Beachhead Dynamic Beta
July 07, 2016
Invest like a hedge fund manager without the constraints.

Smart Money Insights: Weekly Brief July 6

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Italy: A New European Crisis Brewing?

The fallout from the Brexit referendum has left the British political establishment in disarray, with no clear successor for David Cameron in sight. Businesses are postponing investment and some are weighing a relocation to the Continent. Meanwhile, all is not well for Britain’s neighbors to the south; leaders in Brussels are struggling to find a coherent strategy for dealing with the migrant crisis as prosperous Core countries goad struggling peripheral countries to share more of the burden for housing the migrants. More alarming, however, is the nascent banking crisis emerging in Italy. The Wall Street Journal highlighted this week that 17% of loans on the balance sheets of Italian banks are nonperforming—for context, this proportion of nonperforming loans is 10x worse than in the U.S. As the Journal points out, this level peaked at only 5% in the U.S. during the height of the 2008 – 2009 crisis. There are also indications that Italian banks are overestimating the recovery levels for nonperforming loans, especially given the notoriously inefficient foreclosure process there. Credit default swaps on the debt of Banca Monte dei Paschi di Siena, which is heavily exposed to nonperforming loans, imply a 63% chance of default within five years.

Italian banks are caught in the pincer grip of bad debt and regulations from Brussels that prevent authorities from bailing out the banks without first imposing haircuts on bank shareholders, bondholders and depositors (a “bail-in”). Italian authorities are loathe to impose these losses and argue that many shareholders and bondholders are retirees who would be wiped out and further dependent on the state in such a scenario. Writedowns on bad loans eat away at banks’ capital buffers, leaving them struggling to raise more capital to meet ECB requirements—a downward spiral that, in the worst case, leads to either a bank bailout or sharp losses for creditors. If authorities opt for the former in spite of ECB regulations, the authority of E.U. will be diminished. As we pointed out in another post , either outcome will fan the flames of anti-E.U. sentiment on the Continent.

U.K. Real Estate

The Brexit crisis is claiming another victim in the form of U.K. real estate, particularly in the heated London market. The U.K. construction PMI—a gauge of construction activity—has declined to 46.0; values below 50 represent a contraction in construction activity. Shares of U.K. homebuilders have declined by 29% – 40% since the Brexit vote, while U.K. REITS have declined between 23% – 32%. London real estate was once viewed as a safe investment by wealthy foreigners; we should anticipate further declines in the pound sterling as these investors liquidate their holdings and repatriate the proceeds, selling the pound in the process. Further strain could come from financial services employees selling expensive homes in London to relocate to Paris, Frankfurt or elsewhere.

Bank of England

Bank of England governor Mark Carney has emerged as a source of market support and leadership following the political disarray in London. The central bank this week relaxed capital requirements for U.K. banks, enabling them to lend an additional £150BN to domestic consumers and businesses. Carney’s options are limited, however, with the benchmark interest rate at just 0.5%, though he did hint at a possible rate cut and further quantitative easing this summer. In any case, the availability of credit may not provide sufficient motivation to increase spending for businesses who have opted to wait out the Brexit uncertainty. Carney voiced support for Remain in the period leading up to the vote and warned of a significant slowing of the economy in the event of a Brexit.

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