Post-Brexit markets set to become even more volatile
The shock waves from Britain’s momentous decision last Thursday to sever its 43-year membership of the European Union (EU) are rippling through global financial markets.
On Monday, ratings agency Standard & Poor’s stripped the United Kingdom (UK) of its last triple-A rating from one of the big three agencies, warning that the vote to leave the EU was a “seminal” development that will undermine the country’s policy regime, weaken growth and endanger Britain’s macroeconomic position. Fitch, another agency, also cut the UK’s rating.
In the first two trading days since the result of the referendum was announced, more than US$3 trillion was wiped off the value of global equity markets – with advanced economies accounting for nearly all of the losses – in the worst two-day decline in stocks since the outbreak of the 2008 financial crisis.
On Tuesday and Wednesday, investor sentiment improved somewhat, with the pound staging a rally but still 10 per cent lower against the dollar than on the day of the referendum. Global stock markets also rebounded, mainly because of expectations that central banks will be forced to intervene to stabilise markets.
Yet in a sign of the degree of Brexit-induced fear in markets, so-called “haven” assets such as gold, “core” government bonds and the Japanese yen remain in strong demand. The yield on benchmark 10-year US Treasury bonds has fallen to 1.4 per cent – its lowest level since the height of the eurozone crisis in July 2012 – while the price of gold has risen to US$1,320 an ounce, a two-year high.
Moreover, yields on Japanese bonds with a maturity of up to 40 years have fallen to below 0.1 per cent for the first time.
Make no mistake, Britain’s decision to withdraw from the EU is a game-changing development both for the UK and Europe which will lead to political, economic and financial uncertainty at a time when central banks can no longer be relied on to stabilise markets.
While sentiment may have improved following a dramatic two-day sell-off, it is fanciful to think that the withdrawal of the EU’s second-biggest economy from the bloc – and whose London-based financial sector accounts for a quarter of all EU financial services income and 40 per cent of financial services exports, according to the Bank of England (BoE) – will not undermine investor confidence and increase the scope for a much sharper deterioration in market conditions in the coming weeks.
Investors must now contend with a number of extremely worrying developments.
The most conspicuous one is the sudden emergence of a dysfunctional UK political system which has damaged the country’s policy regime and, together with a brewing constitutional crisis (Scotland is already preparing the ground for a second independence referendum as a fallback option to remain in the EU), has cost Britain its remaining triple-A rating.
Amid the financial turmoil unleashed by the UK’s decision to leave the EU, investors now face the prospect of months of political uncertainty, with a dangerous leadership vacuum at the top of both the ruling Conservative party and the opposition Labour party and, just as worryingly, no clear plan from the “Brexiteers” on the way forward.
A potentially more troubling development is the danger that “Brexit risk” amplifies “Trump risk” as investors become more sensitive to political risk, in particular the possibility that Donald Trump, the populist anti-establishment Republican presidential candidate, will win November’s US election.
Convergex, a US brokerage, notes that “the Brexit vote has burrowed its way into American political consciousness with a simple question: “Could it happen here, [or] code for could Trump actually become President.”
The third major risk, which could determine how severe the post-Brexit deterioration in sentiment will be, is diminishing investor confidence in the efficacy of monetary policy.
Ultra-loose financial conditions, in particular the imposition of negative interest rates in Japan and the eurozone, have already triggered a fierce backlash from banks and money market funds and have distorted asset prices to dangerous levels. The Bank of Japan (BoJ), moreover, is unable to counter the surge in the yen, whose status as a haven currency is outweighing the effects of aggressive monetary easing.
Lastly, it is not clear whether a Brexit will occur given that the UK parliament has yet to invoke Article 50 of the EU treaty which sets in motion the legal and formal process of exiting the bloc.
Investors should prepare for a long, hot summer of uncertainty and instability.
Nicholas Spiro is a partner with Lauressa Advisory