First published in Institutional Investor on August 4, 2016.
Corporate chieftains have a ready-made excuse for downgrading earnings expectations. The U.K.’s vote to leave the European Union is providing cover for a range of events that would most likely have happened anyway.
For those looking for cracks in the edifice, the fall in bank share prices following the June 23 Brexit vote was evidence of a seismic event. Bank share prices, however, had rallied ahead of the vote, even as earnings estimates continued to slide. The postreferendum adjustment was merely a return to trend.
Estimates have fallen further in recent weeks. This decline stems not from the Brexit decision but from the Bank of England’s response to the event. The pound has fallen, which has real implications, and some cross-border funding of investments is subject to a new round of scrutiny. Yet there is no evidence from equity markets of the uncertainty that is regarded as a call to action.
Financial markets have a gauge of uncertainty in the volatility of future prices that is implied by options. These securities allow investors to make predictions about how much prices will move over specific periods. The striking feature of the run-up to the U.K. referendum was the stability of predictions that one could infer from equity options, as investors bet that there would be little disruption to prevailing trends. The rapid fall and recovery in U.K. stock indexes in the aftermath of the vote are testimony to the accuracy of these predictions.
For investors, it is important to follow those with skin in the game. As the Brexit furor has given way to hyperbole surrounding the election of a new president in the U.S., such scrutiny is doubly important.
For all the heat and light of the political theater, expect a smooth ride in the equity markets over the coming months. The overarching reason for this is an understanding that the Federal Reserve and its fellow central banks have got investors’ backs. Each time volatility rises, authorities respond with monetary palliatives that have the desired effect of suppressing risk. Volatility is uncertainty, and the more certain investors are about the future, the higher the price they pay for securities.
Low interest rates depress bank profitability, though. That factor, coupled with mounting capital requirements, reduces the availability of loans. Thus, one important mechanism by which confidence in financial markets spreads to Main Street is broken. By responding to political events with promises of more easing, central banks depress the outlook for commercial banks further, even as they provide support for stock markets.
Monetary policy is turning banks into utilities more effectively than is accomplished via regulations. With discussion of negative interest rates out in the open, the prospect of banks charging interest on deposits increases. Commercial customers in parts of Europe are already facing such costs. The beneficiaries will be in the nonbank financial sector. Because these so-called shadow banks are lightly regulated, this result could mean further loosening of the links between central bank activity and the real economy.
Prolonged low interest rates also threaten the profitability of the insurance industry, because companies and their clients in that sector share the pain from the minimal returns on savings. The increasing numbers of middle-class savers fearing for their long-term financial security swells the ranks of those prepared to vote for whatever change is on offer, including Brexit and a businessman candidate for U.S. president. Thus economic policies designed to preserve the status quo may instead be having the opposite effect.
One definite risk to business as usual is being faced by London’s bankers. Access to the single market is at risk if the U.K. is denied the passport rights that allow institutions in one EU country to operate in all others. Executives have responded to the U.K. vote with horror at the prospect of having to abandon London for a European city without the same infrastructure and where English is not the common tongue. For all the grandstanding of politicians around the how-to-Brexit negotiations, we might expect the residency of U.S. power brokers to be the driving force behind an eventual compromise.