Brexit sell-off batters global stocks

Share

The fallout from Britain's vote to leave the European Union has settled on the financial sector, resurrecting familiar fears of a shock that destabilizes some of the world's major banks.

Financial stocks have accounted for the greatest share of the $3-trillion (U.S.) lost on global stock markets over the two frantic days of trading since the Brexit referendum surprised nearly everyone. The sell-off resumed apace on Monday, with major European benchmarks falling by an additional 2.5 per cent to 3 per cent, while North American indexes dropped by 1.5 per cent to 2 per cent.

London's banking giants have been hit the hardest. The city's status as a financial hub stands to be weakened by distancing itself from the rest of Europe, calling into question the future profitability of trading, investment banking and other lines of business. Royal Bank of Scotland shares have lost more than 30 per cent of their value since the vote, while Barclays has dropped 32 per cent.

Outside of Britain, the sell-off has been less potent, but still sizable, with the financial stocks in the United States and Canada falling by 8 per cent and 5 per cent, respectively, over those two days.

While steep losses may invoke fears of global financial contagion, investors are responding to the prospect of lower bank profits because of slower economic growth and ultra-low interest rates, said Eric Lascelles, chief economist at RBC Global Asset Management.

"These markets are still in motion, and this could yet be judged to be much more serious, but as it stands right now, the financial sector should be fairly resilient," he said.

Other financial markets seem to be saying as much. Despite the equity sell-off, credit indicators are not flashing warnings that Brexit could pose a true threat to the financial system.

The uncertainty unleashed by Thursday's referendum is of vital concern to Britain itself. The pound has plunged, a mild recession looks likely and linkages with the world's largest trading bloc are now in question. On Monday, Standard & Poor's stripped Britain of its top triple-A credit rating and downgraded it by two notches to AA, and cited specifically the risk to banks.

"The Brexit result could lead to a deterioration of the U.K.'s economic performance, including its large financial services sector, which is a major contributor to employment and public receipts," the agency said. "The result could also trigger a constitutional crisis if it leads to a second referendum on Scottish independence from the U.K." Beyond Europe's shores, the direct economic costs to the rest of the world should be modest.

Of greater concern, however, are the related issues of falling bond yields and bank profit strains, Matt King, Citigroup's head of credit product strategy, wrote in a note.

"These were at the heart of the markets' disquiet in January and February, and seem dangerously close to becoming so again."

Extremely low yields are bad for lenders, which face compressed net interest margins as a result. The benchmark 10-year yield on British government bonds has declined by 44 basis points to a new record low of 0.935 per cent.

"That's massive," Mr. Lascelles said. "That is coming out of the profit margins of a bank that borrows short and lends long." Price targets have been aggressively cut, while JPMorgan analysts said in a note that profit estimates for British banks in 2018 could now be 20-per-cent lower.

The flare-up in volatility has once again put the world's central banks in a position to provide additional stimulus. The Bank of England may have to cut interest rates and increase its bond purchases, while the U.S. Federal Reserve is likely again on hold to hike its policy rates.

While expected stimulus has made banks less profitable in the future, "the viability of the big British banks is not in serious doubt," Mr. Lascelles said. "In a negative scenario you can conceive of them needing to raise capital, but this is not a situation in which they're hanging by a thread."

Shareholders of many European bank stocks are facing meaningful losses. Deutsche Bank recommended its clients avoid British and Spanish banks and limit exposure to banks in Italy.

But so far, the risks posed by Brexit are not systemic ones. Certain credit market indicators, such as spreads on emerging market corporate bonds over government yields, have not come close to levels indicating cause for grave concern, Mr. Lascelles said.

"It seems as though credit markets are taking this in stride, which is good, because credit is among the most consequential channels for contagion, and does tend to be among the savviest financial indicators as well."