Brexit & the long shadow on global finance

The dust is settling down after Brexit. Speculative moves in the financial sector were gaining ground before the referendum. Uncertainties increased around some of the possible outcomes after Brexit. Concrete steps were unknown after the exit sparking fresh speculations. Global finance was unprepared to deal with Brexit clearly. Without a political time table, the next steps became even more uncertain.

Global financial industry was not prepared and that had caused most of the harm. Global inter-connectedness did the rest. The ultra-low interest rate environment itself had a negative impact on European financial sector. The uncertainties rose after the Brexit, which I have explained in details later.

I would first look at the Bond market to see how the uncertainty sparked a bond market rally. As the prices zoomed, the yields fell.

We cannot miss out on the action around the U.S. 10 Yr Treasury yields in the same time. A comparison with the German 10Yr Bond Yields would complete the story line:

10Yr U.S. Treasury before Brexit: 1.74%, After Exit:1.43%

German 10 Yr Bond before Brexit: -0.11% After Exit: -0.33%

It appears that Brexit flattened the yield curve.

Almost concurrently the banking stocks and ETFs were hammered down from Europe to U.S.

Few things are clear:

1. It simply appears as if the invisible hand of Brexit flattened the yield curve all across. This is like Trillions of dollars moving into Treasury and Bonds making their prices Bzoom and their yields fall.
2. This is simply a picture of ‘inter-connected’ global finance unprepared to deal with a sudden result. The question arises as to why such an event was never envisaged by the banking sector.
3. The growing uncertainty around London as the center of European financial services industry weighed heavily as there was no back-up plan.

 

First of all the financial sector had shown signs of sluggishness in the recent past due to high exposure to Oil and other commodities. Lower global GDP growth coupled with lower emerging market growth had left excess capacities in the system. Global finance had large exposures to these excess capacities that were being financed.

The European banking sector had additional issues to deal with. The ultra-low and negative interest rate regime was itself a difficult environment. According to the Bain & Co. analysis many of these banks were not earning above their cost of capital for a long time. Much of this is attributed to the higher cost of operations than anything else.

The Brexit came on top of this as London is the nerve center for the entire European Financial Services industry.

Brexit has some very clear cut and definitive impact on the European banking. Those who had access to the European common market through their operations in London have to now re-adjust to the changed circumstances. Through London these banks were ‘pass-porting’ their financial services into Europe. It is not clear after Brexit how this could be done. These uncertainties weighed on the financial sector at the initial hours of the Brexit, but there are other deeper concerns.

The housing sector in U.K. on which financial sector had relied on heavily in the last five years went through a major correction after the Brexit. If there was threat of banks shifting their offices, this sector would necessarily see a sudden freeze in fresh investments for some time to come. This is a big shift from the supply stand point as there are not many avenues to make up for this sudden shrinkage.

The financial sector in U.K. is 8% of GDP, but if we combine with the housing & realty sector, the combined entity would hold a combined weight of 12% of GDP. More importantly this sector was the major growth driver, when all other sectors were drawing down on the GDP growth.

The uncertainties are in the following areas:

1. Would the financial sector be able to operate from U.K. for the services it was rendering to the European common market? Would fresh licenses be required?
2. The cost of transferring the offices and setting up new centers in other cities of Europe were not fully known
3. The impact of housing and real estate in U.K., particularly in London would need to be re-assessed

But the timetable for such things to eventually happen is long; it would at least take two years to get there. The investors on the other hand react faster to uncertainties than they do to certainties. The moving of investments into a safe haven like Gold gives an instant solution to these uncertainties. No wonder Gold ETFs have surged ahead as Gold crossed $1320 per ounce within four days of the Brexit.

Brexit is negative on investments into U.K. for some time to come. This is not automatically getting a fresh lease of life from some other instruments other than from safe havens like Gold. The trade deficit for U.K. will likely widen in the future with Europe as new tariffs would have to be negotiated. The tariff and non-tariff barriers were so far non-existent for U.K. to trade with EU.

There is no immediate solution in sight or an alternate option for U.K. that would give some respite. The loss in trade with EU cannot be immediately compensated with a rise in trade with other countries. Longer distance will come in the way for goods sector if trade has to be done with countries that are far away. For the services sector, it is the financial services which have the maximum uncertainty. Given the waning attractiveness of London as the center for transacting business for the European community, the services industry could go through a major shift.

The signaling by the current leaders in U.K. has to change dramatically for uncertainties to subside. Till that time the financial industry has to align with the changed circumstances. The current bond movement is a signal in that direction.

In sum the European banking and financial sector, is not entirely disconnected from the rest of global finance. The global inter-connectedness in finance is one more important factor to consider why Brexit has cast such a long shadow on the financial sector in general.

Instead of waiting for the dust to settle down, we should rather calm the markets with better signals as EU cannot gain at U.K.’s loss and vice versa. Moreover the health of the financial sector cannot be left to wild swings of speculation.