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Could the Economic Climate in Europe Be Contagious?


  • The first hard data after the BREXIT won’t be available until October, but property funds are already frozen.
  • The decline of the pound will lower UK GDP and will spill over into Europe.
  • Italian banks are in trouble as 25% of GDP are nonperforming loans.

Introduction

As two weeks have passed since the BREXIT debacle, most heads have cooled off and we can calmly look at the current situation in Europe, the repercussions of BREXIT and contagion risks. It is important to analyze the full potential impact of the BREXIT by analyzing the stability of the European financial system, business investments, hiring and the political risk premium.

As BREXIT was popular primarily amongst the older population, politicians campaigned on a platform that promised that the money currently being spent on the EU would be diverted into the UK’s national healthcare system, the economic implications of which could be huge.

Situation in Europe

Europe could have done without this BREXIT vote as the last recession just ended in 2013 and the economic consequences will certainly have a detrimental effect on the growth experienced in the last two years.

figure 1 europe
Figure 1: European Union GDP annual growth rate. Source: Trading Economics.

We shouldn’t forget that the UK is still part of the EU and will remain so until all the administrative issues are resolved, presumably for the next two years or possibly even for the next four years. As GDP is always measured in dollars and the pound fell by about 10% in the last quarter in relation to the dollar, we can expect a decline in UK GDP (measured in dollars) similar to what was experienced when the UK left the European Exchange Rate Mechanism in 1992.

figure 2 UK gdp 1980s, 90s
Figure 2: UK GDP in the 1980, 90s. Source: Economics Help.

What saved the UK economy back then was a cut in interest rates, but as the current interest rate is 0.5%, not much can be done there. As the UK’s GDP is $2.8 trillion, it makes up about 15% of the EU economy, so a decline in the UK’s GDP will certainly have a detrimental effect on the EU GDP. An economic slowdown would make credit agencies downgrade the UK or possibly other countries in Europe and thus would create a domino effect of bad news. Moody’s has already expressed concerns about the BREXIT and stated that it will probably change its outlook for the UK from “stable” to “negative,” and Fitch predicts 2017 to be a record year for sovereign downgrades.

In addition to the impact on its currency, the UK economy will be hit by changes in the employment market as well. Some businesses will be forced to move their London branches to elsewhere in Europe. HSBC bank has announced that it will move 1,000 trading jobs to Paris, the same is true for Morgan Stanley, and let’s not forget that London is the European center for financial start-ups which will also have to be moved to somewhere in the EU to serve their primary markets.

The first impact the BREXIT has had is on UK real estate. $23 billion worth of assets in property funds have been frozen for withdrawals. Aberdeen Asset Management marked down the value of its UK property fund by 17% and suspended redemptions with an explanation that this will give time for investors to reconsider. The reality behind this funny explanation is that there is simply not enough liquidity behind the assets for redemptions. A halt in liquidity is also one thing to worry about in Europe.

We won’t know the full impact of the BREXIT for some time as most of the data won’t be published until after Q3 2016 is over. As the BEXIT repercussions become more clear throughout this year, some other risks will emerge as investors become more risk averse in this uncertain European political and economic time.

Italy and Its Banks

In uncertain times, investors look for safety and are much more risk averse. Some assets that were once not considered risky suddenly become risky. As investors withdraw their funds from the riskier assets, those assets consequently become even more risky as there is a lack of liquidity.

This is the situation with Italian banks. Not that Italian banks were ever considered that safe, but at this moment they might tip the stability of the European financial system. It is assumed that Italian banks sit on $401 billion of bad debt, equivalent to a quarter of the country’s GDP. For comparison, the percentage of U.S. nonperforming loans is 1.15% which is around $103 billion or 0.6% of U.S. GDP, thus 42 times less than in Italy which clearly implies that Italy is about to implode if the ECB does not intervene.

On top of Italy’s banking troubles, the country’s own prime minister certainly doesn’t know how to put a fire out. Instead of keeping things as calm as possible he immaturely attacks other EU banks stating that their derivatives exposure is a hundred times bigger problem than the Italian debt issue.

With the BREXIT and other populist leanings—including in Italy as evidenced by the statements by its Prime Minister mentioned above—the European markets should be terrible. In such a climate you’d think there would be plenty of bargains around, but the opposite is true.

Valuation

All of the above may settle down, but the stock market in Europe is highly overvalued for such a political and financial mess. If you look at the iShares MSCI Italy Capped ETF (NYSEArca: EWI) it has a PE ratio of 12.79 but the biggest holdings are oil ENI which is losing money, highly indebted utilities ENEL and the biggest Italian bank Intesa San Paolo which will be in for a wild ride if a banking crisis hits Italy. Therefore, Italy and all other European companies are far overvalued for the potential risks.

figure 3 Europe PE
Figure 3: European PE ratios. Source: Star Capital.

It wouldn’t be a surprise if the above PE ratios are more than halved in the next year or two as a consequence of the BREXIT, which is just a symptom, and debt which is the real disease. As the ECB is buying corporate bonds on the open markets, even the ECB might be in trouble as there is nobody who can bail the ECB out.

Conclusion

The expected sovereign downgrades will push the dollar higher as global investors will seek safety which should negatively impact U.S. exports. Any kind of potential European crisis will bring turmoil to U.S. markets but investors can prepare for that by carefully assessing the situation in Europe.

Traders may want to seize the swings between bad news and ECB interventions, and long term traders might just want to short Europe as a weaker euro will make it easier to cover in dollars.

In general, we can expect uncertain times ahead of us. The last European financial crisis in 2012 with Greece as a culprit resulted in a European recession. The current situation doesn’t look much different, only this time Italy and the BREXIT will probably be the culprits.

 

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