Global Chief Investment Strategist
June 24, 2016
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A majority of U.K. voters decided to leave the European Union, shocking world financial markets and ignoring many warnings.
- The immediate effect in financial markets is likely to be particularly severe as markets ran up sharply in the past week in a false confidence over a “remain” vote. The U.K. pound traded at the highest level of 2016 on early exit polls before plunging more than 10% from that level on the results today.
- Implementing an exit from the E.U.is now a highly uncertain process for the U.K. government and will take significant time. This should have negative macroeconomic consequences for the U.K., the E.U., and the world. Given the immediate shock, it is likely to lower the interest rate trajectory in the U.S. This could mean developed market currencies weaken some relative to emerging markets currencies.
- Policymakers will take steps to battle the shock and any contagion. This may include new monetary policy easing steps. However, one should not expect any pending actions to prevent a plunge in asset prices in the very short term.
- The precedent set by the U.K. referendum will likely embolden isolationists elsewhere. However, we would not jump to the conclusion that there will be actual “copycat” referendums in the Eurozone anytime soon given the visible negative impact that will be felt in the U.K. and its close trading partners.
- The extent of the near-term declines in risk asset prices is likely to exceed the absolute deterioration in global growth. Barring an unlikely breakup of the Eurozone, the output loss for world growth might be measured in just tenths of a percentage point, even if the U.K. experiences a mild recession.
- Volatility will be very high in the near-term, but is likely to “overshoot” and then decline given the binary nature of this event. With such great concentration on the outcome of the vote, we believe that the time it takes to “reprice for maximum uncertainty” will be compressed.
The U.K. public has spoken, and virtually every financial asset price in the world has changed significantly today. With it, the world economy will face one of the largest financial shocks of the post 2008-crisis period.
Despite the shock and uncertainty, we would not jump to the conclusion that the U.K. Brexit vote will challenge the global recovery to the full extent that the Eurozone crisis did in 2011. Emergency actions were taken then to avoid a catastrophic split up of the currency union, but regional economic activity suffered significantly. The turmoil of 2011 helped drive greater integration within the currency bloc - and also the larger European Union. This was one of several factors driving U.K. voters to leave (see figure 1).
Notably, the world economic recovery is older and more extended than during that earlier episode, and likely somewhat less capable of absorbing shocks. Policy flexibility is also lessened after many rounds of monetary stimulus. The high correlation across financial markets today mirrors the UK and European Union's economic interdependence and links to the rest of the world. These links represent a vulnerability, transmitting shocks from one country to another.
Now that the public of a major European Union member has decided to leave, speculation will mount over who might be next. There is much trade and investment uncertainty for the U.K. ahead, yet a breakup of the Eurozone would likely represent a much larger shock for the world economy than the U.K.’s negotiated departure over several years. Unlike the U.K, which has kept its pound, for members of the Eurozone currency block, there are very large currency-linked cross-border liabilities that would create a larger financial catastrophe if the Eurozone unwound.
Isolationists within the E.U. have been emboldened and encouraged by the U.K. vote, judging from comments from anti-establishment politicians in France and the Netherlands already. However, the financial and economic consequences on display today will be a warning to others. The comments of key European leaders will help determine the extent of any contagious fears in the near term. A difficult balance is needed to avoid it seeming there are no consequences for the U.K. without simultaneously inflaming fears of the impact.
Immediate Reaction in Global Markets
While making preparatory asset allocation changes early in 2016, we long counted on “remain” being a higher probability outcome than leave. Most recently, there appeared to be far too much financial market confidence that the result of the referendum would be to remain (please see Divided UK Public Holds Key to World Markets Outlook Near-Term). As confidence in “remain” soared ever higher in the past week, it should make today’s asset price declines particularly acute.
In some respects, the severe decline in asset prices that is likely today should help determine whether the reaction is ultimately excessive. U.K. and E.U. equities have fallen as much as 10% this morning with sterling falling 10% versus the U.S. dollar. With such great concentration on the binary outcome of the vote, we believe that the time it takes to “reprice for maximum uncertainty” will be compressed.
There may well be additional monetary easing steps from the European Central Bank and stepped up implementation of current measures. The Swiss National Bank has already intervened in currency markets. However, we would avoid any expectation that there will be a quick and positive market reaction to such steps. Ultimately, value will be found in risk assets if there is no significant contagion from the U.K. economy to the larger world.
The relative value of bonds and stocks was firmly in favor of equities ahead of today’s vote. That relative valuation gap will be stretched even further today before investors consider whether pessimism has become excessive (see figure 2).
What this means for the U.K. and Eurozone
Uncertainty over the future trading relationship between the U.K. and its largest trading partner, the E.U., will stifle inward investment. This is the driving force behind the collapse of the U.K. pound, which we should likely consider a “permanent releveling.” The weaker U.K. exchange rate and weaker investment spending should drive a significantly worse outlook for growth, relative to inflation, in the coming year or longer.
The financial sector in the U.K. will be a key area of uncertainty going forward as such services do not clearly fit into a variety of alternative bi-lateral trade agreements with the E.U. that are likely to serve as a basis for negotiations.
In estimates of the impact prior to today’s vote, Citi economists pointed to a halving of the U.K. real GDP growth rate in the coming year toward +1.0%. Yet the risk remains that tighter financial conditions become self-reinforcing, and an outright economic contraction is possible, even with the benefit of a weaker pound boosting exports.
For the Eurozone, the “traction” of monetary policy, which had improved significantly in credit markets prior to the Brexit vote, is likely to weaken now. Along with negative feedback effects from reduced trade and economic growth elsewhere, Citi economists estimated a weakening in the Eurozone’s growth rate for the coming year of 0.3%-0.5% below a current forecast of 1.6% in both 2016 and 2017. Of course, these estimates assume “most likely shocks,” and far worse will be feared today. However, the range of possible impacts could be smaller.
U.K. Prime Minister Cameron has already announced his intention to resign. Extremely difficult internal issues now loom in the U.K. as it deals with border complexity in Northern Ireland and voters in Scotland who may look for a second independence referendum of their own. A ratings agency has already telegraphed a U.K. sovereign debt downgrade. In short, there is great uncertainty to price into the short-term. We must weigh this against the solid probability that the world economic recovery does not end with yesterday’s vote.
Just as there were mis-priced hedges ahead of yesterday’s vote, short-term tactical opportunities are now apparent such as benefiting from the now rich price of volatility that is unlikely to be sustained.
For investors with longer horizons, it may pay to wait some days and watch to see just how much asset prices adjust relative to the economic outlook. As is typical, we suspect the economic outlook will be more stable than asset prices in a scenario of shock.
The Citi Private Bank Global Investment Committee will consider the variety of factors that weigh for and against our current asset allocation. We will review these with today’s return opportunities rather than yesterday’s prices in mind.