Keep Calm and Carry On (at least outside the United Kingdom)

Four weeks after the British vote to leave the European Union, and financial markets appear to have followed the British Government’s advice during the second world war, when it encouraged its people to “Keep Calm and Carry On”. Whilst trading on June 27th was subjected to huge variations, markets have indeed kept their calm since. Although sterling has not yet recovered, equity markets are now close to their pre-referendum levels with the FTSE 100 and the S&P 500 even trading higher. The FTSE 100 has benefitted from the many exporters enjoying a drop in the pound. Government bond yields remain below their pre-referendum levels, but there has been no major change in credit risk. Agitation has been kept at bay thanks to the rapid British political transition and the fact that the exit process will not be rushed through.

This relatively calm financial backdrop is important because, leaving aside direct consequences on British imports, financial stress and deteriorating confidence were the most likely channels of contagion and main potential triggers for most of the negative global growth scenarios. July’s preliminary PMI readings show that, so far, the consequences seem confined to the United Kingdom. That said, the road ahead is long and a few surprises are likely along the way.

“Brexit means Brexit”

After an internal campaign rich in twists and betrayals, Andrea Leadsom’s withdrawal ahead of the Conservative party’s leadership vote paved the way for Theresa May’s appointment as the party leader and therefore as Prime Minister. As a result she was able to take office on July 13th instead of waiting until early September as originally planned. For six years, 59-year-old Theresa May held what is considered as one of the toughest posts as Home Secretary. She has a reputation for being clinical, reliable and loyal.

When forming her government, she parted company with David Cameron, George Osborne and Michael Gove, and appointed several Brexit supporters to key roles. Furthermore, she has appointed many state-educated members, in echo of a distrust that was perceptible in the leave vote. Theresa May’s initial declarations highlight her intention to conduct an inclusive policy, in line with the traditional Tory “One Nation” message, and in the same vein as her predecessor David Cameron.

Philip Hammond, the former Foreign Minister, was appointed Chancellor of the Exchequer. His recent statements suggest that a pause in deficit-reduction efforts is likely (-4.2% for the fiscal year 2015), with the goal of a return to budget balance by the end of the current Parliament in 2020 being abandoned. No emergency budget is likely to be announced before November’s traditional Budget Day. Although Philip Hammond has said that the first moves in responding to the Brexit uncertainty shock must be taken by the Bank of England (BoE), he has opened the door to a more accommodative budgetary policy in the years ahead.

Whilst the BoE refrained from taking any action at its meeting on July 14th, it clearly suggested that new measures were on the cards for August. A cut in the base rate that currently stands at 0.50% is a near certainty, but it is worth keeping in mind that Mark Carney, Governor of the BoE, has previously expressed a dislike of negative rates. Depending on how the economic backdrop evolves and most probably further down the line, the BoE asset purchasing programme could be resumed, and potentially extended to the purchase of corporate bonds.

In terms of the exit process, Theresa May has made clear that the British government sees the Brexit vote as binding. She seems unwilling to use delay tactics or to try to shift opinion on the issue and this is why she has appointed several of those who had campaigned in favour of leaving the European Union (EU) to key positions: Boris Johnson has been named Foreign Secretary and David Davis is now Secretary of State for Exiting the European Union.

It has become clear that the UK will wait several months before invoking Article 50. Despite the insistence of the European Commission along with several member states, Angela Merkel has said that the UK needs time to define its approach to negotiations and François Holland has agreed. Article 50 is likely to be invoked at the beginning of next year, but there will be no prior informal negotiations on the fundamentals. However the UK and the European Union will most likely start by discussing a roadmap and a timetable for these negociations. This will include allowing the UK to initiate discussions on new trade agreements before leaving the EU, which is currently prohibited.

David Davis has said that he would like the exit to become effective by the end of 2018. The UK’s objective is to secure tariff-free access to the single market while regaining control of their borders and the movement of people. Theresa May has identified free movement of people as the topic that had the most influence on the referendum and upon which the British Government will not compromise. So far, however, all European leaders have insisted on the fact that access to the single market means accepting free movement of people. If the issues of passporting rights for financial services and reaching new bilateral agreements with other countries are factored in, the UK negotiators will find themselves addressing a multitude of subjects and David Davis’ objectives may prove to be overly optimistic.

An impact currently limited to the United Kingdom

Whilst contagion through the confidence and financial markets channels was a possibility, it now seems a remote one. The UK has been affected in various ways, with the main one being the drop in the value of the pound (see figure 1). Import prices are climbing (see figure 2), and this is likely to cause a rise in inflation and weigh on consumer spending.

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Commercial real estate prices are under pressure, leading to closures of open-ended funds that invest in these assets, and prompting some observers to draw comparisons with the situation at the start of the 2007 financial crisis. But things are very different today. At that time, ‘dynamic’ money market products caused a risk for companies unable to access their cash, whereas today it is a question of products that are known to be risky. Furthermore, this time around the underlying assets are physical, and easier to value and sell than was the case previously with a CDO tranche.

Against the backdrop of very low interest rates, institutional investors may find yield levels attractive, especially if transactions take place at a discount. For example, Bloomberg reports that the Norwegian sovereign wealth fund has bought real estate from Aberdeen Asset Management at a 15% discount. Concerns are primarily linked to liquidity issues, rather than solvency problems: these funds buy somewhat illiquid assets and promise daily liquidity. Funds that had retained significant cash components did not need to suspend operations.

Overall, financial conditions remained accommodative (see figure 3) both in the UK and the Eurozone. However, with the institutional framework within which British companies do international business being called into question, companies are delaying their decisions. Preliminary PMI readings, published on July 22nd, are now at a level consistent with an economic slowdown (see figure 4).

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Keep Calm Figure 4

Based on July’s preliminary indicators, the Eurozone seems relatively unaffected so far. Consumer confidence has only dropped marginally and the composite PMI fell by just 0.2 points to 52.9, against a consensus expectation of a steeper fall to 52.5. 52.9 is consistent with 1.5% annualised growth (see figure 5).

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The behaviour of peripheral countries’ spreads suggests that political contagion seems to have been ruled out by markets for the moment (see figure 6). European Central Bank measures clearly limit the risk on these securities, but the outcome of the Spanish election on June 26th which saw Podemos fail in its efforts to win power should be kept in mind. So far, no other country has announced its intention to hold a referendum on its membership of the European Union. However, in a context where a significant proportion of the developed countries’ populations is angry, where messages from the elite and experts are ignored, and where migration issues prevail over economic issues, the political arena may hold some surprises for the months ahead. That said, as demonstrated by the Spanish vote, the worst-case scenario is never a guarantee.

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Conclusion

The consequences of the UK’s vote seem to be confined to the UK for now, and Eurozone indicators are reassuring. If the absence of both financial contagion and any real impact on confidence levels is confirmed, growth in Eurozone domestic demand should remain steady with any impact being limited to foreign trade. With the American economy also showing reassuring signs and some emerging countries that have had to tackle recession scenarios now seeing their economies stabilise, we could have positive surprises on economic activity in the second half of the year. Positive news could help buoy risky assets, following on from a difficult first half-year in 2016, and especially as preliminary readings for the second quarter have turned out to be better than expected. Pending activation of Article 50, Brexit should take a backseat but the Italian referendum in October and the American presidential elections in November will no doubt continue to heighten political uncertainty.

The opinion expressed above is dated July 2016 and is liable to change.

 

This document is not pre-contractual or contractual in nature. It is provided for information purposes. The analyses and descriptions contained in this document shall not be interpreted as being advice or recommendations on the part of Lazard Frères Gestion SAS. This document does not constitute an offer or invitation to purchase or sell, nor an encouragement to invest. This document is the intellectual property of Lazard Frères Gestion SAS.


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Julien-Pierre Nouen

Directeur des études économiques et de la gestion diversifiée