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Out of the four risk factors to global markets that we focused on in previous write-ups, two seems to be unfolding at present:

§  EU banks tumbling: Currently at lows only seen in 2009 post Lehman and in 2012 European crisis. Uncertainties post Brexit and uncertainties over the bail-in/bail-out of Italian lender MPS helped accentuate the pain. Yields tumbling to new lows, flat curves around zero, also contributed to re-price banks’ profitability more accurately: Deutsche Bank is now worth less than Snapchat. As we stated in the past, in the long run, no bank is ever designed to function in durable negative rates environment: their business model is impaired and needs a rethink/restructuring. However, in the short term, the fate of the sector is in the hands of EU politicians and their capacity/willingness to provide a solution. Ill-conceived bail-in clauses stand in the way of a pragmatic TARP-like intervention and risk trigger a run on deposits. Either bail-in rules are bypassed/suspended on a public sector intervention or a European bank failure lies right ahead. Time is of the essence: dum Romae consulitur, Saguntum expugnatur. Looking across the EURUSD, S&P/DAX, credit spreads, implied volatility, markets seem to be expecting no credit event and some policy intervention to save the day; let’s hope that they are not as wrong as with Brexit. 

§  Chinese Renminbi silently devaluing: during the last month, CNH has been grinding higher, despite weak NFP & a dovish Fed. The CNH is at similar levels to those that spurred large S&P sell-offs in August ’15 and January ’16. Its devaluation is even stronger against the JPY, and also the EUR.

As we write, the UK FTSE 100 is more than 3% higher than the day before the Brexit vote and the S&P is again flirting with all-time highs, which is surprising. Markets seem to price in an expectation that (i) the Brexit is pretty much of a non-event for the state of the world and UK economy, or may not even happen after all, while nevertheless (ii) it will trigger additional easing by major Central Banks, and possibly holds the promise of no more hikes from the FED, perhaps even more FED’s QE down the line. Only such reading can indeed justify stable equity prices, together with heavily lower interest rates, higher Gold prices, lower EUR and GBP vs USD, stronger commodity prices and commodity currencies. 

Overly complacent markets heavily mis-priced the chances of a Brexit event (overwhelmingly crediting bookies over pollers in the run up to the referendum); we now feel that equity markets may again be grossly mis-pricing their prospects from here onwards. Post-Brexit, the reality of sustained uncertainties (i) over the true impact on the economy, and (ii) over the effectiveness of crisis policymaking and the potential for populists backlash, will soon sink in. Equity markets are in denial, their disconnect to other asset classes hard to ignore: GBP is still at 30yr lows vs. USD, UST 10yr yield fell to a record low of 1.31%, Gold and Silver keep surging, USD/CNH is trending higher, EU banks still -38% YTD and not rebounding, the Italian Banking sector burning down while Brussels discusses.

We reiterate our views from last week:

è Short-Term Outlook: Analysing short term prospects for markets seems to be the least contentious matter. The list of unknowns over the next 12 months has just got longer. To valid concerns over China’s credit crisis, Oil weakness / lack of future, EU banking sector (but it is really not just EU), S&P steep overvaluation against a far from robust economy (NFP trend declining will hardly be proven as an outlier), we now can add endless critical question marks (will the UK be granted access to the single market? Will populist parties in Italy, France, Spain take the lead? Will Trump win the elections? Will the economy in Europe, Japan now go into recession, as business leaders postpone the few leftovers investing undertakings?). Uncertainty is hated by markets, often in history leading to steep sell-offs, although with decent time lags. As uncertainty is often associated with higher levels of volatility, large selling flows may also be automatically triggered by CTAs/Risk Parity/passive strategies, feeding the downside Beta. The natural direction for equity markets from here is lower, closing the disconnect to weak fundamentals on the verge of becoming weaker.

è Medium-Term Outlook: On a longer horizon, we believe Brexit has worse consequences for the EU than it has for the UK. We see the UK going into a mild recession in the next couple years, but then emerge from it stronger relative to EU member countries and possibly with a more balanced economy. Brexit is purely an accelerator of an EU disintegration trend that has been at play for several years now. It let the genie of disintegration fully out of the bottle now, and there is no way of putting it back in. On current trends, if radical changes in EU policies are not implemented fast, anti-establishment parties are likely to rise further and provoke a regime change, making the EUR break-up an ever more likely outcome. Many observers seem to believe the EU has an incentive to be harsh on the UK and make the terms of a Brexit the hardest possible, so to make an example out of it and stem the rise in populists’ movements across Europe. That was the strategy pursued with Greece in recent past. We disagree and see such stance as the fatal blow to the EU, leading to disintegration of the currency peg within a few years. Conversely, if a radical change of policy is enacted, Brexit may have offered a most valuable window of opportunity for derailing the train before it hits the wall. In this respect, Brexit may be seen as the last canary in the coal mine, one last warning

EUROPEAN & ITALIAN BANKS are trading at all-time lows

The EU banking sector is trading at levels only seen during the 2009 and 2012 crisis

CNY fixed at weakest level since Dec 2010

China has been silently devaluing its currency in the last three months. CNH is now at levels only seen in Aug ’15 and Jan ’16, when it spurred two big S&P sell-offs.
The comfortable narrative is now that what matters is the speed of adjustment, more than the absolute level. Such narrative may be up for review soon. As likely, CNH devaluation may soon be picking up speed.


RMB depreciation is even more evident against the CFEST Currency basket, the JPY and the EUR

The path of devaluation is clear against the CFEST Currency Basket, ever since its introduction.

The CFEST Currency Basket is the basket of 13 currencies introduced in December 2015 by the PBoC as the benchmark to measure the yuan’s performance.

farsana JPYCNH appreciated ~22% YTD, while EURCNH strengthened ~4% over the same period.


Even after Lehman, it took a while for the S&P to capitulate

Lehman filed for bankruptcy on 15th Sep 2008. On the same day, the S&P lost 4.7%, but then recouped all the losses and closed the week higher than before the Lehman event. After that, it started drifting lower, shedding ~40% of its value in the following two months.

This is by no means intended to draw a parallel between Brexit and Lehman, but rather to provide an example of the time it sometimes takes for reality to sink market complacency> This is to highlight the risks of reading too much into the market action immediately post game-changing events such as Brexit.


BREXIT: Short-term perspective

Equities are not listening to the warning signs sent by  European Banks, CNH, Gov’t bond yields, Gold and JPY.


BREXIT: Medium-term perspective

Brexit is an accelerator of a pre-existing EU break-up trend, which has been unfolding for years now.



Quoting from our Dec 2013 Investment Outlook


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Sheeraz Raza

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