In the end, it happened and Europe will no longer be the same! Contrary to recent market expectations, the “Leave” camp won, leading to increased uncertainty over the future of Europe.
After the unexpected “Leave” outcome of the U.K. referendum, we see conditions for a risk-off environment in the near-term. Markets are opening this morning significantly lower. However, we believe that Central Banks are ready to act and their immediate focus will be to stabilize the markets and provide liquidity if needed.
Over the medium-term, uncertainties over the future of Europe and Central Banks’ reaction will dominate financial markets. Ultimately, we think that the political and monetary policy response will be the major variables to manage an orderly Brexit.
The British vote has a massive impact on the geopolitical equilibrium, as it creates a precedent in the European Union (EU). Britain’s exit could trigger a surge of initiatives similar to the UK referendum. Upcoming elections in Spain and the constitutional referendum in Italy will be the next political events to follow to evaluate the strength of these centrifugal forces within Europe.
From a macro perspective, the victory of the “Leave” camp could increase the probability of the developed world being trapped in a low growth/low inflation scenario. Fears and prolonged uncertainty in Europe following the vote could, in fact, hurt confidence and limit economic activity. A smooth management of the transition, which will take years to materialize, will be a key factor to avoid a deeper crisis that could hit the global economy.
From a market perspective, the short-term impact of the “Leave” vote will result in increased market volatility and a further flight to quality. While over the medium-term, the focus will be on the political and monetary response.
Ken Taubes, Head of U.S. Investment Management, anticipates a rally in US Treasuries, while there may be a sell off of US high yield assets as well as emerging market assets, particularly driven by a perception that the demand outlook for oil will deteriorate in a risk averse environment. From a macro perspective, the negative economic impact of Brexit on the U.S. should be more limited compared to its impact on the UK and Europe. However, Ken Taubes expects reduced global demand due to a higher level of uncertainty and risk aversion. In his view, while the spillover effects on the US economy are unclear, it is possible that in the event of a significant negative economic impact, the Federal Reserve Board might consider other monetary policy options.
Moving to Europe, we believe that the central banks’ immediate focus will be on stabilizing the markets, and to be ready to provide them with liquidity. According to Tanguy Le Saout, Head of European Fixed Income at Pioneer Investments, Brexit will cause a rally in German Bunds, accompanied by an under-performance of other markets, but especially peripheral markets such as Italy and Spain.
A sharp “risk-off” environment, accompanied by widening spreads in peripheral and credit markets could cause Central Banks to intervene. In Tanguy’s view, the monetary policy adjustments will be made, initially through measures of credit easing and broadening of the asset buyback program, but ultimately rate cuts may be implemented. On the currency front, the US dollar (USD) and the Japanese yen could benefit from the “risk-off” environment.
Equity markets are also likely to suffer a period of extreme volatility as investors digest the potential impact of the event. However, the presumed downward pressure on the sterling is likely to be positive for the earnings prospects for certain UK companies, given the predominantly international nature of their businesses. The view of our European Equity team, headed by Diego Franzin, is that the risk-off mode could be mirrored, with domestically focused Eurozone business models (financials for example) most impacted given the unknown ramifications of the decision on the Eurozone economy. In this instance, we suggest that investors consider keeping a cautious stance on the market, focusing on companies with a solid business model, while also being cautious on more domestically focused UK business models.
From a multi-asset perspective, we prefer to keep a risk-off attitude, favoring “safe haven” assets such as US Treasuries. We believe that holding gold could be a natural hedge should the probability of a secular stagnation rise. We also continue to believe the Swiss franc should be favored versus the sterling, as it tends to behave as a safe haven currency, and we believe the USD could outperform the euro.