Views From the Floor

In this week’s edition - We question the solvency of Italian banks; and is a free-floating yuan on the horizon?

Questioning the Solvency of Italian Banks

Italian banks’ balance sheets will come under sustained scrutiny as the Italian government submits its budget to the European Commission later this month.

Italian banks hold roughly €350 billion of BTPs on their balance sheets, alongside €130 billion of net non-performing loans, according to BCA Research. In comparison, the banks’ equity capital stands at €160 billion.

Fears of a clash between the Italian populist government and the European Commission have driven up bond yields, which stood at 3.5% as of about 9:30 a.m. (London time) on October 8, 2018. If bond yields rise and stay above 4%, this would reduce the value of the BTPs by a tenth from its recent peak, BCA calculates. Since the difference between the equity and the non-performing loans is only €30 billion, this big a decline could be enough to wipe out the actual equity cushion of the entire Italian banking sector. While a 50 basis-point jump in yields seems unlikely for this budget, any decrease in the value of BTPs could have a profound effect on the solvency of Italian banks.

Figure 1. Spotlight on Italian Banks

Source: BCA Research, as of 02.10.2018

A Free-Floating Yuan?

The People’s Bank of China (PBOC) has historically been active in the currency markets. By 2015, the activity focused on supporting the value of the yuan against the US dollar and preventing capital outflows.

However, the bank has become less interventionist over the last few years on one measure. This is illustrated by Figure 2, which charts the relative volatility of yuan versus a basket of other currencies. More intervention would imply less volatility. Thus, the black line is a proxy for PBOC intervention. When it is above zero, the yuan is less volatile. Since January 2016, the volatility proxy for the Chinese yuan has been trending steadily lower.

The reduced levels of intervention mirror China’s move from having a current account surplus to a deficit. We think the PBOC could let the yuan depreciate to counter this structural change. While we do not expect any formal announcement of a free-floating yuan, the increasing deficit could provide an incentive for PBOC to increase the yuan’s freedom over time.

Figure 2. Relative Volatility of Yuan Versus Other Currencies

Source: Rhodium Group, as of 28.09.2018

Figure 3. Current Account Balance, as % of GDP

Source: OECD, as of Q1 2018

US Midterms – Impeachment and Infrastructure

As the US midterms draw near, expectations remain mixed.

If Republicans hold the House, we believe they could push forward with President Donald Trump’s proposed infrastructure plan. Investors should be cautious of expecting this to contribute too much to economic growth in our view. As Figure 4 shows, the US seasonally adjusted unemployment rate is close to its historic low. Finding enough workers to actually carry out the infrastructure work could be difficult at this stage in the cycle, muting any expected jump.

If Democrats win the House, it is possible that impeachment proceedings could begin against Trump, even though they will almost certainly fail to gain the two-thirds vote supermajority required to pass the Senate. Previous impeachments of Richard Nixon and Bill Clinton give us very few clues as to how markets might react. With Nixon, US markets were already crashing thanks to the 1973 oil crisis, while with Clinton, US markets were on the rise after the bailout of Long Term Capital Management.

Figure 4. US Seasonally Adjusted Unemployment Rate

As of Q2 2018

Figure 5. S&P 500 Index During Nixon Impeachment

Between December 1971 and December 1975

Figure 6. S&P 500 Index During Clinton Impeachment

Between December 1996 and December 1999

Why your Daily Cup of Coffee May Be More Expensive (Soybeans too!)

Far-right candidate Jair Bolsonaro has won the first round of Brazil's presidential election, with about 46% of votes at the time of writing. If no candidate wins a majority of valid votes – which seems the most likely outcome – there will be a runoff on October 28. With a relatively clear victory path, the Brazilian real has rallied, up 10% against the US dollar since September 131.

The rally in the real is having similar moves in the prices of coffee and soybeans. Brazil is the world’s largest producer and exporter of coffee, which has seen prices increase by 20% since September 18 1. The Latin American country is also the world’s second-biggest producer of soybeans, which has seen prices jump by 6% since September 171.

Figure 7. Brazilian Real Starts to Rally Against US Dollar

As of 08.10.2018

Figure 8. Coffee, Soybeans Prices Have Been Increasing Over the Past Month

As of 08.10.2018

With contribution from: Matthew Sargaison (Man AHL, Co-CEO), Pierre-Henri Flamand (Man GLG, CIO), Teun Draaisma (Man Solutions, Portfolio Manager), Peter van Dooijewert (Man Solutions, Institutional Hedging) and Edward Cole (Man GLG, Portfolio Manager).