Europe

A renewed flare-up in euro area banking sector stress will have ramifications for U.S. bank stocks, despite little direct geographic exposure. The chart shows that risk premiums for U.S bank stocks have been tightly correlated with those of the euro area during previous stress episodes, as this represents a deflationary shock that suppresses the global interest rate structure and undermines global economic activity. Our Global Sector Strategy service has been recommending underweight exposure to euro area banks since mid-March in global equity portfolios. Worrisomely, things are about to get worse before any improvement materializes. The Brexit referendum result has served as a catalyst to expose euro area banks as the weak global financials links. Both absolute and relative performance are probing all-time lows (top panel), dropping even below the depths of the Great Recession. Eurozone banks are plagued by compressing net interest margins, courtesy of NIRP and QE, and still elevated non-performing loans (second panel). This is a lethal combination for bank profits as loan growth is failing to provide an offset. What is missing in the Eurozone is a true bank recapitalization, as happened in the U.S. in late-2008 via TARP. On that front, we are eagerly awaiting the EBA/ECB stress test results slated for July 29 for an update on the health of the euro area's banking sector. Beyond any recapitalization efforts, an opening of the fiscal taps would also serve as a potential positive catalyst to help revive moribund loan demand. Until then, global bond yields will likely dive deeper into negative territory, anchoring bank ROE (third panel). Bottom Line: Resist any temptation to bottom fish in euro area, or U.S., banks. For additional details please visit http://gss.bcaresearch.com/

We test three channels of contagion from the Brexit shock: political, banking system, and economic.

Yield and Protector Portfolios should continue to benefit in current environment. Equities face seasonal headwinds.

A benchmark overall duration stance is still warranted, as central banks will maintain exceptionally accommodative monetary policies to offset potential Brexit-related shocks to confidence.

Special Report

Dear Client, After being ardent bond bulls for many years, it is time to shift gears. As I write these words, the U.S. 10-year Treasury yield has hit an all-time low of 1.37%, the 10-year bund yield is at -0.18%, and the 10-year Swiss yield is at -0.61%. While we do not expect yields to soar anytime soon, the long-term risk for yields is now more to the upside than the downside. This suggests that investors should sell bonds on any rallies. We are maintaining a neutral stance towards global equities for now, but will be looking to overweight stocks later this year if (as we expect) the post-Brexit shock running through policy circles leads to a further easing in fiscal and monetary policy. With this in mind, we are opening a new structural trade recommendation: Short an equally-weighted portfolio of Japanese, German, and Swiss 10-year bonds. We regard these three negative-yielding markets as among the most overpriced in the world. Details will follow later this week in our Q3 Strategy Outlook. Best regards, Peter Berezin, Managing Editor

For the month of June, the model performed in line with both global equities and the S&P 500. For the month of July, the model is increasing its risk exposure.

The Brexit vote will either usher in the complete dissolution of the euro area, or it will prove to be a blessing in disguise. Our bet is the latter, but the next few months are still likely to see heightened political uncertainty and elevated financial volatility, warranting a cautious stance towards risk assets. Investors have become too complacent about the prospect of Fed hikes over the coming years. Even a slight upward move in rate expectations could cause the dollar to surge. Underweight U.S. stocks in currency-hedged terms.

Special Report

The only certainty regarding the next steps in the Brexit Saga is uncertainty. In the attached report, BCA's Geopolitical Strategy presents the BREXIT Decision Tree and reviews the possible next steps. We also collate all of the BCA investment views and strategies - tactical and strategic - that relate to the ongoing saga.

Global uncertainty is elevated, but markets know this. Brexit could prove extremely negative for the global economy if it prompts a questioning of the EU's integrity. The cyclical outlook for the pound remains poor, but a short-term opportunity to buy GBP/JPY has emerged. We still like the SEK and commodity currencies. The SNB will continue to intervene, but the peg is increasingly dangerous.

Post-Brexit uncertainty will continue for some time. But we were already cautiously positioned, and would not go any more defensive.