Monday, June 27 2016
The outcome of the Brexit has clearly come as a shock to markets which had been following polls and betting markets to expect the UK to remain in the EU. We analyse the potential economic impacts and market impacts below.
Given the shock of the vote, we would expect consumer and business confidence to take a hit especially in Europe and the UK. The extent that confidence remains low will depend on leadership across Europe and central bank statements which we would expect will try to firstly provide some certainty regarding the process that will be undertaken to enable the UK to exit Europe and secondly we would expect further liquidity injections to support the economy. We would expect the Pound to remain under pressure, the US$ to rally as a safe haven currency and interest rates to remain low globally.
The longer term impact on the global economy will depend on the deal negotiated by the UK with Europe. In some respects globalisation is in retreat which is a negative from a global growth perspective. Nonetheless, early comments from European leaders suggest a rational course of action will be followed, and we would expect self-interest to drive a rational outcome (which would have a modest impact on global growth).
A further risk that will continue to overhang confidence is that geopolitical risk will remain heightened and fears of further EU countries exiting Europe will create some uncertainty, although the UK is an outlier in terms of Euroskepticism. We would not expect another EU country to vote to leave the EU, though tail risks are up.
Given the shock of the vote it is not surprising to see markets react violently in the short term. Despite the direct trade, investment and earnings consequences for Australia of Brexit likely being relatively modest (3.5% of Australian exports are to the UK), the immediate moves in the local equity, bond and currency markets have not been dissimilar to those offshore. While risk assets might recover some of these losses in coming days, we would expect some permanent damage has been done to the rating of the market. In assessing the outlook for the market we consider the potential earnings impact and the potential market rating.
Clearly companies exposed to the Pound will suffer from a translation impact of the currency. In addition there is some risk to stocks exposed to Europe should the economy suffer from a downturn. Of greater uncertainty is the broader impact on global growth and global credit markets. We tend to think the market is likely to over-react on the broader implications which is likely to create some interesting opportunities. We note that parallels are sure to be drawn to 2008 and we would think the level of debt among corporates and consumers remains substantially below 2008. Furthermore central banks are in a position to inject liquidity so the risks of a credit crunch remain low.
We think the greater impact on markets can come from a permanent de-rate to accommodate heightened geopolitical risk. A de-rating towards the lows earlier in the year seem possible in the short term. However with interest rates likely to be moved lower, we would think this would provide support for the market. Ultimately this type of volatility can create significant stock opportunities and we will remain alert to these.
Outlook for stocks
- The market has de-rated financials especially European ones first which seems fair enough.
- Global growth stocks have also been hit which looks a little harsh given the outlook remains uncertain.
- High PE stocks could suffer a de-rating in time as a higher risk premium is applied to all markets.
- Do we chase expensive defensives? We are reluctant to be too reactive. We would expect a concerted effort by central banks and Governments to get this under control and we do not want to be too reactive.
- We have been increasing cash in the lead up and subsequently to provide us with ammunition to take advantage of the volatility.
- We have reduced market beta largely by reducing Macquarie Group (ASX:MQG).
- We have been reducing exposure to the UK given this is where the economic uncertainty is greatest.
- Banks are already at lows from earlier in the year. We think they have already factored in the bad news.
- Likewise we are not convinced on the global growth impact (and the central banks will pump liquidity into the system).
This document has been prepared by DNR Capital Pty Ltd, AFS Representative – 294844 of DNR AFSL Pty Ltd ABN 39 118 946 400, AFSL 301658. It is general information only and is not intended to be a recommendation to invest in any product or financial service mentioned above. Whilst DNR Capital has used its best endeavours to ensure the information within this document is accurate it cannot be relied upon in any way and recipients must make their own enquiries concerning the accuracy of the information within. The general information in this document has been prepared without reference to any recipients objectives, financial situation or needs. Before making any financial investment decisions we recommend recipients obtain legal and taxation advice appropriate to their particular needs. Investment in a DNR Capital individually managed account can only be made on completion of all the required documentation.