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A trader from BGC in London's Canary Wharf reacts as European stock markets open after the UK voted to leave the European Union |
As the news came in that the UK had voted to end its long-held membership of the EU, the pound collapsed by more than 10%, levels not seen since 1985.
Elsewhere, emerging market (EM) currencies saw massive declines and safe-haven currencies surged. Banks are assessing the practical significance of the Brexit vote for their operations in London, and with much depending on the terms of the exit, there is no end in sight to the uncertainty.
Market players say the violence of the sell-off, in part, reflects illiquidity and position squaring, but the Bank of England’s (BoE) promise of £250 billion to guarantee liquidity at least calmed fears for the interbank market.
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Chris Turner, ING |
Chris Turner, head of FX strategy at ING, says the BoE will not defend any particular level for the pound, and it will only want to maintain liquidity.
“For the BoE, it’s all about adding liquidity and it will point to another 6m GBP LTRO next week and will also offer USD and EUR liquidity should it be necessary,” he says.
However, Robert Bergqvist, chief economist at SEB, says the BoE will likely cut its key interest rate or expand its stimulative bond purchases, and might intervene in the currency market if the GBP continues to depreciate.
“The UK is suffering from both budget and current-account deficits, making it dependent on foreign capital inflows,” says Bergqvist.
“Given the uncertainty resulting from the referendum outcome, the appetite of foreign investors for pound-denominated assets is likely to be limited until the effects of British withdrawal from the EU become clearer.”
UBS reckons the global volatility will postpone a Fed rate hike from September to December, while the BoE will cut rates to zero and embark on asset purchases, initially in the region of £50 billion to £75 billion.
Bilal Hafeez, global head of G10 FX strategy at Nomura, reckons further declines for the pound are highly likely, reflecting short-term uncertainty around the UK leadership election and the possible terms of the UK’s exit. Sterling devaluation will rise import inflation, worth 2% to 4% of CPI, he says.
ING predicts EUR/GBP could rise to 0.90, with the speed of the move determined by how international investors, and British politicians, react. However, Turner warns the political vacuum around prime minister David Cameron’s resignation would likely expedite the pound’s losses.
The City had been almost unanimous in warning against a Brexit, and JPMorgan was first to confirm fears about London’s role as a financial centre had not been mere scaremongering. The banks is looking at relocating between 1,000 and 4,000 employees as a consequence of the result, says the bank’s CEO Jamie Dimon.
Much depends on what settlement the UK can negotiate with the rest of the EU. Elizabeth Budd, financial regulation expert at law firm Pinsent Masons, says the City will lobby for broad equivalence with EU financial regulation.
Budd says: “What we may see is a subtle divergence in regulatory requirements over time. Given the UK’s position against the bankers’ bonus cap, the assumption is that this will be one of the first EU-led initiatives to change – but it remains to be seen how this would be done, and to what extent this would impact on equivalence negotiations.”
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Chris Turner, ING |
The fact that countries such as the US do not have equivalence has not prevented them from conducting substantial amounts of business with EU-based firm, she adds.
Yet none of this will mean much in the short term.
“Markets will principally be driven by beta to risk in the short term,” says ING’s Turner, and as the news unfolded overnight in the UK the stand-out performer was that classic safe-haven currency, yen. However, there has been no indication the Bank of Japan will intervene, with liquidity provision seen as more likely.
Analysts assume a resurgence of a dollar-bull trend is likely, with the Fed expected to postpone its hike this year due to uncertainty and increased chance of instability. The news is likely to mean sustained gains for yen, as well as traditional safe havens such as gold and CHF.
However, the euro itself might also do well, says Turner, adding: “As long as the current environment does not lead to the EMU existential crisis, EUR should do relatively well. As was the case overnight – although falling against USD it should do better than most of European currencies, bar CHF, and higher beta G10 commodity currencies, with an exception of CAD.
“The lack of a pronounced EUR sell-off provides a degree of cushion to other European currencies, both in the G10 and EM space, and should limit their sell off compared to the 2010-2012 period of EMU existential crisis.”
Compared with the 2010-2012 period, EUR/USD is cheap, notes ING, with the eurozone’s current-account position having improved and the European Central Bank seen as more credible than it was then. Market participants believe it will do whatever it takes to save the EUR, the bank adds.
Bloomberg Intelligence notes that the UK economy grew by 2.3% in 2015, losing momentum in Q1 this year as it slowed to 0.4%, from 0.6% in 4Q15.
“It’s possible that activity will decelerate further in 2Q, as uncertainty around the outcome of the EU referendum weighed on demand,” it states. “Growth is likely to slow markedly in the second half of the year, but if financial stability is preserved, a recession should be avoided.”
The UK economy has been operating at close to full employment with spare capacity having almost disappeared, according to BI Economics’ calculations, but that slack will now increase as growth in demand slows. “Unemployment is likely to be higher than if the UK had voted to remain in the EU,” says Bloomberg Intelligence.
“It seems unlikely that access to the single market for labour will be preserved, so what happens to the population will depend on migration policy. A clampdown on EU migration would lower British trend growth.”
Banking fears
A bloodbath for banking stocks – as bellwethers for macro sentiment – with RBS falling by an astonishing 34% in the immediate open, have left markets and analysts reeling.
A research note from Cenkos, an independent securities firm, pulls no punches on the cloud of uncertainty hovering over the UK economy over the medium-term.
“In macroeconomic terms, it is hard for us to see upside in this three to five-year scenario of interlinked breakups – the aggregated GDPs of separated England/Wales, Scotland and Northern Ireland are almost certainly going to be lower than that of the formerly United Kingdom, average household incomes will be correspondingly lower, and house prices as well,” it states.
“Yes, there is the opportunity for the politicians in each of these countries-to-be to restructure their economies to be more competitive – but there will be several years of logistical turmoil (eg currency separation, sovereign debt reallocation, establishing separate central banks) to contend with beforehand.”
It’s an unambiguous negative for lenders exposed to the UK, with sovereign spread widening expected, possible changes in carry trade strategies, and increase in funding costs.
“Falling house prices will hurt Lloyds the most, whilst Scotland voting to leave the UK in a rehash of their referendum will hurt Lloyds and RBS particularly badly in terms of how much it will cost to separate their Scottish operations,” continues Cenkos. “In a Northern Ireland break-up, RBS will also have Ulster Bank to worry about.
“We’ve long had Lloyds on a sell, but we are downgrading RBS from buy to sell on this view, despite the attractive relative valuation of RBS. Similarly, we are downgrading Barclays from hold to sell, and HSBC from buy to hold; these are much bigger winds than views on valuation. We leave Standard Chartered on a buy; it has no UK exposures except its London headquarters (where its USD-denominated running costs have just fallen by 10%).”
Eurozone banks are also exposed, with Citi economists predicting a 1% to 1.5% fall for eurozone GDP. Primary and secondary capital markets volumes are likely to slow, given heightened uncertainty, which will be negative for banks generally.
Citi says Nordic banks should prove most defensive in the current environment, given only 5% of Denmark’s goods and service trade is with the UK.
Meanwhile, in the UK, British Land is pricing in average property price declines of around 10%.
Moody’s says heightened uncertainty will likely dent investment flows and confidence, weighing on the UK’s growth prospects – a credit negative for the UK sovereign and other UK debt issuers.
It sited risks around potential changes to the UK’s commercial relations with the EU, regulatory upheaval, access to funding and immigration policy.
The rating agency has less concerns around EU-based issuer credit risk, although political risks within the union could increase, it warns.
“Over time, the UK and the EU will come to an arrangement to preserve most – but not all – of their current trading relationships,” Moody’s predicts.
FX prospects
Besides the pound, there will be many losers. The rand and zloty were among the big ones in the immediate aftermath.
ING singled out NOK as particularly vulnerable, second only to sterling among G10 currencies, with oil down 2%, meaning the rouble is also likely to feel increased pressure. ING also expects downward pressure on EUR/DKK to build.
China’s renminbi has been weakening for months and might see continued weakness with increased outflows, leading to more general EM volatility.
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Murat Ulgen, HSBC |
Murat Ulgen, global head of EM research at HSBC, predicted pressure on EM financial assets would continue, based on immediate risk aversion and dollar strengthening. However, in the longer term, the absence of G3 and China inflation worries – for now – provides a more benign backdrop, he says, meaning there should be no drastic turn in EM fortunes. “Selective opportunities will exist within the EM space depending on the economic and financial exposures of individual countries to the UK and Europe,” says Ulgen.
In the meantime, Ulgen says: “There is likely to be greater risk aversion in the EM FX markets than in bonds.”
CEE currencies PLN and HUF are most exposed, due to their strong trade and investment links with the UK and the rest of the EU, he says.
PLN is the most vulnerable among the CEE4, says ING, while CZK should be the relative outperformer.
Currencies with large foreign portfolio exposures and wide external imbalances could face significant downside pressure, says HSBC.
“These currencies are also the most risk-off currencies and include the IDR, MYR, TRY, ZAR, BRL and MXN,” it states. “Meanwhile, any GBP and EUR weakness could cause the RMB to strengthen against the basket, which may be a source of stability.”