Traders get ready for more volatility in eurozone

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.

One broken euro coin

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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 sell-off.

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. Concerns are stirring again about the integrity of the euro itself, as new pressures push the monetary union’s financial systems further 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 the June 23 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 sell-off took 2016 losses for the Euro Stoxx 50 to 15%, compared with a 0.3% fall for the S&P 500.

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 sell-off 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 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 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 €360 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 financial-data provider 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 UK investment office at UBS Wealth Management, said that the sell-off in Southern European debt reflected an increased chance of these countries leaving the euro.

“It’s a return of convertibility risk,” 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 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,” Franzin said of the British vote. “It has raised a question mark on the political agenda for Europe.”

Write to Christopher Whittall at christopher.whittall@wsj.com and Jon Sindreu at jon.sindreu@wsj.com

Riva Gold contributed to this article, which was published by The Wall Street Journal

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