July 01, 2016

Jonathan Rochford, CFA @ Narrow Road Capital

Portfolio Manager at Narrow Road Capital

June Review: Brexit’s Impact on Markets Overstated

Risk assets were mixed with commodities mostly higher, equities lower and credit flat. US equities eked out a gain of 0.1% but falls were seen in Japan (-9.6%), Europe (-6.5%), Australia (-2.7%) and China (-0.5%). US natural gas soared 27.5%, with iron ore (11.0%), gold (8.8%) and copper (5.3%) also strong whilst US oil (-1.5%) fell.

June Review:

Brexit’s Impact on Markets Overstated

Key Data

June

May

June

US Investment

Grade Spread

0.70%

0.77%

AUD Investment

Grade Spread

0.98%

1.26%

1.27%

US High Yield

Spread

5.00%

5.97%

6.26%

AUD Listed Note

Spread

.60%

4.32%

4.24%

Risk assets were mixed with commodities mostly higher, equities lower and credit flat. US equities eked out a gain of

0.1% but falls were seen in Japan (

9.6%), Europe (

6.5%), Australia (

2.7%) and China (

0.5%). US natural gas soared

7.5%, with iron ore (11.0%), gold (8.8%) and copper (5.3%) also strong whilst US oil (

1.5%) fell.

The big news for markets this month was the Brexit vote. The uncertainty of what happens now is real, as there are at

least

ten different ways Britain can leave the EU

and

they might not leave at all

. However, blaming Brexit for the falls

is superficial.

Over

priced risk assets

have bee

n a bug in search of a windshield and Brexit is just a good excuse for a

sell

off. Well before the vote the wave of predictions of tough times ahead continued with

key US data continuing to

signal a recession is possible

. A

Barclays report

predicts net job losses

in the US

in the next year

LinkedIn is saying

that jobs ads have been falling since February

with May the worst month since February 2009.

Despite waves o

f dire commentary, in the long term the vote for Britain to leave the EU was a win for democracy and

a win for sound economics. It’s a victory for democracy as a bad government (the European Parliament) has effectively

been voted out by the British people.

The 51.9% vote to leave is extraordinary and demonstrates that this is not a

mere protest movement but a widespread feeling of discontent. A rag

tag bunch of campaigners with the better

arguments defeated the big guns of British officialdom. It has been s

ummarised as a scare campaign on economics

(remain) versus a scare campaign on immigration (leave) but there is so much more to the anti

EU sentiment.

Relentless red tape, wasteful spending, atrocious monetary policies and the disastrous handling of refu

gees has shown

how out of touch the European bureaucracy has become. The

spectacle of a drunk

EU Commission President slapping

and giving military salutes

to various heads of sta

te at a functio

n sums up how bad it has become. It is no surprise that

other wealthy and independently minded countries are also considering

whether they should leave as well

In the long term, the vote raises the possibility that European nations will start to take seriously the many economic

issues they face and return to rational economic policies. Whilst the uncertainty of change is neg

ative in the short

term, the future instability created by high debt and deficit levels, and inefficient economies is far worse. Change is

inevitable for Europe; Britain may have just chosen to get off a sinking ship whilst there is still space in the life

boats.

The Brexit vote is just one symptom of how disenfranchised many have become with the current political offerings. In

Europe (far left and far right parties) and the US (the Tea Party, Bernie Sanders and Donald Trump) non

mainstream

candidates are

winning enough votes to take power or to be influential coalition partners. Faced with an awful choice

between presidential candidates from the two major

parties,

support in the

for

the Libertarian party

is growing

. As

an economist, it’s tough not to like a party with a first priority to end wasteful spending and balance the budget.

The immediate impact on markets from t

he vote was for risk assets to fall with most equity indices down by 3

8%.

Banks were amongst the hardest hit with the poorly capitalised Spanish, Italian and Europe’s largest bank by assets,

Deutsche Bank, down 10

30%. The

ECB handed out €400 billion of four

year funding at 0%

as part of liquidity measures.

One short

term positive/long

term negative point this month for undercapitalised European b

anks was the deferral

of risk weightings for sovereign debt. It was thought that banks would need

another $195 billion in equity

to meet

potential changes as existing bank capitalisation ratios consider sovereign debt to be completely risk free. This means

banks can get cheap funding from the ECB and load up on higher yielding Spanish and Portuguese government debt,

artificially p

ushing down interest rates for those countries. In the short term the governments and banks both love it,

but in the long term it means that if one gets in trouble the other is almost guaranteed to follow it down. Worse still,

Greek debt is now considered suitable collateral for ECB funding

after Greece cleared the hurdles for the latest round

of bailout money.

Italy’s bank bailo

ut fund, Atlas, is set to be drained of another

€1 billion this time by Veneto Banca

. Those thinking

about asking Atlas for help b

etter hurry up as more than half of its capital will be gone in the first three months. Just

like the Chinese, Italian banks are exploring securitisation of non

performing loans. The ECB is said to be ready to help

allowing senior tranches as collateral for funding

. There’s rumours that the Italian government will use the Brexit

uncertainties as an excuse to push through a

bank bailout of up to €40 billion

. Germany is trying to kill off that idea

insisting that investors must take some losses as part of any plan

. Spain’s Banco Popular is offering

low interest loans

to buy shares in its c

apital raising

In a case of trying to board after the ship has sailed, the ECB is investigating whether

European banks ne

ed to increase

their provisions on shipping loans

Korean banks may need a government bailout

due to their outsized exposures to

e shipping industry. The global glut of ships is expected to take years to clear with continued

deliveries of very large

ships making the situation much worse

The CEO of a Kazak bank is openly saying his country’s banks will need a

bailout

too.

Vladimir Putin’s favourite bank needs a bailout

after funding too many non

economic projects.

India’s

banks might need $18 billion to recapitalise

$140 billion to meet new Bas

el requirements

and the restructuring firms

setup to buy their non

performing loans

only have enough capital to buy 13% of th

ose loans

Across the Atlantic there’s more examples of stupid lending involving governments with high risk mortgages being

bought or insured by US government programs. Last time around subprime mortgages were sold in securitised

tranches without govern

ment insurance, but now

Ginnie Mae is insuring

loans

with 98%

LTVs

and minimal income

coverage

Fannie Mae is buying similarly toxic mortgages

and offers the same interest rate for borrowers regardless

of the risk characteristics.

Non

government backed subprime might be a better risk/return option with

Credit Suisse issuing a small subprime

deal

where borrowers had to document their ability to service the debt and the issuer kept 5

% of the deal.

government backed student loans

continue to see outsized growth in size and default rates.

Credit cards arrears and

losses

are picking up

. There’s concern about marketplace lenders

not ch

ecking whether borrowers are taking out loans

with multiple lenders at the same time

. The Federal Reserve’s stress test had all 33 banks passing, but it was

conceded pass for Morgan Stanley, Deutsche Bank and Santander

. An alternative model has the

top six banks needing

another $376 billion of capital

in a scenario that involves a 40% fall in the stock market.

For Australian banks this month there was an excellent

piece by Simon Fletcher at NAB that

estimated $1

53 billion of

additional subordinated capital will be required by the four major banks

. Get ready for a wave of preference share and

subordinated debt issuance in the next three years. Exactly how much and what types of capital is still being considered

y APRA, but European regulators have shown that there are

many different ways to address total loss absorbing

capital (TLAC) requi

rements

Chinese banks are still seeing

exponential growth in their short terms loans

. That sort of activity is worrying as

$350

billion of Chinese debt comes due in second half of this year

The

Shanxi government is asking banks to go soft on

zombie coal miners

in order to preserve jobs.

Chinese mutual funds have been leveraging up,

buying debt from banks

in exchange for credit lines

. This means they can expand their asset base and returns without having to raise more

from ordinary investors. Online loan sharks are getting

borrowers to submit pictures of themselves naked

in order to

blackmail them if they don’t make their loan repayments.

Chinese companies are following their

US peers and

borrowing for share buybacks

China’s stocks were rejected for

the MSCI indices again

with government restrictions on capital movements and share sales issues that still need to be

overcome. Currency wobbles resurfaced with the Yuan hitting

5 year lows against the US dollar

and

bitcoin surged on

Chinese purchases

Chinese investors are buying US dollar denominated local government

debt

as a strategy to avoid

Yuan devaluation. In theory you’ve got a hedge, but it depends on the borrowers being able to repay the loans.

McKinsey is optimistic on productivity growth

being a boost for China, but that requires dealing with zombie

companies. The IMF joined the chorus in

recommending that the government address exploding debt levels soon

. The

central government is estimated to be running

a deficit of more than 10% of GDP

in order to stimulate the economy.

That might explain why

business a

ctivity

measured in the China beige book was generally positive

. Such enormous

stimulus will inevitably result in overbuilding and malinvestment, with

10% of Chinese prope

rty thought to be vacant

An unofficial gauge shows

underemployment in China is surging

. Not everyone is bearish about Chinese debt though,

there are some

arguments why China won’t have a banking crisis

The Chinese foreign

minister had a tantrum

when a

journalist asked a question about human rights.

Brazil is starting to see

a wave of bankruptcie

, with

a deep recession

and a devalued currency belting companies that

have borrowed in US dollars. The telco company

Oi has filed for bankruptcy with $19 billion of debt

Corporate farmers

are

set to

default on billions of dollars of debt

. The conglomerate

Odebre

cht is struggling to rollover some of it

$32

billion of debt

. The bankrupt airline

Gol is attempting to swindle its internati

onal creditors

whilst protecting its

shareholders and local debtors. The government itself is facing a

deficit far larger than

expected

and

its debt to GDP

ratio is rising fast

. Months out from hosting the Olympic Games

Rio has declared a “state of calamity”

and is begging

for additional funds.

Emerging markets are pushing for a new rating agency

as they believe they aren’t treated fairly by the existing players.

The problem is that rating agencies already routinely over

rate sove

reigns so the right outcome would be for highly

indebted developed nations to be downgraded not emerging markets to be upgraded. Alternatively, they could try

the Chinese rating agencies, who routinely over

rate China’s government and its companies. It has

a hint of the awards

charade that industries often go through. If you don’t win the award you want sponsor a new set of awards and there’s

a pretty good chance you will win. It’s a lot easier than actually doing the hard yards to win a rating or an award

fair

and square.

Puerto Rico has said it will

default on general obligation debt on July 1

as it prioritises services to citi

zens over debt

repayments. It is also saying it will

void $4.4 billion of debt

. Venezuela hasn’t defaulted yet, but

Moody’s expects the

nation and the state owned entity that produces its oil

will both default this year.

When security guards have to

accompany trucks loaded

with food to protect them from being ransacked by a starving population the end is nigh.

The main communist ne

wspaper in China wins the bull of the month award with its view that

Venezuela won’t default

on its debts

. Perhaps they have in

side information that the

Chinese government will do a deal on its existing debt to

Venezuela

, in exchange for years of cheap oil. China is learning some hard lessons about

lending to weak governments

Another oil dependent economy,

Nigeria, saw a 30% fall in its currency

when the peg to the US dollar was dropped.

Japan’s 75

year

old finance minis

ter

old

elderly people to hurry up and die

if they won’t spend their money. The

problem for Japan in making necessary reforms is that

old people have almost all the savings and a majority of the

votes

In a desperate search for yield,

Japanese banks are offering 60

year subordinated l

oans

The city of Chicago is considering buying the debt of its

nearly broke school system as an “investment”

, strenuously

denying it is a

bailout. Its home state, Illinois comes in third on

Truth in Accounting’s list of Zombie states

, highlighting

its debt and deficit position. The “wi

nner” was New Jersey, followed by Connecticut. Hospitals in Mississippi

skipped

pension contributions for 5 years

President Obama wants to expand social security

and he believes the rich can pay

for it. One small problem is that

social security has been on a pathway to insolvency for decades

and needs a lot more

funding just to meet its existing obligations.

A stream of articles this month highli

ghted the similarities between

current economic conditions and those of the

1930’s

There’s an open revolt against ultra

easy monetary policy with Deutsche Ba

saying that

the ECB has lost the

plot

Citibank wrote that we should remember the folly of

Rudolf von

Havenstein

the German central banker who

printed money in the 1920’s

noting that economies are not a petri dish.

That’s the problem with having academic economists runn

ing monetary policy

hey don’t recognise the damage they

are doing as

they

don’t have

the

practical experience to understand how businesses and individuals respond to

incentives. They are willing to experiment with untested policies or worse still, try po

licies that have failed in the past

believing that this time is different.

The ECB has tried to defend the indefensible,

giving six reasons why negative rates

are ok

. One study found that

ld and young people both hate negative interest rates

European green

parliamentarians

are calling for helicopter money

. The ECB started buying corporate bonds in June and its first purch

ases included

company that has a sub

investment grade rating

Mutual fund liquidity was back in the news with the

Financial Stability Board airing its concerns

about illiquid assets

being held by funds that offer regular liquidity. Australian investors may well remember the

property funds that locked

up the early 1990’s

and again in the early stages of the financial crisis. Mortgage funds and high yield debt funds also

locke

d up in the financial crisis. Unwinding these vehicles typically takes years, arguably due to the managers who

continue to harvest management fees whilst investors are restricted from getting out. If you think I’m cynical about

some of my fellow fund manag

ers without cause, this article notes that

hedge funds take 80% of the alpha

they create.

I’m on record as saying that

managers should only get 10% of alpha

Fund lock

ups push asset prices down, as either assets are cleared quickly in a fire sale or are delayed from sale and

create th

e perception of an overhang. This is why many well regarded investors have been selling down recently, it is

a lot easier to buy assets cheaply when you are one of the few cash bidders left. I’m not sure that US investors have

yet grasped the gravity of th

e situation faced with

high yield bonds and leveraged loans held

mutual funds

I’m careful to separate unlisted mutual fu

nds from exchange traded funds, as they will act very differently in a time of

crisis. A run on a mutual fund will result in lock

up unless the assets are truly liquid. All remaining investors will get

stuck if too many try to exit. A run on an ETF will tr

ash the market price, but holders have the choice of selling at the

available price or sticking it out. ETFs are not a perfect solution, the

large

drops in several equity ETFs in the flash crash

of August 2015

showed that the floor can fall away when markets are illiquid. The concept of market makers taking

possession of the underlying assets and selling those for an arbitrage profit if an ETF falls

too much relies on liquidity

existing for the underlying assets. That liquidity and the arbitrage possibilities won’t always be there.

Whilst tech start

ups have been a source of much financial chicanery a couple of events give some hope that not

every

one is drunk on unicorn juice.

The Dropbox CEO stated his firm is cashflow positive

noting

“

ash is oxygen, and if

you keep havi

ng to go to investors to fill up your scuba tank, you can run out”

. Another

tech start

up actually paid a

dividend

The referendum on

universal basic income (UBI) in Switzerland was soundly rejected

, but votes in other countries are

likely to follow. For those who

haven’t been following the debate UBI is the idea that rather than having welfare come

with strings attached, every adult should receive a basic regular payment from the government. Generally simpler is

better when it comes to government programs and UBI c

ertainly meets this by ignoring whether people are trying to

get work or are earning enough already not to need government support. However, the simplicity comes by killing off

the incentive to work particularly in low skill jobs.

Many proponents of UBI a

re profoundly socialist in their outlook. One often cited reason for its introduction is that it

will save people from working in really boring jobs and allow them to pursue their interests elsewhere. Often examples

are given of people who would concentrat

e on artist pursuits if they didn’t have to work in boring, low paid jobs. The

argument runs that these jobs might even disappear as a result making society better.

When UBI meets basic economics it quickly runs into a brick wall. In countries like Switze

rland or Australia with a high

cost of living, the increase in taxes required to give every adult a basic income is enormous. Marginal tax rates would

have to increase and cut in from the first dollar earned. You can see how this becomes a socialist versus

capitalist

debate, as those working and earning income are heavily taxed to fund payments to those who aren’t willing to work.

If UBI was introduced you could expect to see a large increase in the number of people who are trying to be

professional sport

s people, models, writers, actors, musicians and artists. Many young people will spend years

hopelessly trying to gain employment doing these things before figuring out there are very few people who earn good

money in these glamourous areas. An even larger

group will play computer games and watch television all day. The

number of people gainfully employed will drop. This creates spill

over costs in mental health, crime and drug use.

Those boring jobs that people should apparently be saved from will become

more expensive and difficult for

businesses to fill. With their basic income need satisfied, some people will be unwilling to take on boring jobs without

a substantial increase in their income. The effective minimum wage could rise to $30

40 per hour, as

after tax pay

would decrease due to the higher tax rates. Substantially higher wages for low skill work would create the twin effects

of skyrocketing inflation and offshoring of jobs. At this point the socialist dream breaks down just as it has in Venezuel

UBI isn’t the solution,

productivity, taxation and government spending reforms

are.

ritten by Jonathan Rochford for Narrow Road Capital on

June 30

201

Comments and criticisms are welcomed and

can be sent to

info@narrowroadcapital.com

Disclosure

This article has been prepared for educational purposes and is in no way meant to be a substitute for

professional and

tailored financial advice. It contains information derived and sourced from a broad list of third parties, and has been

prepared on the basis that this third party information is accurate. This article expresses the views of the author at

point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to

publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including

securities linked to the pe

rformance of various companies and financial institutions.

Disclaimers