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High Street Brexit Fallout

If an economic crisis happens, but nobody acknowledges it, does it really make a sound at all? Leading up to the Brexit referendum, global banks warned that if the U.K. voted to leave the E.U. they would likely be forced to locate many jobs to E.U. countries.
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If an economic crisis happens, but nobody acknowledges it, does it really make a sound at all? Leading up to the Brexit referendum, global banks warned that if the U.K. voted to leave the E.U. they would likely be forced to locate many jobs to E.U. countries. The people voted to leave, so banks have made no secret of the fact they're preparing contingencies to move jobs to the continent. According to the U.K. Treasury, those public pronouncements are "not helpful." U.K. officials are apparently pressing JPMorgan and other banks with U.K.-based operations not to speak about potential job losses. Last week they were forced to sign a half-hearted, non-binding statement of intent saying they would try to keep jobs in London, but exchequer officials believe its tone was not optimistic enough. The banks don't much seem to care, with UBS investment bank chief Andrea Orcel telling Bloomberg Tuesday that "most probably we would need to consider moving a ... significant percentage of its 5,000-strong London workforce" to an E.U. country.

Speaking of the banks, JPMorgan (JPM), Citigroup (C) and Wells Fargo (WFC) kicked off earnings season this week. JPMorgan posted stronger-than-expected results on an increase in trading revenue and reduction in costs, causing shares to initially rally more than 2.5%. Citi shares rose by a similar margin after its earnings topped estimates. Wells Fargo (WFC) was not so fortunate, its shares falling modestly after in-line earnings as its steady lending-driven business model was more significantly impacted by low net interest margins.

JPMorgan CEO Jamie Dimon announced his firm's decision to give its lowest-paid employees, bank tellers and administrative staff, a raise in a New York Times op-ed. Starbucks CEO Howard Schultz, in a letter to employees Monday, announced his company would do the same. Both expressed a desire to do their part in combatting income inequality, but economists suggest there might be a more business-oriented motivation. As a labor market tightens, demand for competent low-skilled workers often exceeds supply. In the case of JPMorgan, greater automation had led to a smaller labor force at bank branches, putting greater productivity demands on its workforce. If it wanted to maintain a strong customer service experience, the company likely had little choice but to entice its workers with a higher wage.

When pieces of major financial regulation are passed, banks usually get years to comply. The Volcker Rule was passed in 2010, leading most of Wall Street to make preparations for the new reality by beginning a gradual exit from proprietary trading operations. However, some firms decided to hold onto lucrative operations for as long as possible, hoping the additional extraction of revenue would outweigh any losses created by hasty selling. U.S. banks got a one-year extension last week to comply with a Volcker Rule ban on investing in private equity and hedge funds, but Goldman Sachs and Morgan Stanley still face the tall task of exiting billions of dollars worth of positions without getting ripped off.

When CalPERs announced its decision to dump its entire hedge fund portfolio in late 2014, it was supposed to be a death knell for the industry. When several other large pension funds followed suit, the narrative went that the hedge fund model would surely bleed out. But while performance has been lackluster in the last 18 months, it appears the industry's death has been greatly exaggerated.

New data out this week shows the appetite for hedge funds remains as healthy as ever. Pension fund allocations to hedge funds increased 4% year-over-year, with the top 10 biggest institutional investors increasing their exposure to the asset class by 10%, or $183 billion. A pan-European survey of 116 institutional investors conducted by Dutch firm NN Investment Partners in March also found 52% of respondents said they favored investing in hedge funds over the next six to 12 months. While hedge funds aren't for everyone, on the whole institutional investors appear to value the diversifying and risk management properties of well-built alternatives allocations.

U.K. Property Goes on Sale

Last week we focused on troubling redemption halts in U.K. property funds in the aftermath of the Brexit referendum. While not necessarily being harbingers of another global financial crisis, the developments were at the very least symptomatic of a distorted risk-taking and liquidity environment. The worry was that if investors maintained a desire to raise cash despite markdowns, it could cause forced selling within the U.K. property market that would add further pressure onto a fragile banking system. Well, it took less than a week for those forced sales to begin taking place.

On Monday, a frozen Aberdeen Asset Management fund reportedly hired a broker to sell $136 million London office building, 10 Hammersmith Grove. On Wednesday, Standard Life and Legal & General joined the property fund sales rush, offering multiple buildings for sale in order to rebuild liquidity positions.

MSCI conducted a full study on what the Brexit may mean for the London property market. They found London's office market has about 30% exposure to non-domestic tenants "who might decamp completely or shift some of their workers to Ireland or the Continent." However, it believes the reduction in cost of London commercial operations created by the sudden depreciation of the pound may lessen the incentive to relocate.

The ultra-low interest rate environment around the world has boosted once again the attractiveness of real estate investments, raising the possibility of another bubble. The good news, however, is that while British banks have more than 65 billion pounds ($84 billion) of exposure to domestic commercial real estate, post-crisis efforts to strengthen balance sheets and retrench from commercial property markets may prevent systemic destabilizing impairments within the financial sector.

Bank of England's (BOE) Surprise Inaction

The U.K. finally found someone interested in leading the country through the tenuous post-Brexit period. Pro-Remain Tory MP Theresa May was tapped by her party to become the second female Prime Minister in British history after her top challenger, the pro-Leave Andrea Leadsom, bowed out of the race in the name of national unity. Although May supported the campaign to remain in the E.U., she is seen as being flexible and pragmatic enough to effectively negotiate the kingdom's departure from the bloc.

News of her appointment sent both British stocks and the pound soaring, with the FTSE 100 technically entering a bull market after rallying 20% off its post-Brexit lows. While the pound staged its first meaningful bounce since the Brexit vote, the currency remains at multi-decade low, prompting opportunistic dealmakers to see once-in-a-generation M&A opportunities in the U.K.

Adding significant fuel to the pound's turnaround was the Bank of England's (BOE) surprise decision not to raise interest rates at its July meeting. Amid the post-Brexit turmoil, BOE governor Mark Carney took the unusual step of explicitly promising stimulus. By the time the meeting rolled around, futures markets had priced in an 80% probability of a hike. However, in an 8 to 1 vote, the BOE's rate setting committee decided to keep rates unchanged at 0.5%. While central banks rarely express currency-driven motivations for monetary policy decisions, it would be hard not to see the BOE's inaction as driven by worries over the pound's swift collapse. And with initial Brexit shocks subsiding and the new government indicating no hurry to trigger Article 50, Carney retains flexibility on future policy. The BOE maintained a dovish tone in the release by indicating the strong possibility of a rate cut at the August meeting.

Italy Moves Closer to Referendum

Last week we also talked about urgent concerns over Italian banks in the wake of Brexit. E.U. anti-bailout rules prevent the government from giving the financial system a much-needed cash injection, and the Italian people aren't happy about it. Anti-establishment candidates in Italy's nationalist Five Star Movement swept to surprise mayoral election victories in Rome and Turin in late June. With the country's lawmaking body paralyzed as the result of an archaic political system, Prime Minister Matteo Renzi pledged two years ago to revise Italy's constitution. Brexit only added a bit of urgency to that process, with Renzi saying Italy's referendum on a new constitution will take place on either October 30th or November 6th. If the referendum fails, he has said he will step down as Prime Minister, paving the way for new leadership to potentially seek an "Italeave" or "Quitaly" vote.

Swirling winds of change in the E.U.'s fourth-largest economy is the next brick in Europe's tall wall of worry, but it's far from the only concern. The Portugese and Spanish banking systems desperately need a bailout. On Tuesday, a vote of the European Council found that governments in Portugal and Spain did not try hard enough to get their deficits below 3% of GDP, which could prompt the first-ever E.U. fines over deficit levels. The decision to fine any European country in the current economic climate would be ill-advised. If European banks continue down this road, Germany may be forced to reluctantly lead a continent-wide effort to recapitalize the banking system. And while they're re-writing the rules, why not address immigration standards in such a way that would prevent the U.K. from leaving and slow the rise of Marine Le Pen's National Front party in France?

While the E.U. contemplates its future, yields on 10-year government bonds in Germany and the Netherlands entered the negative-rate club for the first time ever.

China's Tough Week

It wasn't a great week for China. The government's belligerent South China Sea claims were rejected by a Hague tribunal, although Beijing refused to accept the legitimacy of the ruling. It's refusal to abide by international law puts the communist power at odds with the United States at a time when it is demanding monetary policy coordination to help with a soft landing. China's Q2 GDP held steady thanks to record stimulus, but the government's stimulus efforts are producing diminishing returns. Also, China is responding to rising defaults among zombie companies by simply ignoring them.

Herbalife's $200 Million Pyramid

Herbalife reached a deal with the FTC preventing it from being labeled a pyramid scheme, causing the stock to rally nearly 20%. But while the company's business model is allowed to go by any other name, the settlement wasn't as sweet. In addition to paying a $200 million fine, Herbalife will be forced to overhaul its marketing efforts. The company will be forced to stop misrepresenting how much its members are likely to make, while distributors will no longer be rewarded primarily for recruiting rather than sales. The stock is up nearly 70% since Bill Ackman famously announced his short position, but he said he will remain short as the new "fundamental structural changes will cause the pyramid to collapse." Carl Icahn, meanwhile, took a victory lap on the other side of the trade, with Herbalife rewarding his PR contributions by raising his ownership limit from 25% to 35%. Right now he owns around 18% of the company.