Brexit and markets: What next?

Larry Hatheway (pictured), Group Chief Economist and Head of Multi Asset Portfolio Solutions at GAM, looks at what happens next following the UK’s vote to leave the EU…

The UK’s historic referendum has, predictably, sent powerful shockwaves through global capital markets. Intra-day volatility in sterling, European equities and selected other asset classes has approached or even exceeded that seen during the most turbulent episodes of the global financial crisis. The market moves – particularly the sharp fall of sterling – are very much in line with the estimates made by most economists and strategists in their Brexit scenarios.
 
What comes next? In what follows, Larry Hatheway, Group Chief Economist and Head of Multi Asset Portfolio Solutions at GAM, outline the firm’s tactical and medium-term views…
 
Tactical considerations
 
In the near term, we would expect above-average volatility to remain a feature of global equity, fixed income, currency and commodity markets. Sharp moves in both directions are possible, but it will be difficult to draw much lasting inference from them. The primary near-term driver of market volatility will be portfolio re-positioning and risk management, not high-conviction fundamentals-based trading.
 
Asset prices will also be sensitive to the words and actions of political leaders and policy makers. Over the coming days various governments, international organisations and central bankers will attempt to reassure investors and the broader public that the political and policy-making apparatus can and will address the challenges and risks associated with Brexit. But it is also likely, given various latent political tensions unleashed by Brexit, that markets will be occasionally jarred by political rhetoric that provides unpleasant reminders of the enormous challenges that lie ahead for Britain, Europe and their joint relationship.
 
Central banks will stand behind markets, offering liquidity as needed. In the event of disorderly markets, central banks may also intervene, potentially in coordinated fashion. But outright changes in monetary policy – for example, interest rate cuts or stepped-up asset purchases – are likely to be adopted with a lag and only if Brexit and associated market turmoil are judged to warrant a fundamental policy shift. In all likelihood, however, Brexit and its uncertainties will lead the Fed to postpone any rate hike until late 2016 or 2017.
 
In sum, markets are likely to be volatile and directionless in the near term, making for a challenging environment in which to invest.
 
Medium-term considerations
 
Over the remainder of this year and probably for longer, markets will have to cope with elevated political and economic uncertainty stemming from Brexit. That applies to the UK as well as to the EU.
 
In the UK, Prime Minister Cameron’s decision to resign effective October is unusual and a potential source of considerable uncertainty. It comes after a referendum that exposed significant geographic and socio-economic divisions across the UK, as well as their associated fault lines in Britain’s Conservative and Labour parties. Investors may well doubt the ability of a ‘lame duck’ government to adequately address policy priorities for the next several months. But they may also question the ability of the UK to form a strong government over the medium term, one that will have to conduct difficult diplomatic negotiations with the EU and other countries as the UK transitions to a position outside of the EU. In either case, investors may be unnerved by the potential for a second Scottish independence referendum or increased tensions in North Ireland that could also ensue from Brexit.
 
For Europe, Brexit is the single-greatest challenge to European integration of the post-war period. Support for ‘Europe’ on the Continent cannot be taken for granted in an environment of rising dissatisfaction with its institutions and the broad undercurrent of populism. The EU must find a compelling message, but will it?
 
These uncertainties pose significant risks for the investment outlook. Against the backdrop of an already slowing UK economy, Brexit anxiety could precipitate a large enough reduction in consumer and business spending to tip the UK economy into recession. Indeed, that scenario has been forecasted by most independent observers as a likely Brexit consequence.
 
Sterling remains vulnerable. With a current account deficit in excess of 5 per cent of GDP, the UK requires steady capital inflows to support sterling. Doubts about the UK’s attractiveness as an economic platform into Europe and the increased risk of a UK recession accompanied by further easing from the Bank of England could still send the pound sharply lower. Valuation alone may not support sterling.
 
Europe’s recovery is also at risk. Uncertainty-induced weakness in household or business spending could easily push the eurozone back into stagnation or even recession. In that case, the fallout for global equity, credit, emerging and commodity markets could be considerable, harkening back to the pronounced market declines of last August/September or the first quarter of 2016.
 
It is quite unlikely that Brexit will only have short-term adverse market consequences. The extraordinary political, economic and financial uncertainties unleashed by the referendum outcome have the potential to reverberate across the global economy and capital markets for considerably longer, just as forewarned by most independent observers in advance of the vote.

 

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