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Asset Allocation - Post-Brexit in a few questions and answers

 

THE ESSENTIAL

After 43 years of membership in the European Union, the United Kingdom has voted in a referendum to withdraw. The purpose of this article is review the political and economic impacts on the one hand, and the impacts on the financial markets and asset allocations on the other. It addresses the main current concerns.

Our baseline scenario is: i) that the UK will trigger Article 50 and begin exit negotiations with the EU; ii) that a petition is not enough to cancel the results of the referendum; and iii) that there will be no second referendum. Damage to the European economy will be limited (no doubt to -0.3% of GDP spread out over at least two years). It will probably be worse in the UK, with a recession that will be worse if final negotiations produce restrictive agreements. Two key components here would be the loss of European passports and favoured trade status. Politically, the UK will suffer considerable damage in the short term. Will the future Conservative prime minister be pro-Brexit or anti-Brexit? Only time will tell. For the EU, managing the UK’s exit, as well as immigration, growth and employment issues are major challenges that will (or will not) show the firmness and cohesion of the remaining 27 member-countries. Financially, this is the last thing the banks needed, as it comes on top of negative interest rates, high cost of capital, and the market’s inability to make distinctions between banks and between banking systems. One thing is certain: central banks will stick to their accommodating monetary policies (the Fed in particular) or even move them up to the next level (ECB, BoJ, BoE, etc.)

 

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PUBLICATION

 

After 43 years of membership in the European Union, the United Kingdom has voted in a referendum to withdraw.

The market impact has been great. Within one week (from the reporting of the referendum’s result to the morning of 30 June), the GBP lost almost 8% to the EUR (and -12% on the year to date). Meanwhile, European equities fell 5% (as measured by Eurostoxx) and safe havens like Bunds or US Treasuries posted sharp gains. Ten-year Treasuries and 10-year Bunds are now yielding, respectively 1.50% (-19bp) and -0.12% (-18bp). Corporate bond spreads have widened but this was offset at least partially by the interest rate impact. Bank securities (equities and debt), however, have dropped sharply, (-12%, for example, by the MSCI EMU financial index). As for sovereign spreads, the widening was held in check thanks to the ECB's QE. The Italian spread returned almost to its pre-Brexit level (+13bp, or 150bp above the 10-year Bund), while the Spanish spread actually narrowed a bit (by 5bp) to 138bp).

It is worth reviewing the political and economic impacts on the one hand, and the impacts on the financial markets and asset allocations on the other. The purpose of this research note is to address the main current concerns.

QUESTION # 1

Can the UK stay in the EU despite the approval of Brexit via a referendum?

QUESTION # 2

Could there be a second referendum?

QUESTION # 3

Is a petition enough to reverse the process?

QUESTION # 4

How can (should) EU countries react?

QUESTION # 5

Will the coming negotiations between the UK and EU be decisive in Brexit’s economic impact on the UK?

QUESTION # 6

What are the political impacts of Brexit on the United Kingdom?

QUESTION # 7

What are the direct economic impacts of Brexit on the European Union?

QUESTION # 8

Could Brexit alone cause a global economic slowdown?

QUESTION # 9

Does Brexit jeopardise banking systems in continental Europe?

QUESTION # 10

Will Brexit have repercussions on the London financial sector?

QUESTION # 11

What is the risk of a series of referendums in Europe?

QUESTION # 12

Does Brexit make it more likely that accommodating monetary policies will continue?

QUESTION # 13

Does Brexit reinforce the low-interest-rate environment and the quest for yield?

 

QUESTION # 1 Can the UK stay in the EU despite the approval of Brexit via a referendum?

Is it possible to imagine that a democratic country like the UK would not adhere to the outcome of a vote as important as this one and with such a high turnout? It seems unlikely. And yet, despite the referendum’s clear verdict, this option seems to have been put on the table. Yes, of the 650 MPs in the House of Commons, 479 came out in favour of “Remain”, but it’s hard to see how the government and Parliament could act against the wishes of almost 17.5 million voters. The lawyers are now going at it. Some are calling on the people’s representatives to decide, instead of the people themselves; in other words, MPs should vote before triggering the exit process. Others acknowledge that this is possible in theory but impossible in practice, as the people’s representatives must adhere to the decision of the voters, as in any democracy.

Under the current procedure, any country wishing to pull out of the EU must invoke Article 50 of the Lisbon Treaty (see box below). This opens the path to negotiating an exit from the EU (this is the only legal way out of the EU). To do so, it must serve notice of its decision to the European Council, which would take note of this decision. That is when negotiations would begin. That would be a challenge indeed, as this is shaping up as the most complicated divorce in history. This is no doubt the reason for the UK government’s stance (“Only the UK can trigger Article 50. In my judgement we should only do that when there is a clear view about what new arrangements we are seeking with our European neighbours”, in the words of George Osborne, Chancellor of the Exchequer). Moreover, David Cameron would rather leave this (burdensome) task to his successor and play for time. Remember that negotiations will begin as soon as the procedure is triggered and will last for up to two years if an agreement is reached and longer if necessary on the unanimous vote of EU member states. Baring unanimous agreement to extend the negotiations, the UK will be out of the EU with no trade agreements and no free-circulation agreements. Some feel that it is possible for the UK to never invoke Article 50 and to remain de facto in the EU. We see this as highly unlikely. But one thing is sure: EU member-states are not displaying much cohesion. Some (like France) want the Brexit procedure to begin as soon as possible, while others (Germany) are not in as much of a hurry. The final agreement with the UK must be approved by the 27 member-countries at a qualified majority.

 

Article 50 of the Lisbon Tready

  1. Any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements.
  2. A Member State which decides to withdraw shall notify the European Council of its intention. In the light of the guidelines provided by the European Council, the Union shall negotiate and conclude an agreement with that State, setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union. That agreement shall be negotiated in accordance with Article 218(3) of the Treaty on the Functioning of the European Union. It shall be concluded on behalf of the Union by the Council, acting by a qualified majority, after
    obtaining the consent of the European Parliament.
  3. The Treaties shall cease to apply to the State in question from the date of entry into force of the withdrawal agreement or, failing that, two years after the notification referred to in paragraph 2, unless the European Council, in agreement with the Member State concerned, unanimously decides to extend this period.
  4. For the purposes of paragraphs 2 and 3, the member of the European Council or of the Council representing the withdrawing Member State shall not participate in the discussions of the European Council or Council or in decisions concerning it.
  5. If a State which has withdrawn from the Union asks to re-join, its request shall be subject to the procedure referred to in Article 49.

 

QUESTION # 2 Could there be a second referendum?

In theory, anything is possible. But do not expect the situation to bog down, leading sooner or later to a second UK referendum. True, the pro-Brexit British press has softened its tone and some pro-Brexit politicians are now proclaiming their fondness for Europe, but foot-dragging is out of the question (European countries are obviously against doing so), as is preparing a second referendum. However, a second referendum is entirely possible… but in Scotland alone. This would be a referendum on whether to pull out of the United Kingdom. Nicola Sturgeon, the Scottish prime minister, has already announced that if the polls are favourable, she will call for a referendum and, if it’s successful, to apply to join the EU. A Scottish pull-out would be very bad news indeed for the UK from an economic viewpoint, as the UK would lose the North Sea oilfields, which are located in Scottish territory.

QUESTION # 3 Is a petition enough to reverse the process?

A petition with more than 100,000 signatories can also have consequences: in such a case, Parliament may debate the issue (but is not legally required to do so). There is currently a petition circulating for a new referendum and stating that if one camp wins less than 60% of the votes and voter turnout of less than 75%, a new referendum must be held. This is the case, and the petition now has 3.9 million signatures. Keep in mind, however, that the petition was initially launched by a Brexiteer, before the referendum, at a time when “Remain” was ahead in the polls. This petition does not appear to be serious. An investigation has found that some signatories were minors, some were not British, and others were simply made up: 39,000 signatories from the Vatican’s 900 inhabitants, 23,000 from North Korea, whose people have no Internet access, and so on. In short, not only do certain aspects of the petition invalidate it, it would not be enough to reverse the outcome of the referendum, but merely to lead to a Parliamentary debate. Not enough, then to go against the referendum’s verdict.

QUESTION # 4 Will the coming negotiations between the UK and EU be decisive in Brexit’s economic impact on the UK?

While everyone agrees that the British economy will suffer long-term damage from its decision to exit the EU (50% of its exports are sent to the EU, and they currently account for almost 70% of GDP, vs. 20% 40 years ago), negotiations with the EU will determine just how much so. There are several possibilities:

1st scenario: the UK retains access to the single market and its membership in the European Economic Area (EEA), as is the case for Norway, which, incidentally, contributes to the European budget and allows free circulation of goods and persons but is not bound by any free-trade agreements with the EU;

2nd scenario: the UK retains its membership in the European Free-Trade Association (EFTA), like Norway, but with trade agreements negotiated with the EU, like Switzerland. Keep in mind that Switzerland is subject to some restrictions, for example on access to the EU for its banking industry. This will
be a crucial point for the UK;

3rd scenario: the UK does not get any special trade agreements but does get tariff-free status between the UK and the EU, as is the case of Canada, for example. Some Brexiteers want to lift tariffs with the EU.

4th scenario: the UK renegotiates trade agreements with EU partners, one by one. Remember that it takes four to 10 years to implement trade agreements.

The impact on GDP is expected to be quite negative, especially as if trade agreements are not rolled over. The UK would “lose” between 2.5% and 9.5%
of its GDP, according to the UK Treasury, while the employers’ association estimates that the EU alone contributes 4%-5% of GDP, or about GDP 70bn. Trade volumes and costs would be affected, specifically in financial services, chemicals, and automobiles – all sectors that are closely woven into the EU.

The British Treasury fears a 6% decline in GDP, a 4% decline in wages, and the loss of more than 800,000 jobs within two years. The Centre for Economics and Business Research nonetheless hopes that the UK will avoid recession, assuming a favourable policy mix (monetary and fiscal policy). No wonder the ratings agencies downgraded the UK (it has already lost its AAA rating).

We also understand better why the UK would rather reach an agreement (prenegotiated before triggering Article 50) giving it sole control over its migrant flows and allowing it to forego contributing to the European budget and to hold onto the current trade agreements. In a word, it wants to obtain even more than what it had been granted prior to the referendum. Any chance of that happening? Not really.

QUESTION # 5 How can (should) EU countries react?

European countries must now show cohesion, and two major issues stand out.

1st issue: get out of the stalemate that is emerging around the UK’s intention – or lack thereof – to invoke Article 50. It’s up to the UK to do so. Barring that, negotiations cannot begin. Although they do not represent all of the EMU or the EU, Germany, France and Italy do agree that there will be no pre-negotiations with the UK. But the European Council has no way to force the UK’s hand. Waiting for a new prime minister to take office (on 2 September) and for him or her to pull the trigger would leave Europe and its institutions in a stalemate. Who would have imagined that a country wishing to leave the EU would end up not following through? This once again raises issues on the Treaty’s content and governance.

2nd issue: show (soon) that Europe is not out of ideas. Among EU countries, interests sometimes diverge, and electoral calendars hinder joint decisionmaking, while lofty, broken promises feed extremist votes. Angela Merkel, François Hollande and Matteo Renzi presented four priorities early this week: security, growth, youth, and tax and labour harmonisation in the euro zone. Nothing new there. The hard part is not laying out objectives but meeting those objectives. All this is underlain by other basic issues, such as the debt burden in some countries, disenchantment with Europe, the rise of extremism (on the right in core countries and on the left in peripheral ones), reforms in France, foot-dragging on EU banking union, fears of a pick-and-choose Europe, and so on.

EU countries must now demonstrate their willingness to tackle these issues and head off temptations of a pick-and-choose Europe that the Britons have stoked.

QUESTION # 6 What are the political impacts of Brexit on the United Kingdom?

During the campaign David Cameron often said that, in the event of a pro- Brexit vote, Article 50 must be triggered promptly, as negotiations with the EU promised to be long and hard. Since the outcome of the referendum, his political agenda has changed. He announced he would resign in October but refuses – at least for now – to invoke Article 50 of the Lisbon Treaty, which would give the go-ahead to Brexit negotiations. He does not want to be held accountable for a political act that would most likely drive the British economy into recession, leaving this for his successor, probably a Brexiteer. Meanwhile, resignations are coming one after another within the Labour Party. All parties appear to have been shaken by the situation. We are therefore entering a phase of political instability that is blackening the picture a little more, especially as many Europeans want to get this over with as soon as possible.

On top of all these complications, the next prime minister will have to deal with a number of domestic splits:

  • A sharp split between urban and rural areas: major cities like London voted 75% for “Bremain”, while more rural areas voted 75% for “Brexit”;
  • A split between generations: most young people voted “Remain” and seniors “Leave”;
  • A split between countries: England (at 53.5%) and Wales (at 52.5%) in favour of leaving; Scotland (at 62%) and Northern Ireland (at 56%) for staying;
  • A split within the very heart of political parties, whether they were for “Leave” or for “Remain”. The shockwave has begun to be felt, with some leaders resigning and some serious dissension being aired;

In other words, the referendum’s outcome will have a lasting impact on British society. Moreover, the EU referendum may give way to a UK referendum. Scotland (where most oil is produced, among other things) has already announced that it wants to stay in the EU, which points to a new referendum.

We know the next prime minister will be a Conservative, and will be a woman. What we don’t know yet is whether she will be pro-Brexit or pro-Bremain. This will no doubt make a difference in negotiations and could also drive the financial markets in the coming weeks, through public statements and poll results. So there is more political instability to come in the UK. The start of the voting process within the Conservative Party has named Theresa May (Home Secretary, pro-Remain) and Andrea Leadsom (Energy and climate change minister, pro-Leave). The final verdict is set for 9 September.

QUESTION # 7 What are the direct economic impacts of Brexit on the European Union?

The EMU will now account for 86% of the EU’s GDP (vs. 71% previously, when including the UK). At first glance, Brexit will not have serious economic repercussions for EU countries, particularly as growth is driven mainly by domestic demand. However, a look beneath the surface shows that Brexit will have visible impacts, which will vary somewhat from one country to another.

There are three main angles:

Angle #1: impact on exports: Ireland, Malta and Cyprus, as well as the Netherlands, Belgium and Norway would be affected the most;

Angle #2: impact on direct foreign investment: Malta, Ireland, Luxembourg, Cyprus, Switzerland, Belgium and the Netherlands would be affected the most;

Angle #3: impact on the financial sector: Luxembourg, Switzerland and Malta would be affected the most.

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All in all, Ireland, Malta, Cyprus and the Benelux countries would be affected the most by Brexit, and Austria, Italy and Finland the least, as they are the least connected with the UK. All in all, we believe Brexit will have little impact on euro zone growth. We estimate euro zone growth at 1.5% in 2016 (vs. 1.6% previously) and 1.3% in 2017 (vs. 1.5% previously).

Lastly, remember that the UK contributes 200 million euros each week to the European budget, an amount that will have to be taken over by EU countries, prorated to their current contribution. That shouldn’t be insurmountable at this point.

QUESTION # 8 Could Brexit alone cause a global economic slowdown?

The British economy will no doubt sink into a recession in the next two years. Even if its growth stays in positive territory in 2016 and 2017, it is very likely to suffer at least two consecutive quarters of contraction. Will this be enough to send the global economy into a general slowdown? Probably not. As the world’s fifth largest economy before the drop in the GBP, the British economy is not big enough to cause a global economic slowdown. Growth in other developed economies is solid enough to head off a new collapse in global growth. Keep in mind also that growth in many countries is currently being driven more by domestic demand than exports (especially exports to the UK). As for “emerging” economies, the impact will be too weak to make any radical change. All in all, global growth will remain at about 3%, and dangers will come from elsewhere: China, the United States, geopolitical risks, etc., and these are the risks to global growth, not the consequences du Brexit:

  • In developed economies, weak investment, Chinese growth, and a possible slowdown in consumption remain major risk factors.
  • In emerging economies, Fed monetary policy, Chinese growth, commodities prices and global growth expectation are the main risk factors.

QUESTION # 9 Does Brexit jeopardise banking systems in continental Europe?

European banks are nothing like the banks of 2008 or 2011. Not only have they raised very heavy amounts of equity, but the ECB’s anti-crisis mechanism is now well established, with bank supervision, stress tests and so forth. Moreover, for more than one and a half years they have had access to ECB liquidity, something that has reduced specific and systemic risk considerably.

  • Surveillance of banking systems has improved considerably since the financial crisis, along with disclosures in this area. The ECB has undertaken a full and extensive audit; stress tests have been reassuring, and risks well identified;
  • European banks are now well-capitalised: they have raised €500bn in equity since the crisis;
  • Last 10 March, the ECB launched a new TLTRO programme, which provided reassurance on central bank support for euro zone banks;
  • Credit exposure is nothing like it was in 2008: we have moved from a credit bubble to a credit “deficit”.

Banks nonetheless remain weakened by the fall of interest rates into negative territory and the stubborn relatively high cost of capital.

And yet, falling interest rates were effective at first. Banks were given immediate access to very low financing costs and, more importantly, without relation to their real risk level. True, some banks early in the crisis had a hard time securing funding on the interbank market and all banks’ share prices collapsed, but in the US and Japan as well as in Europe non-conventional policies at first boosted bank profitability. QE programmes sent bond yields down sharply, while deposits are of a far shorter duration than bank portfolio assets. Abundant liquidity and persistently low interest rates in some cases allowed banks to put off shoring up their balance sheets. In a second stage, lower yields and the flattening of the yield curve led to an outright collapse in the interest margin and profitability receded. In other words, the interest rate gap between (short) liabilities and long (assets) almost vanished.

Meanwhile, banks’ cost of capital did not decline, for several reasons:

  • The weight of past crises: the return to normal never actually happened, as the 2011-2012 bank crisis left long-lasting traces;
  • Fears of future crises: the banking environment is still weak in some countries (Italy with its bad bank and Portugal) and there are persistent fears and rumours surrounding Deutsche Bank);
  • Regulatory uncertainty is another reason that cost of capital has remained high. What will Basel 4 ultimately look like? At the very least, regulations, whose purpose is to prevent future crises, do not foster growth and the business cycle. This is the usual debate over the pro-cyclical nature of regulations;
  • The market’s failure to make distinctions between different banking systems. Regarding banks, there is still talk of systemic risk, interactions and contagion. None of that helps the interbank market function properly, and even undermines the weakest banks and thereby impacts the most solid banks through contagion! This vicious circle is encouraging deleveraging and domestic retrenchment more than fluid exchanges, pooling of risks, and the assumption of additional credit risk. By weakening UK banks, Brexit will raise fears of contagion, even though the coming challenges facing UK banks offers European banks some opportunities.
  • The “abnormally” low level of interest rates and yield curves, with a direct impact on profitability and, hence credit supply. We might also add interest rate risk, which is now totally asymmetric. The more that banks believe that interest rates will remain low for a long time, the more they will be encouraged to dial back risk and ride against the tide of monetary policy.

The British financial sector – and banks in particular – will be weakened by Brexit, due mainly to their loss of European passports, the potential impact on the London financial market, and the prospect of a UK recession. If European banks are being undermined, that is due to the inability to make distinctions between different banking systems and additional squeezes on short- and longterm interest rates. But there’s no point in betting on a collapse of European banks. Rather, attention should be focused on their excessive undervaluations.

QUESTION # 10 Will Brexit have repercussions on the London financial sector?

The London financial market will not be left unscathed, and that’s why the City (and the Bank of England) was against Brexit.

  • The first consequence is that UK banks will very likely lose their European passports, which allow a credit or payment establishment certified in one EU country to do business in other EU countries. With their passports revoked, London-based banks will have to be accredited elsewhere and will therefore have to transfer activities and employees, unless they wish to bet that their European passports will be spared in the EU-UK negotiations. But that’s a bet not worth making, as the timing is too long and too uncertain. So some activities will be transferred, particularly at US and Swiss banks (some, like JP Morgan and HSBC have already raised this possibility), along with jobs (London employs 2.2 million people in banking and finance). Where will they go? To Ireland, Luxembourg, France, Netherlands, Germany, etc.? While the first two (Ireland and Luxembourg) offer tax benefits, major banking groups and first-tier asset managers have deep footprints in France.
  • The London Stock Exchange / Deutsche Börse merger could be cast into doubt for economic and financial reasons (how much is LSE worth since the recent collapse in the GBP?). Could the German federal state of Hesse also use its veto right for political reasons (to block the merged entity from setting up in London)? Time will tell (soon).
  • So the key will be in the stance taken by European bodies. The EMU’s major financial infrastructures are currently located in the EU but not the EMU, but this does not look realistic under the new paradigm. Is it still possible to allow entities that are crucial to the proper running of the euro zone to be located outside both the euro zone and the European Union? Unlikely. That means that the Europeans will probably work to repatriate certain activities to Europe, and in particular the clearinghouses (which handle and centralise payments between commercial banks).
  • The European Banking Association, incidentally has already announced that it will relocate from London to the continent.
  • The European Central Bank (ECB) had announced a few weeks ago that the matter of the location of the euro market would not arise in the event of a Brexit. The UK capital is the top global venue for currency transactions (including the euro), but it is also crucial for transactions involving euro-denominated corporate and sovereign bonds.

All in all, the London financial market is likely to lose some influence, as long as the Europeans, led by Germany and France, can be bothered to take over.

QUESTION # 11 What is the risk of a series of referendums in Europe?

Brexit has revived expectations of referendums in other EU countries, backed by a number of opposition parties who see an opportunity to reject ruling parties. There have been referendums in many countries in recent years. Slovenia, Slovakia, the Czech Republic, the Netherlands, Malta, Luxembourg, Lithuania, Latvia, Ireland, Hungary, Spain, and Estonia have held referendums on a European constitution, the Lisbon Treaty or their membership in the EU, while Portugal and Poland cancelled theirs. Scotland is a special case: it wants to get out of the UK and stay in the EU, and a referendum there has become highly likely. Many people in Scotland feel greater affinity with Europe than with Great Britain and would like to create an independent and European Scotland. But things are not that simple. For one thing, the UK Parliament would have to green-light a referendum. For another, the transition period would be highly complex. First of all, Brexit includes Scotland. So not until the outcome of negotiations on the official exit of the UK would Scotland be able to request membership in the EU, assuming that it had become independent. This would be a long and uncertain process, involving the introduction of a national currency – not the GBP and probably not the euro, as Scotland would no longer even be in the EU. A real conundrum. Things are not necessarily any simpler in the other countries. In Germany, the fundamental law does not provide for referendums except to change the borderlines in the Länder, merging or dividing them. Any referendum would be held in the states concerned. However, legislation in some states and local communities provides for local referendums. The Belgian constitution has no provisions for referendums. In Italy, 500,000 signatures are needed to hold a referendum, but the process takes at least one year… and referendums on treaties are not currently possible and the constitutional court will probably not allow any. Same thing in Austria, where treaties are not subject to referendums. In France, a national referendum (Articles 11, 88-5 and 89 of the Constitution) mainly covers legislation, treaties and constitutional issues. Only the president can call a referendum and, for the moment, his mind is on the presidential elections (next April and May). It’s hard to see the Republican or Socialist parties taking this route after the presidential elections. Without the president’s consent, support must be obtained from at least 25% of members of Parliament (National Assembly and Senate) and at least 10% of the voters. In Finland, 50,000 signatures can force parliament to debate but it is not required to call a referendum. In Poland, 500,000 signatures are enough to trigger a referendum, which cannot call for rejection of the provisions of a European treaty. In Hungary, 100,000 signatures are enough to trigger a referendum, but there can be no referendums against an EU treaty or against the obligations flowing from an international treaty. So we are unlikely to see a series of referendums but are likely to see these issues debated extensively.

QUESTION # 12 Does Brexit make it more likely that accommodating monetary policies will continue?

If there is one good thing about Brexit, it’s that it reinforces the low-rate environment. Growth will weaken in the UK; the impact on trade is certain; and the fear of an impact on economies will encourage the major central banks to stick to their cautious stance.

Regarding the Fed, we have long known that no monetary normalisation or true tightening cycle is in the offing. The Fed is “behind the curve”, and it has thus far not managed to restore its leeway on interest rates. True, the dollar’s effective exchange rate has appreciated considerably (+13% since 2008), and acts as implicit monetary tightening. Fed models suggest that a 10% rise in the dollar’s effective exchange rate is equivalent to a 175bp rate hike! An additional appreciation in the greenback, driven by its safe haven status (and the safe haven status of US Treasuries) would therefore act as additional implicit monetary tightening. However, on the year to date, the dollar (in real effective terms) has actually fallen by 0.6%. Even so, in the current context, the Eurodollar curve is now pricing in the next Fed Funds rate hike for 2017.

We also know that the Bank of Japan is being forced to stick to an ultra-lowrate (now negative-rate) policy and QQE (Quantitative and Qualitative Easing) to restart economic growth and inflation and steer the yen downward. Brexit has triggered a significant appreciation in the yen, as a safe haven. So the BoJ is nowhere near ready to reverse its monetary policy. In fact, it must now use exchange rate policy (through market interventions) to keep the yen down, as that would otherwise be bad news for profits, share prices and growth.

The ECB will continue to ensure that rates remain low for some time to come. Brexit’s impact on euro zone growth is still not clear (everything will depend on UK-EU negotiations), but it will be visible.

The Bank of England probably has no choice but to ease its policy to head off the coming economic slowdown. At least, this is what can be gathered from the recent statements of the BoE governor, Mark Carney.

So much for those who were betting on rate hikes. They will probably lose that bet once again.

QUESTION # 13 Does Brexit reinforce the low-interest-rate environment and the quest for yield?

Clearly, yes.

  • First of all, Brexit is good news for US Treasuries, which are safe havens, are denominated in USD (also a safe haven), and offer significantly better carry opportunities than European bonds. US bonds have received a boost during this murky episode;
  • Brexit is also good news for euro zone sovereign bonds. To ease widening pressures on credit spreads and risk premiums, the ECB could speed up its asset buying programme, which makes it a good idea to reassume positions on the markets affected by the ECB’s QE. With this in mind, being short duration and underweighted in safe assets is not a wise course.
  • And it is good news for euro zone corporate bonds, especially investment grade ones, thanks to the ECB’s buying programme. The ECB has accelerated the pace of its buying since the outcome of the referendum. This offers additional proof, in any were needed, of its determination to prevent an increase in risk premiums on the European corporate bond markets.
  • It’s good news for high yield, as this not only stabilises its environment (sovereign yields, IG spreads, etc.), it also gets good access to liquidity and to investors’ further quest for yields.
  • Banks are a special case. As mentioned above (in Section 9), lower rates and high cost of capital are two negative markets that have driven down banking stocks for some time now. Brexit now adds growth fears, additional declines in yields, and fears of contagion between banking systems. That’s a lot to deal with in the current environment.
  • European equities have also been driven down by financials and the repricing of risk premiums. The value story is now timelier than ever in Europe.
  • As for emerging markets, we reiterate everything we have written over the past few months on spread and yield oases, equity and debt market valuations, undervaluation of numerous currencies, still-accommodating monetary policies, bottoming out of commodity prices, and so on, and are holding onto our positions.

 

Macro Hedging Strategies

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Is it possible to imagine
that a democratic country
like the UK would not adhere
to the outcome of a vote as
important as this one?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

A second referendum
is entirely possible...
but in Scotland alone

 

 

 

 

 

 

 

Negotiations with the EU
will determine just how
much damage Brexit will
do to the UK economy

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One thing European
governments need to do:
show that Europe is not out
of ideas

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

All parties appear to have
been shaken by the situation
and we are entering a phase
of political instability in the UK

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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Ireland, Malta, Cyprus and
the Benelux countries would be
affected the most by Brexit

 

 

 

 

Global growth will remain
at about 3%, and dangers
will come from elsewhere:
China, the United States,
geopolitical risks, etc

 

 

European banks are being
undermined by the failure
to make distinctions between
the different banking systems,
and additional squeezes on
short- and long-term rates

 

 

The London financial market
is likely to lose some
influence, as long as the
Europeans, led by Germany
and France, can be bothered
to make that happen

 

 

 

 

We are unlikely to see
a series of referendums but
are likely to see these issues
debated extensively

 

 

 

 

So much for those who
were betting on rate hikes.
They will probably lose
that bet once again

 

 

 

 

 

The ECB is keep rates
low and keeping risk
premiums from worsening

 

 

 

 

 

 

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ITHURBIDE Philippe , Global Head of Research
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Asset Allocation - Post-Brexit in a few questions and answers
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