Brexit - Near term and longer term views

The London-based financial institutions were probably too affected by the sentiment in London and therefore unaware of the strength of feeling outside of the M25 London orbital road. Watching the referendum outcomes by constituency, it is very apparent that while London voted almost 60:40 to remain, the proportions were essentially reversed in much of the rest of England and Wales. Scotland voted to remain and with the SNP pushing not just continued EU membership but membership of the Euro. Given the clear divergence between the voting patterns of England and Scotland, we must assume that there will continue to be increased uncertainty not just over the outlook for the European Union but also the British Union itself.

Of course, in the near term, any vote for BREXIT was always likely to cause financial market instability and we can assume that this instability will continue for at least the next six months as the politicians attempt to sort out the ‘constitutional mess’ that has been created by having an ill-considered referendum within the context of the UK’s party-dominated parliamentary system. Quite simply, the two concepts don’t fit and the result has been the unstable and quite possibly unworkable situation in which the likely voting intentions of MPs (60:40 to remain), the executive branch of government, and the electorate are very far out of line, with the result that no one really knows what will happen next.

In reality, we suspect that the UK will soon be obliged to hold a general election and from this elect some form of coalition government in order to decide exactly what happens next. It is quite possible that BREXIT never actually occurs under this protracted scenario but the result may take 12 months to become apparent.
In this overwhelmingly uncertain environment, we can expect that foreign investors, who already own US$1.6 trillion-worth of UK-listed equities (virtually an all-time high) and a further US$2.5 trillion of UK domiciled bonds, will defer from acquiring further assets. Given that the UK has close to a US$150 billion current account deficit that needs continual funding by capital inflows, any ‘strike’ or reversal by foreign investors will continue to impact the external value of GBP significantly and potentially the level of domestic yields. Indeed, given that the UK requires an inflow of funds, this implies that in the near term the markets have to find a new way of attracting the necessary funding into the GBP, either by making the currency ‘cheap’ (as is occurring) or yields higher.

Interestingly, we find that the effect of the BREXIT vote on the Gilt markets has so far been almost counter-intuitive in that prospective real yields have in fact fallen quite significantly while (implied) equity yields have actually increased very sharply. It should be remembered that three quarters of FTSE revenues are derived from sales outside of the UK and although importers will likely lose from sterling’s slide, the net impact on corporate profits of the weaker currency should be positive in GBP terms, thereby implying a higher earnings yield for companies even at ‘pre Crisis’ equity price levels. Clearly, BREXIT has raised the equity markets’ risk premium significantly (although not we suspect for purely domestic reasons - see on), and quite possibly excessively.