Brexit et al:It is all about 2nd derivatives &CBs

Brexit seems to have become reality and...

Whilst there are a number of legal and other obstacles remaining, it appearsthat the UK is set to exit EU. Whilst most of the commentary is focusing ontrade links (i.e. companies that have the greatest exposure to the UK), webelieve that the main impact of Brexit is in second and third derivatives.

First, global economy carries ~US$250 trillion of debt (perhaps 5x as much ona gross basis). Thus there is a considerable degree of volatility imbedded inthe financial system, and hence volatility spikes are not just unwelcome butdangerous. Second, Brexit places a larger question mark over the EU projectand it must be remembered that EU is the world’s largest trading block and itsbanks are also the largest suppliers of cross border finance. So rising riskpremiums and unsettling of the EU will have significant secondary derivativeimpacts (growth, deflation & liquidity shocks). Third, we maintain that theprivate sector globally is facing diminishing visibility and thus, investors haveno visibility either. Therefore investors congregate in overcrowded trades andany delta can lead to massive positioning shifts & volatilities.

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

Abenomics at ￥90-100 is likely to completely unwind. Eurozone has just restartedtimid private demand for money and neither the ECB nor investorswant to experience another 2010 Greek episode. In our view, the Fed’stightening 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 PBoCis likely to stop creeping Rmb depreciation. The question is whether CBs arenow completely impotent and hence not much can be done to either reducevolatilities or induce real economy effects. Our view is that CBs still havecapacity to sway financial markets but cannot alter real economy outcomes.

CBs intervention likely; stick to Quality & ThematicsWe believe that CB’s have no choice but to embark on a more aggressivestance. This particularly applies to the BoJ, BoE and ECB whilst the Fed islikely to work hard to reduce the degree of monetary policy divergence. Theobjective would be to reduce volatility, inject liquidity, depreciate ￥ and avoidexcessive US$ appreciation. A difficult task but possibly doable in short-term.

Longer-term, EU and Eurozone will likely face restructuring. Whilst always onthe cards, Brexit should accelerate it. It should also bring forward our ultimatescenario of ‘nationalization of credit’. In other words, instead of waitinganother 12-18mths, the rise in fiscal spending and income support (funded byCBs) could be brought forward. What does this mean for investors?We maintain that conventional business and capital cycles no longer exist.

This implies sector rotation, mean reversion and momentum strategies won’twork. We continue to recommend ‘Quality-Sustainable growth’ and‘Thematics’ investments as they tend to be uncorrelated from CBs and otherstrategies. As for the UK, it seems to us that after “dust settles”, BoE might befighting appreciation rather than depreciation. But this is for another day.