By Ruth van de Belt
Brexit has kept market volatility high over the past few weeks. Equity markets plummeted immediately after it became known that a slim majority of Brits wishes to leave the EU. We viewed this as an overreaction, making us slightly more positive in the short term.
A week later the markets had largely recovered, while the economic picture had hardly changed. Yet the political risk has increased, causing us to revert to a neutral outlook for equities.
Equities continue to be more attractively valued than bonds. However, expected returns on both are low and the Brexit has caused the expected effective return on bonds to fall further. In several countries it is almost impossible to find government bonds with a positive yield (one in three global government bonds has a negative yield). Investors expect central banks to implement additional stimulatory measures (BoE and BoJ), while the Fed will keep its low policy interest rates for longer. A flight to safe havens also occurred, which pushed down yields even more.
Mild recession for UK economy
The UK’s decision to leave the European Union is accompanied by a sharp rise in economic and political uncertainty. In the UK, companies are postponing investment plans and putting plans to hire more employees on hold, while consumers will be more cautious about spending money. We predict a mild recession for the UK in the short term. In order to combat this, the Bank of England will likely ease its monetary policy, even though inflation is rising due to the lower British pound. The medium term will bring greater clarity on the future relationship between the UK and the EU, allowing the uncertainty to abate and the economy to recover somewhat.
There will be a smaller economic impact on the rest of the world. Economic growth will be squeezed slightly in continental Europe, but the European Central Bank is unlikely to turn to monetary action. In Japan, too, growth will be lower as a result of the stronger yen. When combined with worse inflation forecasts, the Bank of Japan will probably implement monetary policy measures. This will keep capital costs lower for longer, and as a result, the recession may take longer to arrive than expected. We are consequently no longer negative about high yield. The Fed is likely to postpone the next rise to interest rates until 2017
Political uncertainty persists
The dissatisfaction among voters that has led to Brexit is not just a UK or European phenomenon. It also applies to the US. This dissatisfaction is being expressed in growing support for anti-establishment parties, on both the left and right sides of the political spectrum. We do not believe that this dissatisfaction will dissipate quickly. After all, the underlying reasons, such as a rise in international competition caused by globalisation, an increase in income and wealth inequality and job-saving technological changes, are not likely to disappear quickly either.
Given the large number of political events scheduled for the coming eighteen months, we anticipate that political uncertainty will remain high. The anti-establishment parties are revising political agendas, forcing established parties to adjust their stances. Moreover, political fragmentation is growing, making it more difficult to form stable government coalitions. There persists a high risk of a risk-off sentiment flaring up prior to important referenda and elections. Investors will demand higher political risk premiums. Partly in view of this, we are now more positive about gold.
Focus shifts back to banks
European equities have not yet reverted to their former levels because the spotlight is once again on problems in the financial sector and banks have been hit hard. The deterioration in the economic outlook means that there is a higher risk of defaults. Furthermore, there is pressure on margins due to the ever-lower yields on government bonds and the rising cost of regulation. Corporate banking activities are also under pressure, as companies are issuing fewer bonds and shares as a result of the increased uncertainty.
The negative outlier is formed by the equities of Italian banks, which are in poor shape due to a large number of bad debts that have not yet been written off. There are few options open to the Italian government for acquiring capital. According to new European legislation, governments may only bail out banks in difficulty after a bail-in by the private sector. Yet if the private sector has to contribute to this, this means political suicide for Italian Prime Minister Renzi.
Moreover, there is a risk of financial contagion. Urgent talks are currently being held with Brussels to see whether a solution can be found based on precedents (Greece, among others). The outcome is highly uncertain.…
Ruth van de Belt is an investment strategist at Kempen Capital Management
