At the start of a new trading week, the pound has declined further versus the US dollar, and at the time of writing is currently below 1.34. Indicative trade suggests further losses for UK and US indices. The Nikkei is higher today, possibly as a result of bargain hunting after the record drop on Friday. The focus is now on a speech by UK Chancellor George Osborne, which is expected ahead of the market open.
The post-Brexit financial landscape:
The UK’s Brexit vote has dramatically changed the financial landscape. It is hard to see how Osborne can offer the markets anything more than promises of BOE support. If he pulls a Cameron and announces a shock resignation this could trigger another round of market panic, as there is no immediate successor to take over the UK’s Treasury.
While the currency market has received the answer to the BIG question of 2016 - will we or won’t we vote to leave the EU - the future is more uncertain than we thought it would be. Essentially, news reports are telling us that the Leave camp doesn’t have a plan for Brexit. Some are even saying that David Cameron’s resignation could make Brexit less likely, since which new PM will want to trigger Article 50 and all of the uncertainty and financial turmoil that it is expected to contain? This is continuing to weigh on GBP as we start a new trading week.
Can the Brexiters settle markets?
Leave supporters must be seething that the promises from the Out campaign, including redirecting EU spending to the NHS and reducing immigration targets have already been dismissed as unworkable. The weekend saw the Leave camp try to neutralise its message and become more palatable to the wider public, which will be necessary if there is to be a new General Election some time soon.
A shift away from the controversial elements of the Leave campaign may not be enough to sooth nervous markets, as investors deal with multiple issues, including:
1, European politicians have called for the UK to trigger Article 50 and begin negotiations to leave the EU sooner rather than later. They failed to notice that we only have a lame duck PM who has no intention of triggering Article 50, setting up another fight with Brussels.
2, Political turmoil in the Labour party and a leadership contest for the Conservatives. This political vacuum is yet another cause of uncertainty weighing on investor risk sentiment.
3, Chinese officials voiced concern about Britain exiting the UK over the weekend. This is significant since building stronger trading relationships with China was a key part of the Brexit campaign. China doesn’t like uncertainty either, so it may wait for the dust to settle before riding to the rescue of the UK economy.
This is the context as we start the first full trading week in Brexit mode, now what about the impact on the markets?
The pound:
The currency remains the cleanest way for a trader to express their feelings about the strength of the UK economy, and right now they don’t have high hopes. Some banks are predicting that the UK will fall into recession by the end of this year. City firms are planning on moving jobs from their London offices to other European centres, rather than deal with years of protracted uncertainty about the UK’s position in Europe. Job losses and a weak economy will likely force the Bank of England to cut interest rates and potentially re-start its QE programme in the near future, which is all bad news for sterling. This is one of the reasons why traders do not look like they will use Friday’s big sell-off as a buying opportunity, and we may not have seen the bottom in GBP/USD quite yet.
Although the extreme volatility in the pound is unlikely to last for the long-term, eventually the fortunes of the pound will be tied to investment flows. If money starts to leave the UK’s shores then we may see a return to the protracted downtrend in the pound for the medium-term.
Stocks:
The FTSE 100 rose back above 6,000 on Friday, after an impressive post Brexit recovery, however after the political turmoil of the weekend, stocks are looking like they will open in the red this morning.
There are some winners from the Brexit vote and a weaker pound. These include gold miners, gold surged on Friday as it considered a safe haven, entertainment and leisure sectors, who could profit from a boost to tourism on the back of a weaker sterling exchange rate, and consumer stocks, which tend to rally in periods of turmoil. There are losers too, including bank stocks and airline stocks, IAG (LON:ICAG) issued a profit warning on Friday as the weaker pound made jet fuel and leasing costs, all priced in dollars, more expensive.
The selling pressure on banking stocks may also have a domino effect on the wider economy. UK banks like Lloyds (LON:LLOY) and RBS (LON:RBS) lost up to a quarter of their value on Friday. In the longer term, this could make inter-bank funding more expensive, which may be passed onto mortgage lending, thus reducing housing market activity down the line.
It is also worth noting that Italian and Spanish shares had their largest ever-daily losses on Friday, and French stocks suffered more than they did in 2008. Watch for further losses in Europe’s stock markets this week. Sustained pressure could trigger another economic crisis in Europe, which may be the final nail in the coffin for global risk sentiment this year. For now, Brexit contagion risk is the buzzword for European stock markets.
Gilt market:
Interestingly, just as Moody’s cut the outlook for the UK’s credit rating and S&P said it was only a matter of time before the UK’s triple A credit rating would be cut, Gilt yields sank to a record low. This may sound like an anomaly, but it actually reflects the dislocation in the financial markets. The flood of money out of global stock markets took shelter in the relative safety of government debt, regardless of warnings from the UK’s credit rating agencies.
When it comes to the Gilt market, the decline in yields ignores the elephant in the room, the UK’s weak financial position. The current account deficit is at a record high and the budget deficit has been growing recently. If Brexit negotiations spook the foreign investors that keep funding our debts then interest rates could rise to attract investment. This would do extreme damage to the UK’s economy. We are not at this stage yet, but with deep-pocketed global investors like China voicing concern over Brexit, any glitch in negotiations that threaten our access to the single market could trigger a wave of reaction in the UK bond market.
Shock and Fear remain
Overall, financial markets are still in the shock and fear stage of their reaction to Brexit, which leaves risk assets and the pound vulnerable to more steep sell-offs this week.
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