07 Juillet 2016

A puzzling price action

Needless to say that the result of the June 23rd UK referendum on Britain’s EU membership was unexpected by most in European markets and was certainly not priced in by credit markets. Instead, European markets were pretty complacent of the risk that such an outcome would occur and chose to see the bright side of the environment, namely a decent outlook for corporate credit fundamentals combined with highly supportive policies implemented by the ECB for fixed income assets (PSPP, CSPP, TLTROs, etc.). Consequently, at the end of June 23rd – before the close of polling stations – and despite several opinion polls showing Brexit was in the lead, credit indexes were broadly flat on the month. Admittedly, there was a significant – though orderly – selloff in the next couple of trading sessions, but the market has subsequently retraced a big chunk of its losses. It is quite shocking, in our view, that the iTraxx credit indexes ended the month tighter than where they traded one week before the referendum result when Brexit was a less-than-50% probability and the balance of risks much less skewed to the downside than today.

No silver lining for European credit

We acknowledge that the Brexit vote triggers relatively few immediate negative consequences for European credit. If anything, it greatly increases the odds that the BoE and the ECB would become even more accommodative than today via a new set of unconventional measures. Little wonder that a CB QE-addicted market reacts quite positively to such near-term prospects. However, we believe that Brexit creates a significant shock to the region’s economy as it remains highly leveraged and it still needs to restore a much stronger and sustainable growth. In this respect, we see three main areas for concern:

  1. The risk of economic recession in the UK has become very high. Although the contagion to the rest of Europe could remain limited, it will have some negative impact on the fundamental outlook for European credit markets: the UK is the second largest economy in the region, UK borrowers account for 25% and 20% of the iTraxx Xover and Financial indexes, respectively, and a significant number of European corporate special situations are UK-based or UK-centric issuers in sectors such as retail, leisure, financials, among others.
  2. The resulting impact on asset quality and profitability will be substantial for UK banks and to a lesser extent for European banks. Such a shock occurs at a moment when confidence in the European banking sector remains selective at best – think of Italian banks, when a new round of stress tests is being conducted by European regulators and when there are still many aspects of the new regulation and creditor hierarchy which require greater clarity.
  3. The risk of a significant tightening in financial conditions and of increased investor risk aversion is likely to materialize soon as a set of negative headlines starts developing on several fronts. Politically, with the election of the new UK Conservatives leader who will also become the country’s next PM and with some potentially heated debates around goals, tactics and timing of the Brexit implementation. Economically, with macroeconomic indicators and corporate earnings guidance starting to filter through from the end of July onwards. Financially, with unpredictable negative catalysts occurring such as the UK credit rating downgrades or the recent activation of “investor gates” by several of the largest UK commercial real estate funds which cannot cope with redemption requests.

The bottom line is that (i) the Brexit process is unchartered territory, full of pitfalls and risks and (ii) the market will be in price discovery mode for some time as the story starts to play out.


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