Britain Exit

03 June 2016

https://catalystresearch.ca-cib.com

Crédit Agricole Corporate and Investment Bank is authorised by the Autorité de Contrôle Prudentiel et de Résolution (ACPR) and supervised by the ACPR and the Autorité des Marchés Financiers (AMF) in France and subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority. Details about the extent of our regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from us on request.

Brexit: last call

Xavier Chapard Global Macro Strategist +33 1 41 89 13 45 [email protected]

Market implications over the short and medium term

Valentin Marinov Head of G10 FX Research +44 20 7214 5289 [email protected]

Harpreet Parhar Head of Credit Strategy +44 20 7214 5534 [email protected]

Mohit Kumar Global Head of Rates Research +44 20 7214 6651 [email protected]

Page 1 03 June 2016

1. How much risk of a Brexit? ● Macro/political analysis, polls and market pricing

2. FX strategy: Brexiting the GBP

3. Rates strategy: hedging Brexit risks

4. Credit strategy: potential impacts of a Brexit

Brexit: last call

03 June 2016 Page 2

Our baseline scenario: no Brexit ● In addition to the rational economic arguments clearly in favour of the ‘remain’, we think risk aversion should prevail when the

time comes to vote. ● A Brexit cannot be ruled out, however: we put the probability at 30–40%. Thus the binary risk is likely to remain until the 23

June referendum. – Polls are unlikely to show a a large enough gap between ‘leave’ and ‘remain’ to indicate a definite outcome.

In the event of a vote in favour of ‘Brexit’

● A vote to leave would give rise to uncertainties on all fronts for the UK: regarding short-term and long-term economic prospects, political stability and even the very existence of the UK (possibility of another Scottish independence referendum).

● For the rest of the EU, the near-term risk of dislocation is manageable, in our view, but this risk will most likely increase somewhat in the short term and affect markets.

In the event of a vote in favour of staying (‘Bremain’)

● We would expect to see a return to fundamentals as Brexit related uncertainty lifts (ie, two-sided risk for financial assets). ● However, some uncertainties will linger.

– For the UK: political uncertainty is likely, as divisions within the Conservative Party would probably lead to a government reshuffle. – For the rest of the EU: other countries might also request some special arrangements, weakening the European project further.

Main economic/political points

03 June 2016 Page 3

Support for ‘remain’ and ‘leave’ too close to call ● Uncertainty around poll results is very high.

– Polls have a poor track record. – The debate between phone and online polling remains

unsettled.

Three key unknowns

● Which way will undecided voters go? – Their share is high at about 15%.

● Will external events sway the vote? – External events before the result could be decisive: eg,

the refugee crisis, terrorist attacks or core–periphery tensions in the Eurozone.

● How high will voter turnout be? – Turnout should be an especially significant factor among

younger voters.

Polls under scrutiny

YouGov online polls (stable methodology)

Source: YouGov, Crédit Agricole CIB

03 June 2016 Page 4

Market expectations How much is priced in?

● The markets priced in Brexit risk from mid-January. – At that time, became almost certain that the referendum would be

held on 23 June. ● The implied probability Brexit increased to 60% in mid-April

before falling below 30% by mid-May. ● Markets have started to price in a higher risk of a Brexit in June

on less supportive polls. But the implied probability remains relatively low at about 35%.

● Others measures have evolved in similar ways since February, but have been less volatile and at different levels. – Polls have shown support for the two sides roughly equally split. – The same has been the case for the big-data-filtered social-media

measure. – Bookmakers’ odds indicate a win for the ‘remain’ side.

Hedging: We have not seen much position taken yet by structurally long corporates and institutional investors.

What to expect until the referendum on 23 June?

● We do not expect a strong sell-off, but risks remain biased towards more tensions.

Our key market concern in the event of a Brexit outcome ● Fairly asymmetric market pricing might create much more

volatility and potentially some short-term liquidity stress for all GBP assets.

Market implied probability of a Brexit

Probability of a Brexit based on different methodologies

Source all charts : Bloomberg, YouGov, Betfair, Quant Cube, Crédit Agricole CIB

Page 5 03 June 2016

FX strategy: Brexiting the GBP

Valentin Marinov Head of G10 FX Research +44 207 214 5289 [email protected]

Manuel Oliveri FX Strategist +44 207 214 5289 [email protected]

03 June 2016 Page 6

Still bullish the GBP

Source: Crédit Agricole CIB

EUR/GBP – CACIB vs. consensus

GBP to recover after the EU referendum


GBP/USD forecasts – CACIB vs consensus

859095

100105110115120125130

Sep-99 Sep-02 Sep-05 Sep-08 Sep-11 Sep-14 Sep-17GBP NEER CACIB Forecast

Brexit fears continue to cloud the near-term outlook for GBP.

We expect the UK to stay in the EU after the referendum and see the recent GBP underperformance as temporary.

We expect the BoE to start hiking rates in H1 2017 as well.

All that should help GBP recover against both USD and EUR over the medium term.

03 June 2016 Page 7

GBP looks cheap and markets are extremely short

Source: Crédit Agricole CIB Source: Crédit Agricole CIB

G10 FX PIX – current vs three month average G10 FX PIX – current vs previous week

The latest GBP sell-off has pushed it below its fair value and we expect consolidation close to the lows. ● Our valuation model is based on panel cointegration

analysis of measures of net foreign asset position, relative productivity and commodity terms of trade.

Investors are still running excessive GBP-shorts that they amassed in recent months.

CACIB’s G10 FX Positioning Index (G10 FX PIX) provides timely updates of market positioning in the G10 FX market. ● We use market as well as in-house FX flow data.

-3.00

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NZD CAD USD AUD SEK EUR NOK CHF JPY GBPCurrent 3M average

77798183858789919395

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Jan-12Jul-12Jan-13Jul-13Jan-14Jul-14Jan-15Jul-15Jan-16CACIB PIX GBP TWI (rhs)

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CHF USD NZD AUD CAD GBP SEK NOK JPY EUR

G10 FX misalignment vs long-term fair value

03 June 2016 Page 8

Some Brexit negatives already priced in, but polls still close

Source: Crédit Agricole CIB Source: Crédit Agricole CIB, Bloomberg

Bookmakers’ probability of Brexit has been on the rise

GBP TWI selloff run well in excess of the spread between GBP 2y rate and the G9 average, suggesting GBP is cheap

GBP collapsed under the weight of ‘Brexit’ fears

Poll results ahead of the EU referendum on 23 June

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Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16Spread (Remain - Leave) Remain % Leave %

-1-0.8-0.6-0.4-0.200.20.40.6

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Feb-11 Feb-12 Feb-13 Feb-14 Feb-15 Feb-16GBP TWISpread 2y GBP rate vs. average G9 2y rate (%, rhs)

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19-May 22-May 25-May 28-May 31-MayBetfair Bet365 Coral PP William Hill

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Apr-15 Jun-15 Aug-15 Oct-15 Jan-16 Mar-16 May-16"Brexit" story count (rhs,inv) GBP TWI

03 June 2016 Page 9

Immediate impact of Brexit (1) Significant damage

● Brexit could trigger a balance-of-payments crisis, aggravated by the UK’s sizeable current account deficit.

● It could lead to a sudden stop of FDI and portfolio inflows that are used to fund the deficit.

● It would raise the question of how to bridge the sizeable gap between the country’s liabilities and foreign assets.

Sharp GBP sell-off ● GBP would have to sell off sharply to boost the value of the

UK’s foreign assets and close the gap. – Using the 1992 ERM crisis as a template suggests that GBP

TWI could drop as much as 15%. – With some negatives already in the price, we see at least

another 8–9% downside in GBP TWI from current levels. ● We see GBP/USD dropping towards 1.3000 and EUR/GBP

surging towards 0.8500 under Brexit. ● We expect EUR/USD to revisit its recent lows below 1.10

and expect other European currencies, such as NOK and SEK, to underperform.

Global risk aversion ● Brexit would trigger global risk aversion and weigh on risk-

correlated and commodity currencies. ● Safe-haven currencies and assets such as JPY, CHF and

gold would be likely to receive a boost.

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727782879297

102

Mar-86 Mar-92 Mar-98 Mar-04 Mar-10 Mar-16CA balance (% of GDP, rhs)GBP TWITrade balance (% of GDP, rhs)

ERM1 cris is

Template: 1992 ERM crisis sent GBP TWI 15% lower

Source: Crédit Agricole CIB, ONS

74

79

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89

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-50-40-30-20-10

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Jun-89 Sep-90 Dec-91 Mar-93 Jun-94 Sep-95 Dec-96Portfolio investment (bn) Direct investment (bn)

ERM cris is

Template: capital outflows weighed on GBP in 1992 and 1993


03 June 2016 Page 10

Immediate impact of Brexit (2)

Source: Crédit Agricole CIB, Bloomberg

Source: Crédit Agricole CIB, Bloomberg

Markets still expecting the next BoE move to be a hike

GBP/USD vol market pricing in lower GBP volatility after the EU referendum

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30-Mar 13-Apr 27-Apr 11-May 25-MayFRA1x4 FRA3x6 FRA9x12 2yr Swap

: Spreads to CB policy rateGBP(%)

579

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1M 2M 3M 4M 6M 9M 1Y 18M 2YLatest Apr-16 Jan-16

Rates and FX vol markets will have to price in Brexit ● Both the GBP rates and the FX vol markets would need

to price in Brexit in full and that could accentuate the moves in FX spot.

● Bets on BoE easing would be likely to grow in response to Brexit, especially if the dire predictions about the negative impact on the economy materialise. All that should erode the rate advantage of GBP.

● GBP implied volatility has reached excessive levels on the back of persistent hedging by foreign investors.

● A Brexit could lead to a protracted period of GBP weakness, which could push long-term vol tenors higher.

● Higher hedging costs could render purchases of UK assets less attractive for foreign investors. All that could add to headwinds for GBP.


Longer-term impact of Brexit

Potentially long-lasting damage ● The longer-term outlook for GBP could remain

subdued under Brexit. This is because the UK’s current account deficit reflects both trade and income account deficits.

Muted impact from weaker GBP ● In theory, a weaker GBP should boost the

competitiveness of the UK exporters and help cut both deficits.

● In reality, however, the fact that these exporters are often part of international (mainly European) vertically integrated supply chains would point at only muted impact from FX depreciation.

● The trade deficit could thus linger, necessitating weaker GBP for longer.

● Even if the FDI and portfolio inflows resume (albeit at a slower pace) after the initial Brexit-induced shock, the income account deficit need not disappear completely, especially if returns on global assets remain subdued.

All this would suggest lingering GBP weakness after Brexit to help reduce UK’s vast current account deficit.

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Jun-99 Jan-03 Aug-06 Mar-10 Oct-13Trade Services Investment Income Trade Goods

Current Account Balance(%GDP)

CA has hit multi-year lows of close to -5% of GDP recently

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3.0

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1015

Mar-00 Jul-02 Nov-04 Mar-07 Jul-09 Nov-11 Mar-14EU Non-EU

UK Current Account, seasonally adjusted(GBP bn)

UK CA deficit is particularly pronounced with the EU



Page 12 03 June 2016

Rates strategy: hedging Brexit risks

Mohit Kumar Global Head of Rates Research +44 20 7214 6651 [email protected]

Afsaneh Mastouri Interest Rates Strategist +44 20 7214 6737 [email protected]


Opinion polls indicate a close call ahead of 23 June referendum ● Average of last five opinion polls: 42% stay, 41% leave, rest undecided (or not voting) ● Betting sites: 15-20% odds of exiting ● Financial markets: FX options and CDS market

Impact going into referendum ● Significant event risks in June: Fed, ECB, Spain, Greece and Brexit ● Position unwind and risk reduction ● Peripherals at risk of sell-off going into referendum

Impact of a ‘Exit’ vote

● Primary: GBP and equities ● Bunds rally, peripherals widen ● Impact on financials, basis ● In the medium term, the impact would fade

– ECB would step in to stabilise sentiment – Negotiations over the eventual impact might drag on for a long while

Binary event risk


Projected market impact of Brexit

1-2 weeks 3 months Comment

Bunds −20 to −30bp −10 to −20bp • Risk aversion and equity market fall creates a bid for

Bunds • ECB turns more dovish

Italy-Bund spread 50–75bp 25–50bp • Risk aversion drives spreads wider • But supportive ECB policies settle the market

Core curve Flatter Modestly flatter • Rally likely to be led by the 10Y sector

Peripheral curves Steeper Modestly steeper • Front end anchored given ECB support • Sell-off likely led by the 10Y Italian futures

Libor-OIS Wider Wider • Brexit impact focused on financial sector • Widening less pronounced than in 2007–08 given ECB

policies

Gilt 2Y −40bp −30bp • Dovish BoE: potential for rate cuts; or at least hikes

pushed further into future • Risk aversion as heavy impact on FTSE

Gilt 10Y −20 to −30bp −10 to −20bp • Domestic investor shift from equities to Gilts • Foreign investors reduce Gilt holdings at the long end



Neutral Bunds • Poor risk reward profile going into the Brexit vote

Short peripherals, in particular Spain • Valuations rich • Risk of a sell-off on position unwinds and risk reduction • Proximity of Spanish elections • Short outright 10Y Spain and vs Italy

Steepeners in peripherals

• Front end supported given TLTRO II • Long end suffers from supply overhang • Favour Spain 3Y10Y steepeners

Short ASW

• Valuations too wide • Would benefit from a positive risk sentiment if ‘remain’ vote

Initiate hedges against a ‘Brexit’ vote

Rates: how we are positioned


Given binary nature of event risks, we recommend investors seek cheap hedges ● Asymmetric profile ● Low cost of entry (option premium or carry) ● Makes fundamental sense

Core rates

● Bund and TY July futures expire on 24 June

Semi core ● Expect semi core spreads to widen ● Spreads wider than expensive April levels, but still present an asymmetric profile

Peripherals

● Sell-off likely to be driven by 10Y sector ● Front end supported by ECB ● Supply overhang at the long end ● Short Spain 10Y, outright and versus 10Y Italy ● Favour steepeners: Spain 3Y10Y

Hedging Brexit risks (1)


Money markets ● Libor-OIS and FRA-OIS at historically tight levels ● Driven by ECB support policies and excess liquidity ● Present an asymmetric risk-reward profile with loss

limited to 2–3bp

Hedging Brexit risks (2)

FRA-OIS basis at historical tights

Cross ccy basis has potential to widen

Source: Bloomberg, Crédit Agricole CIB

Source: Bloomberg, Crédit Agricole CIB

0102030405060708090

100

Jun-11 Jun-12 Jun-13 Jun-14 Jun-15FRA-OIS spread

Current: 9bpLow over last 5 years: 8.7bp

-180-160-140-120-100-80-60-40-20

020

Jun-11 Jun-12 Jun-13 Jun-14 Jun-15EUR/USD 3M x-ccy basis

Cross-currency basis ● Financial sector vulnerable to Brexit ● Leading to widening of cross-currency basis ● Again, presents an asymmetric risk-reward profile

Page 18 03 June 2016

Credit strategy: potential impacts of a Brexit

Harpreet Parhar Head of Credit Strategy +44 20 7214 5534 [email protected]

Elisa Belgacem Credit Strategist +33 1 41 89 38 09 [email protected]


Impact of a Brexit on European credit spreads (1)

Short-term impact ● We would expect sharp spread widening before the market starts to stabilise (3-5 days after Brexit vote)

– iBoxx Non-financials Senior: +12/15bp – iBoxx Financial Seniors: +20/25bp – iTraxx Europe: +25/30bp – iTraxx Senior Financials: +25/30bp

● Not quite enough to take spreads back up to YTD highs ● However, underperfomance in CDS (due to hedging) could see the cash/CDS basis test YTD highs

iBoxx Senior Financial and Non-Financial spreads


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Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16

Financials Senior Non-Financia ls Senior

iTraxx Europe and Senior Financials indices


Cash/CDS basis in Senior Banks and Non-Financials


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Europe Senior Financials

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Impact of a Brexit on European credit spreads (2)

What happens from then, to year-end? ● This would be determined by risk appetite elsewhere

and the market’s interpretation of a Brexit on European and global growth.

● Given that uncertainty is likely to linger, spreads would be likely to maintain a moderate widening bias into year-end – This could see spreads in Financial and high beta

segments (HY and subordinated) temporarily test YTD wides within three to four months, before recovering some of the losses in the fourth quarter.

CSPP buying should keep non-financial senior

spreads well below YTD wides

Subordinated and HY spreads

170

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Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16

Financials Subordinated Non-Financia l Subordinated HY



Dislocation within European credit (1) UK credits have underperformed peers

● That underperformance has been most visible in the financials sector. – UK bank senior and subordinated spreads widened materially

vs core European bank spreads. – Within UK banks, the domestically focused building societies

underperformed their larger UK peers. ● Much of the underperformance has since reversed, but we

expect the trend to reassert itself, albeit to a lesser extent, as we get closer to the vote.

Immediate market reaction in the event of a Brexit vote ● In the three to four days after the vote, we would expect to

see the UK/core non-financial senior differential to widen by 10–12bp.

● The UK/core bank senior differential should widen by c.25bp. ● The UK/core bank subordinated differential should widen by

c.40bp. ● In all cases, this would breach YTD highs.

After the initial sell-off… ● In the week that follows, we could see a 5–10bp convergence. ● What happens after that would be a function of risk

aversion. – We would expect a further moderate convergence over the

summer, but that would depend on how comfortable the market becomes with UK growth prospects.

Differential between UK credit spreads and core European credit spreads


Spreads by type of UK bank


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Bank Senior Non-financial Senior Bank Subordinated (rhs)

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Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-1

Differentia l Building Societies Large UK banks


Dislocation within European credit (2)

Most exposed issuers to UK market iBoxx Corporate GBP vs EUR out-performance

iBoxx EUR Corporate composition iBoxx Corporate GBP vs EUR out-performance

Source all charts: Bloomberg, Crédit Agricole CIB

Use excel sizing PPTx4




0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

VEOLIA ENVIRONNEMENTHolcim

Saint-GobainSHB

FINMECCANICATHALES

HeidelbergCementEDF

VodafoneRWE

SantanderIBERDROLA

BarclaysNATIONAL GRID

CENTRICATesco

BT

Most exposed to UK market (sales)

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Jan-16 Jan-16 Feb-16 Mar-16 Mar-16 Apr-16 May-16 May-16corp hybrids senior

GBP is out-performing

EUR is out-performing89.95%

10.05%

UK incorporated issuers

Non UK incorporated issuers


Certification

Jean-François Paren Head of Global Markets Research +33 1 41 89 33 95 Asia (Hong Kong & Tokyo) Europe (London & Paris) Americas (New York)

Macro Strategy Kazuhiko Ogata Chief Economist Japan +81 3 4580 5360

Louis Harreau ECB Strategist +33 1 41 89 98 95

Xavier Chapard Global Macro Strategist +33 1 41 89 13 45

Michael P. Carey ** Chief Economist US +1 212 261 7134

Brittany Baumann ** US Associate +1 212 261 7140

Interest Rates Yoshiro Sato Economist / Strategist - Japan +81 3 4580 5337

Mohit Kumar Global Head of Rates Strategy +44 20 7214 6651

Romain Blanchet IRD Strategist +33 1 41 89 00 64

Afsaneh Mastouri Interest Rates Strategist +44 20 7214 6737

Orlando Green CFA Senior IRD Strategist +44 20 7214 7467

Jean-François Perrin Inflation Strategist +33 1 41 89 94 22

David Keeble ** Head of US Rates Strategy +1 212 261 3274

Jonathan Rick ** IRD Strategist +1 212 261 4096

Emerging Markets Dariusz Kowalczyk Senior Emerging Market Strategist +852 2826 1519

Gary Yau Emerging Market Strategist +852 2826 1553

Sébastien Barbé Head of Emerging Market Research & Strategy +33 1 41 89 15 97

Jakub Borowski Chief Economist - Crédit Agricole Bank Polska SA +48 22 573 18 40

Alexander Pecherytsyn Chief Economist – Crédit Agricole Bank Ukraine +38 44 493-9014

Guillaume Tresca Senior Emerging Market Strategist +33 1 41 89 18 47

Foreign Exchange Valentin Marinov Head of G10 FX Research & Strategy +44 20 7214 5289

Jennifer Hau FX Strategist +44 20 7214 7468

Manuel Oliveri FX Strategist +44 20 7214 7469

** employee(s) of Crédit Agricole Securities (USA), Inc. Important: Please note that in the United States, this fixed income research report is considered to be fixed income commentary and not fixed income research. Notwithstanding this, the Crédit Agricole CIB Research Disclaimer that can be found at the end of this report applies to this report in the United States as if references to research report were to fixed income commentary. Products and services are provided in the United States through Crédit Agricole Securities (USA), Inc. Foreign exchange disclosure statement to clients of CACIB http://mediacommun.ca-cib.com/sitegenic/medias/DOC/85478/2015-12-08-foreign-exchange-disclosure-statement-to-clients-of-cacib.pdf

The views expressed in this report accurately reflect the personal views of the undersigned analyst(s). In addition, the undersigned analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Xavier Chapard, Valentin Marinov, Mohit Kumar, Harpreet Parhar, Afsaheh Mastouri, Elisa Belgacem, Manuel Oliveri

http://mediacommun.ca-cib.com/sitegenic/medias/DOC/85478/2015-12-08-foreign-exchange-disclosure-statement-to-clients-of-cacib.pdf

























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