We have previously outlined our rationale for why Brexit was not going to be a systemic event for financial markets and the global economy. However, there are some more nuanced implications for Europe going forward, given rising anti-European sentiment in Italy, and the political tensions between Europe (particularly Germany) and Italy over the resolution of its troubled banks.

Brexit provides yet another headwind to European growth prospects due to rising policy uncertainty and negative shocks to business confidence (Exhibit 1). While these effects will take some time to materialize in the economic data, there are some leading indicators providing early warning signals.

Uncertainty Around European Economic Policy Hits New Levels -- OppenheimerFunds

The European Banking Sector Is Key

The main transmission channel is the banking sector. European bank stocks have been underperforming for some time, due to both profitability and solvency concerns. Uncertainty surrounding the long negotiation process between the UK and the EU provides an additional headwind to an already fragile recovery in credit creation. In fact, research shows that economic policy uncertainty has a significant negative effect on bank lending, which in turn affects economic growth.1 Compared to other regions, the Eurozone is even more vulnerable to this transmission channel, since bank lending represents about 85% of funding for the non-financial private sector, compared to roughly 30% in the U.S. A simple approximation of this phenomenon is illustrated in Exhibit 2, showing the strong correlation between European banks stocks and credit growth to non-financial corporates. In other words, falling equity prices reduce banks’ ability to raise capital ratios. In this environment, sustaining bank lending to the real economy becomes increasingly difficult.

Bank Stock Prices Impact Credit Growth -- OppenheimerFunds

The main problem is that the absolute level of economic growth in Europe, even pre-Brexit, is a relatively modest 1.5%. Similarly, the annual growth rate in European credit is also a modest 1.2%. Therefore, any tightening in credit conditions from here is likely to kill the European recovery.

All Roads Lead to Rome

In this context, Italy is the weakest link within the Eurozone. Its banks are known to suffer from a large stock of non-performing loans (NPLs) (approximately € 360 billion), which only exacerbates the vulnerability of the financial sector to another growth shock. Italy’s NPL problem is a longstanding one since the country never recapitalized its banks during the 2008 crisis, unlike many of its European peers, to avoid a political backlash. Today, Italy needs to recapitalize its banks, but the situation is complicated by the newly introduced state-aid and bail-in rules, which stipulate that 8% of a bank’s liabilities must be wiped out before any taxpayer support can be provided, forcing losses on private investors.

However, there are exemptions to these rules. The Bank Recovery and Resolution Directive allows for some flexibility, which should be used. Italy’s case to qualify for these exemptions is a relatively strong one, but all complications arise from politics, in both Italy and Germany. In recapitalizing the banks, Prime Minister Renzi must avoid a loss for retail investors who own bank bonds as deposit-like instruments. His political future is at stake with the constitutional referendum in October/November which, if rejected, will trigger his resignation and potentially new elections. On the other hand, Merkel, who is facing elections in 2017, will not want to show a break-up of the rules in favor of Italian banks to her own electorate.

Europe must realize that Italy poses the biggest risks from an economic, financial and political standpoint. Post-Brexit polls show an alarming rise in anti-European sentiment in Italy.2 Therefore, if Europe wants to avoid another wave of political uncertainty and rising unemployment, it must address Italian banks, maintain the positive credit impulse and deliver more economic growth.

Just like 2,000 years ago, “Mille viae ducunt homines per saecula Romam.” In modern terms, all roads lead to Rome.

Portfolio Positioning

As discussed in our GMAG monthly blogs, our investment process leads us to maintain an underweight position to European equities and the euro, which is further supported by the risks outlined in this blog.

Visit our Global Multi-Asset Group webpage for additional insights about asset allocation and multi-asset investing.

1 Source: Economic Policy Uncertainty and the Credit Channel: Aggregate and Bank Level U.S. Evidence over Several Decades, Federal Reserve Bank of Dallas, 2/8/16

2 Source: https://jean-jaures.org/sites/default/files/notebrexit.pdf, Institute Francais D’opinion Publique , 6/15/16.