A Tenuous Recovery in European Markets
Markets have rebounded following the momentous Brexit vote in the U.K. on June 23rd. The S&P 500 and the MSCI EAFE have both rallied over 8% since June 28th. Despite the post-Brexit rebound, the Wall Street Journal has pointed out that investors are fleeing European equity funds. Approximately $9.7BN has been redeemed in the two weeks following the Brexit vote, which marked the 22nd consecutive week of outflows from European equities and approximately $54BN has been redeemed year-to-date according to the Journal. All of this suggests that investors have come to view European economic fortunes as dependent on increasingly fragile political stability and are beginning to price in a healthy risk premium in response.
Further destabilizing risks loom for the region, including:
- Far-right nationalistic political parties are on the rise and are calling for referendums on membership in the European Union.
- The migrant crisis is worsening and provoking further support for far-right political parties, especially in economically challenged peripheral countries.
- The capacity of central banks to respond to additional economic crises is limited with interest rates already close to zero.
- Italian banks are struggling with record levels of non-performing loans and Italian authorities are loathe to execute the “bail-ins” demanded by E.U. rules, which require bank creditors to accept haircuts on bank liabilities before public money is used to recapitalize the banks. The crisis could further strain the Union unless a compromise is reached. The IMF recently called for a fast resolution to the standoff and noted that the Italian economic recovery is likely to be prolonged and fraught with risks. As we noted in last week’s Smart Money Insights, nearly one in five loans on the balance sheets of Italian banks are nonperforming. Meanwhile, Italian public debt has surged to 133% of GDP, further limiting the ability of economic authorities to respond to crises. As Bloomberg News points out, the average length of bankruptcy proceedings in Italy is 7.8 years, which is nearly 3x as long as the European average; this will be a critical factor affecting the ability of Italian banks to foreclose and recover on nonperforming loans or securitize and sell them to opportunistic investors.
Mirror, Mirror
One interesting line of commentary in the Brexit post-mortem hinges on one deceptively simple question: How could so many professional investors and prognosticators have gotten it wrong? Indeed, the Remain camp was heavily favored among U.K. bookmakers, who gave Leave a paltry 20% or so chance of success on the eve of the vote. As Bloomberg News points out, however, wealthy bettors in London skewed the odds to reflect an unrealistic chance of success for their side. The average bet placed in favor of Remain was £236, compared with £50 for the Leave camp. Consequently, the betting markets were useful as a proxy for sentiment among wealthy Londoners, but useless as a barometer for the referendum as a whole. The Wall Street Journal points out that investors often commit projection bias by betting on the outcome they prefer. Consequently, the currency and equity markets became a feedback loop of validation for investors who preferred Remain rather than an accurate reflection of the risk premium associated with Brexit. Indeed, storied investors such as George Soros were publicly skeptical about the potential for a Brexit given the economic self-harm that would likely result. Apart from the obvious lesson to be cautious about using financial markets as a crystal ball for the ballot box, investors should also refrain from underestimating the scorched-earth inclinations of an electorate that feels left out of a globalized world—or the willingness of populist politicians to exploit that frustration for political gain. We haven’t seen the last of politicians who would incite trade wars and rip up free trade agreements—and the recent records set by the S&P don’t accurately reflect the danger of the rise of these movements. Investors may once again find themselves overexposed to their own preferences and in the flattering presence of like-minded company.