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Brexit Will Create Ripples But Not Waves .

Will the Brexit have long-term effects for the markets? Find out more from Nasdaq's Market Data experts.

Brexit Will Create Ripples But Not Waves

The long-term impact of the historic decision by the United Kingdom to leave the European Union on 23rd June will take investors and analysts time to fully quantify but there is no question that over the short-term, ‘Brexit’ is going to create ripples of volatility.

The sterling, which many anticipated would bounce on the news of a Remain vote, slumped to a 31-year low against the US dollar, falling as low as USD1.3228.

An estimated USD3trillion was wiped off global market indices over the course of two days, leading the FTSE 100 to fall as much as 8.7 per cent when the markets opened on Friday.

However, thanks to ‘Turnaround Tuesday’ the FTSE has since recovered those losses and is now at 6,581: a +5.43 per cent gain YTD.

Even more encouraging is the fact that the FTSE 250 Index, which many regard as a more accurate reflection of the UK economy, has recovered strongly. The index slumped 13 per cent last week and saw GBP25bn wiped off. Since then, it has made a strong recovery and is back up 16,470; still below the pre-Brexit level of 17,333 but encouraging nonetheless.

This has been helped by the Bank of England Governor Mark Carney’s announcement that it would provide more than GBP250bn of liquidity to “support the functioning of markets”. The Bank of England has since injected GBP3.1bn into UK banks.

Brexit had the potential to be another liquidity shock to the financial markets like 2008. But, central banks are now well versed in handling liquidity shocks that the Bank of England quickly stepped in to stop that from happening. Other central banks including the U.S. Federal Reserve voiced their resolve to keep the global economy going as well. Collectively, the central banks provided confidence to the markets which lead to the significant rebounds in U.K. stock indices over this past week.

There’s no doubt that the Brexit decision left many stunned. Currency traders and hedge funds watched as events unfolded and led to huge winners and losers, one of the more prominent being Crispin Odey of Odey Asset Management, who is reported to have made GBP220mn by going short sterling and long gold.

Over 30 million people voted and in the end, it went down to the wire with 16.1mn people (48.1%) voting to remain, and 17.4mn people (51.9%) voting to leave.

Due to uncertainty created by the Brexit result, Standard & Poor’s proceeded to strip the UK of its much cherished AAA rating, downgrading it to AA.

“The good thing, if one wants to look for a silver lining on the back of Brexit, is that a weaker sterling will be good for the UK’s export market and bad for imports, “says Frank Hatheway, Chief Economist at Nasdaq. “Domestic UK companies that might previously have been under pressure from cheaper international imports could become viable again. Whereas the UK labor market is being paid less and producers are being paid less, in real terms and international purchasing power terms, from a global competitiveness standpoint, a weaker sterling will help the UK”.

Last summer, China took the decision to devalue the RMB’s reference rate by 1.9 per cent specifically to support its lagging export market. At the time, Tom Orlik, chief Asia economist at Bloomberg Intelligence, estimated that a 1 per cent depreciation in the real effective exchange rate would boost export growth by 1 percentage point, with a lag of three months.

On the back of improved exports through Q1 2016, the IMF has revised its forecast for Chinese economic growth this year, to 6.5 per cent from 6.3 per cent.

A similar bounce effect could take place in the UK as export numbers grow on the back of a lower sterling.

Hatheway thinks that the Bank of England will necessarily need to be loose with its monetary policy to cope with short-term volatility “but over the longer term we do not think the sterling will be as weak as it is today. It will recover over the next weeks and months once the UK returns to a more normal monetary policy stance and there is confidence that the banks aren’t going to fail.”

However, unlike the ’08 financial crisis, the fact that interest rates are already at significantly low levels (0.5 per cent) means that the Bank of England has fewer levers at its disposal to support the UK economy, if and when a mild recession starts to kick in.

Hatheway observes that countries that have adopted negative interest rate policies have done so for reasons “other than to directly boost the economy; they’re trying to do something with exchange rates, get capital flows moving, as opposed to getting companies to hire more staff and expand facilities.

“The UK is as close as it can go with interest rates. However, in terms of direct financing of the economy there’s more that Mark Carney can do in terms of buying assets and making liquidity available. A decision could be taken, for example, to buy up mortgage assets and transfer them off UK banks’ balance sheets on to the Bank of England’s balance sheet to generate liquidity in the market,” suggests Hatheway.

On Friday 1st July, at the time of writing, Carney announced that some monetary policy easing “will likely be required over the summer", causing the sterling to fall to USD1.326.

On Wednesday 29th June sterling had pared back losses, at one point climbing above USD1.35. That it has again weakened on the back of Carney’s announcement shows the ripple effect that Brexit is having, at least in the short-term.

With respect to the bond markets, the risk premium for euro debt and sterling debt is going to rise on the back of Brexit.

The fact is the UK electorate has decided to walk away from a 40-year economic program that gives the UK access to a single market that represents a trading block in excess of 500mn people.

This is something that international creditors have long taken from granted. Uncertainty and a weaker sterling could lead to the UK bond markets facing higher borrowing rates as the costs to lending to the UK government rise. In the immediate aftermath, however, UK gilts have seen yields fall as investors fly to the relative safety of bonds and gold.

The yield on 10-year gilts has fallen below 1 per cent to 0.96 per cent having reached a record low of 0.93 per cent earlier on Monday; the first time in its history. Both Citi and Goldman Sachs predicted a sub-1 per cent scenario.

A lower yield environment should support a UK recovery in the sense that it should reduce the cost of capital to businesses. Coupled with a weaker sterling, export-focused UK businesses might be in a better position to invest in R&D, hire more staff, and potentially create a virtuous circle, leading to higher stock prices.

Goldman Sachs is forecasting a ‘mild recession’ and has reduced its forecast for UK GDP growth for 2016 by 0.5 per cent to 1.5 per cent.

Indeed, Brexit could benefit the UK’s economy by allowing it to focus its attentions on building stronger trade relations with non-EU nations. In a Wall Street Journal op-ed on 29th June 2016, Nasdaq CEO Robert Greifeld made the point that on a recent business trip to China, New Zealand and Australia, although Brexit was top of mind, and the prevailing wisdom was that the United Kingdom would stick by the EU, “there was also a palpable excitement that an exit vote could open doors to new trade with an independent Britain”.

Asked whether sterling could fall further than the previously recorded low of USD1.32, Hatheway responds:

“It could. All it takes is for the narrative of financial stress to gather momentum, and for the Bank of England to open the safe i.e. loosen monetary policy and engage in quantitative easing and to be perceived as needing to do that for an extended period of time. Right now, I’m not seeing any reason why they would need to do that but the potential is always there.

“Let’s say that banks start to relocate staff from SE England. If they were to vacate buildings this would start to negatively impact the price of real estate. If real estate prices were then to start falling more widely across the UK, it could push the UK economy into a tailspin, causing the sterling to fall even further than we’ve seen in the last few days.”

Fundamentally, Hatheway doesn’t think that Brexit will have too big an impact on the global economy.

There will be some weakness in commodity prices but not, he says, to the same level that was seen in the wake of the financial crisis in 2008.

“Commodity prices will likely quickly return to responding to global economic issues. I think the effect of Brexit will be temporary,” says Hatheway.

Hatheway stops short of saying there will be a recession, but there’s no doubt that Brexit will continue to create short-term volatility in the markets over the coming days and weeks.

For more information on current events and the markets, visit our GIS Insights newsletter.

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