The UK referendum on 23 June returned a clear result backing the exit of the UK from the EU. Turnout was high at 72.2% and the Leave campaign won by 51.9% of the vote vs. 48.1% for Remain. Prime Minister David Cameron announced his resignation the following morning, but stated that he would remain in his position until the Conservative Party chose a new leader, with the aim that this should take place before the October party conference. Critically, he has stated that he will not enact Article 50 of the Lisbon Treaty but would allow the new Prime Minster to handle negotiations with the EU and the decision on how to move forward. It looks probable that Boris Johnson is the clear favorite to be the next leader, followed by Theresa May and then Michael Gove.
Asset prices plunged as it became clear that the vote was shifting towards Leave and rating agency Standard & Poor's (S&P) has stated that it would downgrade the UK's AAA credit rating by at least one notch, with the UK government to be given 24 hours' notice before the rating action. Both the Bank of England and the European Central Bank (ECB) have stated that they stand ready to take action if necessary to ensure financial stability.
Following the initial shock, the critical issues for markets will now be the path that the UK will choose for exit and how the vote will affect the political backdrop in other European countries. We expect to see a continued ‘flight to quality’ in the fixed income market while uncertainty prevails. Risk premiums will likely remain high while the uncertainty of leadership in the UK remains an overhang. In the shorter term, emerging market debt seems relatively insulated; however, there are concerns over the potential for longer term problems. Global credit markets have reacted negatively, as might be expected, but this may provide investors with attractive buying opportunities.
Framework for exit could be better planned than markets currently expect
In terms of the likely path for exit, the Leave campaign released a framework last week which they recommended the government should follow on exit. Given that this framework was written by senior Conservative cabinet members who are expected to take over the party leadership, it seems rational to believe that this provides an insight into how the government will position itself. The framework states:
- It is only after informal negotiations with both other EU members and the Commission that issues such as whether and how to use Article 50 (of the Lisbon treaty) will be clear. It makes no sense to trigger Article 50 immediately after the 23 June vote and before extensive preliminary discussions.
- Given the importance of securing a good deal in the national interest and the cross-party nature of the Leave campaign, we believe the Government should invite figures from other parties, business, the law and civil society to join the negotiating team.
- After we vote Leave, we would immediately be able to start negotiating new trade deals with emerging economies and the world's biggest economies (the US, China and Japan, as well as Canada, Australia, South Korea, New Zealand, and so on), which could enter into force immediately after the UK leaves the EU.
- Funding to organisations from the EU will continue unaffected as the negotiations happen and the Government should continue that funding until the end of the Parliament in 2020.
This framework is quite different than the immediate action which markets seem to be expecting. It is possible that sentiment will calm if it becomes clear that this is the path the UK will be following, but if the government fails to communicate this clearly then uncertainty will prevail.
The other major issue surrounding this framework will be how the EU would react to the UK attempting to negotiate on an informal basis. It is quite possible that the EU could simply refuse to enter into negotiations until Article 50 is triggered. The joint statement issued by the EU Council the day after the vote would imply that it intends to take a firm position on this: “We now expect the United Kingdom government to give effect to this decision of the British people as soon as possible, however painful that process may be. Any delay would unnecessarily prolong uncertainty. We have rules to deal with this in an orderly way. Article 50 of the Treaty on European Union sets out the procedure to be followed if a Member State decides to leave the European Union.”
If the market does believe that the UK exit is further away and better planned than previously expected, it is probable that it would shift from being the market's primary focus and become a more medium term issue. The focus could then switch towards other markets that could be affected by the Brexit vote. The obvious candidates are the Scandinavian markets, with Denmark and Sweden both having the potential to hold referendums on their own status. Norway might also want to revisit its deal with the EU.
UK growth likely to weaken, with interest rate cuts expected
In terms of the UK economy, until there is confidence in the UK's position, there will be a drag on business confidence. This will see business investment and employment slow, which will inevitably be a drag on UK growth. As a result, we expect economic data in the UK to weaken in coming quarters. The Bank of England could react to this by reducing interest rates from 0.50% to possibly as low as 0%, but it will likely need some concrete evidence that the economy is being negatively affected before acting.
Most forecasters are still in the process of reassessing their outlooks, but Bank of America now expects the UK to have a mild contraction lasting three quarters, reducing its forecasts for UK growth to 1.4% in 2016 and 0.2% in 2017. Inflation will be affected by the move in British pound sterling, but further falls would be needed to increase inflation to a level where the Bank of England would potentially worry given the very low current levels.
Flight to quality in developed fixed income markets
We expect the uncertainty premium to persist for some time as the exit process will be negotiated over an indeterminate period. Overall, we have observed an initial flight to quality, with Gilts leading the bond market on an over 30 basis point (bp) rally in yields, while US Treasuries were a close second, rallying over 20 bps on the day after the vote. Gilts have continued to rally despite the indication that S&P will likely downgrade the UK's credit rating. The European periphery was the hardest hit on the news, with Spanish and Italian government bonds selling off more than 15 bps.
A July rate hike for the US Federal Reserve (Fed) now seems very unlikely, with market implied expectations of a rate cut now exceeding the probability of a rise. The Bank of England will likely remain on the sidelines until the dust settles, but remains in play with increased market implied expectations for a rate cut within the next several meetings.
In currency markets, the British pound fell over 7% as of mid-day trading on June 24, and is off more than 3% mid-day on June 25, while the broader foreign exchange (FX) market sold off versus the US dollar. The Yen remained the top performer on the day, up over 3.5%.
Emerging market debt relatively insulated but potential for longer term problems
The impact on external debt has been limited so far. Spreads are 30 bps wider but US Treasuries are 20 bps tighter and overall the JP Morgan Emerging Markets Bond Global Diversified Index lost only 0.6% on 24 June. Local rates were 10 bps tighter in Asia and 10 to 20 bps wider in Latin America and Central & Eastern Europe, the Middle East and Africa (CEEMEA).
Most of the initial risk aversion shock was felt in the FX market and EM currencies are on average 2.75% weaker versus the US dollar.
Overall, as an asset class, emerging market debt has been relatively insulated from the initial Brexit surprise. However, in the long term, Brexit could have an impact on EM fundamentals through other channels, particularly for central and eastern European countries. Indeed, the UK is a significant trading partner and foreign direct investor in the region. Romania is the most exposed when we consider exports to the UK, while Russia, Poland, Czech Republic and Romania are exposed in terms of imports from the UK.
Beyond trade and financial considerations, we can also envision a rise of political risk in the region. Poland and Slovakia are already openly criticising the EU and the anti-EU rhetoric is likely to increase further. The Euro adoption process will likely be stalled as well. Ultimately, increased political risk may further delay the absorption of EU funds and Poland, Hungary and Romania are the biggest net beneficiaries from the EU budget.
Global credit has reacted negatively, but could provide opportunities for investors
Credit markets reacted negatively to the UK's decision to leave the EU. It started with Asian credit, but European markets soon followed suit, with credit default swaps (CDS) as well as cash and bonds trading down. Sterling credit issuers were most affected, while price effects for Euro credit were more muted, given the ECB's bond buying programme. The basic resource sector and banks suffered heavily. We expect trading in US credit to take its lead from European markets. In our view, the correction in valuations and market volatility could provide buying opportunities in some fundamentally strong credits.