By Christopher Whittall and Jon Sindreu
Traders are turning their sights to the eurozone, betting
Britain's decision to leave the EU could put more pressure on the
fault lines running through the currency union.
Stock markets in the countries sharing the euro, and the common
currency itself, were at the forefront of the steep falls in global
markets at the end of last week. But more telling were trading
patterns like those during the eurozone's sovereign-debt crisis
that ran from 2010 to 2012. Government bonds and shares of weaker
economies such as Italy and Spain suffered an even bigger
selloff.
Investors fear that Britain's departure from the EU not only
removes Europe's second-largest economy from the bloc, but that the
precedent could lead to further fragmentation and a period of
investment-sapping uncertainty. At the outside, concerns are
stirring again about the integrity of the euro itself, as new
pressures push the monetary union's financial systems farther
apart.
"Brexit was a black swan event, and I think there are a
potential flock of black swans flying over Europe right now," said
Dominic Rossi, global chief investment officer for equities at
Fidelity International.
The British exit adds to an already long list of worries that
have led investors to sell eurozone shares through much of the
year, including lackluster earnings, concern over the health of
banks and mounting political risks.
The euro dropped 2.4% against the dollar and 4% against the
Japanese yen on Friday.
The Euro Stoxx 50 index closed down 8.6% on Friday. Spain's IBEX
and Italy's FTSE MIB both plunged more than 12%, their worst
one-day percentage losses in at least 20 years. That compares with
a 6.8% fall in Germany's DAX index.
Even before Thursday's vote, investors had pulled money out of
European stocks for 20 straight weeks, withdrawing more than $45
billion so far this year, according to Bank of America Merrill
Lynch. Friday's selloff took 2016 losses for the Euro Stoxx 50 to
15%, compared with a 0.3% fall for the S&P 500.
The eurozone has faced down a series of crisis moments since the
2008, as the monetary union's stronger economies in the north led
by Germany were called upon to bail out heavily indebted members
around its southern edge.
An acute crisis over the prospect of a cascading debt defaults
was fought off with a bailout plan for Greece in 2010, but concerns
mounted about Spain and Italy over the following two years, amid
debates about austerity measures and a weakening eurozone
economy.
Discontent continues to simmer about tough budget cuts required
under the bailouts.
Just last year, two-thirds of Greeks voted "no" in a referendum
on whether to accept international creditors' conditions for
further bailout aid.
A bailout deal was eventually reached, but investors worried
about Europe's integrity will find plenty of fuel. Spanish voters
delivered a strong showing Sunday for an alliance including the
leftist Podemos party, which is skeptical of austerity.
Meanwhile, Britain's referendum has emboldened already resurgent
populist movements in France, the Netherlands and other countries
to ask for their own EU ballots. In Italy, the antiestablishment 5
Star Movement called for a national referendum on leaving the euro
after winning the Rome mayoral race.
Fidelity's Mr. Rossi said investors will approach political
events with extra caution having been wrong-footed by the Brexit
vote.
The British exit from the EU is likely to be a drawn-out
process, and analysts and traders can only speculate about its
impacts.
Already, though, they are casting it as another negative for a
continent that has posted only halting growth that is relying on
heavy assistance from central banks.
Another worry is the strong links between eurozone countries'
sovereign risk and the health of their banks, whose balance sheets
are loaded up on debt from their own governments.
Italian banks have a big health warning: They are carrying
around EUR360 billion ($400 billion) in loans and other debt that
is past due, restructured or where the borrower is insolvent. The
government and industry have been slow to deal with the problem,
just recently forming a fund to buy stakes in lenders and help
create a market for buying bad debt. Weak banks, in turn, have a
knock-on effect across an economy if they lend less.
The FTSE index of bank shares fell 22% on Friday, deeper than
the 18% drop in the banking subindex of the Euro Stoxx index. The
FTSE's index of Greek banks fell 30%.
"European financials are pretty vulnerable," said Jim McCaughan,
chief executive at Principal Global Investors. "One of the main
reasons for the weak growth in the eurozone has been the poor
capital position of the banks."
The declines left the Euro Stoxx bank index at its lowest level
since 2012, around the time of the continent's last debt crisis.
The annual cost of insuring against a default on $10 million of
European senior bank debt for five years using credit-default swaps
rose by $31,000 to $126,000 on Friday, according to Markit.
Markets in the peripheral countries are expected to continue to
bear the brunt of selling anticipated in the coming weeks.
The yields on German, French, Dutch and Belgian sovereign bonds
were pushed lower by investors looking for safer assets, but the
yields on the debt of peripheral countries -- Italy, Spain,
Portugal, Ireland and Greece -- shot up on the bet these countries
had now become a riskier play. Yields rise as prices fall.
"At least in the short term, it will probably exaggerate the
underperformance of the periphery," said Neil Williams, chief
economist at Hermes Investment Management. "This is questioning the
very heart of the European project."
Bill O'Neill, head of the U.K. investment office at UBS Wealth
Management, said that the selloff in Southern European debt
reflected an increased chance of these countries leaving the
euro.
"It's a return of convertibility risk," Mr. O'Neill said.
Some bargain hunters picked up shares on the belief that the
selling was overdone. Diego Franzin, head of European equities at
Pioneer Investments, said he sold domestically-focused cyclical
European companies Friday, but bought European companies with
greater international exposure.
But most expect the pain in European equity markets to persist.
Strategists at Goldman Sachs Group Inc. predict a fall of around
21% for the Euro Stoxx 50 from Thursday's close in the near
term.
"It's a game-changer for European equities," Mr. Franzin said of
the British vote. "It has raised a question mark on the political
agenda for Europe."
--Riva Gold contributed to this article.
Write to Christopher Whittall at christopher.whittall@wsj.com
and Jon Sindreu at jon.sindreu@wsj.com
(END) Dow Jones Newswires
June 26, 2016 20:19 ET (00:19 GMT)
Copyright (c) 2016 Dow Jones & Company, Inc.