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Financial Industry Insights from Advisors Asset Management
On June 24, 2016
A Perspective on the Brexit Results
Though the vote to leave caught the markets by surprise, especially considering the rally in markets yesterday, the byproduct of leaving is substantial in the markets reaction. The reality will be that this is about to enter a slow progression toward the United Kingdom’s (UK) exit of the European Union (EU) that will require years, not hours. When one scenario of a binary result is ruled out, the realization of it coming to fruition will promote wild prognostications of economic collapse. The UK has $2.9 trillion in GDP, one of the largest in the world and this will only fuel anxieties.
The moves in the overnight trading were substantial and will carry over to the morning, but remember that the liquidity in these markets are a whisper of what one would see daily. This allows prices to be bullied by mono directional trades with little volume. Some of the overnight lows are already being tempered.
This will take several years to unfold; but heading into this weekend, expect the bulk of the move downward in risk assets and upward pressure of prices on safe assets to occur in the first few hours today. The best estimates I’ve seen is that all things being equal, this will cause the UK GDP to decline by 1% to 1.25% with a potential hit to the EU by roughly 0.5% to 0.7%. Mainly the higher end of these drops will come from the contagion fear. Contagion in credit markets and capital markets in general is a real thing; however, economic contagion is a bit trickier to come to fruition. The capital outflow situation in the UK will be the main reason the Bank of England will have to act more promptly, this may come as early as today. The fixed investment in the UK – or lack thereof – was already tempered heading in to the vote which should help support some of the pound’s weakness.
Watch the pound as it has erased all the gains and is at levels not seen since mid ‘80s. The level of the pound relative to potential outflows may make the trading choppy. We believe there is value here, just wait for the dust to settle. Look for Scotland and Ireland to secede or push for departing the UK as you look at the map of who voted for Brexit and who didn’t. One thing to remember, this was such a close vote that was completely binary means that the uncertainty card will be played by the media over and over the next few years. Every time a slow news cycle pops up, they will throw Brexit and all of its copycats into the headlines.
The yen hit parity with the U.S. dollar in overnight trading; perhaps this is the biggest impact and could cause the global QEE. By QEE, I don’t mean quantitative easing, but rather Quantitative Exponentially Easing. The JGB 30-year issue is trading at 15 bps (basis points) while the 15-year German Bund is trading at negative yields now. The flight to safety was already overbooked and now is even more so.
Letting the dust settle seems appropriate, but remember as the famous British bander Nathan Mayer Rothschild said, “Buy on the sound of the cannons and sell on the sounds of trumpets.” This most definitely is a cannon as seen in Europe equity markets off 8-12% and the Nikkei down nearly 8%. Fund managers and investors were heavily cash laden and have been for some time.
Many are saying the vote here will lead to copycats across Europe. While this will give rise to the populists of each country, so too will the “remain” crowd who will see the short-term pain in the UK as it takes years to adjust making them more fearful of independence. Remember, it is easier for the UK to leave the EU than an existing EU and euro-denominated country who would have to reintroduce its domestic currency back in the system. This would be more painful than the UK situation.
All in all, the selloff in the European (non-UK) countries appears to be an opportunity. The pound’s drop and the BofE (Bank of England) needing to support it may make the financial debt be more attractive than the equities in England at the moment. Domestically, we believe the FOMC (Federal Open Market Committee) will put off raising rates until September and more than likely, 2017. With the announcement of the success of all 33 domestic banks passing the stress test quite substantially, we think any decline in the financials (equity or debt) should be seen as an opportunity. The Brexit will likely be somewhat localized form an economic perspective, and a bit broader in the capital markets for the short run.
2016-0620-5419 R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.
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