Saturday, Jul 02, 2016

Dubai: It may be a gross understatement to say global financial markets underestimated the outcome of the Brexit vote and the resultant decision of Britain to leave the European Union (EU).

Analysts agree that the broad sell-off across continents and asset classes that immediately followed the exit vote could be because of misplaced initial expectations for a “remain” victory, but say the impact of a weaker UK and EU could have far reaching impact on asset prices for a long time to come.

Following the poll results, global markets lost $2.1 trillion (Dh7.7 trillion) in value while the British pound dropped from a high of (GBP/USD) 1.50 to a low of 1.32 (fall of 13 per cent), a new 30- year low before recovering to close at 1.37 (loss of 8.1 per cent).

Global markets have responded dramatically. The UK equity index futures have slumped and the pound sterling has tumbled to 1980s levels. Safe havens such as gold, German Bunds and US Treasuries are seeing substantial investor demand. The euro has also come under pressure.

No Lehman moment

Although the impact of Brexit on global asset prices have been dramatic in the first few days since the vote, analysts say its impact on global economic growth could be muted while it is unlikely to result in any major systemic threat to global financial systems.

“No doubt this will be the first of many volatile trading sessions, and the major central banks may intervene if necessary. But we caution against reacting as though this were a second ‘Lehman moment,’ as some commentators have suggested,” said Joe Amato, President and Chief Investment Officer — Equities, Neuberger Berman.

While the immediate market reaction to the vote was reflected immediately in equity prices in the UK and across the world, the pain in the corporate world may not be felt evenly. Many of the large companies in the FTSE 100 Index are global rather than UK businesses — 80 per cent of the index’s revenues come from overseas. This should help insulate them from any domestic downturn and potentially deliver a windfall from the weakened pound. Smaller, more domestically-focused companies are more vulnerable to a fall in consumer demand and higher import costs. That could be a source of opportunity during a sell-off in UK assets, particularly if the UK makes its new status work over the longer term.

“Brexit has manifested into a volatile sell off into illiquid markets. We think the FTSE stocks with large US dollar exposure may well outperform due to the likely sharp fall in the GBP. But it would only be on a relative basis. We do not think there are any absolute winners. Mid-cap UK is exposed to the UK economy and will be vulnerable as we think are European stocks, which are less protected by the euro,” said Tommy Ricketts, an analyst at Bank of America Merrill Lynch.

Spike in volatility

Global market volatility is expected to see a spike and remain prolonged. The US dollar is already strengthening which will likely put pressure on commodity prices. This is likely to spread over to other equity markets, with S&P index expected to take a hit of 6-7 per cent, according to Bank of America Merrill Lynch analysts. “The spillover means that global equities will likely remain volatile for a time. While it may be tempting to buy the pullback we would urge patience. The sell-off may go further than the market expects. Eventually though, value will attract buyers,” said Ricketts.

Financials are the biggest victims of a Brexit because of the both the financial and economic shocks. Despite the high yield in these sectors analyst think further earnings downgrades are likely. In general terms investors are advised to remain defensive until all of the volatility subsides and they have a view on the damage to growth.

Focus on fundamentals

Analysts say Brexit is expected to exert only marginal effect on global economic fundamentals, which remain stable but weak. Global economy is still in a slow-growth, low-inflation, low-interest rate environment, characterised by sluggish productivity and investment. “Brexit has been a tail risk stalking markets in the same way that the oil price, the strong dollar and concerns about China created volatility back in January and February, but we think its implications are overstated. For that reason, we again stress the importance of looking through the noise to focus on fundamentals and watching for opportunities to add risk to portfolios. The market reaction may provide opportunities to add to some positions in riskier assets once the worst of the initial volatility has passed,” said Erik Knutzen, Chief Investment Officer — Multi-Asset Class, Neuberger Berman.

The Brexit vote shook financial markets to their core, but commodities as an asset class did not move much. Commodity indices fell between 2 per cent and 3 per cent on the back of a stronger US dollar. Within the asset class, losses in crude oil and industrial metals were offset by gains in precious metals. That said, the impact of a Brexit on commodity markets should be generally limited. It should primarily be related to a strengthening US dollar and deteriorating market sentiment rather than fundamentals. A case in point is crude oil, which lost around 5 per cent on the first trading day after Brexit despite the fact that a Brexit would hardly shift supply and demand balances. “The recent rally in crude oil was driven by improving market sentiment rather than improving fundamentals. The market remains well supplied as Middle Eastern exports are growing while US shale is coming back to life,” said Carsten Menke, Commodities Research Analyst, Julius Baer.

By Babu Das Augustine Banking Editor

Gulf News 2016. All rights reserved.