Just Before Halftime, Brexit Strikes
by Neil Dwane, Allianz Global Investors
Investment outlook at the halfway mark
- Global view: After Brexit's initial shock settled in, many risk markets have almost been ignoring the referendum's result. Nevertheless, investors should expect Brexit to slow the global economy, which means that globally, monetary policy will stay low or move even lower. Volatility should remain high as it follows the roller-coaster of political sentiment swings.
- UK: Large-cap equities will be the clear beneficiaries of the British pound's fall in the short and medium term. Domestic stocks could remain weak as the UK economy slows and uncertainty rises, but many UK assets – property and corporate – may look more attractive in non-pound terms.
- Europe: Even as Brexit causes much uncertainty to hang over the UK, the EU stands to lose the most, with European assets now more vulnerable to political risks. Fixed income will remain supported by ECB policy action through 2017, while equities – especially banks and financials – will remain weak due to Brexit-related uncertainty. Fears over the health of euro-zone banks could also cause a policy headwind for the ECB.
- US and Asia: Asset classes in these regions will be less affected by Brexit. With the Fed taking a divergent path from NIRP-focused central banks, the US equity market should continue diverging as well – though we do expect additional volatility as we head into November's US presidential elections. Meanwhile, China could be poised for a strong end to the year.
Just before the halfway mark of what we fully expected to be a volatile year – yet one that could also reward investors for taking risk – “Brexit" took the world by surprise. Indeed, Brexit's immediate adverse effects on many currency and asset markets make it clear that investors were not expecting this result. Perhaps this is a good time for investors to take stock of additional events, many political in nature, that lie over the horizon and have the potential to move markets.
A look back at the first half
At the start of 2016, many investors were focused on the twin themes of China and oil, which raised concerns over a global recession, failures in emerging markets (EM) and a rising US dollar. The latter became a threatening tax on those who had borrowed in US dollars but earned local currencies – namely, the EMs and the global banking sector, which suffered through the early part of the year and may not be out of the woods yet.
Since then, China has reasserted some sense of economic stability by broadcasting a clearer sense of policy direction with its new Five-Year Plan, and by finding a better balance between reforming the old state-owned enterprises while allowing the new consumption and services sector to blossom. As a result, we believe China will have a better second half of the year.
Oil, too, has shown good signs of stabilizing after its dramatic price collapse in 2015; prices have risen close to 25 per cent this year, with gold the only other commodity performing similarly well. Demand for oil is growing while oil companies' investment plans and capital expenditures are still in sharp decline. We expect physical oil stocks to continue to fall into 2017 as the oil market moves from oversupply into deficit.
As 2016 progressed, fears of a global recession waned and many EMs bounced back, turning the divergence of monetary policy on a global scale into the key narrative. While the US looked for a new opportunity to raise rates again, Japan and Europe moved to negative interest-rate policies (NIRP), to which investors and markets reacted poorly.
Ironically, NIRP resulted in an opposite outcome to what was originally intended: stronger currencies, stressed banking systems and lower share prices. Equities in Japan and Europe have seen some of the worst performance this year, falling 15 per cent to 20 per cent. EMs and the US, on the other hand, are down around five per cent. Clearly, central banks' differing policy measures are causing economies and asset classes to diverge as well.
In this environment of uncertainty and volatility, many investors have sought the safety of sovereign bonds: Yields across the curve have fallen, exaggerated by the aggressive European Central Bank (ECB) policies that have created negative yields on German bunds with durations of more than 10 years.
In the currency markets, the Japanese yen's strength caught both investors and Japan's government by surprise; the yen strengthened nearly 20 per cent against the US dollar this year, even in the face of the threat of rising US interest rates. Yet despite the EM currencies that collapsed due to oil-price pressure – notably Nigeria, Venezuela and Russia – and despite political turmoil now spreading to South Africa, Brazil and the Middle East, we have yet to see systemic EM contagion.
Enter Brexit
However, the key event of the first half of 2016 has turned out to be the unexpected but highly political decision by the UK to leave the European Union (EU). This will be a voyage into uncharted waters, where many rote economic issues – like terms of trade, immigration, law and standards – will have to be altered to reflect the UK's soon-to-be independent status. This will be a challenge for all, given that the UK has been following EU and international standards as a team player since 1972.
The political consequences of Brexit are severe, with the UK's Conservative and Labour parties in acute and possibly terminal disarray. Moreover, not only is the UK Parliament divided, but the UK itself is torn: Scotland, Northern Ireland and London voted to remain in the EU, while England and Wales voted to leave.
With the Brexit process set to take nearly three years to achieve, investment and economic uncertainty will cloud the UK's economic prospects – although the British pound's 10 per cent collapse the day after the Brexit vote may soften the blow. Nevertheless, the key losers of the Brexit decision may not be the UK, but the EU and political elites.
How Brexit harmed Europe
The EU is facing a possible existential crisis, with the Brexit vote turning not on economics but on immigration and sovereignty concerns – as evidenced by post-Brexit market corrections that took more of a toll on European equities than UK equities. To be sure, Europe's economy had been doing well in 2016, but other factors beyond Brexit are eroding confidence. Fears over the health of the euro-zone banks are growing – slow growth, NIRP, rising regulation and low levels of capital were already plaguing banks on a global scale – which is causing yet more policy headwinds for the ECB. Moreover, the many elections on the horizon – in Italy, the Netherlands, France and Germany – may in fact become elections on the EU itself. This could destabilize Europe further, especially with Greece's crisis still simmering in the background.
Brexit takes the establishment by surprise
The other loser was the political establishment, which was unable, incapable and/or unwilling to believe that a Brexit vote would succeed. This lack of touch is similar to the emerging “Trump effect" in the US, where the presumptive Republican candidate, Donald Trump, has appealed directly – often without the support of the Republican Party – to many disenfranchised Americans. As a result, we expect more volatility as we head into November's US presidential elections. With so many voters feeling unrepresented by the current “elitist" political parties, it will be more difficult for investors to assess the new risks and opportunities that such periods of change usually offer.
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