Brexit's biggest losers

July 3, 2016

We stay with the Brexit, whose fallout continued to dominate financial markets this week.
 
Manic market swings from historic loss to historic comeback
 
The post-Brexit panic in financial markets continued Monday, the two-day sell-off wiping out a record $3 trillion of value in global equities. The two-day decline of 6.9% in the S&P Global Broad Market Index was the worst since the 2008 financial crisis and 12 ^th worst in history. The pound sterling also continued its historic sell off, hitting a new 30-year low of $1.3118, 14% off its high of $1.50 from last Thursday. It was the pound’s biggest two-day drop since the free-floating currencies began in 1971. Oil also experienced its sharpest two-day sell-off since the dark days of February, falling more than 7%. After Monday’s close of trading, Standard & Poor’s piled on the misery by downgrading U.K. sovereign debt rating two notches from a perfect AAA down to AA, maintaining a negative outlook.
 
However, the harsh initial reaction to the Brexit appears to have been the result of short-term unwinding of positions related to expectations of a Remain victory in the UK referendum as risk assets rallied for the rest of the week.
 
After two days of historic losses in global equities, we saw three days of historic gains . The British FTSE 100 and 250 indexes rallied to erase all of their post-Brexit losses in the biggest three-day jump since 2009, although the pound didn’t participate fully in the comeback. Driving the resurgence in risk assets were rising expectations of global central bank intervention. The Bank of England looks set to cut interest rates at its next meeting, the European Central Bank (ECB) is now more likely to introduce further stimulus and the U.S. Federal Reserve is unlikely to hike rates until at least next year. Many U.S. investors saw the initial panic as a gross overreaction, stepping in to buy the dip . Another positive is how well global market infrastructure coped with Brexit fallout.
 
Global bonds continued to see heavy inflows despite record-low yields. As the Brexit vote further dimmed the global growth outlook, global sovereign bonds surged the most since 2008 , while corporate bond yields hit a record low .
 
The modulation in financial markets didn’t stop economists from downgrading expectations for European growth. HSBC said the post-Brexit period may just be the “precarious calm” before the real storm . The UK Treasury , European Central Bank (ECB),   International Monetary Fund ,  the Organisation for Economic Cooperation and Development , several independent research houses and  global banks were unanimous in downgrading economic expectations in the U.K. and Europe.
 
British political drama takes another unexpected twist

Markets rallied despite the political game of chess in the U.K. descending further into chaos. Despite only jumping on the “Leave” bandwagon late in the process, former London Mayor Boris Johnson was seen as the likely candidate to become the next Prime Minister. However, he was eerily silent following the vote until penning a Monday op-ed in the Telegraph , in which he backed off some of the stronger rhetoric from the “Leave” campaign and called for unity with pro-“Remain” compatriots. It felt perhaps as he was feeling the same sense of buyer’s remorse as Sun editor Kelvin Mackenzie. In any case, the op-ed was sub-edited by Johnson’s fellow Conservative Party pro-“Leave” campaigner Michael Gove, who then used the article to undermine Johnson’s credentials as a potential P.M. Stung by the betrayal , Johnson made the shock decision to call off his bid for the U.K.’s highest office. The soap opera emboldened Scottish First Minister Nicola Sturgeon in her calls for a second referendum on Scotland’s membership in the U.K. And you thought House of Cards was dramatic…
 
At the first post-Brexit EU summit, lame duck British P.M. David Cameron’s seat was left symbolically empty, where officials took a hard stance against the U.K. retaining access to the E.U. single market without free movement of labor. Cameron has said he will not invoke Article 50 during his three-month transitional period in office, giving rise to hopes from some U.K. officials of a negotiation to remain in the EU under better terms. But German Chancellor said no such negotiations will take place . Britain’s EU Financial Services Commissioner Jonathan Hill also resigned after having campaigned against Britain leaving the bloc. 
 
Financial sector could be Brexit’s biggest loser
 
The largest, and perhaps most lasting, damage from the Brexit vote came in Europe’s financial sector. British bank stocks were hit hard amid worries about the U.K.’s status as a global banking hub, with shares in Royal Bank of Scotland (RBS) and Barclays (BCS) briefly halted Monday after tumbling 26% and 18%, respectively. Banking stocks bounced back with the broader market late in the week, but not to the same extent. In the U.S., financials are the only sector still negative for the year.
 
On the first day of the E.U. summit in Brussels, French President Francois Hollande said London should no longer be able to handle clearing operations for financial transactions denominated in euros. Last year the U.K. won a court case against the ECB, which sought to bring clearing operations under its regulatory control by shifting the role to a euro-area country. U.K. officials believe the victory would not have happened if the U.K. was outside of the E.U. Now, London’s role in clearing trades in the nearly $500 trillion derivatives market is heavily in doubt.
 
The damage wasn’t limited to British banks as financial stocks dropped sharply across the continent amid worries the Brexit, adding to woes stemming from negative interest rates, could cause a banking crisis. To cope with the post-referendum volatility, Italy sought approval to backstop its troubled banking sector to the tune of $44 billion dollars. While George Soros didn’t repeat his famous short bet against the British pound, he did short Deutsche Bank (DB) to great effect prior to the Brexit vote. It was also one of two banks to fail Fed stress tests this week.
 
One of the E.U.'s top voices in market regulation, Markus Ferber, made it clear the U.K. will have to abide by E.U. financial services standards to do any business on the continent, saying “the United Kingdom will essentially have to apply European standards that it can no longer influence.”
 
JP Morgan and UBS both believe London will lose its crown as the financial centre of Europe, with JPM, HSBC, Citigroup, Morgan Stanley, Goldman Sachs and the European Banking Authority already expressing intentions to move significant portions of their staffs to continental Europe. Post-Brexit, regulators are now examining the proposed merger between the London Stock Exchange (LSE) and Deutsche Boerse.
 
The E.U. may be particularly incentivized to drive financial jobs to Paris. A timely boost to France’s flagging economy could do wonders for President Hollande’s tenuous popularity, helping to stave off the nationalist threat of Marine Le Pen in 2017 elections.
 
Brexit puts Chinese, Japanese currencies in a tough spot
 
The Brexit not only has negative implications for Europe, but has the potential to turn every country into a loser . The Japanese, hoping to devalue their way out of deflation, have seen the yen skyrocket this year due to uncertainty in other parts of the world. The yen was the biggest beneficiary, or loser, from safe-haven inflows immediately following the Brexit decision. The yen skyrocketed against the pound and dollar, and for the year is now up almost 20% versus the greenback. The development could spring the Bank of Japan (BoJ) into further action, although the central bank has little room to maneuver with government bonds of up to 40 years in duration already yielding negative interest.

Renewed strength in the dollar is also causing problems for China as it looks to climb from beneath its mountain of non-performing debt. On Monday Beijing took the immediate step of devaluing the yuan by the most since August. Policy sources within the Chinese government, which are rarely quoted by accident, said the People’s Bank of China would tolerate a fall in the yuan to as low as 6.8 per dollar in 2016 to help smooth the economic transition, matching last year’s record-setting 4.5% decline. Chinese officials want to avoid triggering panic and sudden capital outflows that would result from a large one-time devaluation, but with turmoil in Europe ensuring the dollar remains the overwhelming safe-haven currency of choice around the world, the communist government has little choice but to pursue a gradual path of yuan depreciation.
 
Brexit opinions (in case you haven't heard enough)

Henry Kissinger: to inspire the confidence of the world, Europe and America must demonstrate confidence in themselves . 
 
The euro, not the Brexit, is the most serious threat to the E.U .
 
The E.U., not Britain, has a democracy deficit .
 
Puerto Rico gets a path forward
 
On Wednesday, two days before Puerto Rico defaulted on a large general obligation debt payment, the Senate sent a debt relief measure to President Obama’s desk (which he signed Thursday ) giving the beleaguered island a way forward. While Treasury Secretary Jack Lew said the bill did not go as far as he would’ve liked in forgiving Puerto Rican debt, it represents a crucial step in setting the commonwealth on a more sustainable path. The bill did not prevent Friday’s default, but will bar creditor lawsuits retroactive to non-payments from December, providing the Puerto Rican government breathing room to approve a new austere budget.
 
Senate majority leader Mitch McConnell, aware of the optics in today’s post-factual political process, stressed “this bill won’t cost the taxpayers a dime. What it will do is help Puerto Rico restructure its financial obligations and provide much-needed oversight to put into place reforms.” The bill faced critics from the far left and far right in Congress, with Vermont Senator Bernie Sanders, comparing the new oversight board to “a colonial master” for the island, but the moderate factions in both parties, were enough to carry it through to the White House. The bill’s passage is seen as a victory for House Speaker Paul Ryan, who vowed to address the debt crisis despite opposition from members of his own party.
 
Energy Transfer Equity officially calls off Williams marriage
 
One of the longest-running M&A sagas in recent memory came to a close this week, with Energy Transfer Equity (ETE) officially calling off its merger with Williams Companies (WMB) after a Delaware judge accepted last week that Energy Transfer lawyers, in good faith, couldn’t deliver a necessary opinion on the deal’s tax treatment. ETE offered to buy Williams last September in a then-$38 billion deal that would include $6 billion in cash, but the cash component of the deal became a poison pill for the combined entity as oil prices tanked in late 2015 and early 2016. Energy Transfer sought a way to terminate the deal, seizing upon its lawyers' well-timed epiphany that they couldn’t deliver a tax opinion on the deal, a condition for its completion. The collapse of the deal, which would have created the nation’s largest pipeline company, has been a boon to ETE shares, which now trade 3.5 times above their 52-week low.
 
Williams said it plans to appeal the decision, or at the very least pursue damages of up to $10 billion from Energy Transfer related to the deal’s failure. On Thursday, though, half of Williams’ board of directors, including the chairman, resigned after a failed attempt to oust Chief Executive Alan Armstrong, who did not support the merger.
 
In other news…
 
Saudi Arabia hires banks for first global bond sale.
 
There is a wide gap in consumer confidence between young and old Americans.
 
Hong Kong’s richest man, Li Ka-shing, isn’t worried about the survival of his $80 billion empire .
 
Twilio’s successful IPO during the Brexit storm a good sign for the tech industry and private equity market.
 
Hershey rejects Mondelez’s $23 billion takeover offer .