Impact of the Brexit Vote

June 2016

Q&A with Michael Metcalfe, Head of Global Macro Strategy, State Street Global Markets

Q. What are the immediate and longer term implications of the outcome?

A. The near-term implications are going to be a period of uncertainty and likely rise in risk aversion. For many months now, international organisations like the IMF and several policymakers from around the world have warned of the risks of an outcome like this. These risks have now been realised and I think it is fair to say that some markets were perhaps partially prepared for this. Other markets, however, were certainly not prepared and consequently risk premium in these markets were relatively low. We are likely to see a period of continued risk reduction.

The longer term implications and what this vote highlights are the ongoing risks of political developments for financial markets. Of course, the Brexit vote is not the only political development that is going to occur both this year and next year. This weekend there are Spanish elections with Italy holding a referendum in October on political reform and, of course, there is the US election in November. Then next year is, no doubt, going to be a big focus, following the Brexit vote. We will have elections in France and Germany where there are nationalist, populist movements doing quite well in the polls. So I think the political risk premia on financial markets is going to rise and stay high for some time.

Q. How are currency markets likely to react?

A. Of all the markets that were preparing for Brexit, it was in the currency markets where we saw perhaps the most preparation, in terms of investors trying to protect themselves against potential sterling weakness. However it’s likely that in currency markets – being one of the most liquid ways to express views – sterling will continue to bear the brunt of the immediate fallout from Brexit. One of the things to be concerned about is that we are estimating that the fair value for sterling against the US dollar is around 1,47, so yes – based on our estimates of fair value – it’s overshot a little already, but it could still overshoot by a more significant amount from these levels.

Q. What can we expect from global equity markets?

A. It’s curious because in the preparation for the Brexit vote, we noted that international investors had continued to increase their holdings of UK equities. This may, in part, have been a reflection that investors may be somewhat underweight UK equities. However, the fact that they didn’t reduce risk significantly and continued to buy UK equities ahead of the vote is interesting. I think one of the things that we’re concerned about in the aftermath of the Brexit vote, and the uncertainty that will surround it, is whether we see those international investors begin to reduce their holdings of UK equities. This could lead to some pressure on UK markets. One potential offset of course is the fact that sterling weakening could be a supporting factor for UK equities which may limit the potential risks in the equity space.

Q. Will bond markets come under particular pressure?

A. In theory, gilts should provide a safe-haven amid the economic uncertainly that follows the Brexit vote. There are however a couple of areas for concern in the fixed income space. I think the first is on inflation. It seems highly likely that sterling weakness will lead to a pass-through into much higher inflation. In fact, some of our online measures of inflation were already suggesting, before the vote, that the annual UK inflation rate was above 1% which is already above the Bank of England’s year-end forecast. I think one risk is that inflation markets in the UK – in particular inflation-linked bond markets – aren’t ready for a pick-up in inflation.

Then there is, of course, the other risk – similar to the risks for equities mentioned previously – of what foreign investors do with their gilt holdings. In a similar vain to equities, we noted that investors had actually been increasing their holdings of gilts ahead of the vote. There was no sense of international investors reducing their exposure to gilts ahead of the vote or hedging themselves against any Brexit risk. So this is the other angle we’re looking at: whether foreign investors will continue to buy gilts following this referendum.

Important Information
The views expressed in this material are the views of Michael Metcalfe as of June 24, 2016, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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CORP-2067 | Exp. Date: 6/30/17