Shrugging off Brexit, but…

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Over the last few days financial markets have generally been shrugging off any worries related to Brexit, European banks, politics more widely and global economic growth. For instance, the 5-day performance of equity markets around the world is a sea of green. Even the sterling exchange rate and high quality government bond yields have regained some traction.

Although there have certainly been positives over the last few days, significant challenges and risks clearly remain. Nick Kounis Nick Kounis Head of Macro Research

  • Markets have been shrugging off worries about Brexit and other risks…
  • …helped by more UK political stability, better global macro data…
  • …and expectations of a central bank reflation wave
  • However major challenges and risks remain…
  • …negotiations between the UK and EU will likely be tough and long…
  • …the UK is heading for recession, while the eurozone is slowing…
  • …and Italian political and banking risks continue to loom

UK has more direction

One of the factors behind this more constructive mood is that UK political uncertainty is ebbing, with a new government in place. Although the new Foreign Secretary Boris Johnson seems to have in the past insulted many world leaders, the UK has new Prime Minister – in Theresa May – much quicker than expected. As all other candidates dropped out of the process, the nine-week Conservative Party leadership election campaign was no longer necessary. A new cabinet, including a Secretary of State for Brexit, has been appointed.

Macro data more encouraging

In addition, global macro data has generally been encouraging. For instance, last week’s US labour market report was of the ‘not too hot not too cold’ variety. Employment growth seems to be holding up well enough to dispel any recession fears, while not being strong enough to suggest the Fed will hike any time soon. Similarly, China’s economy seems to be slowing at only a gradual pace, supported by the authorities’ stimulus measures. Indeed, China’s economic growth was stable at 6.7% in Q2. In addition, although investment spending continued to slow sharply in June, the growth rate of industrial production and retail sales edged up.

Even the BoE’s decision to keep monetary policy on hold did not rock the boat too much. It was very clear from the MPC’s communication, that it wanted to wait for a full assessment of the outlook next month before easing policy. We expect the BoE to announce a package of easing measures in August, include a 25bp rate cut, GBP 150bn of extra asset purchases and easier lending conditions for commercial banks under its Funding for Lending scheme. The BoE aside, financial markets are expecting other central banks to form a ‘global reflation wave’, starting with the BoJ later this month and the ECB in September.

The UK-EU negotiations will be tough

Although there have certainly been positives over the last few days, significant challenges and risks clearly remain. Just because there is a new UK government in place, that does not mean the negotiations between the UK and EU will be a walk in the park. The foreign, trade and Brexit ministers are all leading Eurosceptics. More importantly, the EU does not want to give the UK full access to the single market without free movement of people, while Prime Minister May has taken a tough line on not allowing free movement. Clearly the negotiations will be tough and could take a long time. This will prolong the uncertainty.

Europe’s economic problems

Meanwhile, there has been more evidence that Brexit will likely have a major economic impact on the UK. The RICS housing market survey of surveyors reported a sharp deterioration of home sales and price expectations in responses received after the EU referendum. The survey for London was particularly weak, with price expectations falling to their lowest level since the financial crisis. We continue to think the UK economy is heading for recession.

We still do not have post referendum data in the eurozone (these come next week). Though the pre-referendum data confirm that the eurozone economy was set to slow significantly in Q2 in any case, albeit following a strong Q1. For instance, both industrial production and retail sales look set to have shrunk last quarter. The uncertainty following the UK’s decision to leave the EU will likely have an adverse impact on business decisions to invest and hire. This will have a dampening effect on economic growth, which will likely remain modest in coming quarters. Even with the US and China showing resilience, global economic growth remains lacklustre.

Political and banking risks

With the eurozone set for weak growth, core inflation very low, and monetary policy facing constraints, the eurozone remains very vulnerable to new economic shocks. Unfortunately it is not difficult to imagine where these might come from. Political risks loom large with anti-EU sentiment on the rise in Italy, the Netherlands, Austria, France and to a lesser extent Germany. These are all countries that will have elections in 2017-2018.

Meanwhile, Italy’s banking sector faces large capital needs given its mountain of non-performing loans, while the Italian government and European authorities are struggling on the way forward. Capital needs could be well above the EUR 40bn often reported. Indeed, we think EUR 65-70bn is more realistic. The combination of the rise of the anti-EU, anti-establishment Five Star party, banking sector problems and weak growth make Italy a prime potential source of risk for Europe. Especially given October’s constitutional reform referendum, which may trigger early elections, if the government loses.

The Nexus between the Fed and emerging markets

Finally, we should not completely forget an area of vulnerability that has gone into the background recently. The Fed’s refrain from rate hikes, the recovery in commodity prices from their lows and stabilising momentum in China have all eased the near-term challenges facing many emerging markets, with capital inflows returning. However, high levels of debt remain a major problem in China and beyond. In addition, although we continue to think the Fed will be on hold this year, some FOMC officials seem to be pushing for further rate hikes at every sign of somewhat better data. There remains a risk that if the Fed does eventually resume its rate hike cycle, emerging market vulnerabilities will come back to the fore.

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