Brexit - No Need For The Sulky Child. Macro Thoughts June 26, 2016,

Macro Thoughts was asked to contribute to ‘Hedgeweek’ and ‘Wealth Adviser’ an analysis of the UK referendum result by midday Friday, please also see Macro Thoughts June 24

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BREXIT - NO NEED FOR THE SULKY CHILD - There is a chance to make a change, to make things better, but is it in the interest of those with the power to do so?

Whatever the outcome for the UK and Europe, the Brexit vote should shock Europe into change and hopefully break the mould that has created a disastrous economic environment across the continent. Macro Thoughts (and now the World Trade Organisation), has warned for some time of the risks from a fast growing trend in stealth trade protectionism, that is threatening global growth. It is easy to blame the UK Brexit vote for further deterioration, yet this trend has been growing since the financial crisis and now there is an unnecessary danger that media speculation and CEO gloom and doom will set a new tone, despite Britain not actually leaving the EU yet and before the years of negotiations start.

Politicians that haven’t had the incentives to create change are now being forced to make changes by populist vote. By the time Article 50 is finally negotiated, what seems scary territory now may well be looked back on after two years as the catalyst for much needed change and progress. Far from the current market gloom and the sulking politicians and media commentators, the UK may have forced Europe into the change that is needed to break the spiral of a deteriorating economy and help the UK maintain its stability and standing in the world. It is in the interests of German and French trade to create stability and maintain a strong economic relationship with the UK, while they still have issues with Greece and other highly indebted countries and unemployment that has seen little improvement since the crisis. If not, then Europe could start to break up anyway and that isn’t good for anyone.

There be many regrets from both sides of the channel and the political landscape of Europe may look considerably different in 18 months’ time, since during that period countries responsible for 90% of Europe’s GDP will be holding elections of their own (as highlighted in Macro Thoughts’ referendum reaction, published on Friday); therefore, by the time the full process of Article 50 has been settled, those politicians that start the debate may not be the ones that conclude it.

Without knowing how the dust will settle, ratings agencies are already spooked by the initial reactions and are downgrading the UK from stable to negative. More than market movements, media coverage is encouraging uncertainty, not only talking about splits between the UK and Europe, but also splits within the UK, even trying to blame a class divide, as well as the political left and right wing divide. Inevitably, there will be casualties; there will be those who will take the high ground, like Cameron, who will resign, some will fear for their political careers, while others will take advantage to boost their careers.

European politicians will want to ensure exit doesn’t become contagious and this could immediately manifest in this weekend’s Spanish election, (it shouldn’t be forgotten the reason Spain hasn’t been able to form a government is the emergence of anti-austerity political parties).

The UK’s economy has so far ridden the waves of 2008’s economic tsunami better than the EU as a whole and this has been reflected in foreign direct investment. Since entering office, Cameron and Osborne have successfully guided the UK away from the 2008 crisis and despite only having limited success with deficits, they have been able to develop a business-friendly economy, with Corporation Tax at 20% (compared with Germany 29.72%, France 33%, Italy 31.4%, Spain 25%, Japan 32%, Canada 26.5% and the US 40%). So why should foreign corporates suddenly take their business elsewhere? BMW, Mercedes and Siemens will not want their exports to the UK threatened; it’s the one economy that has managed to remain stable. Britain now needs to negotiate carefully, to preserve all of its current advantages in order to maintain the best trading environment. It is unlikely that the vote is going to be of benefit to Europe yet simultaneously be painful to the UK, so why then should EURGBP head towards 1.00?

Although market moves on Friday made good headlines for the media, one day’s volatility needs to be taken into context. In Friday morning’s Macro Thoughts (attached) it was felt, ‘overoptimistic positioning that had built in markets needed to be unwound and central banks must not overreact. Even though the market adjustment was extreme to start with, there is not the same panic feel of 1992’.

 FTSE 5 DAY CHART 

Although there were some sharp moves, there was not the panic that is being suggested and nowhere near that of the ERM crisis. During the morning, European markets (perhaps helped by Cameron’s resignation) had managed to recover; Eurostocks, which had traded down to 2736, recovered to 2840 before the US open. There was always a danger the US would overreact (Cable peaked just as the US came in), so despite some midday calm in Europe, once the US woke to the news, equity markets increased in volatility. This was not helped by Friday being a portfolio rebalancing day for the Russell midcaps, which would push volumes high anyway, yet the 2000 only traded within a 40 point range, only twice that of the moves on May 24, but closing within 2 ticks of that day. By the close of markets on Friday, the 5 day change in Eurostocks was a fall of only 2.5%, while the FTSE closed higher by nearly 2% and although the Dow closed the day down 610 points, it is only down 1.55% for the same period.

Friday’s Macro Thoughts expressed the opinion that UK10year yields would find support at 1%, which they did, (the low was 1.015%) yet yields had been trending higher, rallying nearly 30bp since June 16, from 1.115% to 1.40% on June 23, and with the market closing at 1.085%, the net change is only 0.03bp.

CHART, CABLE (GBPUSD) WEEKLY 

It is in the Forex markets that records were being set, Cable (GBPUSD) trading down to 1.3230 (the lowest since 1985), before rallying to 1.3975 and closing at 1.3680. It had traded to 1.50, the highest in 6months, on the day of the referendum, and although option volatility spiked, it has been trending higher for some time, suggesting many hedges are already in place.

Markets need to maintain a grip, despite many geopolitical risks that are likely to develop over the remainder of the year. Fund Managers should be able to see through short term volatility and concentrate on the facts, the known and the fundamentals. Eurostocks closed the day at 2776, yet on February 11 they traded down to 2672, 100 tics lower, and the Dow’s move post European close would indicate February’s level can be reached again next week. Eurostocks should find support at 2660 and potentially start trading within a range for a while if markets remain calm.

The real danger is the Nikkei, which Macro Thoughts has been negative on for the past 6 months, targeting below 10,000, despite expecting BoJ rate cuts. Partly because of the time difference, the Nikkei did trade down to February’s lows, closing below 15,000. Japan’s own elections, along with the US Presidential election in November, are likely to take the emphasis away from Europe.

Over-wary agencies have already moved the UK from a stable to negative rating. Macro Thoughts wrote on Friday, ‘Macro Thoughts felt that Gilt yields would hold 1%. The risk for the UK is its high level of debt; the Current Account deficit is 7%, Public sector debt 4% and Household debt 2.4%, and there is already talk of credit rating downgrades from S&P; therefore, despite investment banks forecasting 1 to 2 rate cuts, the reaction for Gilts is less certain. Any downgrade could lead to higher borrowing costs, putting pressure on Gilt yields, while the fall in Sterling should help compensate exporters, in a world that is looking to devalue’.

Despite the comparative stability in the UK, this has been largely based on house price inflation that has encouraged foreign buying and this is already becoming more volatile as the higher priced properties are showing signs of slowing after Osborne’s tax changes. What Manufacturing the UK has left is stalling, its Finance industry, that drove the economy for a decade, is already less important, yet its employment situation is far stronger than Europe’s, its mother tongue is the international language of business and the UK is able to manage its own fiscal policies.

Bank of England governor Carney will however need to be careful not to over emphasise the potential for rate cuts. Weaker Sterling will help exporters, in a world where all central bankers are looking to devalue to increase exports and household inflation has been falling since 2011, but a run on the pound would knock confidence and foreign investment further. Increased uncertainty in stock markets has already been developing and this will put pressure back on energy prices, so while there are those who suggest petrol prices will go up as the pound drops, this should help counterbalance.

The UK economy has managed to maintain relative stability in comparison to much of the world, while Europe has had to cope with a Sovereign debt crisis, its banks across Europe have had to defend themselves against bankruptcy, its manufacturing is in recession, it has negative interest rates, no coordinated cross border fiscal policies and a central bank running out of options.

Elected politicians are now being forced to make changes, whether for the good of their countries, and Europe, or to save their own political careers, and if a coordinated agreement can be reached with the UK over the next two years or so, then both Europe and the UK can create a strong economic environment to take on the world again.

Keith Grindlay

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Disclaimer: Macro Thoughts are a commentary, not investment research or advice – they are for information only and should be regarded as unregulated by the Financial Conduct Authority. While several people have my agreement to forward Macro Thoughts, I would appreciate being contacted first.