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ASSET ALLOCATION - BREXIT / BREMAIN, volatility / financial stability and bank securities, topics for review



At our most recent investment committee meeting, three topics were at the centre of debate:

  1. The UK referendum on the European Union on 23 June, with the potential consequences of the BREXIT or the BREMAIN. It would be quite dangerous to believe that a BREMAIN (scenario in which the UK stays in the EU) removes all uncertainties as to the UK or the European Union, or to summarise the risks simply as an economic risk for the UK or a political risk for the EU. It is much more complex than that.
  2. The low-volatility environment, partly created by the actions of the central banks and more particularly of the ECB, is of course reassuring on one level, but it also refl ects financial stability that is highly relative, even artificial.
  3. Weakness in financial securities especially banks, since the start of the year, the consequence of negative and now penalising rates; a cost of capital that is still high; and an overall situation (economic, financial and regulatory) that is not conducive to tighter European integration.

All in all, even if the risks have not disappeared and are, on the whole, underestimated, thanks to the central banks' presence, and artificially low rates and volatility, we are not radically changing our asset allocation. However, we are keeping a cautious and watchful stance with regard to any complacency about the nderlying risks.





At our most recent investment committee meeting, three topics were at the centre of debate:

  1. The UK referendum on the European Union, with the potential consequences of the BREXIT or the BREMAIN (UK staying in the EU);
  2. Low volatility, reflecting financial stability that is highly relative, even artificial; and
  3. Weakness in financial, especially bank, securities since the start of the year.

1. BREXIT or BREMAIN… the lesser of two evils?

It would not make much sense to decide on an asset allocation according to future electoral results. On the other hand, scenarios and risks do have to
be assessed, especially when it comes to an important electoral deadline, as the British referendum may be. The latest polls seem to argue in favour of a BREMAIN (even if the BREXIT camp has gained ground), and it is fairly common to see the BREXIT/BREMAIN debate reduced to two conclusions:

  1. A risk for the fi nancial markets with the BREXIT, an appeasement with the BREMAIN;
  2. An economic risk for the UK and a political risk for the European Union.

Unfortunetely, it is not that simple. Here is our take on the issue.

What is the risk for the UK?

A clearly-defined economic risk: 50% of UK exports go to the European Union and, in terms of GDP, trade volumes with the European Union account for 65% of GDP (compared to 20% in the 1960s). If the UK does leave the EU, trade volume and costs would be affected, and some segments that are highly integrated in the European Union, such as financial services, chemicals, or automobiles, would be affected. A depreciation of the pound would certainly give British trade a boost but, according to estimates, due to the end of the European passport and the disappearance of trade agreements with the EU, the impact on GDP would be significantly negative. The London Stock Exchange is in no danger, but there is no reason not to think that the EU could (should) take advantage of this new situation to promote the opening of a financial marketplace in Continental Europe. For example, with regard to economic growth, the OECD considers that the UK would lose 3%-8% of its GDP while British employers announce that the EU by itself contributes 4%-5% of GDP, or about GBP 70 billion. These numbers should be refined according to the different scenarios relating to "treatment" of the UK:

  • If the UK stays in the European Economic Area (which currently has 31 countries), like Norway, the cost would be €3,345 per household per year (a reduction of 3.8% of its GDP over 15 years);
  • If the UK signs bilateral agreements with the EU, as Switzerland has done in past years, the cost would be €5,528 per household per year (a 6.3% loss in GDP over 15 years)… Remember, though, that the negotiation of trade agreements takes between seven and 10 years on average!
  • If the UK were to decide not to renegotiate with the EU, then the cost would be much higher at €6,689 per household per year in this case, i.e. a 7.4% decline in GDP over 15 years.

In light of the foregoing, we understand better why business leaders, the Bank of England, and the British Treasury, to name just a few, are warning UK voters about the consequences of a BREXIT.

A not-insignificant political risk: By leaving the EU, the UK would regain its independence – and some seats – in the major international organisations, but it should be reiterated that the BREXIT camp is not uniform – far from it. Some (extremists) are demanding total independence, even the closing of borders (protectionism, stopping immigration), while others, liberals, want to ease the regulatory constraints imposed by the EU and be able to renegotiate all relations (including trade relations). How can these two camps be reconciled if the BREXIT wins? In addition, the risk of seeing Scotland demand a new referendum for its independence is high, since the Scots have never hidden their close ties with Europe. And let's not forget that the bulk of British oil is located in Scottish territory. If it is a BREMAIN, what will David Cameron's position be? Bolstered by a wide victory, weakened by a narrow one? Will it lead to new elections? Nothing is less certain.

What is the risk for the European Union?

A moderate economic risk: by all appearances, the United Kingdom's withdrawal would have no serious direct economic consequences for European Union countries. The hardest-hit countries would be those with close ties to the United Kingdom, especially Ireland, but also Luxembourg, Belgium, Sweden, Malta, and Cyprus.

A not-insignificant political risk: EU countries have just recently made some concessions to the UK (on immigration, sovereignty, and governance), to avoid the BREXIT scenario. The lack of solidarity within the EU has been demonstrated with every one of these concessions, with some countries expressing their interest in this or that measure. The UK's withdrawal would mean several things: i) first, that it is possible to leave the EU, and nothing is irrevocable; ii) that it is possible to get concessions at any time; and iii) that Europe à la carte isn't just a fantasy. Without going so far as the risk of dislocation, we can clearly visualise, via the referendum, the “spanner in the works" thrown by the British into EU governance. Will Europeans be able to mobilise (simplified governance, budget and tax integration, stronger leadership, improved job market, etc.) and move the institutions forward? A critical question, one which is being raised regardless of the outcome of the UK referendum, because it is as valid if there is a BREXIT as it is if there is a BREMAIN. The rise of extremists and populists (to the right, in Europe's core countries, and to the left in the peripheral countries) goes handin-hand with the worsening economic situation and governance deficit in the EU. Will the referendum be what gets things moving, or gets them stuck? That is the EU's problem in a nutshell.

What will the consequences be for the market?

It is indisputable that a BREMAIN is preferable for the financial markets. This will, of course, not change a complex game, but that game is known and has been part of the day-to-day for several years. Conversely, a BREXIT is a door to the unknown: not everything will be decided quickly (it will take two years before the UK officially withdraws), but no one knows how the issues raised above will be resolved. So we can bet on the possibility of sanguine reactions leading to wider credit spreads, and a weaker GBP – and euro. It seems reasonable not to count on British market capitalisations appreciating: this is the battle between the weak GBP (favourable) and the end of trade agreements, and the (negative) impact on certain major segments. Faced with these uncertainties, we should instead be counting on capital outflows from both the UK and the EU. If needed, the ECB could take advantage of it to accelerate its asset purchases, which makes the EMU's fixed-income markets a relatively protected zone.

2. Low volatility, reflecting financial stability that is highly relative, even artificial

We can—and should—be pleased that the central banks, through their actions, succeeded in calming tensions and reducing the level (and volatility) of rates and credit spreads (businesses, banks, and sovereigns). However, we should admit that this financial stability is partly artificial:

  • Growth has not accelerated, and investment is still a big blank space in the economic recovery, both in Europe and in the US, and in most advanced countries. At best, some countries have managed to return to a significantly downgraded growth potential.
  • We have also quickly recognised that monetary policy transmission channels (rate - effect, credit - effect, spread - effect, wealth - effect, etc.) are not really working any more, which also does not argue for further rate cuts, which are already in negative territory.
  • QE policies have reached their limits: how can we do more? Asset purchase programmes have reached enormous proportions (the ECB is now buying more than twice the total net issuances of the eurozone, and the Bank of Japan has become the primary holder of JGBs). No doubt the pace of purchasing can still be accelerated…
  • Interest-rate policies have also reached their limits. The debate over the "Zero Lower Bound" (ZLB) or "Zero Nominal Lower Bound" (ZNLB) has had mixed success, but Europe and Japan have crossed the threshold, determined to push rates into negative territory… without substantive results.
  • The central banks' credibility is one thing, but still, why believe that the entire solution lies in monetary policy? Taking up fiscal stimulus and tax policies again may seem audacious, given the surplus debt and credit in recent years, and the lack of complacency from the financial markets about public deficits. However, the major international organisations like the OECD and IMF are now arguing for greater use of the budget lever… as long as it is to invest and at the same time carry out structural reforms. This seems like a good opportunity, in light of current interest rates and the fact that we are too dependent on the central banks.

All in all, the problems (weak growth, jobs, deficits, debt, etc.) are not totally solved, and current financial stability is still fragile, even artificial:

  • Either we are looking at consolidation of growth, and artificial financial stability will become real instability, in which the deepening social inequalities and the further worsening of the job market will aggravate social tensions and current geopolitical tensions. In a weaker-growth environment, fears over solvency (governments, businesses) and profits would also surface.
  • Or we are not looking at stabilisation (and improvement) of projected growth by economic policies that are more investment-oriented and that pay special attention to current opportunities for innovation and technical progress. The deepening of inequalities will thereby be curbed (or become more tolerable) while tensions fade. Financial stability would go from artificial to quite real.

3. Weakness in bank securities since the start of the year

Since early 2015 in particular, a general and unavoidable idea has been to maintain a positive trend on bank securities, essentially for five reasons:

  • QE programmes are good for bank securities, because they make it possible to keep rates low and considerably reduce risk premiums on eurozone government bonds, assets which are held in large quantities by the eurozone's banks;
  • TLTROs are good for European banks, especially those that are the most vulnerable, which eases the risks of contagion between banking systems, hence a flattening of the portion of risk premiums related to the banking systems' interdependence;
  • The return to growth is also good for bank securities;
  • Their valuation (equity, spread) is attractive;
  • Their dividend yield is undoubtedly an asset.

In reality, it is not that simple, for three reasons:

  1. The impact of negative rates on banks' profitability;
  2. The "relatively" weak correlation between interest rates and banks' cost of capital.
  3. The vulnerability of some banking systems and fears of contagion.

We've already laid out the harmful effects of negative rates on several occasions. Let's review them briefly, from the banks' point of view:

  • Negative rates are not really necessary. Access to financing (bank credit and access to capital markets) has improved considerably in two years, especially since the QE programme was set up, which kept interest rates low for a long time.
  • The decline of rates into negative territory has made it impossible to reduce the banks' deposits with the ECB, quite the contrary: €100 billion in January 2016, over €750 billion today. Suffice to say, this has not discouraged the banks. These €750 billion have not gone toward the real economy or growth.
  • A decline in bank deposits with the ECB – had there been one – does not guarantee an additional increase in bank loans to businesses in the most disadvantaged zones.
  • If banks have liquidity, it is precisely because the ECB is injecting lots… and instead of buying government bonds (with duration risk, asymmetric risk and negative yields), banks would rather deposit their cash with the ECB. Yes, the rates are negative, but there is no counterparty risk or duration risk associated with the overnight rate, and no asymmetric risk. Who can blame them?
  • Negative rates in no way guarantee that the interbank market will function better. The possible mistrust of one bank towards another would not disappear or diminish because of low or negative rates – quite the opposite.
  • Indeed, when rates dip down into negative territory, they penalise the banks' profitability (all banks, whether in the core of the zone or the periphery). And this is occurring at a time when the banks are struggling to earn the market's blessing while being asked to give the economy more loans. This is a paradox, and an unmistakably counter-productive one. Moreover, the banks are in the process of seeking greater profitability—often at the expense of credit—in order to better withstand or fi ght against disintermediation and digitisation.
  • By sending short-term and long-term interest rates into negative territory, the ECB is also sending negative messages to the financial markets… and to bank securities. Obviously, the greater the weight of deposits, the more it penalises the banks. That is why the stocks of Japanese banks—whose loan/deposit ratios are 20% to 30% lower than those of European banks—plummeted by 30% on the day the Bank of Japan lowered its rates into negative territory.

All in all, we can understand the banks' mistrust of negative rates. Staying on this path would surely be counterproductive.

But that is not all. If we want to really understand the banks' current situation, we must above all not ignore the issue of the cost of capital.

It is not because rates are low that the banks' cost of capital is low. In reality, the cost of capital has not really gone along with the downward movement on rates, for several reasons:

  • First of all, the weight of past crises: the “return to normal” never actually took place, and the banking crisis of 2011 and 2012 has left lasting marks.
  • Next, the fear of future crises: we know for a fact that the banking environment is still fragile in certain countries. We're thinking of Italy and the impossibility of creating a "bad bank." We're also thinking of the banking system of certain peripheral countries, or indeed the direct consequences of recurring fears and rumours over certain (large) banks…
  • Regulatory uncertainty is also a factor behind the persistently high cost of capital. We don't know what the contents of Basel 4 will be. Will regulation stop being pro-cyclical?
  • Another factor that impacts the cost of capital is the difficulty of differentiating banking systems. In reality, the market doesn't know how to make that distinction. As for the banks, the talk is still about systemic risks, interactions between banks, and contagion. None of this is conducive to the smooth operation of the interbank market, going so far as to weaken the weakest banks and thus impact the most solid by contagion! This vicious circle goes more in the direction of "deleveraging" and the national downturn than of smooth trading, risk pooling, or additional credit risk-taking.
  • Finally, the last factor is “abnormally” low interest rates and rate curves, which have a direct impact on profitability, and thus on the credit supply. We could also add interest rate risk, which is now totally asymmetric. The more convinced that banks are that interest rates will remain low, the more likely they will be to reduce risk and go against monetary policy.

Overall, we understand why bank securities have suffered since the adoption of negative rates, which is clearly illustrated in the graph opposite.

Conclusion and consequences for asset allocation

We can clearly see how these three topics – BREXIT/BREMAIN, financial volatility/ stability, and negative rates/banks' cost of capital – are key in the current market environment and in asset allocation considerations. They are there to remind us that the central banks' strong presence on the financial markets is not enough to lower any guard. Without sinking into the darkest pessimism and reversing our asset allocation positions (which have put some risk onto the emerging asset classes, which are maintaining a preference for the eurozone's peripheral countries vs. the core, and are overweight on credit in bond portfolios), conservatism is still the watchword. No complacency toward risk, which is much higher than what the usual metrics seem to show : the UK referendum (June 23) and the general elections in Spain (June 26) recall that the weakness of global volatility might be a trap, and also recall the dangers to underestimate the underlying risks.

One comment before ending: the fact that we are aware of the risk does not mean we are necessarily reversing positions, specifically on markets where liquidity is reduced. It would be much more difficult to re-enter those markets when the time came. We are not expecting a reversal in the trend, so we do not want to find ourselves unable to re-enter these markets. We think protecting and hedging is more advisable.


Macro Hedging Strategies









BREXIT: the impact
on Britain's GDP would be
signifi cantly negative



Business leaders, the
Bank of England, and
the British Treasury have
warned UK voters about the
consequences of a BREXIT




nothing will likely be simple
in the UK






Little impact on the EU,
except for certain specific
countries, Ireland in the lead




One of the major
consequences of a BREXIT:
Europe à la carte isn't just
a fantasy anymore






In case of a BREXIT, we
should rather be counting
on capital outfl ows from both
the UK and the EU





Interest-rate policies
have reached their limits




Still, why believe that
the entire solution lies
in monetary policy?







No doubt: negative rates
are bad for banks



Even if there had been one,
a decline in bank deposits
with the ECB would in no way
have guaranteed a further
increase in bank credit







The cost of capital has
not really gone along with
the downward movement
on interest rates



Bank securities have
suffered since the adoption
of negative rates















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Cross Asset of June 2016 in English

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ITHURBIDE Philippe , Senior Economic Advisor
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ASSET ALLOCATION - BREXIT / BREMAIN, volatility / financial stability and bank securities, topics for review
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