Brexit Beckons…and Aussie Banks in Need of More Capital…Again

It’s going to be wall-to-wall Brexit talk this week. The Brits hit the polls on Thursday, so you should have a pretty good idea of the outcome by Friday.

I have no idea what the result will be. But I suspect fear of the unknown will get the ‘remain’ vote over the line. Markets are punting on this outcome too as the week gets underway.

On resumption of trading this morning, gold dropped around US$15 an ounce, suggesting the market thinks the UK will lump it with the European Union (EU).

Based on the articles I read over the weekend, it seems every person of power and influence thinks the UK will practically disintegrate if it votes to leave.

Here’s Paul Kelly writing about it in The Australian:

The strength of global opinion is revealing. The only conclusion is that leaving is seen as an act of strategic recklessness. US President Barack Obama has deliberately intervened to appeal to Britain to stay.

So have Japan’s PM, Shinzo Abe, Germany’s Angela Merkel and France’s Francois Hollande. Eastern European opinion is extreme for Britain to remain. German public opinion is strongly against Brexit. Malcolm Turnbull and John Key support the Remain cause, with Turnbull saying it is the wise option.

With a line-up of ‘remain’ opinion like that, it makes me want to side with the leave campaign. It sounds like they need some support.

Clearly, Britain remaining in the EU is a vote for the status quo. The world’s major nations don’t want to deal with the fallout if Britain decides to go its own way.

It’s clearly in their interests for the UK to remain. But this isn’t about anyone else. It’s about what the British people want. Or at least it should be. For what it’s worth, I hope democracy is the winner on the day. Let the people decide.

I just hope they don’t consume the opinions of the world’s ‘elites’ too much in the lead up. For example, last week, the BBC ran with this hyperbolic quote from President of the EU council, Donald Tusk:

“As a historian I fear Brexit could be the beginning of the destruction of not only the EU but also Western political civilisation in its entirety,” he told the German newspaper Bild.

Jeez. No pressure, leave voters. Feel free to vote, but you will bring down civilisation as we know it if you decide to go your own way.

This is the EU’s way of saying they will make things very difficult for the UK if they do decide to leave. They don’t want any other separatist movements emboldened by a leave vote. Make no mistake; the UK will be punished if they walk away from the EU.

Global stock markets won’t like it either. They’re worried, but they’re not pricing a Brexit outcome in yet. As I mentioned, stock markets are backing a ‘remain’ outcome as the week kicks off.

How could they price in a Brexit anyway? No one knows what such an outcome would look like, or what the flow-on effects would be.

Central bankers no doubt have their hand on the interest rate button should ‘leave’ gather any momentum, in the hope that another flood of liquidity will sooth the jitters.

The only problem with that strategy is that the additional liquidity will go straight into the bond market, pushing yields lower and, in many cases, even further into negative territory.

Why is this a problem?

Negative interest rates are slowly crushing the global banking system. This is especially a problem in Europe. European banking stocks are down around 25% so far this year.

That’s despite European Central Bank boss Mario Draghi reinflating the ECB balance sheet back to the highs of 2012. All that liquidity is going into government bonds, smashing bank profitability in the process.

Banks hold government bonds on their balance sheets. If these bonds generate a very low, or even negative, yield, it reduces banks’ earning power.

After the Brexit circus subsides, this issue of negative yields will become increasingly problematic for the global banking system.

And while it hasn’t hit the Aussie banking system just yet, we have our own issues to worry about.

That is, the second half of the year will see a renewed focus on capital raisings by the Big Four banks. As The Australian reports today:

A lull in the regulatory capital storm engulfing the major banks is set to end, refocusing attention on potential equity raisings as their surcharge for being a risk to the economy may be doubled and global rules are set in stone.

Put simply, the bank regulator APRA wants the banks to have greater capital buffers. According to NAB credit analysis cited in the article, the Big Four banks are around $30 billion short of ‘tier one’ capital, meaning that each bank needs to raise an additional $6 billion in equity on average.

That means more shares on issue and lower earnings per share in the future for the banks.

Perhaps that’s why the sector continues to languish. For example, benchmark bank stock Commonwealth Bank [ASX:CBA] is trading near its lows for the year.

As you can see in the chart below, CBA’s share price is really struggling. Following the early year selloff, it hasn’t been able to get above $80. Strong support remains around $70 but a break below here would be extremely bearish for the sector.

CBA Share Price

Source: BigCharts
[Click to enlarge]

Is the recent selloff related to Brexit jitters? Or are investors starting to price in a tougher regulatory environment, where banks will need to raise more capital in the months ahead.

We’ll find out soon enough. The Brexit news cycle will exhaust itself and the market will soon move on to a new set of worries.

In Australia at least, the banking sector could be a good candidate for the worrywarts.


Greg Canavan,
For Markets and Money

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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