The June quarter finished in tumultuous fashion as an aftershock of the decision by UK citizens to take their country out of the European Union. The vote caught markets by surprise and the immediate effects included the devaluation of Sterling concurrent with heightened concerns regarding British banks and commercial property values. Equity markets across the world weakened sharply following the vote, before staging an end of financial year rally. The UK equity market staged a remarkable recovery that seemingly matched the fall in its currency.
Following the Brexit vote, the IMF reassessed its economic outlook for the European economic zone. When reading the following, readers should specifically note the inflation forecasts in 2017. They are completely at odds with the yields in European bond markets.

IMF warns Brexit will impinge on eurozone economic growth

  • “The eurozone will grow at slower pace in the coming years due to political and economic uncertainty following the U.K. vote to leave the European Union, the International Monetary Fund said Friday.
  • In its annual report on the currency union’s economy, the Washington-based fund painted a gloomier picture than just four weeks ago, when it released its preliminary assessment of the eurozone.
  • The IMF now expects the gross domestic product of the 19-country bloc to expand 1.6% this year, rather than the 1.7% it predicted before the U.K. voted to leave the EU. Next year, growth will slow to just 1.4%, down from 1.7% forecast previously.
  • The Brexit effect will last through 2018, when the eurozone will grow 1.6% rather than 1.7%, the fund said. Inflation this year is also expected to remain at a super-low 0.2%, below the 0.3% forecast ahead of the referendum, and will rise to 1.1%, rather than 1.2%, in 2017 due to higher energy prices, the IMF said”

Brexit coincided with other developments in Europe concerning Italian banks. Here the news was not new, with approximately 18% of Italian loan books stated to be in arrears. Italian banks are sitting on a mountain of problem loans – which are either behind in their interest payments, or which have stopped paying interest altogether – estimated at about €360 billion (US $533 billion).
Figure 1. In a Class of Their Own: Italian Banks' Swelling Bad-Debt Pile. Source: ECB; Bloomberg
Figure 1. In a Class of Their Own: Italian Banks’ Swelling Bad-Debt Pile
Source. ECB; Bloomberg
However, what troubled markets and concerned wholesale funding markets for banks (including Australian banks) was Germany’s insistence on enforcing Eurozone laws that directly prevents the Italian Government from supporting its banks by way of capital injection. The Italian Government, acting in the interests of its economy, wishes to follow the precedent set by the US Treasury in October 2008 and the UK Government in 2009 by providing capital support for their banks. However current EU regulations dictate that bond holders (many of whom are retail investors) and equity owners must suffer losses before any Government bailout. The result was a collapse in Italian bank shares and heightened potential for another Greek-like crisis to eventuate.
The turmoil in Italy developed as the bureaucrats in Brussels declared that Spain and Portugal would not meet their Eurozone fiscal commitments to rein in their Government deficits in 2016. The declaration opens the way for financial sanctions, at a time when both countries are facing enormous political strains. Spain is still without a stable government, while Portugal’s leftist anti-austerity coalition, which came to power last November, is adamant that it should not be forced to pay for decisions taken by the previous conservative administration. Theoretically, Brussels can enforce a fine of as much as 0.2% of the country’s GDP. If Brussels is too lenient, it will face criticism from Germany, the Netherlands, and the European Central Bank, which believe that maintaining budgetary discipline is essential for the region’s stability.
This added to broad market nervousness and resulted in MORE capital flying into low or negative yielding European bonds, while other funds moved into USD (and with some jumping into $A assets).
Figure 2. Germany Government Bond 10Y Source.; Germany Department of Treasury
Figure 2. Germany Government Bond 10Y
Source.; Germany Department of Treasury
The rally in bond prices (with yields declining) was worldwide, with German ten year bonds moving into negative territory, and these were joined by French nine year bonds. Over in Japan, twenty year bonds moved to negative yields and the ultimate zero yielding bond – GOLD – rallied to US$1350 an ounce. It seems that nearly all countries, including those with worse credit ratings than Australia, were benefiting from near zero interest rates.
Figure 3. Almost $10 Trillion of Negative-Yielding Debt Source. Bloomberg Global Developed Sovereign Bond Index
Figure 3. Almost $10 Trillion of Negative-Yielding Debt
Source. Figure 8. Almost $10 Trillion of Negative-Yielding Debt
Source. Bloomberg Global Developed Sovereign Bond Index

The Eurozone will now see heightened and continuous speculation that other major economies may be forced by popular vote to withdraw from the EU. Indeed, it could be argued that the recent upheaval in Italy presents another reason as to why the liberation of the UK from European laws was logical. Thankfully, the Bank of England is not dictated to by European rules and certainly there will be a growing desire for southern European countries to seek a form of monetary, fiscal and currency independence.
The focus on Europe sets the context for the outlook for world markets in the coming quarter. It seems clear that European events will again dominate proceedings by creating price volatility, currency movements and bond rallies and corrections. Importantly for currencies, it seems that Europe will dictate that the US Federal Reserve will not adjust interest rates – even in the face of near full employment.
As noted above, in early July we witnessed the effect of capital fleeing Europe – a powerful rally in US bonds and support for the $A. Concurrently, we observe bonds with long duration moving into negative yields. It is our view that these market prices are indicative of investor concerns rather than confidence. The bond rallies have been matched by a lift in the gold price, the pre-eminent asset in times of crisis.
The short term outlook for the Australian equity market remains challenging. This is not created by Brexit, the narrow Australian Parliamentary majority or even because of recent concerns registered by S&P regarding Australia’s credit rating. Rather, it is because Australian companies are struggling to grow earnings and dividends. While there will be patches of solid earnings growth provided by a few unique companies, the bulk of Australian listed companies will present earnings and outlook statements that are challenged by the well-documented low growth cycle across the world.
Our valuation analysis suggests that the Australian equity market should produce a single digit return in 2016/17, with the bulk of the return again dominated by dividends. This return will be challenged by a number of factors. In particular, we forecast that bulk commodity and energy prices will trend lower and so too will resource profits unless the $A devalues. Further, Australian banks will be tested by concerns emanating out of Europe, with continued focus on capital adequacy. The broader Australian economy will either be supported by a weaker $A or adversely affected by a stronger $A. So a continuing quandary for Australian investors remains the outlook for the $A.
In our view, the Australian dollar will be lower than the current US75c level in a year’s time. However, the recent developments in Europe outlined above remain the roadblock for short term forecasting and are an impediment for the $A to fall.
Our response to these developments is to maintain a low weighting to resources and financial companies in the Australian market. We continue to suggest weightings to US multinational stocks and a focus on trading opportunities across portfolios. The rally in bond prices (lower yields), are symptomatic of widespread concerns by asset managers. This suggests that volatility in market prices will continue across all asset markets.
We maintain our view that volatility should be accessed and utilised, rather than simply observed. That remains our suggestion for portfolio management – a heightened level of activity. When longer term investment opportunities are accessed, the focus must remain upon those assets with a clear potential to generate growing and sustainable yield.