Europe

The perception that central banks have turned even more dovish has pushed down global bond yields, while also giving stocks a lift. Looking out, bond yields are likely to edge higher as investors begin to focus more on the outcome of easing measures: Higher inflation. As long as yields rise gingerly and in the context of firming economic growth, global equities will remain reasonably well supported. Equity investors should favor the euro area, Japan, and China.

Given that the seemingly unthinkable can actually happen, we reassess how financial markets price uncertainty, and whether the current pricing is correct.

Signs that the median voter is moving to the left are everywhere. Markets will cheer the move as it means more government spending. In the long term, it depends if policymakers stop at fiscal stimulus. In this <i>Monthly Report</i>, BCA's <i>Geopolitical Strategy</i> reviews prospects for "Bremorse," latest in the U.S. election, Italian political crisis, tensions in South China Sea, and the long-term future of Europe.

Signs that the median voter is moving to the left are everywhere. Markets will cheer the move as it means more government spending. In the long term, it depends if policymakers stop at fiscal stimulus. In this <i>Monthly Report</i>, BCA's <i>Geopolitical Strategy</i> reviews prospects for "Bremorse," latest in the U.S. election, Italian political crisis, tensions in South China Sea, and the long-term future of Europe.

Long-time subscriber Mr. X recently visited our office to discuss three issues: Brexit, the outlook for China and the seeming contraction between the performance of equity and bond markets. This <i>Special Report</i> is a transcript of our conversation and, not surprisingly, the broad conclusions supported a cautious investment strategy.

Please see attached our <i>Third Quarter Strategy Outlook<i/> which discusses the major investment themes and views we see playing out for the rest of the year.

Brexit is putting our bearish short-term dollar view in question as global policy uncertainty has surged. Yet, investors are displaying elevated signs of risk aversion but the global economy still looks fine. This dissonance is likely to end with investors increasing risk taking, a bearish development for the counter-cyclical dollar. Favor commodity currencies over European ones.

A renewed flare-up in euro area banking sector stress will have ramifications for U.S. bank stocks, despite little direct geographic exposure. The chart shows that risk premiums for U.S bank stocks have been tightly correlated with those of the euro area during previous stress episodes, as this represents a deflationary shock that suppresses the global interest rate structure and undermines global economic activity. Our Global Sector Strategy service has been recommending underweight exposure to euro area banks since mid-March in global equity portfolios. Worrisomely, things are about to get worse before any improvement materializes. The Brexit referendum result has served as a catalyst to expose euro area banks as the weak global financials links. Both absolute and relative performance are probing all-time lows (top panel), dropping even below the depths of the Great Recession. Eurozone banks are plagued by compressing net interest margins, courtesy of NIRP and QE, and still elevated non-performing loans (second panel). This is a lethal combination for bank profits as loan growth is failing to provide an offset. What is missing in the Eurozone is a true bank recapitalization, as happened in the U.S. in late-2008 via TARP. On that front, we are eagerly awaiting the EBA/ECB stress test results slated for July 29 for an update on the health of the euro area's banking sector. Beyond any recapitalization efforts, an opening of the fiscal taps would also serve as a potential positive catalyst to help revive moribund loan demand. Until then, global bond yields will likely dive deeper into negative territory, anchoring bank ROE (third panel). Bottom Line: Resist any temptation to bottom fish in euro area, or U.S., banks. For additional details please visit http://gss.bcaresearch.com/ Euro Area Banks Are Free Falling Euro Area Banks Are Free Falling

We test three channels of contagion from the Brexit shock: political, banking system, and economic.

Yield and Protector Portfolios should continue to benefit in current environment. Equities face seasonal headwinds.