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Uncertainty over Brexit will continue to bedevil markets

The UK is unlikely to formally begin the process of leaving the EU until 2017 and unease over its position in the EU will be unnerving for investors and firms.
Wednesday, August 24, 2016 - 05:50
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The pound, which fell 8 per cent on the day of the UK referendum, may have found a bottom for now but it could remain at depressed levels until investors are confident that the UK economy is going to weather the Brexit storm.

JUNE was a momentous month for the financial markets. The United Kingdom voted to leave the European Union (EU). The Brexit vote rattled global investors and caused significant market volatility. The pound has been the largest casualty in the whole affair, slumping over 10 per cent this year (as at July 19).

On the day of the UK referendum, it plummeted from nearly $1.50 to around $1.35 against the dollar - an 8 per cent drop. Dragged by contagion fears, the euro also depreciated.

The other immediate impact in the financial markets was a massive sell-down of risk assets. Developed equity markets lost nearly 5 per cent, which was the largest one-day fall in almost five years. There was dramatic action in sovereign bonds as well when investors sought safety.

By the end of June, however, developed international markets had shrugged off the news, trimming losses to only 1.3 per cent, compared to lows of 6.1 per cent just a few days ago. Remarkably, the MSCI Emerging Markets Index remained strong, closing the month with a gain of 3.3 per cent, helped by strength in Latin America.

Why so much strength after the UK referendum? It could be that investors continued to be frustrated over the lack of suitable investment options. There is an increasing proportion of sovereign debt with negative yield. The negative interest rate policy stance adopted by several major central banks propagated this phenomenon. It might also be because investors are looking beyond near-term worries and assessing the vote's longer-term prospects.

Overall, the UK's exit from the EU is going to be a protracted process, with careful and complex negotiations. So there is still much uncertainty regarding how Brexit will actually play out. As a corollary, investors may be wise to withhold judgment for the moment. Moreover, the EU will not begin any formal or informal negotiations until Britain gives a formal notification through activating Article 50 of the Lisbon Treaty.

The EU wants London to start the Brexit process as soon as possible. Former UK Prime Minister David Cameron said that would not happen on his watch. But with his earlier-than-expected resignation and the appointment of Theresa May as the new premier, the process may start any time now. Nevertheless, the new prime minister has said she will not rush to trigger Article 50, and stressed the importance of maintaining market access to the EU.

We are unlikely to see Britain enact Article 50 until 2017. Mrs May has told several European leaders that "some time" would be needed to prepare for EU exit talks. In her new cabinet line-up, she has appointed prominent Leave campaigner David Davis as the Brexit Secretary, as well as Boris Johnson as Foreign Secretary.

The uncertainty concerning the UK's position in the EU will be unnerving for investors and companies. A corporate spending survey by Credit Suisse revealed that firms may postpone investing in the country for the next few years. We may expect slower job creation and weaker wage growth as a result.

What if the UK decides not to withdraw?

The UK referendum on its EU membership is not legally binding. The government can ignore the results and simply maintain the status quo indefinitely. Moreover, the EU cannot force the UK to activate Article 50, although it could attempt to penalise Britain with sanctions using Article 7, rationalising that the delay is creating economic uncertainty which undermines the union. But that is unlikely and considered a last resort. Even if the UK enacts Article 50, the British government could stop the withdrawal at any point during the process.

Brexit and currencies

The currency markets may continue to shift in the coming months. But their movements may not be as dramatic as what we witnessed in June, at least from the impact of Brexit developments later this year.

The pound may have found a bottom for the time being, as the smooth premiership transition was welcomed by the financial markets. But it may remain at depressed levels until investors are confident that the UK economy is going to weather the Brexit storm.

The next bout of market volatility could come in the form of a timeline for the activation of Article 50. That also depends on how well the new government has prepared for the Brexit negotiations. In addition, there is a risk that Mrs May will be tempted to call for an early election to receive a five-year mandate.

The fate of the euro is entwined with that of the pound to some extent. The common currency weakened 2.4 per cent against the US dollar on June 24, but supported above 1.10, and is still around 2 per cent higher on the year.

Rising real yield differentials between US debt and euro-area bonds may cushion any pullback in the euro.

Meanwhile, the relative strength of the Japanese yen is causing problems for the Bank of Japan (BOJ). The safe haven status means the yen attracts strong demand in volatile market conditions even if macroeconomic factors weigh on the currency.

In spite of the BOJ's ultra-accommodative policy stance, the Brexit situation has directed investors to purchase more yen. A disorderly and one-sided movement in the local currency affects the Japanese industry. A stronger yen may strain exporting businesses and reduce inflationary pressure, both of which are of concern to the BOJ.

The prospect of Japan adding fiscal and monetary stimulus may, however, temper the strength in the yen. Currency markets will remain sensitive to any headlines discussing "helicopter money". So far, we have received little specifics about what the policymakers intend to do.

The writer is market strategist at IG Asia.

You may wish to follow him on twitter at https://twitter.com/BernardAw_IG