Disunited Kingdom

The vote in favour of leaving the European Union has seen the UK hit by a triple shock.

The political, economic and financial shocks have increased uncertainty about the future economic policy. Although the shockwaves are being felt beyond the UK, in particular in continental Europe, the epicentre is likely to be particularly hit. The financial sector appears to be the most exposed to the reduced visibility. The good news is that the central banks appear to have been well prepared and are providing ample liquidity.

Political shock. The prospect of a Brexit is high but it is unclear how the situation will unfold. It is uncertain if and when article 50 of the Lisbon Treaty will be triggered by the UK in order to activate the EU exit mechanism. The extreme uncertainty is epitomized by the fact that even the future geographical boundaries of the UK are not known, as Scotland and Northern Ireland have voted in favour of remaining in the EU. The political vacuum created by the outcome of the vote implies that a coherent UK response to the vote will be delayed until after the Summer. One week after the referendum, the options that would involve the UK exiting the EU range from Brexit-lite (a remain, but with a comprehensive review of current EU-UK arrangements) to Brexit-max (full unconditional exit). A muddle-through scenario is still the most likely.

Economic shock. Candriam’s assumption is that the UK economy is worse off in a Brexit scenario in any case. In particular, the confidence shock for businesses and the political deadlock are likely to postpone hiring and capex spending. Consumer confidence will be hit due to higher job insecurity, thereby negatively affecting spending. In addition, the 10% currency depreciation of the British pound will raise inflation as it did from 2007/08. It is also of note that two of the big-3 rating agencies immediately cut the AAA sovereign rating of the UK, with a negative outlook. We also keep in mind that a rise in economic policy uncertainty has a negative impact on business spending. Clearly, restoring visibility is a priority for the next prime minister.

Financial shock. The financial shock has materialized through the rapid decline in the value of the currency, and this has mitigated the equity market sell-off, in particular for export-oriented companies (FTSE100 sales exposure to the UK represents 22% vs. 78% to the RoW). Along with the spike in volatility, financial conditions for the corporate sector have deteriorated mainly for domestically oriented corporates (FTSE250 companies have 48% sales exposure to the UK). It is widely observed that a rise in economic policy uncertainty pushes equity market volatility higher. For the political crisis not to escalate into a genuine financial crisis, it is paramount to dispel uncertainty about activating the EU exit mechanism. Stress in the banking sector will be an important gauge to monitor.

Decline in activity set to accelerate. The UK economy started to weaken ahead of the referendum. The vote in favour of Brexit will reinforce the declining trend as the uncertainty has not been lifted, to say the least. Business confidence surveys in all major sectors (manufacturing, construction, services) have declined since the start of the year. Further, loans to SMEs have been falling since January 2015 and were down -4.9% in April compared to the same period last year. We note that these trends have so far been at odds with those observed on the continent. The rise of the German IFO index for the month of June – ironically released on June 24th – to its highest level in 2016 reflects the pre-Brexit world. We know that the activity level in the Eurozone is fragile. Again, duration of the uncertainty and diffusion among trading partners of the UK are the key variables to monitor in the coming weeks.

Gauging UK financial sector stress. London and its financial services industry might lose full passporting rights as well as euro clearing and settlement. It is likely that these would be preserved only with a permanent Norway-style European Economic Area (EEA) deal including free movement of EU citizens. While fair values for banks are particularly difficult to pencil in, key drivers for future bank earnings are (1) a weaker revenue outlook (lower volumes, revenue margins), (2) increased credit risk (deteriorating asset quality) and (3) broadly flat costs. The good news is that credit metrics (e.g. CET1, Loan-to-Deposit ratios) suggest that banks can withstand these shocks and that neither banks’ capital nor liquidity positions should be a problem.

Central banks follow the financial-crisis template. Central banks, led by the Bank of England, have not been caught off-guard and are ready to provide ample liquidity to markets. As a collateral effect, the Federal Reserve is no longer expected to hike its Funds rate anytime soon while the ECB and BoJ remain accommodative. The BoE is likely to ignore the one-off inflation shock from sterling and ease policy. A re-launch of the quantitative easing (QE) programme is possible at a later stage, if financing conditions deteriorate. The timing is more uncertain as starting QE could be interpreted as the signal of a lot more to come.

In terms of asset allocation, the reduced visibility implies that the investment horizon has shortened. In this context we will remain nimble in our strategy: the announcement of a vote in favour of a Brexit is clearly having a negative impact on the European economy and on financial markets. Consequently, we have decided to reduce our equity exposure to a slight underweight, triggered by an underweight of European equities, and to increase duration.