Tuesday, June 28, 2016

Brexit as Economic Scapegoat

The overreaction against the historic Brexit decision is now in full swing. Financial markets around the world have fallen sharply, though the US has fared slightly better. Britain's FTSE 250 index has fallen 14 percent between Friday and Monday while the US S&P 500 was down 5.3% over the two-day stretch.

Yes, these are nothing if not tumultuous times in the financial markets in the wake of the Brexit. However, it's worth bearing in mind that nothing substantive has changed just yet. It's true that Prime Minister David Cameron has announced his intention to resign, but that event won't take place for a few months. It still remains an open question whether a Brexit will actually take place as the vote itself was non-binding. In the meantime, Britain is still subject to all the same trading and business rules as before. And any changes that do ultimately occur are likely to take well over a year to be determined and will be thoroughly analyzed and  telegraphed in advance.

Given all these obstacles to actual change, one may wonder why the markets are acting like the sky is falling. The answer, of course, is uncertainty. Markets hate uncertainty, and now Europe (and all equity markets to some extent) is full of it. Rather than waiting to see what the real consequences are, investors are selling out of risky assets and running to safe havens like gold, silver, and US Treasuries. This makes sense, if for no other reason than one knows that the rest of the herd will do it.

But again, it bears repeating. The Brexit vote, and the associated uncertainty, explains why financial markets have moved. Its impact on actual business thus far from the vote is and must be negligible.

That's why it was strange (yet somehow predictable) to see the government of Italy propose a new 40 billion euro bailout this week for its long-suffering banking industry. Like other banks around the world, Italy's public banks were hit hard in the two days of trading following Brexit--falling by roughly a third (33%) in that timeframe. Thus, the bailout proposal is being framed as a response or consequence of Brexit. Here's a quote from The Telegraph's write-up on this story:
The country [Italy] is the first serious casualty of Brexit contagion and a reminder that the economic destinies of Britain and the rest of Europe are intimately entwined. Morgan Stanley warned in a new report that eurozone GDP would contract by almost as much as British GDP in a "high stress scenario".
There's just one problem with this narrative. It doesn't make any sense.

Ironically, we learn why within the same Telegraph article that gave us the bad news. Quoting again (emphasis mine):
Italy’s banks are the Achilles Heel of the eurozone financial system. Non-performing loans have ratcheted up to 18pc of total balance sheets as a result the country’s slide into depression after the Lehman crisis.
"Non-performing loans" is a banking euphemism for loans that are not going to be paid back. And it probably goes without saying that 18% is a catastrophically high number. For sake of comparison, a similar ratio at the bank I work for, Umpqua Bank, was 0.29% in the most recently filed, publicly available annual report.* That is to say, Italy's banks have a ratio that is 62 times as high.

The reason we can't blame Brexit for this, however, is that these loans didn't go bad overnight. Unless Italy's banks were loaning an ungodly amount of money to investors so they could speculate in currency markets--which would be problematic in itself--then the Brexit vote cannot explain the looming failure of Italian banks. They were well on their way to failure before Brexit. But now, Brexit is being used as a convenient scapegoat for politicians and central bankers to push for emergency financial bailout measures that they've wanted to implement for some time. Brexit is not the cause, but the excuse. Additionally, Italy probably delayed announcing this proposal till after the vote to avoid giving a last-minute reminder to the British of the various financial calamities that awaited them in the EU if they decided to stay.

Whatever explains the timing, however, the problems with Italy's banks are as real as ever. And the proposed bailout is unlikely to provide even a short-run fix because direct bailouts of banking institutions like the sort being proposed are forbidden by EU rules. In the long run, this is actually a good thing--bailouts provide a bandage fix that effectively reward irresponsible behavior. But politics, in Italy and elsewhere, does not concern itself with the long-run. Thus, Italy could be the next flash point in the EU. And in that strange world, the ones in desperate need are actually the ones holding all the cards. As Zero Hedge points out, the Italians effectively have the ability to give the EU an ultimatum: either permit and/or fund the bank bailout, or face another exit referendum after the Italian economy descends further into chaos. After Brexit, it seems unlikely the EU would be willing to take another chance.

Expect the situation in Italy to be a harbinger of things to come, as unblemished optimism from officials and the mainstream media gives way to catastrophic warnings about the situation the Brexit has put us in. But Brexit did not cause the problems we face; rather, it is the excuse that officials are using to finally acknowledge the deep and substantial problems that have existed for some time.

In a US context, this almost certainly means that any possibility of an interest rate hike by the Federal Reserve is all but off the table, with Brexit offering the perfect out. The real question is when the Fed will shift from the narrative of a strong economic recovery to one of urgent damage control. If Brexit wasn't enough, perhaps the likely $2B default in Puerto Rico this week will do the trick?

*You almost certainly don't care about this, but technically, this is the non-performing assets to total assets ratio at Umpqua. Because the numerators includes things besides loans, it is likely to be a slightly higher than the non-performing loan to total assets (balance sheet) figure presented by The Telegraph for Italian banks. As a practical matter, what this means is that if we were to make a true apples to apples comparison, the Italian banks would look even worse. Also, it goes without saying that all views expressed here are strictly my own and in no way a reflection of the opinions or outlook of any decision-makers at Umpqua Bank.

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