While a ton has been said on the United Kingdom’s European Union (EU) referendum results since the 23rd of June, I will explain 2 major implications that I personally feel could lead to several, long-lasting effects across the world as we know it, as well as some implications that they could have on the investment landscape.
(I) The political winds are changing
Across the developed world, there has been a rise of anti-immigrant, anti-free-trade and anti-establishment sentiments over the past few years since the Global Financial Crisis of 2008-2009. The middle classes in the Western developed countries have been hollowed out, and the lower income classes felt left out as asset prices globally have been inflated up by unconventional monetary policies, leaving them less well-off than before (missing out on the recovery). Perhaps, this is the reason why US presidential candidates like Donald Trump and Bernie Sanders are so popular – the masses just want to get back at the establishment.
The British referendum tells us more or less about the same story. Throughout the Eurozone, the political winds seem to be changing, shifting from the centre to the far right. The rise of Le Pen’s National Front, as well as increasing popularity of far right parties across Central and Eastern Europe could add to further uncertainty over the viability of the Euro-bloc of countries.
After its recent elections on 26 June, Spain is now in political deadlock, as most coalition options are highly unlikely due to the high amount of compromises that all sides have to make. Then there is the thorny Catalonian issue; depending on how the uncertainty ends, the stakes on Catalonia’s independence could be raised if a coalition government is formed. Catalonian independence could also rekindle independence movements elsewhere on the continent (Corsica, Padania, Flanders, Kosovo, Silesia etc). Over in nearby Italy, a referendum organised by Prime Minister Matteo Renzi will be held in October – an attempt by Signore Renzi to structurally reform the current slow, traditional and somewhat ineffective political system in Italy (Italy’s bicameral legislature’s upper and lower houses have symmetrical powers which has resulted in government instability and ineffectual reform proposals). If the referendum’s outcome is a no, instability could result in Italy, which makes the country’s banking crisis unavoidable. Together with uncertainty in Spain, Southern European credits could see a reassessment by creditors leading to renewed volatility in bond markets!
All of the above adds to legitimate concerns of the sustainability of the EU. With high levels of unemployment among its youth, particularly in Southern Europe, there could be a change of the geopolitical environment (for better or for worse) moving forward, which will impact the economic environment. And if so, how would high debt levels in the continent trend going forward? Could a new debt crisis start again despite the European Central Bank’s (ECB) plugs and backstops in place?
(II) High probability of a deflationary environment to follow (for the moment)
Businesses generally tend to like certainty in order for them to carry out corporate investments and operate to provide goods and services to their customers. However, with political winds changing in the developed world and with Brexit accelerating the process, corporate investment plans may be deferred for the moment as the global business community monitor political developments for further clarity. This could weigh on economic momentum in the Eurozone as spending plans are delayed, and is self adding to dis-inflationary pressures across a highly-connected and globalised world.
Policy-makers understand the severity, and have moved in to placate fears – in just over 7 days since Brexit, G7 finance ministers have announced measures in order to calm the financial markets down. The UK’s Bank of England (BOE) have also suggested that benchmark policy rates could be further lowered over the summer (as well as the possibility of quantitative easing). Pressure is also on the ECB to ease their requirements for their asset purchasing programme. As of 30 June 2016, Fed Funds futures pricing indicate that market participants think there is only a 9.2% probability that the US Federal Reserve would hike rates (and that is in December). Market participants are in fact expecting a 8.0% probability of a rate cut by the Fed in September’s FOMC meeting.
With dovish sentiments from major central banks, yields across global bond markets have fallen. Among the developed nations, the US Treasury bond market now looks attractive as compared to other sovereign bond markets. Against the British 10Y Gilt, the US 10Y Treasury Note is yielding more than 56 bps as compared to 2015’s 31 bps average. In terms of their yield curves, both the UK’s Gilt and the US’ Treasury yield curves have flattened on the belly and the longer-end over the past 2 months.
(III) Investment Implications
With central banks going further to support global economic momentum, a global bubble in financial market assets continues to remain supported (as I’ve mentioned in an earlier post). An implosion of this great bubble some time in the near future would cause far worse implications than what was previously possibly conceived, as the years of malinvestments will now be longer. Tread carefully.
- G7 sovereign bond markets could continue to remain expensive, as yields continue to trend lower (Australian and Canadian sovereign bonds could continue to rally)
- the USD could strengthen against all currencies on further risk aversion and political uncertainty stemming from Europe (did we forget the Scots and the Irish?). The greenback could also see gradual appreciation due to the relatively attractive Treasury yields vis-à-vis other developed nations’ yields due to global yield seeking behaviour by real institutional money
- With economic growth in the European continent already so sluggish, and with their long term structural story looking dismal due to aging demographics, there is a very real possibility of a “Japan-like malaise” permanently developing if countries turn their backs on globalisation and free-trade
- On a longer term basis, if more developed countries move to the far-right, and impose protectionist, anti-free-trade policies, these countries are probably unlikely to be a good place for foreign capital to be in.
*cover image of Britannia taken from www.friesian.com; yield graphs are plotted using Bloomberg *
Kean Chan 