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Europe Navigates Brexit Storm - for Now

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Europe Navigates Brexit Storm - for Now

(Editor's note: S&P Global Ratings' Credit Conditions Committees meet quarterly to review macroeconomic conditions in each of four regions (Asia-Pacific, Latin America, North America, and Europe, the Middle East and Africa). Discussions center on identifying credit risks and their potential ratings impact in various sectors, as well as borrowing and lending trends for businesses and consumers. This article reflects the view developed during the EMEA Credit Conditions Committee discussion on Sept. 27, 2016.)

The dark shadows cast by the U.K.'s referendum vote to exit the European Union in June--including fears of global market volatility and capital flight to safe havens--may not be as gloomy as initially thought. Available data for the intervening months point to a remarkable resilience of economic activity in the vote's aftermath, aided by the speedy formation of a new government, postponement of the formal EU exit procedure, and the Bank of England's vigorous monetary policy response. Still, the U.K.'s economic pulse was already weakening before the vote, and we think GDP growth will be around a mere 1% in both 2017 and 2018.

Brexit may have had a muted reaction so far, but it might have energized broader, populist trends already pulsating through Europe. Citizens of other EU member nations have expressed interest in holding referendums of their own to exit the group. Separately, Italy is holding a referendum in December, which although unrelated to EU membership, could lead to heightened political uncertainty and invigorate even more anti-European parties. The refugee influx spawned new political parties in Germany, upending its traditional party system. And populist parties in France, while not likely to gain the presidency next year, are polarizing the political landscape and the electorate.

Political uncertainty is also blowing from across the Atlantic, as a contentious U.S. presidential election could potentially alter trade treaties throughout Europe, the Middle East, and Africa (EMEA).

More broadly, geopolitical risks remain a top concern. While terrorist attacks similar to the ones in Brussels and Nice have not had a large or lasting effect on consumer and business confidence, we are mindful that more frequent and random terrorist activity could lead to a longer and deeper slide in business and consumer confidence.


  • Credit conditions have so far been less adversely affected by the Brexit referendum in the U.K. than we initially expected.
  • We nevertheless still consider that uncertainty over Britain's exit process from the EU will hamper growth in the U.K. and other European economies over the next few years.
  • We project a protracted period of feeble growth in Europe, with the prospect of zero/negative interest rates for years to come, slower international trade growth, and a lack of political solutions.
  • A handful of Western European banks are vulnerable to adverse scenarios, owing to high problematic assets, risk of litigation charges, and the need to restore profitability and complete restructuring plans.
  • For insurers, the low interest rate environment is the No. 1 risk to their capital and earnings.
  • While corporates are showing resilience to exogenous risks, our slight negative outlook bias reflects the downside risks in certain industries.

Credit conditions in EMEA, in general, continue on a path of mild improvement, but the continuing aggressive accommodative monetary policy by central banks masks the structural issues of most European countries' economies that still linger. While we don't believe Europe will sink into deflation-tinged lost decades like Japan, we do see a protracted period of feeble real economic growth, to which it is becoming increasingly more difficult to see an end. A number of factors contribute to this belief. They include zero or negative rates for years to come, high unemployment, an inability to aggressively mobilize fiscal policy, and lack of political ability to find solutions. Moreover, banks in a few countries (namely on the periphery) are still saddled with a raft of nonperforming loans, which is slowing credit expansion. The dependence of the European real economy to the banking system is even higher than in U.S., where a mature capital market plays a big role in financial intermediation. Therefore, efforts to restructure the banking system (for example, by reducing the high stocks of nonperforming loans, strengthening capital ratios, and further consolidation and downsizing) is more critical, but, at the same time, more unpopular.

On top of this, reminders of the global financial crisis struck in recent weeks when Deutsche Bank's stock tumbled 7.5% in a single day amid concerns over news in regard to the $14 billion to be settled with the U.S. Justice Department over a residential mortgage-backed securities (RMBS) investigation.

Overall, low profitability of the whole banking sector and more stringent regulations are casting doubts on the future of European banks' current business model.

In addition, the eurozone's overall indebtedness hasn't substantially diminished since the financial crisis, and is made more onerous by a continued low interest rate environment.

Finally, growth in international trade keeps on disappointing and doesn't seem to have a bright future either as more protectionism finds its way into the political debate in most of the developed world. This is bad news especially for export-driven Europe and emerging markets.

The Eurozone Is Weak But Is Not Another Japan

"To become like Japan" is a recurring expression in the marketplace when discussing whether the eurozone is experiencing the same problems as Japan since the 1990s. Although there are some similarities between the eurozone woes and the Japanese experience of the past two decades, the differences are important too, and we will just mention the main ones.

Japan essentially entered into outright deflation in the 1990s and stayed there after an unprecedented asset price bubble burst bringing in strong deflationary forces that the government failed to counter. The European Central Bank (ECB), on the other hand, is fiercely battling low inflation and, although still far from its 2% target, outright deflation isn't on the cards.

Japan has been experiencing such a sharp diminution of growth that the current nominal GDP is still 4% below its 1997 peak. The eurozone instead has already surpassed its pre-crisis peak of 2008 in terms of real growth, except for a few countries, notably Italy and Greece.

Both Japan and the eurozone suffer from aging demographics, but the eurozone can at least rely on a migration influx, which may be painful in the short term but helpful to demographics in the long run. Japan doesn't have a considerable immigration influx.

Japan didn't have a sustained policy to tackle the issues in its banking system. It played forbearance for quite some time, hoping banks would grow out of their problems. On the other hand, although there hasn't been the same clean-up as in the U.S., the eurozone banking system is in a better condition as balance sheets have strengthened substantially in recent years. The latest bank stress tests indicate that most banks would have sufficient capital to withstand an adverse scenario. And some of the countries most impacted by the downturn, such as Spain and Ireland, are making good progress in reducing the stock of nonperforming loans.

Nevertheless, the eurozone is still very fragile and its growth prospects are weak. Unemployment is still too high and real GDP is just a percentage point above its pre-crisis peak. There is a lack of political ability to find a solution by aggressively mobilizing fiscal policy or tackling labor reforms. This leaves the ECB to insist on doing whatever it takes to stimulate the economy. Hence, a low or negative interest rate environment is here to stay for a long time, and a major external shock, like a China hard landing or a sharp reduction in international trade, could topple the eurozone into deflation, in which case the Japanese experience might start looking a bit more familiar.

Impact Of The U.S. Election: Too Early To Tell

As indicated by many market commentators, for this election in particular, discerning what the U.S. economy and political landscape is going to look like after Nov. 8 is very challenging. Both candidates' policies are still rather vague. The gap between the rhetoric and what the next president will really try to implement and achieve is quite large. The Obama Administration's eight years have shown how the composition of the congress really defines what a presidency can achieve.

Nevertheless, trade, immigration, infrastructure spending, and taxation are the main areas we will look into carefully as the new presidency gets to work. In our opinion, policies on trade will be by far the biggest driver of credit conditions for the U.S. and the entire world economy since both candidates, although with different intensity, seem to favor more protectionism and less globalization.

Risks And Imbalances

We are maintaining the impact of Brexit as a high risk (see table 1). Although the negative market reaction to the vote was initially strong, it has now subdued. However, the uncertainty surrounding the exit process, which will start in March 2017, has not abated and we still believe that it will hamper both the U.K. and the EU economies in the next few years.

The low/negative interest rate environment is here to stay for much longer. Hence, we are increasing its risk classification to "elevated" with an "increasing" trend. Low interest rates might alleviate borrowing costs, but do not seem to be spurring lending and real growth in a decisive way. They affect profitability of banks and insurers negatively, increase the burden of pension liabilities, and force a yield search that can lead to asset bubbles creation.