The effects of the UK's vote to leave the European Union have
been felt around the world. Markets have re-priced to reflect
heightened political uncertainty, the threat of lower growth in
Europe, and the potential for deeper contagion to the global
economy and financial system.
Equity markets initially traded down sharply, but in some cases
recovered ground during the day. Meanwhile, the dash for safe
havens led the Japanese yen to rally by more than 6% at one point,
10-year gilt prices are +2.7%, Treasuries +1.7%, and Bunds +1.5%.
The Swiss franc did not rally materially against the euro, but only
due to intervention from the Swiss National Bank to limit currency
It is important to remember that although the equity market
moves have been significant, they come in the context of a sharp
rally in recent weeks, as markets had moved to largely price out
the risk of Brexit. Betting markets had moved from pricing the risk
of Brexit at around 40% last Friday to as little as 15% yesterday.
While expectations clearly needed to readjust, markets are now, in
general, back to levels of last week, and above the lows of last
month. As such, today's moves should not be considered a major
change in momentum at this stage. Even the British pound is overall
down by only 2% in the past 10 days.
This kind of volatility goes to show that core investment
principles like rebalancing, diversification across asset classes
and geographies are key, particularly as nations move further into
uncharted political and economic territory.
Looking forward, global market outcomes will be shaped by the
progression of central bank intervention, global risk appetite,
political risk, and economic contagion.
Central banks have already moved quickly to stabilize market
conditions. The Bank of England has made an additional GBP 250B of
liquidity available, and confirmed open currency swap lines if
banks need them. The European Central Bank ((ECB)) also said it
stood ready to provide additional liquidity if required. Both the
Swiss National Bank and the Bank of Japan intervened to mitigate
the appreciation of their currencies. The US Federal Reserve
highlighted Brexit as a key risk for financial markets in its last
statement. We now believe it highly unlikely that US interest rates
will rise at the Fed's July meeting, and we now only expect one
interest rate hike in 2016.
So far, global central banks have continued their recent form by
acting with determination to maintain financial stability, while
supporting growth and inflation. We expect them to remain on the
alert to any indications of tightening financial conditions, and
respond promptly if they arise. But signs of central bank
indecision or unwillingness to act could be considered a negative
signal for risk markets.
Ahead of a series of political events, including the Spanish
election, Greek debt negotiations, and US presidential election,
the shock result in the UK referendum could dampen the markets'
confidence and overall risk appetite. Popular angst about
globalization and technology made itself felt in the UK - and
markets will be wary of repeats.
For now, we believe risk appetite is still high enough to
support risk assets, including equities, in the months ahead. But
we will continue monitor market volatility, breadth, and liquidity
to assess overall risk appetite. Signs of further diminishment of
"animal spirits" could be cause to take a more cautious stance.
Political risk will be important to monitor. Right-wing parties
in France, the Netherlands, and Italy have praised the UK's
decision, and hinted at the possibility of follow-on referenda.
Recent surveys show levels of euro-scepticism in France and Spain
are even greater than those in the UK. Any EU exit of a member of
the euro and the Schengen agreement could constitute a more
significant unravelling of the European project than Brexit, and
present financial risks akin to the euro crisis of 2011 and 2012.
This remains unlikely for now, but we will monitor such risks by
watching bank credit spreads. Today's 30-50 bps spread widening
should be manageable for European banks, since it represents an
effective cost in the low single-digit percentages of capital. That
said, if we were to see a significant widening in spreads for a
prolonged period, without ECB action helping to reduce spreads,
this could lead us to grow more cautious on risky assets.
The longer-term impact on global risk assets will depend on how
the above factors feed through into global economic growth. The
primary channels for contagion to the real economy are through
higher borrowing costs (due to financial market volatility) or
economic uncertainty. Both would hinder investment and
So far, the increase in borrowing costs looks manageable, and
the level of uncertainty is more likely to fall than rise now that
Brexit has passed. We have downgraded our forecast for Eurozone
growth by 0.25%, reflecting a modest deterioration in business and
consumer confidence through both sentiment and wealth effects.
However, we continue to expect growth of 1.25% in the Eurozone.
Signs that our optimism on growth is misplaced would be a further
reason to grow more cautious.
US equities have fallen today but we remain overweight. The US
has limited export exposure to the UK (3%), and may be more
insulated from the first-round effects of Brexit. Furthermore, we
are confident that tightening US labor markets should continue to
support US domestic consumption. We will monitor second-round
effects such as the trend for the US dollar, which could become a
potential headwind to equity earnings if its recent strength
continues. But, on balance, a material underperformance of US
stocks may offer opportunities for us to increase the size of our
Our currency positions rely on the potential for central bank
policy divergence, and overweight the US dollar and Norwegian krone
relative to the Australian dollar and euro, respectively. We
continue to believe that policy between the US and Australia will
diverge, and risk-off flows should support the US dollar in the
near term. We will monitor the risk of a far more dovish outlook
from the Federal Reserve that could lead to US dollar weakening.
Equally, Norway maintains a growth and inflation advantage over the
Eurozone, but we will monitor the risk of renewed calls for Norges
Bank easing, given Norway's small, open economy.
Note that given the increased uncertainty over the future of the
European Union, we lower the EUR/USD forecast to 1.08 in three
months, 1.10 in six months, and 1.10 in 12 months (from 1.10, 1,14,
and 1.16, respectively).
Outcomes for UK assets will be primarily impacted by political
developments within the UK. There are three layers of uncertainty:
leadership, trade negotiations, and regional independence.
Prime Minister David Cameron has announced he will step down
from October of this year, and a successor is yet to be identified.
A more Eurosceptic successor could make trade deals with the EU
more difficult to achieve. Alternatively, a smoother path of
negotiations might lend some support to UK assets. Meanwhile,
Nicola Sturgeon, leader of the Scottish National Party, has said a
new Scottish independence vote is "highly likely." Concern about
Scotland's independence had previously led to significant
volatility in UK assets in 2014.
Within the equity market, companies most leveraged to the UK
economy, including the financials, consumer discretionary, and FTSE
250 mid-caps, are likely to continue to underperform the more
internationally-exposed FTSE 100, for whom a weaker pound is an
We expect gilt yields to remain low in the immediate term, as we
expect two further rate cuts from the Bank of England this year to
stave off a further growth slowdown.
We expect the pound to trade around 10% weaker than before the
referendum. We therefore change the GBP/USD forecast to 1.32 in
three and six months (from 1.46 and 1.52) and to 1.35 in 12 months
(previously 1.56). Given the significant political uncertainty, our
forecasts represent a mid-point around which the pound is likely to
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