The Brexit referendum stoked historic levels of volatility in financial markets, but only a week after the vote most major stock indexes around the world had already recovered all losses. Observers wondered whether the global economy had avoided a systemic-level crisis. This week, however, we got a reminder of what happens when severe dislocations take place in distorted environments.
On Wednesday and Thursday, seven of the U.K.'s largest real estate funds froze around $35 billion in combined assets as investors sought to stampede out of British real estate investments. Several managers also simultaneously marked down the value of those funds, hoping to discourage further withdrawals. One fund run by Aberdeen Fund Managers Ltd. suspended redemptions for 24 hours while making a dilution adjustment that reduced its value by 17%, giving panicked investors time and cause to reconsider. Another fund run by Legal & General Group Plc adjusted its value down by 10%. The first three funds to halt redemptions- M&G Investments, Aviva Investors, Standard Life Investments - were forced to do so despite having liquid cash-equivalent positions of 7.7%, 9.3% and 13.1%, respectively.
London-based research firm Green Street Advisors last week revealed it sees London office prices falling 20% within three years following the affirmative Brexit vote. Investors, naturally, didn't like the sound of that. Frenzied selling early last week erased more than 3 billion pounds of market value from the FTSE 350 Real Estate Investment Trust Index, with the U.K.'s largest REIT, Land Securities Group Plc, at one point falling nearly 10%. Prices recovered somewhat Thursday and Friday, but investors still appear to have an itchy trigger finger.
If the redemption halts and value adjustments aren't enough to prevent further withdrawals, the situation could require forced sales of commercial properties in the U.K. Already more than 650 million pounds worth of proposed real estate deals in London have collapsed in the wake of Brexit, most notably the proposed 465 million pound acquisition of a landmark office block by Germany's Union Investment from U.S. property developer Hines. Another German real estate investor, KanAm, pulled out of its 190 million pound purchase of 1 Wood Street, the London headquarters of the law firm Eversheds.
One of the most concerning twists in the saga is the revelation that while many U.K. property funds maintain strong liquidity buffers (which were reinforced leading up to the Brexit referendum), those buffers are often held in shares of other REITs. M&G, for example, owns more than 2 million shares in Aviva's suspended fund, while Standard Life holds about 2.4 million shares in M&G's fund.
The decision to hold liquidity buffers in the only-moderate safety of REIT shares is part of a larger distortion of risk taking that has resulted from unprecedented monetary policy following the 2008 financial crisis. With safe-haven bond yields around the world at historic lows, both retail and institutional investors have sought the fantastical combination of liquidity and yield offered by assets like REITs and utilities. The desperate search for income has pushed investors down the risk spectrum, potentially creating bubbles in dividend and distribution yielding instruments.
U.K. property funds also suffer from a liquidity mismatch, offering daily liquidity on an underlying foundation of illiquid assets such as commercial real estate, which can take months to sell. Together these factors create the potential for a domino effect within the already fragile European banking system, made worse by the incestuous relationships within the U.K. property market.
During the 2008 financial crisis, a similar wave of redemption halts served as a canary in the coal mine for global markets. Janus Capital's Bill Gross, in an interview with Bloomberg TV, didn't shy away from the comparison: "It's reminiscent of Bear Stearns' subprime funds before the Lehman debacle. The system doesn't allow liquidity to flow into the proper places. If these property funds are just one indication, perhaps there will be others to follow. I think it's something to worry about."
Having learned lessons from 2008, the financial sector has less leverage and policy makers are more acutely aware of their crucial role in providing liquidity during the worst of the storm. This week's episode, though, highlights the precarious position of global markets. Seven years of experimental monetary policy has reflated asset prices in the absence of corresponding improvement in economic fundamentals. These events may not be the spark to set the global economy aflame once again, but they're a reminder that we've built the recovery on a bed of kindling.
Brexit Currency Fallout
While British stocks bounced back post-Brexit, the pound this week traded to fresh multi-decade lows versus the dollar. The shellacking has gotten so severe the sterling overtook the Argentine peso as the worst performing currency against the dollar in 2016. Argentina, if you don't remember, triggered a massive peso devaluation late last year when President Mauricio Macri removed its peg from the dollar.
Goldman Sachs, Citigroup and Deutsche Bank think the pound plunge is just getting started. Goldman and Citi see the GBP/USD weakening to 1.2000, while Deutsche Bank sees the exchange rate falling even further to 1.1500 (GBP/USD closed Friday at 1.2952). The sharp decline is an acceleration of the British pound's 100-year debasement, which, as currencies tend to do, reflects a decline in the kingdom's global influence.
The inverse relationship between the pound and British stocks, however, is not an anomalous divergence. With companies in Great Britain's benchmark FTSE 100 index deriving nearly 70% of their revenues from outside the U.K., the sterling's depreciation actually serves to boost equity valuations. But that doesn't mean the pound's plight is a net positive as investors continue to pull back from investment in the kingdom in light of uncertainty over its trade and employment relationship with the E.U. and other global powers.
A major impetus for further devaluation of the pound is policy intervention from the Bank of England (BOE), which looks set to cut rate in hopes of limiting the economic fallout from the Brexit. BOE governor Mark Carney has stepped up admirably (amid the U.K. Treasury's silence) in the wake of the referendum result. He took the unusual step of explicitly signaling intent to pump more stimulus into the British economy, boosting risk assets and weighing further on the pound.
However, Carney's helping hand wasn't enough to prevent U.K. consumer confidence from plunging the most in 21 years. U.K. Treasury chief George Osborne finally found his voice more than three days after the vote, saying he wants to cut the kingdom's corporate tax rate from its current level of 20% to below 15% in order to signal that Britain is still "open for business."
The real losers in the sterling's pounding are emerging market currencies, which in aggregate have lost around 10% of value versus the dollar so far this year. The International Monetary Fund (IMF) believes the dollar is 10-20% stronger than it should be based on current economic conditions. Devalued currencies can benefit economies by making exports more attractive, but that dynamic becomes much less powerful when global aggregate demand for goods is low. In addition, as currencies depreciate, debt-ridden emerging markets see the effective cost of interest payments increase.
As the largest borrower of dollar-denominated debt, China's private sector is the most exposed to this phenomenon. On cue, Chinese trade minister Gao Hucheng this week lamented the "grim" global economy at a two-day G20 trade summit in Shanghai, calling for the international community to "inject impetus for recovery and growth." Translation: Janet Yellen, don't even think about raising rates anytime soon.
The Brexit has only exacerbated risk aversion resulting from the global financial crisis. In a low growth world, investors are willing to pay a high price for income and the perception of safety. They also want the returns associated with illiquid investments while maintaining the ostensible protection of liquidity. The Brexit has only made anxious investors even more skittish, but don't tell them to be calm and patient - that really grinds their gears.
Get Ready For "Quitaly" or "Italeave" Speculation
While all the attention has been focused on the U.K., a more urgent crisis is beginning to rear its ugly head in Europe: the undercapitalization of Italian banks. Within the Italian banking system, 17% of loans are non-performing. By comparison, at the height of the 2008 financial crisis, the percentage of sour loans in the U.S. banking system was 5%. If Italy was the only European country facing a banking crisis, the E.U. would have the tools to help them through it. But given the precarious capital position of banks in even the bloc's most stable countries (see: Germany -> Deutsche Bank), plus the uncertainty surrounding the entire union post-Brexit, the E.U. is not in the best position to cope with the current crunch.
The benchmark European financial sector index is already down 30% this year, more than half of those losses coming in the last two weeks. E.U. policymakers are considering the creation of a system-wide non-performing debt market, but the Brexit has caused bad loans to pile up more rapidly in the meantime. And with the further erosion of confidence comes the possibility of bank runs. Think Greece, but on a much larger scale.
In response to the 2008 financial crisis, global economic officials kicked the can down the road in hopes improved economic output would paper over cracks created by many years of irresponsible lending. That hasn't happened, and Brexit has only accelerated the inevitable reckoning.
Blockbuster Jobs Report
Giving investors a respite from the doom and gloom was Friday's stellar U.S. employment situation report. After seeing non-farm payrolls increase by just 11,000 in May, the U.S. economy created 287,000 jobs in June (versus consensus estimates of 180,000). It was the strongest jobs number relative to expectations since December 2009 and the largest month-to-month jump in job creation ever (owing in part to the Verizon workers strike, which began in May and ended in June, eliminating and subsequently returning around 35,000 jobs to the labor force).
The wild swing reinforces the fact it's important to focus on employment trends rather than individual data points. Averaging the May and June totals, the U.S. economy created 149,000 per month, closer to the 2016 average of 175,000. While representing a downshift from the 200,000-per-month average from the last six years, the figure is hardly a harbinger of recession.
Digging further into the report, the unemployment rate ticked up to 4.9% thanks to an increase in labor force participation. The U-6 unemployment rate, which counts discouraged and reluctant part-time workers, fell from from 9.7% to 9.6%, its lowest reading since April 2008. Slow wage growth has tempered enthusiasm over strong employment gains over the last six years, but in June wages grew 2.6% year-over-year, the largest increase since the financial crisis. The tightening job market is leading to larger pay increases for workers switching jobs, just one indicator that has economists seeing stronger wage growth just around the corner.
Had the U.K. voted to remain in the E.U., such a strong report would have likely caused stocks to sell-off in anticipation of Federal Reserve tightening. But with post-Brexit turmoil in global markets eliminating basically any expectation of a Fed rate hike in 2016, a blockbuster report was the goldilocks scenario for risk assets this time around. The S&P 500 responded in kind, rallying sharply Friday to close the week just below all-time highs.
Even U.S. Treasuries participated in the rally as investors flocked toward the safe-haven of an insulated American economy. Yield on the the U.S. 10-year note finished the week at an all-time low of 1.3579%. Meanwhile, Japan's 20-year bond yield entered negative territory for the first time. It all goes to show there is no such thing as impossible in markets anymore.
The stock market is so far ignoring a flattening yield curve, typically one of the most reliable indicators of a looming economic slowdown. Morgan Stanley and Deutsche Bank believe a recession is on the horizon, but in our analysis, the rapid decline in U.S. Treasury yields says more about the pitiful prospects for rest of the developed world than it does about the U.S. economy.
E.U. Cities Court London Jobs
French politicians have finally rallied around a common cause, and we're not talking about the national football team's run to the finals of Euro 2016. Seeing an opening from the Brexit, a bi-partisan coalition of government and corporate officials have joined forces in a bid to woo finance jobs from London. And they're not alone. The German government is erecting billboards in London promoting Berlin as a destination for entrepreneurship. Dublin is finalizing an advertising assault on London business executives. Milan thinks European banking regulators would look good in Dolce & Gabbana.
JP Morgan, Goldman Sachs, Bank of America Merrill Lynch and Morgan Stanley gave London a half-hearted vote of confidence on Thursday after a meeting with the U.K. Treasury. The banks, along with Citigroup, signed a statement letter saying they would try to maintain support for the city's financial sector, but there was no firm commitment on keeping jobs in the British capitol. There's a big difference between a promise ring and a wedding band, and Jamie Dimon seems to be pinning his hopes on the U.K. having second thoughts about its divorce from the E.U.