Europe: The Final Countdown?
- Shrinking earnings render equities overvalued
- Globally, things are not as bad as they may seem
- Uncertainty and illiquidity are likely to increase
- Click here for more Brexit analysis by Saxo's experts
“I guess there is no one to blame” – Europe, The Final Countdown
Today, a large percentage of the UK population may be more concerned about exit from the Euro 2016 Football tournament than from the EU, however, with just a week to go until the historic referendum, the Brexit debate is taking centre stage on a global scale. Moreover, Brexit is not just a source of uncertainty among investors and forecasters, but increasingly it has been used as a (convenient) source of blame for global policy makers.
The Bank of Japan left policy unchanged this morning, as was broadly anticipated (some had looked for further policy easing), a decision that saw the JPY soar to its highest level in almost two years. While governor Haruhiko Kuroda stated that he “would not hesitate to take action if needed” he highlighted that the BoJ was in close contact with the BoE, amid Brexit concerns that it was inferred were the dominant force behind the safe haven bid in the JGB market.
“With so many light years to go” – Europe, The Final Countdown
In the US, the Federal Open Market Committee also left policy unchanged and while the statement omitted explicit reference to international factors, the Q&A referred to the Brexit referendum and the “great deal of uncertainty” associated with it.
While the Fed left rates unchanged, its latest Summary of Economic Projections highlighted a sharp downgrade of growth and interest rate projections (the ‘dots’). From our perspective, herein lies the important issue for markets. The Fed’s reduction in medium-term growth expectations and a significant downwards shift in the expected path of interest rates (albeit to levels still significantly above market expectations) highlights the more secular nature of the low growth, low inflation backdrop.
Furthermore, Fed chair Janet Yellen clearly pointed out that there are a number of factors keeping interest rates (and interest rate expectations) low, from the expected rate path, to the lower (and probably declining) term premium, which she suggested was likely further impacted by asset purchases by the European Central Bank and the BoJ. A lower (and flatter) US interest rate curve should in our view undermine the USD. However, against the current backdrop where JPY, EUR and GBP all have their own real and imminent concerns, expressing this view is more complex than usual.
There is, however, one area that we see as increasingly clear, rather than increasingly complex, and that is the overvaluation of equities. Irrespective of our view that the US is behind the curve on interest rates, high valuations and shrinking earnings question the near-record levels for equity markets (particularly in the US).
“Will things ever be the same again” – Europe, The Final Countdown
In the UK, the chancellor and the prime minister have been widely criticised for the scare tactics of "project fear". However, if we take a step back from the coalface of the global macroeconomy it could be argued that things are not as bad as policymakers would lead us to believe. The US is growing at a solid, if unspectacular, 2-2.5% range, with a 4.7% unemployment rate, yet real interest rates are firmly in crisis mode at around -1.0%. Japan has one of the highest GDP per capita rates in all developed market economies, yet its central bank remains fixated on attaining a 2% inflation target – at all costs.
In Europe, negative interest rates have demolished the business models of the banking and insurance industries, ironically the sector upon which it relies for the transmission of its non-standard monetary policy activism. As the options to stimulate growth and reduce debt in the Eurozone become increasingly narrow it is likely that the most effective route (though in some sense most complex) is through fiscal measures and structural reform, and no longer through monetary channels. Tighter fiscal unity within the Eurozone places a UK with its exemption from "ever closer union" increasingly on the outskirts, even if it votes to Remain.
“And still we stand tall” – Europe, The Final Countdown
As we enter the final countdown for the EU referendum proselytising, opinion polls (and interestingly the bookmakers' odds) have clearly ebbed towards a ‘Leave’ vote. The connotations for financial markets are mixed. Uncertainty and illiquidity are likely to increase over the coming days. While the further dovish evolution of the Fed should undermine the USD against GBP, EUR and JPY, at these levels it is not clear that US dynamics will be the dominant force.
The risk-off backdrop is, however, likely to be maintained and on that basis buying gold and selling equities (particularly US equities). In many respects, a healthy correction in overvalued stock markets may be welcomed by global central bankers, especially if they can blame the whole thing on Brexit.
– Edited by Clare MacCarthy
Neil Staines is head of trading at The ECU Group