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Brexit: It Is All About Second Derivatives & Central Banks

The response of the public sector, and in particular central banks, will be the key of financial asset pricing and volatility.

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By Viktor Shvets

Britain has voted to leave the European Union, forcing the resignation of Prime Minister David Cameron. Whilst most of the commentary is focusing on trade links (i.e, companies that have the greatest exposure to the UK), we believe that the main impact of Brexit is in second and third derivatives.

First global economy carries $250 trillion of debt (perhaps 5x as much on a gross basis). Thus there is a considerable degree of volatility imbedded in the financial system, and hence volatility spikes are not just unwelcome but dangerous. Second, Brexit places a larger question mark over the EU project and it must be remembered that EU is the world's largest trading block and its banks are also the largest suppliers of cross border finance. So rising risk premiums and unsettling of the EU will have significant secondary derivative impacts (growth, deflation & liquidity shocks). Third, we maintain that the private sector globally is facing diminishing visibility and thus, investors have no visibility either. Therefore investors congregate in overcrowded trades and any delta can lead 10 massive positioning shift and volatilities.

... public sector (CBs) response would be critical
In our view, the response of the public sector (and in particular CBs), will be the key of financial asset pricing & volatility. Will central banks (CBs) procrastinate, allowing volatility to get out of control or will they embark on a co-ordinated strategy lo lower risks? It seems inevitable to us that joint co-ordination ordination (under the rubric of market disruption) is a high probability event.

Abenomics at ¥90-100 is likely to completely unwind. Euro zone has just restarted timid private demand for money and neither the ECB nor investors want to experience another 2010 Greek episode. In our view, the Fed's tightening is now off the table for Jul'16 and Sep'16 and likely beyond. BoE, having been passive for several years, is likely to re-engage whilst the PBoC is likely to stop now completely impotent and hence not much can be done to either reduce volatilities or induce real economy effects. Our view is that CBs still have capacity to sway financial markets but cannot alter real economy outcomes.

CBs intervention likely; stick to quality & thematics
We believe that CB's have no choice but to embark on a more aggressive stance. This particularly applies to the BoJ, BoE and ECB whilst the Fed is likely to work hard to reduce the degree of monetary policy divergence. The objective would be to reduce volatility, inject liquidity, depreciate ¥ and avoid excessive US$ appreciation. A difficult task but possibly doable in short-term.

Longer-term, EU and Euro zone will likely face restructuring. Whilst always on the cards, Brexit should accelerate it. It should also bring forward our ultimate scenario of 'nationalization of credit'. In other words, instead of waiting ano1her 12-18 months, the rise in fiscal spending and income support (funded by CBs) could be brought forward. What does this mean for investors?

We maintain that conventional business and capital cycle no longer exist. This implies sector rotation, mean reversion and momentum strategies won't work. We continue to recommend 'Quality-Sustainable growth' and 'Thematics' Investments as they tend to be uncorrelated from CBs and other strategies. As for the UK, it seems to us that after "dust settles", BoE might be fighting appreciation rather than depreciation. But this is for another day.

(The author, Viktor Shvets, is Managing Director at Macquarie Securities)


Tags assigned to this article:
Brexit second derivatives central banks markets