The sharp reaction to the eventual Brexit came as a huge surprise for the market which was assuming a Bremain ahead of the Brexit polling. Importantly, the declining probability of the Brexit ahead of the polling had resulted in a strong bull run in the global equity markets. Contrastingly, other markets including treasury, commodities and FX had a more realistic view. Consequently, the reaction post unanticipated result has been disproportionate in equities. The follow up risk-on sentiment has triggered rush to safe havens like US, German, Japanese treasuries and Gold. While there appears to be a general outflow from Europe, particularly UK (across most asset classes), in EM Asia the outflow is largely from Equities. Hence, we believe that the intensity of risk off trade is non-uniform and concentrated in equities. The fact that the risk off has not permeated across multiple asset classes, probably implies that equity markets is being penalized for over-pricing a positive outcome earlier. Therefore we believe that as the dust settles markets will revert to normalcy with a moderate recovery. In the ensuing scenario we see equity markets trading sideways real economy uncertainty lingers as UK works towards re-establishing its global economic relationship, which is likely to take at least couple of years. There is also a likelihood that markets may start extrapolating UK’s exit to relapse of fears of disintegration of European Area as more countries opt for similar referendum. But such concerns will likely fade overtime as we believe that it will be more difficult for others to opt out as they are also bound by common currency and single Central Bank. Importantly, beyond just the economic considerations, UK was a reluctant to be a part of the European Union in the first place.
Brexit tremors more intense in equities
1) Brexit fall out has triggered a large scale tremor across financial markets with Equities shedding off 8-10% in the advanced markets and lower in EM Asia as 2-4%. Indian benchmark has shrunk by 4%.
2) The risk off has resulted in in strengthening in the US dollar index to rising 2.6% to 96.7 while EUR depreciated by 2.7% at 1.1. GBP depreciated steeply to 1.37 (-8%). This fall has been steep particularly because till a day earlier the market was broadly pricing in Bremain, which saw a steep appreciation in GBP by 5.6% to 1.5.
3) Asian currencies have depreciated 0.5-2%, India by 0.8% at 68.Responding to this risk off the chase of treasuries has intensified with around 20-25bp decline in US treasury yield (10 year at 1.5%). In Europe the trend is mixed with intense decline for German bonds, yields for which declined by 20-25bb; elsewhere in Europe yields on treasury has risen sharply (Italy up 25bp to 1.6%, Spain 21bp to 1.7%). In Asia ex Japan the bond markets remain steady or hardened mildly.
4) Commodities has seen risk off eroding the bullishness seen during the past three months; Crude oil declined by 4.7% at USD48.5 from recent peak of USD51; Gold rallied by 5.1% at
It will be a while before UK rebuilds economic tiesThe terms of withdrawal and the details of the future relationship with the Union will determine the long term impact on Britain. The current expansion in their CAD and setting in of need to renegotiate their trade relationships might continue to put the GBP under pressure. CAD is as large as 5.2% of GDP in UK, with probability of reversals in flows with the separation from the EU the external balance would be under pressure. Trade restrictions and tighter immigration laws along with a weaker GBP could induce inflationary pressure in the UK.
Implications for Indian marketsThe sentimental impact will be larger through the currency and flows rather than through the economic pass-through. INR has depreciated sharply and is moving in our range of 68-70. With every 100bps change in currency the impact on CPI is 17-20bps and on WPI is expected to increase by 22-25bps. In the current juncture, with rising concerns on diminishing structural support to external flows, the volatility of the external financial conditions would create a further pressure on the forex reserves. In the near term, this development could increase the probability of higher outflow from the upcoming FCNRB redemptions during Sep-Nov’ 2016, thereby adding to the expected liquidity deficit.