Strategy: UK referendum: a regional shock with global monetary policy fallout

30 Jun 2016

SUMMARY

  • Risk assets sell off after UK referendum, safe havens benefit
  • Period ahead marked by political uncertainty
  • UK exit from the EU would be a regional shock…
  • with implications for global monetary policy

A narrow majority of the British electorate voting to leave the EU was not what most market participants had expected and accordingly, the pound dropped by almost 8% against the euro to its lowest since March 2014 (see chart), while the STOXX Europe 600 fell by almost 11 %, which was more than the UK FTSE 100 which lost almost 6%. European equities slid to close to their February lows, but equities elsewhere held comfortably above those 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 such as US Treasury bonds, Bunds, Japanese government bonds and the yen (see chart). Among commodities, gold stood out positively. It had already been benefiting from the drop in bond yields, 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. We had treated the referendum as a risk factor, but had not let it dominate our asset allocation. 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.

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. But it has not. It has left UK politics in disarray. It is unclear who will start the statutory procedure to exit the EU. With Prime Minister Cameron resigning, it could be the new leader of the governing Conservative party. 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 it will have to accept the free movement of capital and labour as well. Reduced integration within the EU will, in our view, have 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 see any EU country where a referendum would result in a majority backing an exit.

Political risks in Spain appear to have diminished. 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

In our view, the long-term consequences of the UK referendum outcome depend on the level of economic integration between the UK and the EU after the UK exit. We expect the UK economy to shrink in the final quarter of this year and the first quarter of next year, cutting our GDP growth forecast for this year from 1.9% to 1.5% and for next year from 2.4% to 0.0%. Business investment is likely to drop with companies putting spending on hold in a climate of heightened uncertainty and unpredictability. The uncertainty, weaker sentiment and falling house prices could sap consumer spending . Sterling’s drop should boost inflation, also curbing consumer spending.

In the eurozone, it is only the spreads and yields on high-yield corporate bonds which are still higher than before the UK referendum. While the weakening of the euro has actually eased financial conditions, 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.

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. For emerging markets, we still foresee a further slowing in China and relatively modest growth in other Asian economies. We expect the Russian economy to stabilise. Any recovery in Brazil should be shallow given the headwinds from fiscal austerity and the credit cycle.

MONETARY POLICY: LOWER FOR LONGER AGAIN

We expect the outcome of the referendum to have profound implications for monetary policy. The Bank of England will likely cut interest rates, flanked by renewed quantitative easing. The BoE has room to cut rates by 50bp before they enter negative territory, but could take a gradual approach given the negative impact of rate cuts on bank profitability.

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, which should be foreshadowed by leading indicators, and inflation remaining far below the ECB’s target of close to 2%.

In the US, the tightening cycle will likely be delayed once again. An interest-rate rise by the Federal Reserve next month is off the table, in our view. Even a move in September now looks premature, leaving this December as the moment when the Fed will raise rates further. Even one further increase this year seems improbable, looking at fed funds futures. In fact, 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, which from the low by the middle of last year has gained almost 20%, damping inflation and hurting Japanese company profitability. More easing by the Bank of Japan is likely, first and foremost 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 bank profitability, is also a possibility.

So overall, the UK referendum will likely keep monetary policy at a more stimulative stance than before.

ASSET ALLOCATION: UNDERWEIGHT IN EUROPEAN EQUITIES VS. US AND JAPAN CLOSED

When we initiated this position in April, we saw only modest earnings growth in the eurozone and an unsustainable dividend pay-out ratio. Since then, earnings estimates for 2017 have stabilised in the US and Europe, but at a relatively lower level in Europe, so we think there is more room for improvement there. The dividend sustainability issue was most pronounced in the UK. With the British pound weakening and therefore foreign earnings set to increase in sterling terms, paying a sustainable dividend should become less of an issue for UK companies. All in all, with many of the arguments for the position shifting, we decided to close the underweight.

Click here to see all Multi Asset Solutions asset allocation positions (for professional investors)