#$barc

By Mark Melin                        

Technology is moving to disrupt as many business models as it can and investment banks are not immune, an August 26 91 page Bank of America Merrill Lynch report points out. Banks in the European Union are struggling with different challenges than some of their US or Japanese counterparts. Inside banks, there are emerging approaches that differ from one bank to the next which can primarily be described based on how technology spending is categorized. It is this approach to managing the future and embracing or rejecting technology that could determine winners and losers in a segment beset by relatively low stock price-to-book value multiples.

Banks have been the only stock category trading below book value

In a stock market environment where banks are trading below book value -- the only industry group to be doing so, as we have noted inValueWalk -- bank managers are searching for a solution. That solution could be found inside a powerful societal trend: eliminate humans and replace them with technology as therobots come for the jobs. The major investment banks will not be the first in financial services to go down this path. It was the human trading floor that was first automated -- most notably pushed aside by high-frequency trading. What resulted was a market structure where information traveled around the world in microseconds, the subject of a pitched battle at the Securities and Exchange Commission over the IEX Exchange.

The next real battle that matters to banks is trading in SWAPs, which firms such as Citadel and Bloomberg are both looking to automate. Speed is one part of the technology-driven formula to reduce costs at major investment banks, but the exchange clearing systems typically also include the risk management benefit of the organization facilitating the trade not facing directional market risk. The August 26th 92 page BAML report, "Optimus Primer: how technology is transforming the investment bank," touches on these issues but goes deeper. While it explores the time advantage, focusing mostly on European banks, it raises issues that apply regardless of geography. (The benefit of clearing swaps on a central exchange was not discussed in detail in the bank report.)

Robotics are a societal trend and banks can leverage IT to reduce costs 4% to 12%

The report documents the societal trend, part of their thematic work on millennials, that shows a preference for robotics despite concerns over cybercrime. In the financial services industry, it is witnessed in the rise of Robo advisors and low-fee Exchange Traded Funds over active mutual funds. With general consumer preferences tending to favor robotic interactions as a powerful trend indicator, the report is about more than consumers. Perhaps the most material point is how technology can be used to reduce overhead burden and immediately improve rate of return to shareholders. "Industry estimates have suggested savings could be significant," the report said, pointing to areas automation disruption areas. "The status quo has a multitude of duplicated systems and processes that need humans to operate, maintain and reconcile them.

Automating much of this process could yield substantial IT and staff cost savings." BAML estimates that by deploying innovative technologies it could cut costs anywhere from 4% to 12%. "An 8% reduction in group costs improves RoNAVs by 2-3%," the report noted. But one of the problems with the cost reductions in a stock market world driven by quarterly earnings is that "some technology solutions seem long-dated."

Banks are not embracing technology to revolutionize their business

With such a rich estimated return, one might think the banks would all be moving in unison. But they are not, the report noted. The majority of bank IT spend, nearly three in four dollars, is directed towards maintenance, while a smaller percentage directed towards innovation. The banks have been under criticism for their failure to innovate, and the tech spending points to a divergence in thought process among the largest European players. Banks at the top of the list in IT spending include Spains Banco Santander, Deutsche Bank, Barclays, RBS and HSBC, with significant differentials in technology spend from top to bottom. France's Societe Generale, for instance, spends $354 million on technology, 79th on the global spending list, while Banco Santander spends near $1.3 billion, at the top of the IT list. Numerous areas of cost reduction in bank process could be impacted:

Artificial intelligence comes in many forms which may be useful to banks. At the extreme, it can replace many functions currently carried out by humans. Key uses will be populating Big Data sets, carrying out maintenance reports, corporate audits, monitoring of conduct, compliance, risk, and trading.

A large portion of technology spend cost reductions come in the compliance department, with automated systems monitoring and flagging inappropriate behavior at a significantly more efficient rate than humans:

...if a trade looks odd, if there is a problem, if the trade looks very different to how that client normally trades. Machine learning may be able to automate and resolve many of the issues, referring fewer exceptions to the trader.

The report, using "the industry rule of thumb" that one third of all investment bank costs emanate from the back office, says this area could be best automated. Citing a study from Santander Innoventures, BAML points to 20-50% of back office clearing and settlement costs could be eliminated with technology, for example. Technology and artificial intelligence solutions could also monitor trading and asset transfer regiments for red flags, tasks now monitored by humans.

Bank research could be automated -- including the filtering of reports for the buy-side -- but will research results ever be tracked?

One area that could be impacted is bank research, a notable topic of interest. Those inside bank profit centers have had research costs assigned to their division balance sheet. Bank research is projected to be a cost / revenue center of its own, with buy-side clients paying for the research. This will create an interesting dynamic where the valuable research will be identified through a free market system rather than the somewhat socialistic system where bank research is less accountable as a clear bottom line revenue generation number. From BAML's perspective, automation first streamlines the compliance function:

Research is a heavily regulated area with each regulator applying its own set of requirements. There are a myriad of regulations which require research divisions and its analysts to operate specific procedures to protect the quality of the research output. Analysts are generally required to distribute their views simultaneously to all their clients to prevent selective dissemination. That includes the salesforce and/or clients of their own firm. This can take up valuable time (as the analyst works out the consequences of an economic event, finds relevant data, makes some charts, and then edits and publishes a report).

Not only will technology streamline research production, but also how it is consumed. Buy-side analysts are inundated with research. Technology could be used to help organize and differentiate among research thesis and information. Could advanced technology -- gasp -- lead to success tracking of a researcher's thesis, predictions and modeling? While this might be a great fear among researchers -- rarely is the success of their analysis fully tracked -- it could likely separate the research wheat from the chafe. There will be winners and losers if this occurs.

Citadel and Bloomberg looking to disrupt traditional investment banks while investment banks pushing back in other ways

A new paradigm is reshaping banking and certain industry innovators are gunning to disrupt the status quo. The BAML report highlighted three primary forces targeting technological improvement that included two well known names: Citadel and Bloomberg.

Some non-bank competitors have been far more successful than the banks in pushing down variable cost per trade which has allowed them to creep into areas that have traditionally been fulfilled by banks. New entrants have the luxury of building their infrastructure from scratch for the new rules, rather than needing to make alterations to legacy systems. Well-known examples include Citadel which has pushed into the trading of liquid, standardized swaps, or XTX which ranked top 10 in the latest Euromoney survey for FX trading. Bloomberg is also making in-roads into being a SEF in CDS and also encroaching into some of the traditional sell-side research roles of providing analysis of standardized data sets through Bloomberg Intelligence.

And the report also notes:

The tools of research broadly similar for 10 years – expect this to change A decade ago, the main tools of the average analyst were Excel, Word, email, pdfs, Bloomberg chat and a phone. Today, these are pretty much the same. Client relationship management systems are better, more integrated and matter more than they did 10 years ago. But essentially, the tools are unchanged. Meanwhile, Facebook has grown from 6m monthly users in 2005 to 1.6bn in 4Q15. In 2005, the best-selling phone was a Nokia 1110; the iphone was a mere glint in the eye of Sir Jonathan Ive (1st gen not launched until 2007); 2MB broadband had just been launched for UK households (now 100MB is fairly standard). The word “Fintech” would certainly not get past the editors. It seems likely that research will need to make faster technological progress over thenext decade. In our view, as the value of Research becomes more clearly defined, there is the potential for a raft of changes.

Perhaps the behind the scenes race to watch will be who disrupts whom first? Will Bloomberg disrupt the banks first or will the banks disrupt Bloomberg ?

We live in interesting times. We continue to see repercussions from Brexit. The other major players—in Europe, China, and Japan—seem to be in a downward spiral. Not to mention, the bubble-like issues we see in Canada and other parts of the world.

The world is quickly getting far more complex… something that central banks’ (and everybody else’s!) models can’t capture. We are tiptoeing into a period of enormous uncertainty. 

Bill Gross addresses these topics in two of his recent letters (I featured them in my free weekly newsletter, Outside the Box). His first deals with the expectations that most investors have about future returns over the long term—as opposed to what reality suggests. Of course, your mileage may vary. It depends on how you choose to create your portfolio. The average investor, however, is at best looking at about a compound 4-5% over the next 10 to 15 years.

And that’s if everything works and we see the top end of the expected returns. Given current bond yields and stock valuations, that outcome may be unlikely.

Bill’s take is not significantly different from what I’ve been writing, but he makes a number of very good points and has data sets that are really worth paying attention to. Plus, Gross is just a fun writer.

His second letter starts with the simple game of Monopoly that we are all familiar with. Bill then begins to develop an analogy to the real economy. 

Nowadays, central banks keep increasing the amount of money you get every time you pass Go. If that happens in Monopoly, your investing strategy changes significantly— the price of assets goes up because the supply of money increases at an ever faster rate. Which means that the velocity of money rises until at some point you have a problem. Quoting:

[H]owever with yields at near zero and negative on $10 trillion of global government credit, the contribution of velocity to GDP growth is coming to an end and may even be creating negative growth as I’ve argued for the last several years. Our credit-based financial system is sputtering, and risk assets are reflecting that reality even if most players (including central banks) have little clue as to how the game is played.

Bill is shouting a warning about the viability of the current economic system. 

He didn’t quote Yeats, but I will: “The centre cannot hold.”

Bon Appetit!

(Originally published on the Janus Capital website, June 2, 2016)

The economist Joseph Schumpeter once remarked that the “top-dollar rooms in capitalism’s grand hotel are always occupied, but not by the same occupants”. There are no franchises, he intoned — you are king for a figurative day, and then — well — you move to another room in the castle; hopefully not the dungeon, which is often the case. While Schumpeter’s observation has obvious implications for one and all, including yours truly, I think it also applies to markets, various asset classes, and what investors recognize as “carry”. That shall be my topic of the day, as I observe the Pacific Ocean from Janus’ fourteenth floor — not exactly the penthouse but there is space available on the higher floors, and I have always loved a good view. Anyway, my basic thrust in this Outlook will be to observe that all forms of “carry” in financial markets are compressed, resulting in artificially high asset prices and a distortion of future risk relative to potential return that an investor must confront.

Experienced managers that have treaded markets for several decades or more recognize that their “era” has been a magnificent one despite many “close calls” characterized by Lehman, the collapse of NASDAQ 5000, the Savings + Loan crisis in the early 90’s, and so on. Chart 1 proves the point for bonds. Since the inception of the Barclays Capital U.S. Aggregate or Lehman Bond index in 1976, investment grade bond markets have provided conservative investors with a 7.47% compound return with remarkably little volatility. An observer of the graph would be amazed, as was I, at the steady climb of wealth, even during significant bear markets when 30-year Treasury yields reached 15% in the early 80’s and were tagged with the designation of “certificates of confiscation”. The graph proves otherwise, because as bond prices were going down, the higher and higher annual yields smoothed the damage and even led to positive returns during “headline” bear market periods such as 1979-84, or more recently the “taper tantrum” of 2013. Quite remarkable, isn’t it? A Sherlock Holmes sleuth interested in disproving this thesis would find few 12-month periods of time where the investment grade bond market produced negative returns.

 The path of stocks has not been so smooth but the annual returns (with dividends) have been over 3% higher than investment grade bonds as Chart 2 shows. That is how it should be: stocks displaying higher historical volatility but more return.

But my take from these observations is that this 40-year period of time has been quite remarkable – a grey if not black swan event that cannot be repeated. With interest rates near zero and now negative in many developed economies, near double digit annual returns for stocks and 7%+ for bonds approach a 5 or 6 Sigma event, as nerdish market technocrats might describe it. You have a better chance of observing another era like the previous 40-year one on the planet Mars than you do here on good old Earth. The “top dollar rooms in the financial market’s grand hotel” may still be occupied by attractive relative asset classes, but the room rate is extremely high and the view from the penthouse is shrouded in fog, which is my meteorological metaphor for high risk.

Let me borrow some excellent work from another investment firm that has occupied the upper floors of the market’s grand hotel for many years now. GMO’s Ben Inker in his first quarter 2016 client letter makes the point that while it is obvious that a 10-year Treasury at 1.85% held for 10 years will return pretty close to 1.85%, it is not widely observed that the rate of return of a dynamic “constant maturity strategy” maintaining a fixed duration on a Barclays Capital U.S. Aggregate portfolio now yielding 2.17%, will almost assuredly return between 1.5% and 2.9% over the next 10 years, even if yields double or drop to 0% at period’s end. The bond market’s 7.5% 40-year historical return is just that – history. In order to duplicate that number, yields would have to drop to -17%! Tickets to Mars, anyone?

The case for stocks is more complicated of course with different possibilities for growth, P/E ratios and potential government support in the form of “Hail Mary” QE’s now employed in Japan, China, and elsewhere. Equities though, reside on the same planet Earth and are correlated significantly to the return on bonds. Add a historical 3% “equity premium” to GMO’s hypothesis on bonds if you dare, and you get to a range of 4.5% to 5.9% over the next 10 years, and believe me, those forecasts require a foghorn warning given current market and economic distortions. Capitalism has entered a new era in this post-Lehman period due to unimaginable monetary policies and negative structural transitions that pose risk to growth forecasts and the historical linear upward slope of productivity.

Here’s my thesis in more compact form: For over 40 years, asset returns and alpha generation from penthouse investment managers have been materially aided by declines in interest rates, trade globalization, and an enormous expansion of credit – that is debt. Those trends are coming to an end if only because in some cases they can go no further. Those historic returns have been a function of leverage and the capture of “carry”, producing attractive income and capital gains. A repeat performance is not only unlikely, it is impossible unless you are a friend of Elon Musk and you’ve got the gumption to blast off for Mars. Planet Earth does not offer such opportunities.

“Carry” in almost all forms is compressed and offers more risk than potential return. I will be specific:

•    Duration is unquestionably a risk in negative yielding markets. A minus 25 basis point yield on a 5-year German Bund produces nothing but losses five years from now. A 45 basis point yield on a 30-year JGB offers a current “carry” of only 40 basis points per year for a near 30-year durational risk. That’s a Sharpe ratio of .015 at best, and if interest rates move up by just 2 basis points, an investor loses her entire annual income. Even 10-year U.S. Treasuries with a 125 basis point “carry” relative to current money market rates represent similar durational headwinds. Maturity extension in order to capture “carry” is hardly worth the risk.  

•    Similarly, credit risk or credit “carry” offers little reward relative to potential losses. Without getting too detailed, the advantage offered by holding a 5-year investment grade corporate bond over the next 12 months is a mere 25 basis points. The IG CDX credit curve offers a spread of 75 basis points for a 5-year commitment but its expected return over the next 12 months is only 25 basis points. An investor can only earn more if the forward credit curve – much like the yield curve – is not realized.  

•    Volatility. Carry can be earned by selling volatility in many areas. Any investment longer or less creditworthy than a 90-day Treasury Bill sells volatility whether a portfolio manager realizes it or not. Much like the “VIX®”, the Treasury “Move Index” is at a near historic low, meaning there is little to be gained by selling outright volatility or other forms in duration and credit space.  

•    Liquidity. Spreads for illiquid investments have tightened to historical lows. Liquidity can be measured in the Treasury market by spreads between “off the run” and “on the run” issues – a spread that is nearly nonexistent, meaning there is no “carry” associated with less liquid Treasury bonds. Similar evidence exists with corporate CDS compared to their less liquid cash counterparts. You can observe it as well in the “discounts” to NAV or Net Asset Value in closed-end funds. They are historically tight, indicating very little “carry” for assuming a relatively illiquid position.

The “fact of the matter” – to use a politician’s phrase – is that “carry” in any form appears to be very low relative to risk. The same thing goes with stocks and real estate or any asset that has a P/E, cap rate, or is tied to present value by the discounting of future cash flows. To occupy the investment market’s future “penthouse”, today’s portfolio managers – as well as their clients, must begin to look in another direction. Returns will be low, risk will be high and at some point the “Intelligent Investor” must decide that we are in a new era with conditions that demand a different approach. Negative durations? Voiding or shorting corporate credit? Buying instead of selling volatility? Staying liquid with large amounts of cash? These are all potential “negative” carry positions that at some point may capture capital gains or at a minimum preserve principal. But because an investor must eat something as the appropriate reversal approaches, the current penthouse room service menu of positive carry alternatives must still be carefully scrutinized to avoid starvation. That means accepting some positive carry assets with the least amount of risk. Sometime soon though, as inappropriate monetary policies and structural headwinds take their toll, those delicious “carry rich and greasy” French fries will turn cold and rather quickly get tossed into the garbage can. Bon Appetit!

******

Just a Game

(Originally published on the Janus Capital website, July 6, 2016)

If only Fed Governors and Presidents understood a little bit more about Monopoly, and a tad less about outdated historical models such as the Taylor Rule and the Phillips Curve, then our economy and its future prospects might be a little better off. That is not to say that Monopoly can illuminate all of the problems of our current economic stagnation. Brexit and a growing Populist movement clearly point out that the possibility of de-globalization (less trade, immigration and economic growth) is playing a part. And too, structural elements long ago advanced in my New Normal thesis in 2009 have a significant role as well: aging demographics, too much debt, and technological advances including job-threatening robotization are significantly responsible for 2% peak U.S. real GDP as opposed to 4-5% only a decade ago. But all of these elements are but properties on a larger economic landscape best typified by a Monopoly board. In that game, capitalists travel around the board, buying up properties, paying rent, and importantly passing “Go” and collecting $200 each and every time. And it’s the $200 of cash (which in the economic scheme of things represents new “credit”) that is responsible for the ongoing health of our finance-based economy. Without new credit, economic growth moves in reverse and individual player “bankruptcies” become more probable.

But let’s start back at the beginning when the bank hands out cash, and each player begins to roll the dice. The bank – which critically is not the central bank but the private banking system– hands out $1,500 to each player. The object is to buy good real estate at a cheap price and to develop properties with houses and hotels. But the player must have a cash reserve in case she lands on other properties and pays rent. So at some point, the process of economic development represented by the building of houses and hotels slows down. You can’t just keep buying houses if you expect to pay other players rent. You’ll need cash or “credit”, and you’ve spent much of your $1,500 buying properties. To some extent, growth for all the players in general can continue but at a slower pace – the economy slows down due to a more levered position for each player but still grows because of the $200 that each receives as he passes Go. But here’s the rub. In Monopoly, the $200 of credit creation never changes. It’s always $200. If the rules or the system allowed for an increase to $400 or say $1,000, then players could keep on building and the economy keep growing without the possibility of a cash or credit squeeze. But it doesn’t. The rules which fix the passing “Go” amount at $200 ensure at some point the breakdown of a player who hasn’t purchased “well” or reserved enough cash. Bankruptcies begin. The Monopoly game, which at the start was so exciting as $1,500 and $200 a pass made for asset accumulation and economic growth, now turns sullen and competitive: Dog eat dog with the survival of many of the players on the board at risk.

All right. So how is this relevant to today’s finance-based economy? Hasn’t the Fed printed $4 trillion of new money and the same with the BOJ and ECB? Haven’t they effectively increased the $200 “pass go” amount by more than enough to keep the game going? Not really. Because in today’s modern day economy, central banks are really the “community chest”, not the banker. They have lots and lots of money available but only if the private system – the economy’s real bankers – decide to use it and expand “credit”. If banks don’t lend, either because of risk to them or an unwillingness of corporations and individuals to borrow money, then credit growth doesn’t increase. The system still generates $200 per player per round trip roll of the dice, but it’s not enough to keep real GDP at the same pace and to prevent some companies/households from going bankrupt.

That is what’s happening today and has been happening for the past few years. As shown in Chart I, credit growth which has averaged 9% a year since the beginning of this century barely reaches 4% annualized in most quarters now. And why isn’t that enough? Well the proof’s in the pudding or the annualized GDP numbers both here and abroad. A highly levered economic system is dependent on credit creation for its stability and longevity, and now it is growing sub-optimally. Yes, those structural elements mentioned previously are part of the explanation. But credit is the oil that lubes the system, the straw that stirs the drink, and when the private system (not the central bank) fails to generate sufficient credit growth, then real economic growth stalls and even goes in reverse.

(To elaborate just slightly, total credit, unlike standard “money supply” definitions include all credit or debt from households, businesses, government, and finance-based sources. It now totals a staggering $62 trillion in contrast to M1/M2 totals which approximate $13 trillion at best.)

Now many readers may be familiar with the axiomatic formula of (“M V = PT”), which in plain English means money supply X the velocity of money = PT or Gross Domestic Product (permit me the simplicity for sake of brevity). In other words, money supply or “credit” growth is not the only determinant of GDP but the velocity of that money or credit is important too. It’s like the grocery store business. Turnover of inventory is critical to profits and in this case, turnover of credit is critical to GDP and GDP growth. Without elaboration, because this may be getting a little drawn out, velocity of credit is enhanced by lower and lower interest rates. Thus, over the past 5-6 years post-Lehman, as the private system has created insufficient credit growth, the lower and lower interest rates have increased velocity and therefore increased GDP, although weakly. Now, however with yields at near zero and negative on $10 trillion of global government credit, the contribution of velocity to GDP growth is coming to an end and may even be creating negative growth as I’ve argued for the last several years. Our credit-based financial system is sputtering, and risk assets are reflecting that reality even if most players (including central banks) have little clue as to how the game is played. Ask Janet Yellen for instance what affects the velocity of credit or even how much credit there is in the system and her hesitant answer may not satisfy you. They don’t believe in Monopoly as the functional model for the modern day financial system. They believe in Taylor and Phillips and warn of future inflation as we approach “full employment”. They worship false idols.

To be fair, the fiscal side of our current system has been nonexistent. We’re not all dead, but Keynes certainly is. Until governments can spend money and replace the animal spirits lacking in the private sector, then the Monopoly board and meager credit growth shrinks as a future deflationary weapon. But investors should not hope unrealistically for deficit spending any time soon. To me, that means at best, a ceiling on risk asset prices (stocks, high yield bonds, private equity, real estate) and at worst, minus signs at year’s end that force investors to abandon hope for future returns compared to historic examples. Worry for now about the return “of” your money, not the return “on” it. Our Monopoly-based economy requires credit creation and if it stays low, the future losers will grow in number.

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BY JOHN MAULDIN

I spent considerable time last week discussing Brexit with my good friend George Friedman.

George’s opinion is invaluable to me because he is the most dispassionate person I know. He analyzes geopolitics by looking at facts and following them wherever they lead.

George is no one’s cheerleader or nemesis. He calls the shots exactly as he sees them, and he’s usually right.

(If you haven’t done so already, subscribe to his free column, This Week in Geopolitics, at Mauldin Economics)

As for Brexit, George says it is the logical consequence of the European Union’s decisions in recent years. Some country was going to take this step. As it turned out, the UK was first, but it would have happened somewhere eventually.

Who’s in charge of the EU?

George was not at all surprised to hear the EU bureaucrats in Brussels instantly take a hard line after the vote.

Of course, they say they’ll treat the UK harshly. Bureaucrats, and especially those of the EU Commission, always resist when someone tries to escape their grasp.

The important point to remember is that the EU Commission, which is the executive body that implements policy, is not in charge of the EU. The leaders of the member states, collectively called the European Council, are the real power.

And within the European Council is a smaller group of powerful states that usually gets its way. Their opinion is what counts. So what did they think of Brexit?

The foreign ministers of the so-called “EU 6” original members (Belgium, France, Germany, Italy, Luxembourg, and the Netherlands) issued an unusual joint statement shortly after the Brexit vote.

For Europe, that is a lightning-fast move. The statement leads off with the usual platitudes about the EU’s magnificent achievements then expresses regret at the UK’s decision to leave.

But then we see reality begin to seep in. These Inner Six countries basically said, “Okay, we get it, some people are justifiably upset. Maybe we haven’t run this railroad quite as well as we should have. We are going to listen to you and change.”

Now here’s the key paragraph of this short statement (emphasis mine):

It is to that end that we shall also recognize different levels of ambition amongst Member States when it comes to the project of European integration. While not stepping back from what we have achieved, we have to find better ways of dealing with these different levels of ambition so as to ensure that Europe delivers better on the expectations of all European citizens.

This is a big deal. The Brexit vote made it inevitable that smaller and less wealthy members will try to follow the UK out. The EU 6 have little choice but to drop their hard line and look for compromise.

George and I both read that statement Saturday afternoon, and we came away with the same “aha!” moment. The acknowledgement of “different levels of ambition” was a message to those less-advantaged countries, essentially saying, “Don’t go away. We can negotiate.”

But that wasn’t the end of it.

The full European Council met to discuss Brexit, with the UK’s David Cameron leaving the meeting early as the other 27 countries pondered their next moves.

Their statement reads much like the earlier one from the EU 6.

Here is the key part, again with my bold highlights.

5. The outcome of the UK referendum creates a new situation for the European Union. We are determined to remain united and work in the framework of the EU to deal with the challenges of the 21st century and find solutions in the interest of our nations and peoples. We stand ready to tackle any difficulty that may arise from the current situation.

6. The European Union is a historic achievement of peace, prosperity and security on the European continent and remains our common framework. At the same time many people express dissatisfaction with the current state of affairs, be it at the European or national level. Europeans expect us to do better when it comes to providing security, jobs and growth, as well as hope for a better future. We need to deliver on this, in a way that unites us, not least in the interest of the young.

7. This is why we are starting today a political reflection to give an impulse to further reforms, in line with our Strategic Agenda, and to the development of the EU with 27 Member States. This requires leadership of the Heads of State or Government. We will come back to this issue at an informal meeting in September in Bratislava.

Strip away the banalities and we again see the EU leaders recognizing how the game has just changed and acknowledging that they need a different approach to governance.

The conclusion of the statement is important, too. They will “come back to this issue” in September.

A battle for power

What happens between now and then? Probably, a series of informal, closed-door meetings among the members. Factions may form as they each set priorities and seek allies.

We’ll probably hear a lot of conflicting rumors in the coming weeks. However, pay very close attention to whether it is the EU Council or the EU Commission that gets to take the lead role in negotiating with Britain.

This point is already the subject of a very acrimonious debate in Europe. If the Commission (basically the Brussels bureaucracy) wins, it will want to punish Britain.

If the EU Council gets the right to be the lead negotiator, it will want to try to figure out a way to make it all work, especially trade and commerce.

The lawyers from both sides are arguing forcibly that it’s their team that should be responsible for the negotiations. This is a legal battle with real consequences.

Free Special Report: How Brexit Will Affect the UK, Europe, and the US

Britain’s vote to leave the EU sent shockwaves throughout the world, plunging markets into chaos and Europe into an existential quagmire.

BY MAULDIN ECONOMICS

Euroskeptiscism is on the rise in Europe. Countries like Poland and Hungary have actively sought to limit the EU’s influence and ignore its rules—most recently with regard to refugee policies.

Even the most Euroskeptic governments, however, campaigned against Brexit. While European nations may want to limit the EU’s role and influence at home, both economic and security interests led them to support the UK’s membership in the EU (read our free special report on Brexit implications).

This opposition to Brexit is an example of why interests—much more than ideology—matter in geopolitics.

European powers depend on exports to the UK

European nations are heavily invested in their relationship with the UK. The UK is the fourth-largest importer in the world, and the EU needs British import demand.

EU member states’ trade ties with the UK vary, but several European economies send a significant amount of their exports to Britain.

Nearly 14% of Irish exports went to the UK in 2015. 9% of the Netherlands’ exports and 7.4% of Germany’s exports also went to this nation in 2015.

With countries like Germany facing reduced global demand for their goods, European governments cannot afford to lose access to British customers.

The UK was a major contributor to the EU’s budget

12.6% of the EU’s revenues came from the UK in 2015. When less developed countries joined the EU, the older members took on a greater financial burden. They hoped that expansion would boost investment opportunities and enhance the bloc’s security in the long term.

The UK was one of only 10 net contributors to the EU budget – along with Germany, France, the Netherlands, Italy, Sweden, Austria, Denmark, Finland, and Ireland. For these wealthy European economies, a British exit means an increased financial burden.

Eastern Europe needs access to UK labor markets

British job opportunities and remittance flows are highly significant for Eastern Europe. Eastern Europe has enjoyed low unemployment rates—in large part because millions of Eastern Europeans work in other EU countries… most notably, the UK.

Over 740,000 Polish citizens and over 160,000 Lithuanian citizens resided in the UK in 2014 according to Eurostat. There are also reportedly over 500,000 Hungarians abroad, with an estimated 300,000 in the UK.

Britain and the EU are likely to reach a trade deal. Nevertheless, if this deal is bilateral, there are no guarantees that workers from Central Europe could continue working in the UK.

Brexit is more than just an economic threat to Europe

Europe’s unease is about more than economics. Some countries see Brexit as a threat to the region’s security interests. The Kremlin has been working to split the Western alliance, while the EU has been fragmenting under the weight of internal challenges and diverging interests.

Eastern European nations fear that Western Europe may abandon them. Countries like Poland know that a more divided Europe is even less likely to act rapidly and cohesively to aid allies in the east.

The UK is a highly strategic ally for European nations. Britain boasts one of Europe’s most powerful militaries, despite some downsizing and a reduction in overseas operations over the years.

Plus, The Royal Navy remains the second-largest navy in NATO, after the US Navy.

All of this confirms that Europe can’t afford a break-up with Britain. The EU and Britain, therefore, are likely to reach a trade deal and maintain close economic and military ties despite the Brexit vote.

Free Special Report: How Brexit Will Affect the UK, Europe, and the US

Britain’s vote to leave the EU sent shockwaves throughout the world, plunging markets into chaos and Europe into an existential quagmire.

BY JOHN MAULDIN

Europe was already in a shambles before the Brexit vote (read Mauldin Economics’ special report on Brexit implications). The UK’s decision may have made a bad situation more volatile. Europe, however, would still be a mess if “Remain” had won.

If Remain had won, refugees from Africa and the Middle East, many with the UK as their destination, would still be struggling across the Mediterranean or taking land routes into Eastern Europe. The EU would still be desperately trying to stem the tide and to accommodate those whom it can’t stop. 

If Remain had won, thousands of refugees would still be dying as their rickety boats capsized and sunk.

If Remain had won, Greece would still be chafing under EU-imposed austerity as its economy endures depression-like conditions. Spain and Portugal would still be wondering if they are next.

If Remain had won, Poland and Hungary would still be fighting against EU mandates that disrupt their internal affairs. 

If Remain had won, several EU governments would still be engaged in deficit spending that exceeds EU guidelines (and the EU’s inability to stop them would continue to expose its inability to enforce its decisions).

If Remain had won, the European Central Bank would still be holding interest rates below zero, buying private assets with public money and propping up insolvent banks that must fail if the Eurozone economy is to ever recover.

If Remain had won, Russia and NATO would still be facing off in the Baltic Sea, forcing already stretched governments to boost defense spending. 

If Remain had won, ISIS-sponsored or ISIS-inspired terrorists would still be plotting attacks like the ones in Paris and Brussels.

If Remain had won, border checks would still be in force within the supposedly free-travel Schengen zone countries, making one of the EU’s greatest achievements into a mockery.

If Remain had won, sizable minorities or even majorities in other European countries would still be agitating for their own exit opportunities. Catalonia would still be trying to separate from Spain. The Lega Norde in Italy would still be agitating for Northern Italy to secede. The Walloons and the Flemish would still want to sunder their ties with Belgium. Marine Le Pen would still be gaining strength in France.

If Remain had won, the Supreme Court of Austria’s ruling that an extremely close presidential vote must be taken again would still stand, opening up the possibility that a far-right-wing party might take control of a major European country.

If Remain had won, the frustration over immigration and immigrants would still be growing. Nationalism, as opposed to loyalty to the European Union, is a rising tide that shows no sign of receding.

If Remain had won, Italian banks would still be down some €400 billion, an enormous proportion of Italy’s GDP. German banks would still be teetering. I’ve written about both before. What I haven’t mentioned is how desperate the situation is becoming for European insurance companies, which are even larger than the banks. Arguably, many are in worse shape in a negative-rate regime.

If Remain had won, the growing criticism of the ECB would still be growing, and negative rates would still be distorting European financial markets.

I could go on, but you get the point.

Europe already faced a whole host of serious problems before the Brexit vote. It has done perilously little to resolve them and could make some of them worse.

Now let’s take a deeper dive into the two most dangerous developments in post-Brexit Europe: the Italian banking crisis and the rise of Marine Le Pen in France.

The Italian banking crisis

Italian banks have a big problem: something like €400 billion in nonperforming loans. Imagine a much larger version of Greece (in terms of total government debt and banking problems) only a few years ago, and that’s Italy.

The Italians have successfully extended and pretended for years, but working that magic gets harder every day. With the banks, government debt, the refugee crisis, and now Brexit, Italian Prime Minister Matteo Renzi has his hands full.

Italian GDP is around $2 trillion. At today’s exchange rate, Italy’s nonperforming bank loans total roughly 25% of GDP. Compare Italy to the US, where nonperforming loans amount to only 1.2% of GDP, or $128 billion. If nonperforming loans in the US were 25% of US GDP, they would amount to an astronomical $4.5 trillion.

Italy is one good global recession away from a major crisis. But now that the ECB has decided that it can use the funding mechanisms created in the last crisis, it will be able to print the money, piling the resulting debt on the back of all of Europe. Then, of course, there will be Spain or Portugal or whichever domino falls next.

That brings us to one of the most dangerous parts of Europe: France.

The French gambit

Socialist President François Hollande has not yet said whether he will stand for re-election (he wouldn’t even make it into the runoff), but we know Marine Le Pen of the National Front is running.

She has a fair shot at winning, too. If she does, a National Front victory would be a thunderbolt at least as serious as Brexit.

Le Pen congratulated the Brexit voters in a New York Times op-ed last week, at the end of which she summarized her own manifesto. I’ll quote her at length because what she says is so important. In particular, pay attention to what she says about Merkel and Germany.

Brexit may not have been the first cry of hope, but it may be the people’s first real victory. The British have presented the union with a dilemma it will have a hard time getting out of. Either it allows Britain to sail away quietly and thus runs the risk of setting a precedent: The political and economic success of a country that left the European Union would be clear evidence of the union’s noxiousness.

Or, like a sore loser, the union makes the British pay for their departure by every means possible and thus exposes the tyrannical nature of its power. Common sense points toward the former option. I have a feeling Brussels will choose the latter.

One thing is certain: Britain’s departure from the European Union will not make the union more democratic. The hierarchical structure of its supranational institutions will want to reinforce itself: Like all dying ideologies, the union knows only how to forge blindly ahead. The roles are already cast — Germany will lead the way, and France will obligingly tag along.

Here is a sign: President François Hollande of France, Prime Minister Matteo Renzi of Italy and acting Prime Minister Mariano Rajoy of Spain take their lead directly from Chancellor Angela Merkel of Germany, without running through Brussels. A quip attributed to Henry Kissinger, “Who do I call if I want to call Europe?” now has a clear answer: Call Berlin.

So the people of Europe have but one alternative left: to remain bound hand-and-foot to a union that betrays national interests and popular sovereignty and that throws our countries wide open to massive immigration and arrogant finance, or to reclaim their freedom by voting.

Calls for referendums are ringing throughout the Continent. I myself have suggested to Mr. Hollande that one such public consultation be held in France. He did not fail to turn me down. More and more, the destiny of the European Union resembles the destiny of the Soviet Union, which died from its own contradictions.

The People’s Spring is now inevitable! The only question left to ask is whether Europe is ready to rid itself of its illusions, or if the return to reason will come with suffering. I made my decision a long time ago: I chose France. I chose sovereign nations. I chose freedom.

That does not sound like someone who is going to be all that compromising with Brussels and the EU. There is the real possibility that Sarkozy will be in the runoff with Le Pen, and like Bernie Sanders moved Hillary Clinton to the left, Le Pen will force Sarkozy’s politics even further to the right.

Big changes might be around the corner

I have readers in every country in Europe; it’s not my place to take a side here. As an outside observer, I see a level of frustration and antagonism that is reflected in the US and certainly is evident in England.

Unless this frustration is addressed, it will not help the post-Brexit EU rebuild itself into an alliance that can handle Europe’s many challenges more effectively.

We should not underestimate the EU’s ability to postpone the inevitable. They’ve done it far longer than I thought possible seven years ago. Maybe they will again paper over the unpleasant disagreements and buy a few more years.

Yet I think hanging on is getting harder for them. We may, in fact, be near the big turn.

Free Special Report: How Brexit Will Affect the UK, Europe, and the US

Britain’s vote to leave the EU sent shockwaves throughout the world, plunging markets into chaos and Europe into an existential quagmire.

George Friedman is an old friend of mine and one of the top editors at Mauldin Economics. Here’s a great read from him that I recommend for everyone interested in Brexit.

BY GEORGE FRIEDMAN

The British voted to leave the European Union. Even at only 52%, Brexit couldn’t have been imagined 10 years ago.

This fragmentation has been evident throughout Europe (read more in my free special report on Brexit), but it’s the first case of a nation actually deciding to leave. I doubt that it’s the last.

Now we should try to understand why the majority of Brits favored an exit from the EU and learn lessons. There are three main factors that led to this outpouring of votes to leave.

Economics

The first was simple.

Opponents of the EU argued that it is a dysfunctional economic entity. The EU failed to address the economic problems that had been developing since 2008… for example, 20% unemployment in southern Europe.

The difference between the lives of southern Europeans and Germans—who enjoy 4.2% unemployment—is profound. Europe as a whole has stagnated economically.

The argument for remaining in the EU was that the alternative was economic disaster. However, staying in a stagnated organization to solve British problems seemed shortsighted and made little sense to opponents.

They believed that remaining in the European Union would make Britain follow Europe’s lead.

Obviously, they didn’t think that Europe would throw up trade barriers against Britain. The UK is Germany’s third most important export target. The last thing Germany wants is a trade war with Britain.

Similarly, the threat that London’s banks would decamp for Frankfurt is logistically implausible. Clients from around the world enjoy visiting London, and in finance, it’s the clients that matter.

The European Union didn’t create the existing financial relationships. Britain’s financial role goes back almost two centuries. The EU is a system that aligns with financial reality. It does not create it.

If London’s banks were to move to Frankfurt, New York would become a unique magnet. In the end, the Europeans need a financial center in London. They will not lock it out.

Sovereignty

The second reason for Brexit is the rise of nationalism across the world.

There’s a growing distrust of multinational financial, trade, and defense organizations created after World War II. The EU, the IMF, and NATO are good examples of this.

Many who oppose the EU believe these institutions no longer serve a purpose. Not only that, these organizations take control away from individual nations. Mistrust and fear of losing control made Brexit a reasonable solution to them.

But for the supporters of the EU, such organizations are self-evidently valuable. They may need to be tweaked but not abandoned.

The immigration crisis in Europe was a trigger. Some EU leaders argued that aiding the refugees was a moral obligation. But EU opponents saw immigration as a national issue, as it affected the internal life of the country. Steering clear of this issue was an important driver for the “leave” vote.

The EU doesn’t understand the power of nationalism. It attempts to retain nationality as a cultural right. On the other hand, it deprives individual nations of the power to make many decisions.

This may have worked before 2008, but it has become increasingly difficult to accept.

Political Elitism

Finally, the political leadership of Britain faced a profound loss. The “leave” voters rejected both the Conservative and Labour parties. Both parties had endorsed remaining with the EU and saw many of their members go into opposition on the issue.

Ultimately, it was a three-way struggle. Two established parties wanted to remain in the EU, and a third faction, drawn from both parties, opposed it. People in this third group saw both of the establishment parties as hostile to their interests.

This should be considered in the broader sense.

The possibility of Brexit frightened financial markets. They said so loudly. What they did not grasp was the degree to which they had lost legitimacy in 2008.

Most “leave” supporters believed that the financial industry’s recklessness and incompetence had created a disaster for many. Besides, they saw no benefit to themselves in the success of the financial industry… even though it wasn’t true.

It’s vital to understand that Brexit was a vote against the British elite. Voters thought politicians, business leaders, and intellectuals had lost their right to control the system.

Voters thought the elite had contempt for their values—for their nationalism and interests.

This is not a new phenomenon in Europe. This is not a British phenomenon, either. It is something that is sweeping Europe and China. And with the rise of Donald Trump, it’s also present in the United States.

Trump’s entire strategy is to attack both the Democratic and Republican leadership… and the elite who have contempt for the nationalism and moral principles of those beneath them.

It’s a shift in politics that the West is undergoing. Now, it’s in London.

Free Special Report: How Brexit Will Affect the UK, Europe, and the US

Britain’s vote to leave the EU sent shockwaves throughout the world, plunging markets into chaos and Europe into an existential quagmire.

Patrick Watson is an old friend of mine and one of the top editors at Mauldin Economics. Here’s a great read from him that I recommend for everyone interested in the EU. 

BY PATRICK WATSON

The Mother of Parliaments just got an earful from the public it ostensibly serves. The UK’s Brexit referendum passed easily.

Now, someone has to make it happen.

It won’t be Prime Minister David Cameron. Having led the losing side, he sensibly—and honorably, I must add—said he would resign.

Strictly speaking, the referendum was only advisory. But, the government can’t ignore it. The rest of Europe certainly isn’t. Brussels EU bureaucrats instantly snarled in derision, demanding the UK move quickly.

Then something unexpected happened.

EU foreign ministers backpedal

Foreign ministers from the six original European Union members (Belgium, France, Germany, Italy, Luxembourg, and the Netherlands) issued a joint statement in response, complete with a weekend photo opportunity. They obviously wanted to make a point. What was it?

You can read it yourself. Here’s the key phrase: “We shall also recognize different levels of ambition amongst Member States when it comes to the project of European integration.”

This is new. The EU’s party line had been that everyone sought an “ever-closer union.” But there’s more.

“We are aware that discontent with the functioning of the EU as it is today is manifest in parts of our societies… We have to focus our common efforts on those challenges which can only be addressed by common European answers, while leaving other tasks to national or regional levels.”

If this were a poker game, that statement would mean “I fold.”

Enforcing “common European answers” is the EU’s main purpose. Now its six original members are giving that up. Why? Because UK voters said no, that’s why.

Europe still needs the UK

The leading EU powers know the Brexit vote emboldens other restive members. Their only hope is to change from an “ever-closer” union to a “call us when you need us” union.

Core EU nations have their own challenges, too.

Germany must have free trade with the UK. Italy’s banks are teetering and could collapse (read more about Germany’s invisible crisis in Mauldin Economics’ free report). France is… well, it’s France.

No matter what they say, the reality is these nations can’t afford to rudely dismiss the UK from their club. The British side has the upper hand.

We’ll see a lot of strutting and posturing in the coming months as everyone jockeys for position in the new order. But make no mistake: a new order is coming. What will it look like?

Tough times ahead

Many envision a stripped-down European free trade area whose member nations govern their own internal affairs.

I’m not sure that plan is feasible.

Free trade, as it’s now defined, is more than just the absence of tariffs. It has come to mean uniformity on patents, copyrights, occupational licensing, immigration, environmental laws, and all manner of other public policies. That’s why TPP and other recent trade deals are so complex.

I don’t see any way to construct a European “free trade” zone that doesn’t also leave the EU meddling in local affairs.

It’s a sticky wicket, as the Brits like to say.

Sorting this out will take years. Meanwhile, the global economy is getting no better and could get worse. Financial markets hate the lingering uncertainty.

We were entering a rough road even before Brexit obliterated the pavement. Now the only choice is to slow way down.

Free Special Report: How Brexit Will Affect the UK, Europe, and the US

Britain’s vote to leave the EU sent shockwaves throughout the world, plunging markets into chaos and Europe into an existential quagmire.

George Friedman is an old friend of mine and one of the top editors at Mauldin Economics. Here’s a great read from him that I recommend for everyone interested in Brexit. 

BY GEORGE FRIEDMAN

The vote has come and gone. A major European nation has chosen to leave the EU. The markets have had their obligatory decline. A few weeks have passed. It is time to think about what exactly has happened… and what it means, if anything.

The EU’s economy has been in wretched condition since 2008. It has been unable fix dire unemployment in southern Europe or revive the stagnant economy.

The EU’s founding treaty promised prosperity. It has failed. Germany has the healthiest economy in Europe, but even it struggles to grow.

The case for staying in the EU was that leaving would ruin the British economy. This assumed, of course, that staying in a broken union would help the economy. That logic escaped me.

It is hard to see any economic benefits that would be lost (read my free special report on Brexit implications).

The EU, not Britain, is the weaker player

The UK is Germany’s third-largest export market. It is the fifth-largest for France and Italy. It is absurd to think these countries would stop selling to Britain or put tariffs on British exports. The British would respond in kind, and Europe cannot afford a trade war even if it feels insulted.

The EU did not create the existing trade patterns. They were already in place. The EU’s members will not allow Brussels to disrupt them. Nor did the EU create the patterns of investment. Britain’s banks channel global capital and are a huge source of investment for the Continent.

The EU is hardly going to hamper that flow by blocking investments.

The notion that regulations could force EU banks to relocate jobs and resources to Frankfurt misses a number of points, too. Given Europe’s weakness, the burden is on the EU to show continuity. It needs the flow of capital.

Further, it’s the clients who determine the world’s banking hubs. London has been a traditional banking center preferred by foreign clients. New York—not Frankfurt—is the alternative to London. If clients had wanted to bank in Frankfurt, they would have already done so.

Obviously, nothing will happen in the immediate future. But it’s not clear to me that there will be any real economic blowback. The UK is not Greece. Attempting to shun the British carries heavy potential consequences. Anything imposed on the British will resonate on the Continent.

And Germany—which gets almost 50% of its GDP from exports (read our special report on Germany’s invisible crisis)—is not likely to let anyone hinder that trade.

The economic impact of the UK leaving the EU is minimal because the EU—not Britain—is the weak player. The EU is fighting with Poland over political changes… has criticized Hungary on human rights… is still engaged in the Greece disaster… has an emerging Italian banking crisis.

Additionally, Finland is in grave economic trouble, and anti-EU parties are gaining strength in several member states.

The EU has so many internal issues they are hard to count. Its retaliation is the last thing Britain should fear.

A vote against the elite

As troubling as Europe’s economy is, it was not the prime mover in the referendum. The contentious immigration debate holds that honor.

And immigration itself was not really the issue. The EU dictating the rules was the problem.

Britain was quite comfortable with immigrants until Brussels began making demands. It was a question of sovereignty. The idea that the EU could make decisions that would change the character of Britain was not okay.

Granted, there was a large vote for staying. The British media have been eager to point out that those who voted to leave were less educated, had lower incomes, and so on. They were also most likely to be affected by immigration.

Immigration is socially destabilizing. There is always friction between older residents and immigrants. I immigrated to the US as a small child. The buffeting of that experience on both sides is burned into my memory.

But, better educated and wealthier individuals normally don’t experience this element of immigration. The tension on the streets rarely enters the halls of academia, senior civil service, or banking.

Not surprisingly, the question of sovereignty wasn’t critical to this class.

The immigrant issue created a sense of powerlessness. First, Britain was not in control of its immigration policy. Second, the British who were for it, to a large extent, did not feel the profound social costs of immigration.

That fee was going to be paid by those who—again with many exceptions—voted for leaving. So it was a revolt against the British establishment and the EU.

As with most things, it was much more complex than it seemed.

A gloomy picture of Europe’s future

The EU has already responded. This statement from the foreign ministers of Belgium, France, Germany, Italy, Luxembourg, and the Netherlands, defines the future:

We will continue in our efforts to work for a stronger and more cohesive European Union of 27 based on common values and the rule of law. It is to that end that we shall also recognize different levels of ambition amongst Member States when it comes to the project of European integration. While not stepping back from what we have achieved, we have to find better ways of dealing with these different levels of ambition so as to ensure that Europe delivers better on the expectation of all European states…. However, we are aware that discontent with the functioning of the EU as it is today is manifest in parts of societies. We take this very seriously and are determined to make the EU work better for all our citizens.

This was the EU’s answer to Brexit. They recognized that not everyone wants the same level of integration and will respect that. They are aware that many are discontent with the EU.

In other words, after the British vote, they acknowledged the obvious. This is a unique evolution. It is not clear what they are going to do, but they are not going to punish Britain. They can’t afford to.

At the same time, there is a bit of humor in the statement. The EU has 27 member states, and apparently, only six foreign ministers met and drafted this response. Poland wasn’t there. Neither was Spain. Nor were the other 19 members.

The new “inclusionary” EU has met and promised to do something. We’ll see if anything actually happens.

Free Special Report: How Brexit Will Affect the UK, Europe, and the US

Britain’s vote to leave the EU sent shockwaves throughout the world, plunging markets into chaos and Europe into an existential quagmire.