Brexit or no Brexit, risks remain
- Markets showing signs of apathy with just 30 days till UK referendum on Europe
- Polls and bookmakers' odds point to victory for "Remain" side
- Relief rally can be expected if pro-EU camp wins June 23 referendum
- Markets struggling to price assets efficiently in approach to starkly binary event
- MPC member Vlieghe said UK may need more stimulus to counteract slowdown
- It will take time for policymakers to gauge transiency of current UK slowdown
- US-UK interest rate differential likely to widen further in favour of US
- GBPUSD also becomes vulnerable against this backdrop
- Equities remain overvalued in our view
By Neil Staines
“I don’t decide my politics based on the flavour of the month” — Nandan Nilekani, Indian entrepreneur and politician.
With just 30 days left until the UK's referendum on its future in Europe, you would be forgiven for sensing a degree of apathy in the UK and GBP markets this week. The outward appearance of apathy, however, likely masks a subdued, illiquid, consolidatory phase.
Polls (and, possibly more importantly, bookmakers' odds) clearly, if not entirely convincingly, show the "Remain" side prevailing, and while that is the most likely outcome, we would expect at least a brief comeback from the "Leave" camp and a subsequent lurch lower in GBP and related risk assets at some point (probably closer to the June 23 referendum) over the next 30 days.
Markets struggle to price assets efficiently in the approach to a binary event where the two outcomes have significantly opposing implications, particularly if the perceived probability of a particular outcome is liable to change (polls, sentiment). In this instance, however, there is also a third equally interesting dynamic, which is the current slowdown in the UK economy, and whether this is a function of Brexit uncertainty or an unrelated economic slump.
“Not sure why some UK data has been softer” — Kristin Forbes, Bank of England MPC member
Last week, Gertjan Vlieghe, a member of the Bank of England's monetary policy committee, highlighted his concern over the recent decline in UK economic activity and said the “UK may need more stimulus if growth does not improve”, suggesting that rate cuts and more quantitative easing were “on the table if the outlook worsens”.
From a currency perspective, this is very significant, particularly because GBPUSD has had one of the most consistent relationships between a currency pair and relative rate differentials over recent years. If we overlay the current uncertainty of UK interest rate normalisation (even ignoring the potential Brexit implications) onto the current hawkish revival at the Fed, it is rational to expect the US-UK interest rate differential to widen further in favour of the US. Two-year GBP rates are now more than 20 basis points lower than US rates, something we haven’t seen since 2006.
If the "Remain" side wins the referendum 30 days from now, there will undoubtedly be a relief rally in GBP, as hedges and (downside protection) derivative structures are unwound, but the relief rally would also extend to the rest of the world, including the US. In the UK, however, it will take time for policymakers to gauge the transiency of the current slowdown. Rate differentials, and therefore GBPUSD, become vulnerable against this backdrop.
“There is not enough union in the European Union” — Jean Claude Juncker, European Commission president
Irrespective of the outcome of the UK referendum, the EU and the Eurozone have their own problems. While recent economic data for the Eurozone have been almost encouraging, it is likely (as has been strenuously reiterated by ECB chief Mario Draghi) that the recent recovery is cyclical. Structural inadequacies remain.
Forecasts from the Bundesbank and domestic institutions suggest that the pace of German economic activity will decline in the second half of 2016. We expect this pattern will be mirrored across the Eurozone. Once the distraction of the Brexit debate passes, we expect the euro to come under increasing pressure as the resumption of US normalisation highlights the inadequacies of Eurozone reform on future growth potential.
“You cannot build sustainable growth on a pile of debt” — Jens Weidmann, Bundesbank president
In broader financial markets, we continue to view equities as overvalued and vulnerable to (perhaps significant) declines. US rate normalisation and persistent weakness in the Eurozone and China (albeit with a degree of self-correction) provide an increasingly negative backdrop for equities, from our perspective, for the remainder of 2016.
US equities have been buoyed disproportionately over recent quarters by corporate buybacks, and, as normalisation progresses, the balance-sheet implications of such actions sour. So Weidmann's words are just as valid for US stocks as they are for Eurozone sovereigns.
— Edited by John Acher
Neil Staines is head of trading at The ECU Group