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Putting Brexit market moves into context

You may be surprised to hear that following the Brexit fallout global shares remain 10% above February lows.
 
MSCI World

Source: Bloomberg

UK equities are 14% above February lows. Note that UK equities represent 6% of total global equities including emerging markets (EM) and 7% excluding EM.
 
NZ shares, global property, global infrastructure and commodities are all +15% above Jan/Feb lows. 
However, UK bank shares are close to February lows and Eurozone banks are at new lows.
 
UK and Eurozone bank share prices are down 33% and 50% in the last 12 months and this alone must be a concern for bank executives, lending managers and staff.
 
Economic projections
Following Brexit, analysts are subtracting around 1.5% from UK growth next year (raising the likelihood of a mild recession) and taking ~ 0.5% off Eurozone growth and ~ 0.2% off global growth.
 
Here are some shorter run (2-3yr) cumulative estimates of UK deviation from baseline growth (with no Brexit baseline circa 2% pa growth).

Source: IMF

UK banking and systemic risks
The UK represents 2.5% of global GDP but we should not downplay the risks from a simple size perspective; too many people did that with US subprime mortgages at first.
Nominal UK house prices are 20% above pre-GFC levels according to BIS data but real house prices are a touch lower.
 
UK real house prices

Source: BIS

Also, household debt and debt service ratios are notably lower than pre-GFC levels. Household debt is 87% of GDP versus 99% pre GFC. The household debt service ratio is 10% versus 14% pre GFC.
 
UK household debt/GDP

Source: BIS

While a lower risk than during the GFC, a sharp fall in house prices would be a concern for UK banks. How much of a concern? In its bank stress tests earlier this year the Bank of England (BoE) stress scenario included a 31% decline in residential prices and a 41% decline in commercial prices. The results are due later this year but in his post-Brexit speech BoE Governor Mark Carney said the capital requirements of the largest UK banks are 10 times higher than before the financial crisis.
 
Looking at my Bloomberg screen, on a risk-blind basis (i.e. no risk weighting applied to assets), the UK has a 7% equity/assets ratio and Eurozone banks have a 6% ratio.
 
This has increased from ~4% pre GFC, which represents a sizeable improvement. Note that US banks have a 11.5% equity/assets ratio. 

Source: Bloomberg

But there is more to banking risk than adequate capital levels. The level of complexity is also important because greater complexity makes it harder to discern where the true risks lie.
 
In terms of global financial linkages, UK banks are among the most important in the world. And the large UK banks (like their global counterparts) have not reduced complexity since the GFC on proxy measures such as size of balance sheet, notional value of derivatives and trading assets. See more in this speech: On microscopes and telescopes.
 
That said…
  • UK banks are better capitalised than they were (regardless how you measure it) and they currently hold £600bn of high-quality liquid assets.
  • The BoE is supporting banks with $250bn of liquidity, plus foreign currency lines. 
  • It's likely the BoE will cut interest rates and restarting quantitative easing (QE) is an option.
  • Household debt levels and service ratios are lower.
  • Indicators of bank funding risk, such as overnight indexed swap (OIS) spreads, remain relatively benign compared to GFC and Euro crisis levels.

UK interbank (Ted) spread

Source: Bloomberg

Equity risks premiums rise as they should
While US and global equities are above February levels, lower bond yields have pushed equity risk premiums back over 6%.

Source: AMP Capital

If 4% is the long-run average equity risk premium, you can argue that equity investors are being paid for heighted uncertainty.

One area of uncertainty I can see that may be diminishing is Clinton getting further ahead of Trump in the polls. But who can trust the polls?

 


 

This blog post has been prepared to provide general information and does not constitute 'financial advice' for the purposes of the Financial Advisors Act 2008 (Act). An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.

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