Citi Private Bank

Browser Requirement

To best view Citi Private Bank's site and for a better overall experience, please update your browser to a newer version using the links below.

Perspectives

Brexit: a regional shock?

Steven Wieting

By Steven Wieting

Chief Investment Strategist

June 27, 2016Posted InEquities, Investment Strategy and Investments

  • However, world markets have stronger concerns for Eurozone cohesion.  The U.K. economy is 3% of world GDP measured in U.S. dollars.  The Eurozone is 21%, and carries special financial risks associated with a currency whose existence has previously been questioned.

 

  • Enlarged political concerns could cloud much of Europe’s outlook for the foreseeable future.  Inward direct investment in the U.K. seems particularly suspect.  Yet it is difficult to tally a very large, immediate economic impact away from uncertainty premia and adjustments driven by the U.K. pound’s decline.

 

  • A broadening of the shock to the world economy still seems only a tail risk.  The Eurozone economy contracted 1.7% in 2011-2012, yet slowed global growth minimally.  Global equities did drop 21% on anticipation of a broader crisis, but soon recovered. The U.K. pound also bore most of the brunt of the impact from the decision to abandon a peg to the predecessor of the euro in 1992.

 

  • A third example follows the same pattern: Southeast Asia’s economies contracted very sharply in 1998, some other regional emerging market economies sank, yet global growth slowed minimally.

 

  • A powerful exception to the rule of relatively low regional growth correlation was 2008-2009, the period which most strongly lives in investor memories.  This example illustrates that when a credit and banking shock in one region is large enough to catalyze shocks in others, regional economic contractions can become synchronized.

 

  • The fear of a Eurozone breakup with debt defaults is not utterly inconceivable.  However, quite significant steps were taken in 2011-2012 to lower such risks and the policy backdrop is very different.  Investors may be surprised that correlations between the growth rates of the U.K. and E.U.’s largest economies are nearly negligible in periods other than 2008-2009.

 

  • Looking forward, we have to question whether the U.K. and Eurozone’s financial markets have fully discounted the new threat to the region’s economies. In contrast, we are keenly on the lookout for investment opportunities in other regions that have- or may sell off inappropriately.  

The world is waking up to the vast complexities of the U.K.’s prospective split from the European Union, a “messy divorce” as some have put it.  

Press reports now point to political disarray in both the Tory and opposition Labor party.  London’s status as the continent’s financial center  is sorely questioned as its exceptional arrangement or “passport” - which allows it to provide financial services to E.U. customers - may hinge on the U.K. agreeing to maintain free movement of labor with the economic zone. This is what Brexiteers fought to end. The internal cooperation and status of Scotland is a complex story we won’t attempt to address here.

Some E.U. officials have warned that in the absence of immediate actions on the part of the U.K. to begin its break with the E.U., uncertainty would strengthen isolationist politics, with calls for referenda in Eurozone countries. This is reigniting fears of a splitting up of the Eurozone, which helped drive a double-dip recession for the region in 2011-2012. 

Given that politics will drive these challenges to European fundamentals, we are left to question whether the Brexit-driven uncertainties can be priced into markets so quickly. While we long argued that 80% of the market impact would be priced into the space of two months in the event of a vote to leave, we are only in the second trading day to follow the vote.

Market pricing will eventually point to the extent of economic damage that will occur because of uncertainty and actual disruptions to business.  However,  we can't trust market pricing so immediately.  As we mentioned Friday (please see Strategy Bulletin: UK Votes Brexit. Markets Likely to ‘Overprice’ The Shock), equity valuations are favorable for Eurozone assets in particular given very low credit costs. U.K. dividend yields are a global standout.  But we are not of the view that European and U.K. markets have clearly overshot the new economic risks to the region already.

 

Historical Precedent Suggests Limited Lasting Impact In Other Regions

The precedent of previous shocks suggests we should not jump to the view that the Euro’s existence is in any immediate danger. Given lasting economic divergences among Eurozone members - which means it was never an optimal zone for a single currency -  we would expect the “euro question” to recur when the world economy is under greater stress than it is now.  However, the rise in risk premia in Eurozone government bond markets is significantly less than was the case in 2011-2012 (see figure 1). 

The 2011-2012 period preceded large scale easing by the ECB, the official assumption of most Greek debt, common regulation of banks and significant regional bank recapitalizations.  The ECB tightened monetary policy in 2011 and fiscal policy tightened in the Euro periphery at the time. The Eurozone economy as a whole contracted 1.7% in 2011-2012. Yet global growth, including the Eurozone, never slowed below 2% in the period (see figure 2).

Figure 1: Eurozone Crisis Indicator: Germany, Italian and Spanish Bond Yield Divergence

Source: Bloomberg as of June 24, 2016.

 

Figure 2: Global vs Eurozone GDP Growth Y/Y%

Source: Haver Analytics as of June 23, 2016.

How much impact should the U.K.’s decision, in isolation, have on the Eurozone and others?  History suggests surprisingly little. As figure 3 shows, only in the case of 2008-2009, when the collapse of highly leveraged, mispriced housing assets threatened the solvency of the banking system and basic market functioning, was there a synchronized global contraction.  Excluding the years 2008-2009, the correlation between GDP growth over annual periods in the U.K. and largest Eurozone economies is just 0.1%.

It is not just Europe that has fallen in relative isolation.  A very severe regional contraction in Southeast Asia and other parts of the emerging world in 1998-1999 had little bearing on global growth (see figure 4).  Collapsing interest rates, commodity prices, and large flows of savings to the U.S. offset the regional contraction.  To be fair, we see less capacity for a repeat now of this trend given market interest rates that are plumbing the depths of logic and with some key monetary policymakers with both feet on the peddle already.  Even as global growth was not derailed by either the Euro crisis of 2011-2012 or the Asian regional crisis of 1997-1999, global share prices did fall 21% and 24%, respectively at their low points before recovering. We should also bear in mind that these cases represented severe regional economic contractions.

Figure 3: Real GDP Growth: UK, EU, US Y/Y%

Source: Bloomberg as of June 24, 2016.

 

Figure 4: South East Asia vs World GDP Y/Y%

Source: Haver Analytics as of June 23, 2016.

Finally, last week’s referendum was not the U.K.’s only move to distance itself from the E.U.  The U.K. considered joining what would become the Euro currency zone before finding the currency’s pegged regime unsustainable.  The pound fell 4% on September 16, 1992, and about 12% over three months.  While markets other than the U.K. weakened over that period, they made large gains over the full year (see figures 5-6)

Figure 5: GBP underperforms….

Source: Bloomberg as of June 27, 2016.

 

Figure 6: …Equity returns recover gains

Source: Bloomberg as of June 27, 2016.

 

Conclusions

Certainly, the world does not need yet another source of economic slowing.  As we mentioned Friday, we see the more mature global recovery, led by the U.S., as less “shock proof” than periods such as 2011-2012.  This makes us keenly on the lookout for sustainable, high quality yields, such as U.S. dollar investment grade corporate debt and some emerging markets assets where yield spreads compensate for risk.  As noted by the Global Investment Committee, as interest rate pressures fall even further, some risks to U.S. interest rate-sensitive assets have actually come down with Brexit.  Depending on how severe the near-term asset price declines prove to be, we may alter our regional equity allocations away from Europe despite favorable valuations.  At the same time, we are keenly on the lookout for investment opportunities in other regions that have- or may sell off inappropriately.   

1 We use a composite of German, French and Italian GDP due to data availability constraints over the whole period.