Brexit Fallout Continues, But Markets Recover Some Ground

July 01, 2016

After the initial shock of the vote wore off, investors moved back into equities. Now the hard part of negotiating Britain’s new status begins.

What it means – Beyond political posturing, the vote means very little today. No one knows how trade negotiations between the UK and the EU will play out, so it’s a game of wait and see.

Some think the EU will punish Britain for leaving by offering onerous trade agreements, but that seems unlikely. Britain has a trade deficit with the Continent, so the Brits buy more from the Europeans than they sell to them, particularly the Germans. It would be idiotic to upset that apple cart. Expect a lot of bluster over the next six months to two years, but in the end, Britain will most likely get exactly what it wanted – almost free trade, and yet control over its borders and internal regulations.

In an interesting twist, Britain will most likely report higher GDP growth in the coming quarters. The Brexit took 15% off the British Pound, which instantly boosts the profitability of exporting companies. In Japan, where the currency has strengthened, government officials must be green with envy.

First-Quarter GDP Revised Slightly Higher to 1.1%
Exports edged up, pushing the report over 1% annualized.

What it means – A better report is welcome, but it’s still just 1.1% annualized, which is horrible. The U.S. economy remains in the doldrums. Unfortunately, more than half of the growth in this report came from increased health care spending. Those aren’t dollars that consumers are happy to spend, which makes this gain even less than meets the eye.

Second-quarter GDP reports at the end of July and should be markedly better, somewhere around 2.5%. But don’t get excited. It will represent less of a trend than a normal bounce after two dismal quarters, and it’s still an anemic number.

S&P/Case-Shiller 20-City Hope Price Index Up 5.4% in April Over Last Year
The growth rate has slowed since earlier this year, but it remains solid.

What it means – Home prices have continued to appreciate much longer than we thought possible. For prices to move higher, there must be buyers willing to pay up, which apparently is the case. But this drives out buyers that can’t afford the higher prices, narrowing the number of potential buyers.

Without solid income growth, this situation will eventually fall in on itself. First-time home buyers represent about 30% of all purchases today, well below the long-run average of 38% to 40%.

Italy Gets EU Permission to Bail Out Banks
The EU sanctioned Italy’s $166 billion bank guarantee program, citing Brexit as an extraordinary crisis, allowing Italy to take government action before executing a bail-in. 

What it means – The Italian banks – like the Greek, Spanish, and German banks – never recovered. They carry billions in non-performing debt. The problem in Italy is so bad that several banks need more cash right now. But EU regulations developed during the Cypriot banking crisis calls for bank bail-ins, or for equity investors to lose their money and bondholders to take haircuts, before any public dollars are spent. There is a loophole. If extenuating circumstances exist, the bail-in can be ignored. 

The Italians saw their opening with Brexit. Even though the British referendum didn’t cause any of their current banking woes, they can use the current confusion as cover to bail out the banks without dinging their bondholders, investors, or depositors. As is usual, the facts are tortured to fit whatever the bureaucrats want to do.Lost in the noise is the fact that, after six years, the Italian banks still need cash. Europe isn’t fixed, and it’s not moving in the right direction.

Japanese Yen Falls to 102 per U.S. Dollar
The yen reversed almost all of the weakness engineered by the Bank of Japan (BoJ) over the last three years, making Japanese exports more expensive and cutting the profits of exporting companies.

What it means – Given how far the British pound fell after the Brexit vote, the Japanese must be searching for their own way out. In the wake of the turmoil, the Japanese currency recovered half the ground it gave up over the past four years, which isn’t a good thing.

The BoJ wants a weak yen to stimulate exports, and it has printed more currency than any other central bank pursuing that goal. In six short months, investors drove the yen higher. Japanese central bankers must be wondering what they have to do to drag the yen back to earth. As I’ve said many times, the current situation is intolerable for Japan. The bankers and government officials will come up with some new plan, possibly helicopter money, to drive inflation up and the currency down.

The Chinese Yuan Dropped to 6.70 per U.S. Dollar
The Chinese government signaled it would be comfortable with the yuan falling compared to the buck.

What it means – The Chinese peg the yuan to the U.S. dollar at a rate set daily by the Chinese government. The currency then trades within a 2% band around the peg. As the dollar shot higher since Brexit, it dragged the yuan with it, causing angst in Beijing. But the Chinese can’t let the yuan fall too far, since that motivates anyone with capital to get their coins out of the realm, and presumably into dollars or yen. As capital flees, the Chinese must use more of their foreign reserves to keep the yuan from falling too fast.

U.S. Congress Approves Puerto Rican Bailout
Congress approved legislation that allows Puerto Rico to renegotiate its debt, and calls for a federal financial oversight board for the Commonwealth.

What it means Since Puerto Rico is defaulting on up to $2 billion worth of bonds today, this bill didn’t show up a minute too soon. Puerto Ricans will get some relief from their crushing debt, but the rule of law will take a hit. Bondholders will be forced to take losses, even the bondholders that own general obligation bonds with a constitutional right to be paid before all other creditors. And none of this deals with Puerto Rico’s pension issue.

The Commonwealth owes more than $40 billion in pensions, and currently holds less than $4 billion in assets.  No matter what deal is struck on their current debt, Puerto Rico will be broke for many years to come.

Next Week – The week of July 4 starts with Independence Day in the U.S. A holiday week is normally quiet, but next week the markets will still be adjusting to life after Brexit, and on Friday, the U.S. releases the Employment Situation report. 

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