Brexit: what to expect in the markets
Abu Dhabi, 26 June 2016
The UK’s referendum verdict is finally out and contrary to financial market expectation, the UK has decided to ‘leave’ the European Union (EU). The event was closely watched by investors given the importance of the UK and EU in terms of repercussion on global markets.
After the results were announced, we saw a sharp price reaction in both currency and global equity markets, clearly that the outcome was not widely expected and its binary nature constrained a pre-emptive positioning. Investors looked for safe havens gold prices increased by 5%, USD strengthened against major currencies and the US ten year yield touched 1.41% before recovering to 1.57%. On the other hand the Pound (GPB) weakened by close to 7% - 8% against major currencies as GBP touched a thirty one year low of 1.32 against USD before closing at 1.38. The US markets were down by around 3% on Friday however on weekly basis the markets were down by 1.4%.
The event led to resignation of UK Prime Minister David Cameron, who was advocating to ‘remain’ in the EU. While the UK gets a new Prime Minister, much will need to negotiated with EU before the UK exits and early signals from the EU are that they want UK to exit the EU quickly in-order to protect remaining EU members. In the post Brexit era economic growth in the UK is expected to slow by approximately one percentage point and growth in the Euro area is expected to slow by 50 basis. The Bank of England and ECB have indicated that they are well prepared for immediate challenges, the UK has committed GBP 250 billion to stabilisation measures thus a further injection of liquidity can be expected and if required measures such as interest rate cuts in the UK might be enacted.
- Beyond near term volatility and the global growth implications of the event itself, a key concern is with regards to whether this event becomes a poster child of EU disintegration. Such an extrapolation across the EU is difficult but will be influenced partly by EU-UK negotiations to decide on the terms of the British departure over possibly a two year period. As the growth versus independence compromise becomes clear from these negotiations, subject to country specific politics, referendum calls elsewhere may intensify or weaken. In addition to an extrapolation risk another clear takeaway for us would be an increasingly accommodative stance of central banks across the globe after this event.
- Given global market volatility the possibility of near term US interest rate hikes is now unlikely. Already over the past two months, the FED Chairwoman Ms. Janet Yellen has raised concern over faltering global growth and uncertainty surrounding Brexit, we now believe that the FED will adopt a wait-and-watch approach. Of late the US macro data set has given mixed signals of economic recovery and given that there is a US presidential election in November, the probability of a US increase in interest rates is further reduced. Low US interest rates will act as a cap on strengthening USD and support global growth.
Impact on regional markets
- We think that the direct impact on the regional markets should be limited in the medium term but do expect near term volatility. There will likely be an indirect impact due to lower oil prices on the back of a stronger USD and a slower global economic growth environment. However, we also believe that the evolving dynamics of demand supply equilibrium in the oil market is expected to materialise during the latter half of this year and will have a material impact on oil prices.
- Global volatility and the fundamental impact for GCC countries would largely be transmitted through oil prices to the extent that this event disturbs global oil demand as well as investor flows and relative valuations. GCC currencies are on the whole pegged to the USD which will benefit from risk-off sentiment. To an extent GCC investors see GCC growth as driven by domestic factors and somewhat disconnected from oil prices in the near term as intended through reform plans, we expect GCC countries to ride through this event. The real exposure to global factors which transmits through the exports channel, either on account of demand or relative competitiveness that currency movements bring about is not pervasive in hydrocarbon dominated GCC exports. In addition, we see import substitution to precede an exports pursuit in a reform driven non-oil sector growth which implies internally focused capital investments.
- At the sectoral level we think petrochemicals as a sector is more exposed to risk with companies like SABIC having large presence in Europe, weakening of Euro and GBP will adversely impact the profitability of these companies. The port operator DP World also has sizeable operations in UK and Europe. Some regional banks such as NBAD, QNB and QIB are also relatively active in the UK and European markets. The number of tourists coming from the UK and Europe to the UAE might also be impacted given that a weaker currency reduces purchasing power. In Dubai’s real estate market, British citizens are among top most investors and a weaker currency may deter further investments.
- In the context of GCC government borrowing plans, a risk-off environment is expected to widen spreads but an accommodative central bank stance is expected to lower benchmark rates, thus if investors are convinced of a credible fiscal policy investor appetite for regional sovereigns may revert after initial weakness. On the positive side we think due to the reduced probability of an increase in US interest rates regional companies and sovereigns would benefit in their endeavor to raise funds at a lower cost and simultaneously existing issuers will benefit from lower cash outflow.
Impact on frontier markets
- Within the frontier space the markets that we favour growth is anchored on domestic factors and expected to be fundamentally resilient. Lower commodity prices, especially oil, are expected to keep inflation expectations from inching higher thus enabling a soft monetary stance.
- We note that most countries in our frontier universe have improved their external balances and thus currency weakness is not expected to be a key influence on monetary policy. Depending on the duration of GBP and Euro weakness trade dominated Vietnam could be particularly vulnerable, Bangladesh and Sri Lanka’s trade with EU given Euro’s weakness is also expected to be a headwind for exports.
- Pakistani currency which has been resilient at the cost of weak exports could find a catalyst in this event to trend lower.
Our strategy and positioning
Since the beginning of the year we have been cautious on the markets and we prefer defensive sectors like utilities and telecoms. After the unfolding of Brexit, we continue to maintain the same strategy. However, further weakening or a sharper correction in the market might warrant increasing cash and reducing beta of the portfolios. We think in the near term global market volatility will remain high due to the complexity of this event and its ramification on global markets. Policy makers seem to be equipped to ride through this challenge despite obvious hurdles. After an initial risk-off stance our cash deployment will be stock specific with preference for Saudi Arabia. Lower oil prices and global growth concerns mean that cyclical space may not participate well in a market recovery.
The global financial markets initial reaction to this event has seen a broad based correction in equity markets. The real impact will take time to crystallize and during this transitionary phase the role played by policy makers to calm the market will be paramount.
- We don’t expect a prolonged impact on regional markets but EM constituents and companies that are widely held by foreigners in UAE and Qatar are expected to sell-off in addition to companies that have seen a strong run recently.
- As of late the Saudi market has been range bound and didn’t react to a detailed NTP plan, while Brexit specific impact appears muted in the Saudi context despite absolute declines we expect the market to outperform. Within the financial space wholesale funded banks are expected to underperform. The petchem space is expected to react negatively to lower oil prices and translation impacts of weaker Euro and GBP in addition to global growth concerns. Businesses with global trade exposure like DP World are also expected to trade lower. However, in the wider context and fundamentally for regional markets long term oil price movements will be key given the significance of oil price to the region.
- With Ramadan expected to come to an end markets will gear up to focus on the second quarter results, we expect soft numbers for the second quarter, however further announcement on reforms in Saudi Arabia through its NTP plan or any progress on banking sector consolidation could act as a positive catalyst for regional markets.
Saleem Khokhar, NBAD's Head of Fund Management