&P cut the UK’s AAA credit rating by two notches to AA and the UK’s outlook remains negative. S&P stated:
“The downgrade reflects our view that the “leave” result in the U.K.’s referendum on the country’s EU membership ("Brexit") will weaken the predictability, stability, and effectiveness of policymaking in the U.K. and affect its economy, GDP growth, and fiscal and external balances. We have revised our view of the U.K.'s institutional assessment and we no longer consider it to be a strength in our assessment of the U.K.'s key rating factors. The downgrade also reflects what we consider enhanced risks of a marked deterioration of external financing conditions in light of the U.K.’s extremely elevated level of gross external financing requirements (as a share of current account receipts and usable reserves). The Brexit result could lead to a deterioration of the U.K.’s economic performance, including its large financial services sector, which is a major contributor to employment and public receipts. The result could also trigger a constitutional crisis if it leads to a second referendum on Scottish independence from the U.K.
We believe that the lack of clarity on these key issues will hurt confidence, investment, GDP growth, and public finances in the U.K., and put at risk important external financing sources vital to the financing of the U.K.’s large current account deficits (in absolute terms, the second largest globally behind the U.S.). This includes the wholesale financing of the U.K.’s commercial banks, about half of which is denominated in foreign currency.”
“The negative outlook reflects the risk to economic prospects, fiscal and external performance, and the role of sterling as a reserve currency, as well as risks to the constitutional and economic integrity of the U.K. if there is another referendum on Scottish independence.”
Fitch also cut the UK’s rating to AA from AA+ and left the UK’s outlook negative.
There have been some press reports that later on Tuesday 28 June, Moody’s will revise UK banks’ credit outlook to negative. Given the downgrades that we have seen at the sovereign level, it certainly seems plausible.
The UK banking sector again bore the brunt of investors’ disappointment; the index of UK banks fell 7% on Monday after falling 10% on Friday. Barclays and RBS closed down 17% and 15% respectively; on Monday, RBS fell by as much as 26%. Both Barclays and RBS have fallen by 30% in the last two days of trading.
It hasn’t just been banks’ equity that has been losing value; credit spreads have also widened. The iTRAXX senior financial index closed at 136 (Thursday at 94) and the subordinated index closed at 276 (Thursday 205). As is normal in a deteriorating credit environment, spread differentiations in capital structure increase and that is exactly what has happened over the last two days – senior bank bonds have outperformed subordinated bonds.
In addition, UK bank Contingent Convertible bonds (CoCos/AT1s/hybrids) have fallen. For example, Lloyds 7.625% 2023 CoCos are trading at about 90, near the February lows, and down from 101 on Thursday
Is contagion possible?
I am starting to become more concerned that we could be seeing the start of a more serious event, similar to the GFC. I think on a scale of 1 to 5 (1 the highest risk), we have moved to 3 from 4. With the weakness and volatility that’s been observed in the UK financial sector, the prospect of contagion has increased.
I like to use the analogy that banks are the heart of the financial system. They pump the money (blood) to other sectors (arms and legs) of the global economy that need it. During the dotcom bust, we lost the tech/cable sector (an arm) but the banks (heart) remained relatively unaffected. Default rates spiked in 2002 and 2003, but it was largely contained to specific sectors. Banks continued to finance most sectors.
During the GFC, the banks (heart) became infected and were unable to function normally. This prevented many sectors from having an adequate supply of capital (blood). This saw those sectors experience high default rates as liquidity dried up.
It is worth noting that at the moment, it is just largely equity valuation of banks that are under increasing pressure. Currently, capital ratios remain intact. There is no indication that assets on banks’ balance sheets are impaired, will have to be written down and subsequently reduce capital adequacy ratios.
However, given the probability that the UK economy’s growth will slow substantially, with some economists now calling for a recession, it is likely that bank assets could become impaired in the near future. In addition, given the probable path of interest rates, banks’ net interest margins are likely to be narrower than expected, impacting on future profitability.
If bank assets become impaired again, then the impact will be felt more broadly than just the financial sector. This impairment may not even be based on fact; it may be sufficient that a broad perception of major losses is enough to start a deposit run on UK banks. This is one of my major concerns and one area that I will be watching closely.
An associated article
discussing Brexit's impact on FIIG originated bonds is also available.