Brexit shock. And now what?
From: Erwan Mahé
” This is why one of the only ways to get out of the current mess is to bring together all the major decision-making states in Europe, including Germany, to decide on a clear-cut stimulus programme, minus the sterile Maastricht criteria.”
Brexit shock. And now what?
All the investment scenarios have been shaken in the wake of the surprise victory of the Leave forces in the Brexit referendum last Thursday. The many discussions I have held with clients since the referendum have focused on the “exogenous” character of the shock, which brought back a whole slew of major risks to the financial landscape. So let’s go over these risks, one by one.
The return of the “fat-tail” probabilities
We commented in recent days how this was already clearly apparent in option pricing, be it on the forex, stock or interest rate markets. This was clearly visible in the highly marked calendar slopes (dearness of the shortest maturities due to the referendum’s ‘binarity’) and in the out-of-the-money Risk-Off options, which have rarely been so skewed. This return of the fat-tail distributions, which may extend to entire lengths of the calendar slopes of implied volatility now that political uncertainty appears set to continue for some time to come, will push investors to factor in an extra risk premium in the valuation of financial assets.
The economy may suffer from a natural slackening of the “animal spirits, and this new risk premium couldn’t happen at a worse time; it goes in exactly the opposition direction desired by the central bankers, who have tried in the last several years to contain it (forward guidance, QE, etc.).
The economic impact.
The animal spirits will indeed suffer from these new uncertainties and impact investment projects for quite some time, be they companies or households. It is often said that nature hates a vacuum, and that applies to investors, as well. The ‘forecasters’ have thus revised substantially downward all their GDP growth projections for the quarters ahead, be it for Great Britain, the eurozone and, more marginally, the United States. Some argue that the worries are overblown in view of the weight of Great Britain in the world economy, but fear their thinking is based on a static view of economic activity without considering the impact of the freezing of many ‘real’ projects in Great Britain, obviously, but also in the rest of the world, particularly in the eurozone.
The international political contagion
The results of Sunday’s legislative elections in Spain were not enough to reassure the markets, which are already looking to future events. Whilst the lower score for Podemos enabled a tightening of the yield spreads between Spanish and German bonds, the overall Risk-Off movement continued unabated, with the steep fall on stockmarkets, off 2% in Europe, as I write these lines. The yen climbed to 101.50 against the USD, and the implied option volatility on indices remains sustained like the price of gold. Now that we can vote for whatever programme we want and swallow whole or in part the most absurd claims and lies imaginable, many pundits are trying to determine today what impact the Brexit have on the American presidential elections, with the emphasis on the parallels between Boris Johnson and Donald Trump. Given the new loss of credibility in the opinion polls and the gambling platforms for this sort of event, we can look forward to heightened uncertainty for quite a while. And let’s not forget the newly charged significance of the October referendum promised by Matteo Renzi in Italy (at the latest). He promised to resign if he lost the referendum, although it will be limited to the reform of the electoral system. Imagine if, like in Great Britain, a coalition of political opponents and assorted discontents were to come out victorious in the referendum. How would you value financial assets in Europe, if the resultant legislative elections led to a new government headed by the M5S party and Beppe Grillo, who wants Italy to drop the euro? It is also worth noting Mr Sarkozy’s conversion Sunday to the idea of a European referendum in France, which he was rejecting just a month ago. I would not want to say that this turnabout by Mr Sarkozy was in any way related to win votes from the National Front, whose leader enthusiastically supported the Brexit, but the French presidential campaign will surely add fuel to the debate.
Has monetary policy been rendered impotent?
Following the Brexit, many observers immediately looked to the central banks to see to what extent this new shock would force them bail out markets, with new monetary easing measures. The central banks reacted in a fairly coordinated manner assuring that they were ready to inject any needed liquidity, that the swap lines were open and that they would act, as need be. The interest rate markets anticipate new easing measures (rate cut or QE) or at least a break in the case of the Fed, but the general feeling is still that, if such measures remain within their current framework, they will have little real impact on economic activity, growth or inflation. Longstanding readers are well aware of my views of the little impact that negative interest rates have on stimulating the economy when governments refuse to use the leeway gained from them to offset the shortfall in aggregate demand. The free-fall in financial securities since the Brexit vote says it all. This is why one of the only ways to get out of the current mess is to bring together all the major decision-making states in Europe, including Germany, to decide on a clear-cut stimulus programme, minus the sterile Maastricht criteria. But, for Germany to participate in any such move, it would need to be sufficiently frightened at the prospect of its partners undergoing, one after another, a wave of populist rebellion leading to the implosion of the eurozone (followed by the EU).
Imagine a €1 trillion 5-year stimulus plan, financed with the EU’s triple-A rating, to be used for infrastructure investment, the renewal of green economy projects (COP21) and a steep hike in education spending, which is the key productivity gains in the medium term (new economy), and a reduction in hysteresis (reconversion formations). Such a plan would satisfy investors’ insatiable appetite for risk-free assets whilst resolving part of the problem of bank portfolios too concentrated in the debt of their own country. If that were to lead to a rise in the long-term rates in Germany, wouldn’t that mollify the attitude of that section of its population that has been fiercely opposed to such supranational programmes? If we want to avoid a Mellon-Brüning-style liquidationist phase with all the political consequences that would imply, this would be the ideal solution. However, despite my persistently optimistic nature, I have a hard time believing such an outcome.
The Macro Geeks’ Corner (MG)
Liberty Street Economics, NY FED, June 22, 2016
President James Bullard, June 17, 2016
David Beckworth, June 2016, MERCATUS WORKING PAPER
IMF June 2016, Jonathan D. Ostry, Prakash Loungani, and Davide Furceri