Uncertainty and risk aversion have played a prominent role in financial markets over the last year. This was triggered by three events: The Yuan devaluation in August 2015, the global economy concerns in January 2016 and now the European Union (EU) Referendum result on 24 June.
Markets reacted quite sharply to each of these events. The result to leave the EU was not anticipated by many market participants and in a single day we saw double digit losses in both the equity and currency markets. On top of this, many economic themes impacting markets are still to be addressed. We face slow growth across Europe and Japan, the public sector is propping up the financial system in many economies and the US is moving ahead of other markets to normalise interest rates in the wake of the financial crisis.
In the last few weeks we have added a complicated political situation between the UK and Continental Europe, leadership battles in the two main UK political parties, a new Prime Minister and an increase in the noise from many of Continental Europe’s nationalist parties.
There are so many moving parts that it is quite difficult to interpret the current macro-economic picture. This is further distorted by the financial repression from many of the central banks, in some markets central bank policy is leading to negative returns if bonds are held until maturity.
Having said this, it is possible that optimism could re-enter the investment community.
Further coordinated monetary action by global central banks
We could see central banks across the world working closer together to stimulate global growth. This would mean there would be a less pronounced divergence in currency between developed nations and would be a step towards removing competitive devaluations that boost exports.
The central banks want to see a global pickup in inflation as this would improve public finances. But how might this be achieved?
The governor of the European Central Bank (ECB) has called for coordination in monetary policy. In our interconnected world any changes in policy can impact other markets; either positively or negatively. So far this year we have seen central banks struggle to have the impact on risky assets that they once had and economic growth has slowed as a result.
We are likely to see a cut in interest rates from the Bank of England and the anticipated rate hike in the US is now looking unlikely. BREXIT has not helped the global economy on its path to normalisation and interest rate hikes at this time could have an adverse effect.
European banks can start focus on cost cutting
BREXIT could signal the end of Britain’s status as the largest European trading and clearing hub of financial instruments. Banks may start to relocate workforces to new financial hubs such as Dublin or Frankfurt.
But this is not the doom and gloom story it appears to be on the surface. Relocation would create a round of redundancies and then a hiring spree in the new cities. Financial services wages in Dublin are around 40-50% lower than they are in London, indeed many technology giants have located their head offices in Dublin for that reason. In an environment where revenue is constrained by interest rate compression from the central banks, cost cutting becomes a key driver of revenue increases.
This would give a boost to bank profitability even in an economy with slow growth. This could trigger optimism across Europe.
Europe starts a “real” integration process
The UK referendum could trigger an economic and fiscal union across the EU. Whilst this is unlikely in the short to medium term it could provide a huge boost to European assets. This would minimise the impact of local interests and remove much of the bureaucracy that currently exists. This would reduce a lot of the uncertainty that exists in European markets and boost assets in the medium terms.
An investment strategy that relies on these outcomes is unwise. Focusing on the fundamentals of investing by combing diversification with a long-term view and strong risk management will continue to be a winning strategy. It is crucial that investors have a realistic outlook on the financial markets and have the liquidity in their portfolios to respond to all outcomes.
