Sector update - Brexit
POSITIONING FOR BREXIT: WHAT NEXT FOR THE BANKS?
Claudia Von Türk Myers, banking sector analyst at Lombard Odier, assesses the implications of Brexit for investors with exposure to banks.
The impact on the market of the UK’s decision to leave the EU has so far been profound, with the government bond and currency markets reacting violently in the aftermath. Within equities, banks have borne the brunt of the fallout with European and UK names suffering their worst two days on record1 before staging a rebound on Tuesday 28, 2016.
While UK banks were logically down sharply, many other banks, notably the French and the Benelux2, corrected nearly as much despite not being affected to the same extent. But as the realities of Brexit sink in, it is worth noting that the central banks have all the backstops in place and will provide the necessary liquidity, so we should see no liquidity events in the near term.
Banks in peripheral Europe saw stronger declines given fears of a domino effect. In Italy, the weakness in bank shares has led to the country’s prime minister Matteo Renzi seek to a more holistic solution to the sector’s problem. Many solutions are being talked about including a suspension of the state aid ban, though this might face resistance from the European Commission. Either way, a solution that addresses the sector’s current problems would be welcome.
Beyond immediate concerns, we believe the current weakness in the sector could present interesting opportunities, but given the high volatility and likely lack of liquidity, we would wait for the dust to settle before adjusting our stance.
Three things we know for certain
In terms of the impact of Brexit, we believe there are three clear consequences that investors must be braced for, and several others that remain, for now, uncertain. Starting with the certainties:
- First, interest rates are likely to stay lower for longer – which is bad for bank profitability. Should they go even lower than they are now, it would be even worse. Earnings estimates across the banking sector are coming down on the back of this.
- Second, widening credit spreads3 could lead to an increase in funding costs – also a negative for the sector.
- Third, the current uncertainty warrants a high risk premium4 on banking stocks which directly affects how these names are valued. As a result, price targets5 are coming down.
On the less certain points, we note the potential negative impact on GDP growth outside the UK and a possible deterioration in credit quality as a result of this. Both would be negative for banks. Finally, there is the issue of passporting6 which affects primarily the investment banks. We have no clarity on the issue but note this could lead to a decrease in flexibility on costs - at best - at a time when we expect further weakness in revenues.
In conclusion, Brexit is a negative for the sector both in terms of impact on profitability and uncertainty. Meanwhile, we maintain a cautious approach with regards to the sector, favouring defensive, well-capitalised banks.
1As measured by the Eurostoxx50 and the FTSE 100 as at June 27, 2016
2Benelux is the union of Belgium, the Netherlands, and Luxembourg
3The variation in yield between shorter and longer-dated bonds
4The additional return that an investor expects in return to taking on more risk
5The best price that an investor expects a security to reach in order to realise a favourable return on their investment
6The favourable rights that EU banks have to sell their services into the rest of the single market
Source of all market data: Bloomberg, as at June 29, 2016
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