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Trading  | December 25, 2017

Yesterday we published the first set of 7 “What If” scenarios that didn’t make it into the Citi Credit team’s (already rather gloomy) year-ahead forecast. Because while Citi’s “base case” was clearly bearish (our summary can be found here), what was left unsaid was even more unsettling, if not troubling. As the bank’s credit team wrote “what about the outcomes that didn’t quite make it into our base case? The scenarios that aren’t central, but which aren’t entirely implausible either – both bullish and bearish.” Citi then listed the following 7 scenarios in the first part of its quasi-forecast:

  • idiosyncratic risk is returning to credit?
  • European corporates get more aggressive?
  • global growth & commodity prices disappoint?
  • inflation accelerates as output gaps close?
  • the US yield curve inverts?
  • central bank tapering really is a non-event?
  • the market doesn’t like the choice of ECB successor?”

A full discussion of the above scenarios was posted yesterday.

Today, we follow up with part 2, or the second set of 7 hypothetical questions for 2018, which shifts away from economics and finance, and focuses on politics and Europe. As Citi’s credit team writes “you tend to worry less about your leaky roof when the sun is shining. And at the moment the cyclical economic upturn is beaming across Europe. Yet there are clouds which might conceivably hold moisture – or as our economists have put it: political risk is not dead in Europe.”

So to avoid a leaky roof turning into a flood, Citi once again set out some of the economic and fundamental scenarios for 2018 that aren’t in the bank’s base case, but which remain reasonably plausible nonetheless; specifically Citi looks at the list of “potential political dark horses for next year.” These include the following “what ifs”:

  • … the market falls out of “amore” with BTPs?
  • … Catalonia declares independence (and means it)?
  • … meaningful EU reforms actually happen?
  • … the UK leaves the EU without a deal?
  • … Brexit is called off?
  • … Corbyn becomes PM?
  • … US tax reform fails?

While Citi concedes that there are many others it could have included, like Middle-East tensions, North Korea tensions, global trade relations, US mid-term elections, escalation in the South China Sea or relations between Russia and the West, these will have to wait for another time. Until then, here is a breakdown of the political “What Ifs” that would keep Citi at night if they were allowed to be part of the bank’s official base case.

1. the market falls out of “amore” with BTPs?

Markets seem largely to have grown comfortable with the idea of an unusually large number of different political constellations that are feasible after the next Italian general election. Legally, they must take place by May, but national newspapers have reported that a deal has been made to hold them on March 4.

Our economists see a centre-right victory as marginally the most likely outcome, but longer-term, big question marks remain over which individual party will dominate within the bloc and the true depth of ostensible EU-scepticism. A grand coalition over the middle also remains a possibility, albeit a fading one. Either would probably be seen as somewhat positive by markets in the immediate aftermath. However, with the M5S still gaining in many polls at the expense of a struggling PD, their involvement in a future coalition of the left remains a reasonable probability. Although M5S has certainly shifted its stance on the EU significantly, with its candidate for PM declaring he wants to stay in the EU and toning down his party’s opposition to the euro, other of their desired reforms would likely be seen as negative by the market. A less likely coalition between M5S and a party on the right, like Lega Nord, could potentially be more confrontational and even less marketfriendly.

While the moderation in stances and the cyclical upturn in Italy have diminished the probability of more extreme outcomes, demand for BTPs could still prove fickle amid the uncertainty and a reduction in ECB purchases.

Indeed, you could argue that private investors fell out of love with BTPs quite some time ago. As illustrated in Figure 1, just about every other major investor type has become a net seller (to the ECB) or a non-buyer of BTPs over the last couple of years. To change that behaviour, we think it remains pretty likely that there will need to be an adjustment in prices. As our rates strategists have pointed out, the ECB could counteract this through an “Italian Operation Twist” (lengthening the maturity of their BTP holdings), but such a response might not come immediately, given the ECB’s reluctance to favour individual countries, unless associated with the conditionality that comes with an economic adjustment programme.

To our minds, this remains one of the most significant political risks to € credit in 2018. Most likely the spillover on credit would be concentrated on Italian and other periphery names, banks in particular. The scenario of a full-on funding crisis is a much lower probability in our view, but would obviously have more systemic implications across the € credit market.

* * *

2. Catalonia declares independence (and means it)?

Then there is the question of Catalonia. Opinion polls suggest that the separatist and non-separatist camps are neck and neck. How the marginal mandates fall will have a very important bearing on what happens next. The scenario where nonindependence parties secure a majority would probably put the whole question on the backburner for the time being, even if they fail to form a formal coalition. Yet with risk premia already so suppressed we doubt that the reaction in the broader market would be discernible – it would not change our central scenario at all.

However, most polls still suggest a narrow majority of seats will go to the three independence parties. In recent statements, two of the three have moved away from a formal deadline for independence, and indicated more openness towards alternative solutions to independence, implying a moderation in their stance. As such, even if they secure a small majority of seats, there is a good chance a repeat of the standoff from October with the central government can be avoided.

Risks arise in the scenario where the more radical separatist parties do materially better than the polls suggest. In particular, if the independence parties were to achieve more than 50% of the overall vote (as opposed to a mere majority of seats). We think the probability has receded greatly in recent weeks, but in an outcome where tension with the government in Madrid escalates again and major protests break out in the region, a more assertive unilateral declaration of independence remains conceivable.

Although actual independence from Spain even in the long term would remain unlikely even under such a scenario, we’d expect a rise in Spanish risk premia especially on those companies with direct exposure to the region. We note that the main banks have already shifted legal domicile to ensure access to ECB liquidity. In all but the most extreme situations we would expect the broader reaction across € credit to remain muted, as it was in October.

We would assign no more than a 10-15% probability to such an outcome and for impact on the wider € IG market you have to move significantly further out on the tail.

* * *

3. Meaningful EU reforms actually happen?

Optimism about major EU reforms following Macron’s election were dealt a significant blow by German voters in September. Yet there seems to be widespread recognition among policymakers that Europe runs a high risk of another sovereign crisis whenever the ongoing cyclical upturn ends, unless the framework is reformed. Banking union remains incomplete, capital markets union remains an ongoing project and with limited scope for a major increase in the EU’s budget, a strengthened lender-of-last-resort mechanism for sovereigns, like the European Monetary Fund proposed by the Commission, would potentially increase resilience considerably.

The differing objectives in European capitals likely either imply protracted negotiations or watered-down compromises that fail to provide markets with much reassurance. Even beyond resources devoted to Brexit negotiations, tensions with several Eastern European member states (though outside the Euro area) also act as a distraction. Poland’s prime minister has stated that he expects the Commission to propose an article 7.1 determination as early as next week. Article 7 is intended to safeguard the values of the EU, which may ultimately result in a member state having voting rights suspended. 7.1 is a warning stage in that process.

As such, major reforms are not in our base case for next year, but are not  inconceivable either. We would argue that sovereign risk premia in European credit are minimal at the moment, limiting the upside from such a scenario to a handful of basis points. Evidently, a strengthened framework ought to have the biggest impact on periphery credit, especially those whose fortunes are tied to their sovereigns, most obviously the banks.

4. the UK leaves the EU without a deal?

In a strictly legal sense, it’s difficult for a “no deal” scenario to materialise next year. According to Article 50 TEU, the EU treaties only cease to apply either when a withdrawal agreement comes into effect or after two years have passed since activation, i.e. March 2019. In practice, though, even with the first phase of negotiations now agreed, the chasm between what many in the UK believe can be achieved on trade in a short space of time and what the EU seems likely to offer means that a complete breakdown of negotiations is a real possibility.

And realistically, to allow for ratification across member states a final deal will need to be reached before the end of 2018. The fact that the trade agreement with Canada was nearly prevented by opposition in Wallonia, while the EU-Ukrainian trade deal was delayed by a Dutch referendum, illustrates that ratification is by no means guaranteed. Article 50 does, of course, leave scope for an extension should more time be needed, but this too, requires unanimity of the EU27 (and the UK) in the Council – and as such may not be completely straightforward.

So if negotiations do break down to the extent that “no deal” becomes central scenario, that should be reflected in spreads already next year.

From a trade perspective, the particular weak spot would be those sectors of the UK economy with a high EU trade intensity while not being covered by WTO goods trade rules, like tech and transport. More than tariffs, we suspect the chief impact would come through increased friction, in the form of additional paperwork and lack of mutual recognition of standards.

The sector that is most obviously exposed is the heavily regulated world of financial services. Admittedly, all banks passed the rather strict “hard Brexit” stress test conducted by the Bank of England, but spreads on those UK banks and insurers that depend on Europe for a significant proportion of their revenues should still react to the considerable uncertainty associated with a “no deal” scenario,  if it becomes central late in 2019.

The broader impact of “no-deal” on domestic UK sentiment also needs to be considered. It would evidently depend on the policy stance adopted by the UK government. But given both the limited fiscal space it is already confronted with, together with the balance of Brexiteer opinion favouring a more protectionist “drawbridge” Brexit as opposed to the “Singapore-on-Thames” that some aspire to, the economic consequences for the UK would likely be severe and rapidly felt. Though some of the negative impact of a “no deal” would likely be offset by a weakening currency, we doubt that would suffice to counteract the otherwise deeply market-unfriendly implications.

A trajectory towards a no-deal Brexit probably has only limited implications for broader credit spreads, but it should still leave spreads on credits with material exposure to the UK, and UK-EU trade in particular, 10-30bp wider relative to our central scenario.

5. … Brexit is called off?

Calling off Brexit (Brexit-exit) entirely would, in practical (though not in legal) terms, almost certainly require another referendum – it is hard to imagine any politician doing without consent from the electorate. Until now a second vote hasn’t appeared very likely. But a Survation report for the Mail on Sunday last week found that 50% of voters now want a referendum on a final deal, while only 34% were against. As recently as in June, the same poll showed a majority against a second vote, so this is a significant shift, likely in response to the arduous negotiations.

However, we think a second referendum called by the current government remains unlikely unless there is also a significant shift in the polls on the likely outcome. Though even among Leave voters only a small minority (28%) now expect the UK to secure a “good deal” in its negotiations with the EU, YouGov data indicates that the decline in support for Brexit among UK voters is still quite small. Many polls still suggest the outcome of another referendum would be within the statistical uncertainty. However, as Gordon Brown has suggested, it is possible that this changes if more of Teresa May’s red lines are crossed next year.

If the UK did opt for a second referendum and voted to call off Brexit, between the ambiguity in article 50 and goodwill among other member states, we believe the rest of the EU would agree on surmountable terms.

All else equal, Brexit-exit should be a positive for UK assets, and would likely help £ spreads erase some of their YTD underperformance against € and $ credit (albeit the latter have been boosted by ECB buying and the prospects for US tax reform respectively). Even the scenario where the UK ends up staying in the Single Market and the Customs Union for all intents and purposes is probably a positive relative what is priced currently (unless it involves the scenario below also). And the probability of that happening is significantly higher than of Brexit-exit. Either would in our opinion be viewed as a positive for European cohesion as a whole, shaving perhaps 3-7bp of spreads from our base case scenario.

6. Corbyn becomes PM?

We assume that PM May will survive both the recent brouhaha over the Irish border, being voted down in Parliament and, more importantly, trade negotiations over the coming year. But not with great conviction. The status quo remains highly vulnerable: after all, the threat of a Corbyn government is probably one of the main factors that has held Ms May’s fragile coalition together thus far, in our  view. That logic should continue to hold over 2018, but even if the appetite for another election is miniscule within the Conservative party, the risk of a party split remains elevated. Recent opinion polls suggest that Labour is pulling ahead, with some suggesting they would potentially end up with an overall majority.

For markets, this would have mixed implications.

On the one hand, a Labour government would almost certainly mean a more flexible approach to Brexit. While the Labour leadership has not come down firmly in favour of continued customs union and single market membership (with their preference in favour of keeping the UK “in the customs unions and single market in the transition period and leaving the options on the table for after the transition period”, in the words of Labour Brexit spokesman Keir Starmer), a Corbyn premiership would certainly make that more likely.

At the same time, Mr Corbyn’s policy platform of higher taxes and nationalisations is unlikely to be welcomed by business. Shadow Chancellor John McDonald recently stated that shareholders in key utilities would be offered government bonds in exchange for their shares at rate determined by the government. In theory, government ownership should be positive for bondholders, but under the  associated uncertainty we doubt that’s how risk premia would react initially. And Corbyn’s strong rhetoric towards the City of late doesn’t portend a particularly easy relationship were he to be in power either.

Ultimately, a narrow mandate, a coalition or merely the responsibilities of government might demand a more pragmatic approach once in power. But in the run-up to an election where opinion polls show a Labour lead, we doubt markets would afford UK credit the benefit of the doubt. We’d put the probability of a Corbyn premiership in 2018 at around 15-25%, so it is already somewhat reflected in our base case for £ credit. This anticipates underperformance of names with a high degree of UK exposure, but in an election scenario there we still see further downside to our forecast numbers.

7. US tax reform fails?

As far as credit specifically is concerned, our previous principal worry over US tax reform, namely that the removal of interest tax deductibility would lead US companies to transfer more of their issuance to overseas entities, potentially driving up reverse yankee supply significantly, has largely been dealt with by the current plan’s allowance for interest to be tax deductible up to 30% of earnings. But to the extent that the envisaged mandatory repatriation lowers US corporates funding requirements (a prospect our US colleagues are admittedly more sceptical of than most), failure to pass tax reform would increase the funding requirement in US credit next year, potentially adding to reverse yankee issuance too. On its own this would be a somewhat bigger spread negative for the US, and a smaller one for euro credit, especially for existing reverse yankee bonds.

Failure to get tax reform through would also curtail the earnings boost that European multinationals (concentrated in the health care, consumer staples, industrials and commodity sectors) can expect to see from a reduction in tax rates on their US subsidiaries (estimates we have seen put this in the range of 2-4%). This would be a bigger deal for equities than credit, and it’s not clear how much the assumption of a tax reform-driven boost to earnings have been factored into consensus expectations yet anyway, but at the margin this would also be a small negative for the companies that stand to benefit most.

Overall though, a failure to get tax reform through, after health care reforms had to be shelved earlier this year, would call into question the feasibility of the Republicans’ legislative agenda. Our economists have factored in a 0.4% boost to US growth next year from tax reform, and a scaling back of US growth expectations. We think the spillover on global risk appetite would likely lead to at least 5bp of widening from current levels.

So ‘what if’ then?

As mentioned at the onset, none of these scenarios are base case individually. They weren’t meant to be. But what’s striking is how many are at play in 2018: we managed to come up with more with more than 40 ‘what ifs’ in less than an hour. What you see above is merely a selection. To us, it again illustrates the uncertainty around the prevailing paradigm as we head into 2018. How they play out remains to be seen and there are positive risks too, but overall the exercise has really rammed home how lop-sided risk-reward is at the onset. When spreads are at historical tights, no news is probably the best news one can realistically hope for.

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