A recent topical joke going around social media imagines that the next James Bond movie will just be a 2-hour long shot of him waiting in the Passport Control queue at the Charles de Gaulle airport (somewhat shaken and stirred). Unfortunately the implications of the so-called Brexit are far more serious.
Britain has voted to leave the European Union taking markets and even its political leaders by surprise. Globally, equity markets were in the red, volatility as measured by VIX index has spiked and oil weakened on weaker global growth prospects. Those who wanted to take Britain back to its old glory days at least saw the pound drop to levels last seen in 1986!
First round effects: FX market volatility, liquidity strain
The first round effects are being felt globally already. FX markets have been marred by volatility. JPY has gained the most while commodity currency such as AUD have weakened. There has been a flight to safe haven currencies, implying a redistribution of wealth between economies and sectors. Emerging markets with higher USD denominated debt will naturally be adversely affected. On this count, India with lower foreign currency debt will see muted impact on its debt levels. The GCC remain largely unaffected on this front due to lower debt levels and the USD peg that continues to provide the necessary economic anchor to these economies.
Secondly, liquidity in money markets is showing signs of strain with inter-bank risk premium spiking the most since 2012 (as measured by FRA-OIS spread). Markets will be closely watching developments in the UK as well as wider Europe to see how the workings of exiting the Union are implemented. As PM David Cameron steps down, the mechanics of exit will be crucial to a) contain uncertainty around the exit terms as the new pro-Brexit leader replaces Cameron; and b) contain a domino effect in peripheral Europe. Heightened uncertainty may cause businesses to get into ‘liquidity trap’ a situation where people prefer to hoard cash due to expectation of adverse events in the economy. We believe that in this context the role of central banks in managing liquidity as well as business sentiments, will be critical until the dust settles down. On a positive note several central banks including the Bank of England, Bank of Japan followed by People’s Bank of China have already announced their intentions to intervene to ease liquidity. In the near term however, worsening in business sentiments due to bad news-flow exacerbated by the chaos around new leadership in the UK, cannot be ruled out.
Fed unlikely to hike rates in July
With mounting uncertainties, tighter liquidity conditions and a stronger USD, the Fed will likely postpone hiking rates in its July meeting. This will be a positive development for the GCC markets that have USD pegs in place.
Further, we expect oil prices to regain lost ground once the initial shock of Brexit had worn off and fundamentals take over sentiments. Our view is further bolstered by the JODI data that shows stockpiles declining in Saudi to the lowest level in two years.
Rise of protectionism and slower global growth
We will be surprised to see talks around the finalization of Brexit without being marred by increased protectionism emanating from Europe and spreading globally. It will likely begin with European Union taking steps to reduce access to its markets for UK whose export competitiveness has increased with a weakened GBP. All in all, tighter liquidity conditions, subdued business sentiments will likely cloud Europe’s investment outlook having a ripple effect on global economies through the trade channel. We therefore expect, global growth to be slower than it was in 2015 – the extent of damage control, however, depends on the firefighting prowess of central banks globally.