OCBC OneWealth App– Brexit: Largely a European problem

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Brexit: Largely a European problem

29 June 2016

Recession for the UK; Slower growth in the EU

From the outset, it is clear that UK's economic growth will be materially slower. The near-term adjustment costs of Brexit will inevitably include a short-term recession and a protracted period of political uncertainty as negotiations of exit terms can be painfully long-drawn. We should assume that the EU will make negotiations as difficult as possible to deter other member nations from seeking the same agenda.

Europe will not be spared from the effects of higher political uncertainties as well. European companies with significant exposure to the UK may hold back investment plans until such political uncertainty subsides. Hence, we expect Europe to endure a period of slower growth (as if it wasn’t slow enough).

But no global recession

Yet, it is difficult to make a case for the slowdown in the UK to drag the global economy into an outright recession given that it accounts for a slim 2.3 per cent of world GDP.

The fall-out in the UK should have limited direct impact on Asia as well. As OCBC Treasury Research notes, exports to UK range from a low 2-3 per cent for economies such as Hong Kong and Vietnam to an even lower 0.2 to a little over 1 per cent for most of the rest including Indonesia, Singapore and Malaysia.

Furthermore, growth in the U.S. is largely consumption driven and will therefore be less affected by UK's economic woes.

Hence, at this stage, we view the chance of a global recession to be very remote. We believe the fall-out from Brexit should be localised to Europe without much lasting impact on global growth.

Limited financial contagion at this stage

Meanwhile in Europe, the impact of Brexit will be most felt by European countries that have the strongest trade links to the UK. Countries like Ireland, Spain, Portugal and Cyprus have the highest total trade with the UK as a proportion of their GDP and may find yields on their sovereign bonds increasing as fears over peripheral Europe emerge.

However, we have not seen this scenario play out after the referendum results. Spain, Portugal and Ireland's 10 year bond yields have not shown an appreciable rise relative to historically stressed levels to merit concerns over potential financial contagion.

In addition, the credit default swap spreads of most European banks are fairly stable and below the highs reached in February this year amid the bank sell-off.

European bank stocks were badly hit as the weaker economy and displacement costs of potentially having to move part of their London operations elsewhere may hurt the profitability of their business. But this should not have that much impact on solvency.

Hence, at this stage, we believe financial contagion remains limited with little prospect of a Lehman moment for European banks. Even so, central banks should be ready to provide liquidity support to mitigate any financial contagion.

What does this mean for central bank policy?

Bank of England

On account of the UK's large budget deficit, we believe the government may not have the scope to undertake massive fiscal stimulus to generate growth in the short-term.
We expect the Bank of England (BOE) to provide liquidity support to prevent any potential market disruptions and may look through the rise in short term inflation (due to a weaker GBP) to keep monetary policy loose so as to provide some support to economic growth.
They may even look to extend their asset buying programme as well.

European central bank

Slower growth in the Eurozone may force the ECB to extend and expand its quantitative easing programme in its next policy meeting.

Federal Reserve

Notably, Brexit has little implication for U.S. growth. However, the Fed will be more concerned with the impact of UK’s exit on financial market conditions. Tighter financial market conditions as well as higher volatility ahead will weigh on the Fed's decision to hike rates in the next few meetings.
At the same time, safe haven flows during this period of political uncertainty have pushed up the U.S. Dollar. The strengthening of the greenback acts as form of monetary tightening and may further complicate the decision to raise interest rates.
The confluence of these factors lead us to believe that the Fed may hike interest rates just once this year at best, assuming prevailing political and economic uncertainties subside by December.

Bank of Japan

The Bank of Japan must be considering foreign exchange intervention as the Yen rises on safe haven trade – and would likely intervene if USDJPY falls below 100.
Further policy easing by the Bank of Japan at its end-July meeting looks increasingly likely.

While any monetary action by central banks could lift markets higher, we believe this would be a short-term rebound and not a sustained rally. Monetary stimulus at this point would likely serve to limit risk assets’ downside rather than spark a sharp and sustained risk rally.

Don’t underestimate the political risks

More than anything, Brexit is a political issue. Post the referendum results, we’ve seen chaos ensue in the upper political ranks of the UK government. We've also seen an increase in support for other separatist agendas within the UK itself. In particular, Nicola Sturgeon, the leader of the ruling Scottish Nationalist Party (SNP) have publicly stated that she may seek an independence referendum following Scotland’s desire to remain part of the EU.

Elsewhere in Europe, nationalist and anti-EU parties are paying close attention to the developments in UK before potentially calling for their own referendums to leave the bloc. With the UK setting a precedent for such an event, it is important that we monitor the political developments across Europe to assess if such rejectionist ideas gain traction and threaten to break-up this union.

Admittedly, this is a long term development, but it is no less important for the implications to the overall European economy. If the UK does fare well outside the EU, these anti-EU establishments may mobilise to seek the same recourse.

Other political risks take the form of upcoming elections in Germany and France, both of which are struggling with public anti-EU sentiments and political parties that espouse such populist rhetoric. They are expected to have elections next year and this will be greatly followed.

On the other side of the Atlantic, Brexit has a supporter in U.S. Republican presumptive presidential nominee Donald Trump. The triumph of populist rhetoric in the case of the UK referendum alerts us to the potential risk of a Trump success come the U.S. election in November. Admittedly, while we are less concerned about his politics, we are a great deal more sceptical about how his xenophobic and anti-globalisation agenda will translate into formal policies which would have deep ramifications on the global economy.

What’s more, the failure of polls and betting markets to foresee the results in the lead up to the UK referendum means markets will see greater unpredictability in foretelling such events. We cannot discount the fact that we may encounter the same problem in assessing the chances of Trump winning. Brexit may not be the only event risk this year.

Our investment strategy

While we expect the effects of Brexit to be contained, we remain cognizant that markets will enter a short-term risk-off phase as investors pull back to assess the implications of Brexit to the global world order.

Is it the end of the EU or even the UK? Such are unknowns at this point and are purely guesswork. There are many moving parts to this story, both political and economic, and we can expect higher volatility ahead. Let's not underestimate the risk of political contagion even as we seek investment opportunities.

As with all risk-off phases, markets tend to overreact before finding a bottom, once valuations and fundamentals become compelling. Markets will eventually grapple with the reality of Brexit and this risk-off phase will in due course fade away, but in the meanwhile, risks are skewed towards the downside and we prefer to de-risk our portfolios.

As we believe European equities will be the most adversely affected by the implications of Brexit, we continue to urge investors who are heavily exposed to this asset class to trim their exposure.

Alternatively, for investors who are low on European equity exposure, they may consider investing in Europe as the current risk-off sentiments may offer opportunities. In this case, we would prefer taking exposure through a diversified portfolio of quality and dividend-yielding stocks.

In line with potentially higher volatility ahead, we prefer to take exposure to multi-asset solutions like BlackRock Global Multi-Asset Income fund. This strategy allow investors to participate in markets to benefit from any potential rebound whilst providing downside mitigation through diversification of assets.

The information below solely constitutes the views of OCBC Bank and does not consider the specific investment objectives, financial situation or needs of anyone. The Bank is therefore not responsible for any loss or damage arising from this information. Investment involves risks. If you wish to make an investment, you should first speak to your OCBC Relationship Manager or a Personal Financial Consultant.

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