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Macro Insight - 'Post-Brexit' issue

13/7/2016

A post-Brexit rally has occurred that has bought many equity markets back to their pre-Brexit levels. A strong US June payroll number last week, expectations of additional easing from the BOE and BOJ this month, coupled with some form of stability returning to UK politics has provided additional support for risk assets. The question is how long will this rally last? Intuitively it seems sensible to reduce risk gradually into this rally. While risk assets have recovered, traditional 'safe haven' assets such as US Treasuries and Gold have not sold off materially and technically the picture still looks supportive for Treasuries. For example since 1997, the 200, 100 and 50 week moving averages on US 10 year treasuries have crossed for lower yields only on 3 previous occasions and each time there were significant drop in yields thereafter. Questions on European banks remain, China has been off radar for a while but a stronger USD could put pressure on the Chinese financial systems again and the US presidential race now begins to heat up.

The effects of 'Brexit' on Europe and the UK in particular will take time to digest. Within the space of the next 18 months, countries representing 90% of Europe's GDP will be holding elections. This is particularly relevant for the UK's exit process from the EU as, assuming Article 50 is triggered (the new UK PM Theresa May has said this won't happen this year), politicians that start the negotiation process of Brexit may not be the ones that conclude it. Sterling after a 21 standard deviation event has settled down but the outlook for GBP looks challenged. Moves witnessed in GBP, traditionally regarded as a stable currency, serve as a reminder that there are no risk-free markets. To say it is has been an unusual month in the UK is an understatement: within the space of a month a UK MP has been assassinated, the UK has voted to leave the European Union, the UK Prime Minister has resigned (but was asked not to), the Leader of the Opposition has been asked to resign (but has refused to), the main protagonist of the Brexit campaign, Boris Johnson, suddenly withdrew from the race to become the new PM and the Head of UKIP, Nigel Farage, arguably the originator of the Brexit idea almost 20 years ago and Enfant Terrible of the European Parliament, also threw in the towel. The only usual thing that has happened recently was the English football team performing poorly at a major international football tournament, managing to lose to a country with a population less than Croydon.

In terms of the impact of Brexit on the European Monetary Union (EMU), it is too soon to say. Clearly Brexit is more problematic for some European countries than others: for example 8% of German exports go to the UK (consequential for the influential German car industry). However the European economy is not only the largest in the world, it is also highly diversified. Some recent polls have also shown that European citizens have become more pro-Europe post-Brexit. The European Commission, which has been criticized over its role in Brexit, may be (finally) forced into change for the better. On the negative side in Europe, if there are going to be problem banks, despite Brexit it seems they won't in all likelihood be in the UK. Earlier this month, Lloyds bank issued GBP 750 million of 5 year bonds in the US without any problems and Carney immediately after the Brexit vote noted that UK banks have GBP 600bn in liquidity and the BOE is prepared to add a further GBP 250bn should it be required. Italian banks on the other hand have well documented NPL problems and it was subsidiaries of Deutsche Bank and Santander that US stress tests exposed due to 'broad and substantial weakness across their capital planning process'. According to the IMF, Deutsche Bank 'appears to be the most important net contributor to systemic risks.'

Emerging Markets (EM) having endured a torrid past few years are flavour of the month with last week seeing EM bond funds post the largest weekly inflow on record (despite a public holiday in the US) according to data from JP Morgan. It is possible that EM allocations may soon become a classic momentum trade, having been out of favour for years. EM bulls argue that given that the UK accounts for less than 2% of global GDP, a UK recession will barely register in most EM countries. The argument that EM bonds are more appealing than developed market bonds is not without merit. At the current low yields an investor would have to hold a 30 year maturity German government bond for 82 years in order to make up for the loss associated with just a 150bps move in the yield curve. If there is a 'sell Europe' as the long-term effects of Brexit take hold (this is debatable), that money won't necessarily go to the US given rich valuations there. EM could therefore benefit further.

We believe it is important to add value to investors by sharing our thinking as much as possible. Our communications are meant only for our clients and we appreciate your continued efforts to keep communications to you confidential

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