Our principal remarks with regard to price action in asset markets on Friday 24 June 2016:
A multi-dimensional event - The UK’s vote to leave the European Union (EU) clearly represents a significant shock. However, we do not expect broader contagion from Brexit. The impact will primarily affect the UK. If there is to be a broader impact, we see 'peripheral' EU asset markets and US dollar strength as potential channels of contagion. It will take time for the political arrangements to become clear. In the meantime, there will be some political uncertainty, but in our view, investors should seek market entry points and dislocations.
Markets have so far functioned in an orderly manner - There was no widespread blockage in trading on Friday, in the immediate aftermath of the referendum, nor any investor panic. Friday was of course only day 1 in the post-Brexit vote era, but fears of a global systemic crisis looked overdone. It will take time before the ‘all-clear’ can be given, but the G4 central banks - the US Federal Reserve, the Bank of England, the Bank of Japan and the ECB - have said they stand ready to provide liquidity should it be required. Given that financial markets were on the whole not positioned for Brexit, the moves on Friday were not particularly remarkable (see exhibits 1, 2 and 3 below). A significant part of the volatility was the unwinding of the strong rallies that had occurred previously.
Friday's market movements suggest investors have now adopted a defensive posture across asset classes: they favour quality over value in equities and credit markets, overweight safe-haven bonds (Bunds, US Treasuries and UK Gilts), underweight 'peripheral' EU debt, underweight emerging market (EM) debt and commodities and they are long the Japanese yen and US dollar versus all European/EM currencies.
How markets reacted to Brexit on Friday 24 June 2016:
Exhibit 1: Movements in principal equity indices, selected currencies and commodities on 24 June 2016Source: Bloomberg, BNPP IP, as at 24 June 2016
Exhibit 2: In bond markets, a movement out of riskier assets into safe havens was apparent - the chart shows movements in bond spreads/yields for selected segments of European/US bond markets on 24 June 2016Source: Bloomberg, BNPP IP, as at 24 June 2016
Exhibit 3: The initial reaction of European and US (S&P) equity markets on 24 June 2016 was relatively restrained relative to other, recent sell-offs – experience, however, suggests the sell-off may have further to run (peak to trough in 2011 took 217 days).Source: Bloomberg, BNPP IP, as at 24 June 2016
What’s next for asset markets:
- Longer term, valuations of all asset classes will be dependent on economic data and investor sentiment. If, for example, datas suggest growth in the US or China is stable or even picking up, then market concerns over Brexit are likely to recede.
- Until there is proof to the contrary, financial markets are likely to treat Brexit as disinflationary (it may be inflationary for the UK as a result of sterling weakness, but not for the rest of us). Gains in the US dollar and the Japanese yen are trends which central banks may seek to counter.
- The assumed threat to growth means markets anticipate that Brexit could lead to looser monetary policy from the G4 central banks. The market now prices the probability of an interest-rate hike by the Fed this year at 15% (50% prior to the Brexit vote). US fed fund futures currently even price in a 10% probability of the Fed reversing course and cutting rates. The Bank of Japan may cut rates further to counter the rise in the Japanese yen and the ECB could cut policy rates further and/or increase the size of its quantitative easing programme.
Text written on 27 June 2016 in London