- Risky assets sell off in the wake of the UK referendum while safe havens benefit
- Period ahead to be marked by political uncertainty
- UK’s exit from the EU is a regional, not a global shock…
……but it has significant, dovish implications for global monetary policy
Financial markets were volatile prior to the EU membership referendum in the UK. Their reaction after a narrow majority of the British voted to leave the EU demonstrated that the result caught most market participants completely off guard. The British pound was the main victim, dropping by almost 8% vis-à-vis the euro to its lowest since March 2014. From its peak in July 2015, sterling has shed close to 17% of its value relative to the euro. Europe-wide equity market indices such as the STOXX Europe 600 fell by almost 11 %, more than the UK FTSE 100 which lost almost 6%. In euro terms the fall in British stockmarkets was even more severe.
Exhibit 1: The pound absorbs the impact of Brexit – in line with the U.K.’s natural inclination in the past – it is the pound that takes the strain during times of crisis (the graph shows changes in the euro/British pound exchange rate between January 2014 and 30 June 2016)
While the daily falls in equities were large, they followed a rally in the run-up to the 23 June referendum as polls indicated that most voters favoured remaining in the EU. European equities fell to close to their February lows, but did not break below that level. Equities in other parts of the world held comfortably above the February lows. This appears to show that equity markets are treating a British exit from the EU as a regional shock, not a global one. We would agree.
Investors fled to safe-haven assets. US 10-year Treasury yields fell to 1.44%, not far from their all-time low of 1.39% set in 2012. German 10-year yields dropped deeper into negative territory, while Japanese yields are now negative for maturities up to 15 years. Among commodities, gold stood out positively. It had already been benefiting from the decline in bond yields, which reduces the opportunity costs of holding gold, but in recent days, it has also gained on the back of its haven status.
Going into the UK referendum, we had been positioned defensively. This was not just because of events in the UK. We had treated the referendum as a risk factor, but had not let it dominate our asset allocation because of the binary outcomes. Other reasons to be – and remain – cautious are the outlook for modest economic growth, low inflation and weak earnings growth, the rich valuations in some asset classes and other political risks in Europe and in the US.
In our asset allocation, we closed our underweight in European equities versus the US and Japan, but we maintained our underweights in global equities, emerging market debt in hard currency and commodities.
A period of heightened uncertainty ahead
The outcome of the UK referendum was generally supposed to bring clarity and remove this source of uncertainty for investors. It has achieved the contrary, leaving UK politics in disarray with both main parties struggling with leadership issues. The referendum result by itself does not take the UK out of the EU. The country has to start the statutory procedure to leave itself. At the moment it is unclear who will take this step and when. Prime Minister Cameron has announced he is resigning and it appears that the new leader of the governing Conservative party will not be known until 9 September. Cameron has left it to his successor to start the exit procedure. And even then, there are several options when it comes to the future relationship between the UK and the EU. Basically, if the UK wants to benefit from a free flow of goods and services, it looks likely that the country will have to accept the free movement of capital and labour as well. Reduced integration within the EU will, in our view, have more dire consequences for the UK economy.
A negative scenario could include political contagion spreading to Europe as Eurosceptic parties in other countries plead for exit referenda. We see this as unlikely at this point. Continental leaders have so far rallied behind the European project and we struggle to identify any EU country where a referendum would inevitably result in a majority backing an exit.
Political risks in Spain appear to have diminished somewhat. Last weekend’s elections did not deliver a clear winner and forming a coalition will likely still be difficult, but we expect the parties around the political centre to find a way to form a government.
For financial markets, in terms of political risk generally, that leaves the Italian constitutional referendum in October, which may turn into a confidence vote on the current reform-minded administration, and the US presidential elections in November.
The British referendum: a regional shock
The long-term consequences of the UK referendum outcome are difficult to assess at this point. In our view, it all depends on the level of economic integration between the UK and the EU after the UK exit. In the second half of this year and next year, we foresee a recession in the UK, albeit not a deep one. We think the economy will shrink in the final quarter of this year and the first quarter of next year. This would have a profound impact on the annual growth rates for this year and next. We have cut our forecast for this year from 1.9% to 1.5% and for next year from 2.4% to 0.0%. We expect growth to suffer as business investment drops with companies putting spending on hold in a climate of heightened uncertainty. We also foresee a slowdown in consumption, due to the uncertainty, poorer sentiment and falling house prices. Sterling’s drop should boost inflation, curbing consumer spending power.
The eurozone economy could be impacted mainly through the sentiment and financial channels. Financial contagion has so far been limited: equity prices are down, although they have bounced back somewhat this week; risk spreads and yields on ‘peripheral’ sovereign bonds rose before the referendum, but have since come down. It is only the spreads and yields on high-yield corporate bonds which are still higher than before the UK referendum. The weakening of the euro has actually eased financial conditions. We will have to wait and see to what extent business and consumer sentiment will be impacted. The German Ifo index and consumer confidence had improved further in June, before the referendum. For now, we have cut our growth forecast for the eurozone for this year by a notch to 1.5%. For next year, we have trimmed our forecast by 0.4 percentage point to 1.4%. This should have hardly any impact on inflation, which we see rising gradually to 1.3% at the end of next year.
Without global financial contagion, we expect a British exit from the EU to have little impact on the rest of the world……
Growth in the US could be slower in the last quarter of this year and the first quarter of next year, but in our view, this will have hardly any effect on the annual growth rates. Japan could suffer from the appreciation of the yen, which has acted as a haven in Asia. We have not changed our emerging market outlook: we foresee a further slowing in China and relatively modest growth in other Asian economies. We expect the Brazilian and Russian economies to stabilise, although in Brazil, any recovery should be shallow given the headwinds from fiscal austerity and the credit cycle.
Monetary policy: Brexit reinforces the trend for interest rates to be lower for longer
We expect the outcome of the UK referendum to have profound implications for monetary policy:
The Bank of England (BoE) will likely cut interest rates, flanked by further quantitative easing. The BoE has room to cut rates by 50bp before they enter negative territory. Given the market scepticism over the efficacy of negative interest rates and the unhelpful impact of rate cuts on banks’ profitability, the BoE may be hesitant to cut rates all the way to zero, especially if it re-starts quantitative easing.
In the eurozone, the prospect of an extension of the ECB’s asset purchase programme beyond March 2017 has been heightened. Triggers could be more subdued growth later this year, which should be foreshadowed by leading indicators beforehand. If inflation continues to remain far below the ECB’s target (of close-to-but-below 2%) it could also trigger an expansion of assset purchases).
In the US, the tightening cycle will likely be delayed once again. Prior to Brexit we viewed a ‘remain vote’ in the UK referendum as one of the conditions for an interest-rate rise by the Federal Reserve next month. With that precondition now not fulfilled, the July option is off the table, in our view. Even a move in September now looks premature, leaving this December as the moment when the Fed could raise rates further. Even one further increase this year would exceed current market expectations: fed funds futures discount a 0% probability of a hike before the November Fed policy meeting and a likelihood of just 8.6% for the December meeting. In fact, fed funds futures discount a (marginally) higher probability of a rate cut rather than an increase up to December and no hike before September 2017.
The Japanese authorities have expressed concerns about the strengthening of the yen. At 102 Japanese yen per US dollar, the currency is roughly at levels seen after the depreciation in 2012 and in 2013 during the initial stages of ‘Abenomics’ (see exhibit 2 above). From the low by the middle of last year, the yen has appreciated almost 20%. While this should be positive for consumer spending power, yen appreciation should damp inflation and hurt Japanese company profitability. More easing by the Bank of Japan is likely, in our view. First and foremost, we expect an increase in the pace of asset purchases, although cutting policy rates deeper into negative territory, flanked by measures to mitigate the negative impact on banks’ profitability, is also a possibility.
Exhibit 2: Japanese authorities are expressing concerns about the latest, post-Brexit, bout of yen strength versus the US dollar (the graph shows changes in the US dollar/Japanese yen exchange rate – number of yen per US dollar – for the period between June 2011 and 30 June 2016
Source: Bloomberg/BNPP IP as of 30 June 2016
So, overall, while the impact of the UK referendum result on global growth and inflation should be limited, we do think it will lead to more stimulative monetary policy stance from G4 central banks.
This article was written on 29 June 2016 in Amsterdam