Global markets fell sharply on Friday in the wake of the shock result the UK had voted to leave the European Union. Financials shares have been the hardest hit in terms of sector, and the main European share market index was down -8.6% on Friday. The UK market initially fell -8% before recovering to end down -3.1% (as the Bank of England pledged to support markets), while closer to home the ASX also lost -3.1% and the NZX was down -2.5%. Given the big one-day move, we will be watching developments very closely this week, as volatility is likely to remain high.
The initial reaction of markets has been one of panic and chaos, and it is set to be a period of exceptional uncertainty for the UK. It is very early to tell how the Brexit process will play out, which means more uncertainty is on the cards and volatility is set to remain. For equity markets globally, including AU/NZ, the surprise result and the unpredictability of the political process is likely to weigh on investor sentiment and willingness to take risk. In saying that, it is often the case that in periods of market panic and fear (as was the case at the start of this year) brave investors can find opportunities, and we would urge investors to remain calm as the dust settles from the initially Brexit shock.
The Vote
In the referendum 51.9% of voters opted for Brexit, on a high turnout of 72.2%. London, Scotland and Northern Ireland plumped for "Remain", while the rest of Britain voted "Leave". A striking amount of the variation in the vote can be explained by demographics – the majority of voters aged 18-24 voted for Remain, while more of voters aged 65 and over voted for Leave. Further, in terms of education levels, the majority of degree-holders voted to stay in the European Union, while most of those with only secondary-school educations wanted to leave. Given the narrow majority, there has been a petition for a second referendum, although this seems unlikely to play out. Scotland are also calling for their own independence referendum, as results show they wish to remain in the EU with a solid majority. To add to the uncertainty, British Prime Minister David Cameron has announced that he will step down as prime minister.
British Pound
The pound plunged to a more-than-30-year low against the dollar on Friday as results slowly became clear that the U.K. was on course to leave the EU. The fall was lowest level since 1985 and came only some 6.5 hours after the pound reached a year-to-date high of $1.5018. It was the steepest one day fall for the currency in its history. A lower currency signifies a loss in investor coincidence. Uncertainty around the outcome and implication for the UK and EU economy led investors to liquidate their GBP holdings and seek safer waters.
The currency ended the day at $1.368 after falling as low as $1.32 before recovering slightly into the close of the day. Most GBP forecasters expect the pound to settle close to the $1.20-$1.30 range over time as the outcome of leaving the EU becomes clearer. Meanwhile safe haven assets surged with the Japanese yen, Gold and Bitcoin strengthening as investors searched for protection from the fallout. It is likely that we see protracted political and economic uncertainty, leading to a weaker GBP, higher inflation, and a hit to growth from here. It will take some time for clarity to be reached and markets hate uncertainty.
London bankers working through the night said they had not seen anything like the volatility sweeping across UK assets as was experienced on Friday. The moves were to some degree exacerbated given that early poll indications and the days running up to the vote indicated that the stay vote would prevail. Because markets had wrongly anticipated the outcome the reaction was far more hectic than with a neutral expectation.
The Bank of England said on Friday it would take all necessary steps to secure monetary and financial stability after the vote. While a lower currency does mean British made goods and holidays to the UK are now relatively cheaper for foreigners, but the negative impacts are likely to outweigh these benefits. Loss of trade with key European nations and an exodus of large multinationals is likely to have a serve impact on economic growth and employment. A weaker economy reflects a weaker currency. British retailers along with Travel and leisure stocks were hit hard had due to fears of the effect the vote could have on consumer confidence and spending. Housebuilders felt the heat, due to uncertainty over investment in the U.K. post-Brexit.
Contagion Risks for Europe
The biggest concern for markets is arguably what the implication of Brexit will be for the European Union. As we have discussed previously, a Brexit has been seen as a negative for markets primarily due to the uncertainty it creates. Not only in terms of uncertainty of the UK and its relationship with the EU, but the EU itself. A Brexit raises issues such as to whether other countries such as Germany can also leave. There is a strong incentive for the EU to make the UK’s exit as punitive as possible to severely diminish the risk of other members making the same move. Clearly the shocked reactions of many European leaders suggested they had not fully absorbed the possibility of a vote for Brexit, as Germany’s Angela Merkel called a crisis meeting of parliamentary leaders and cabinet members.
As an example of anti-euro movements, Matteo Salvini, the leader of Italy’s right-wing populist Northern League, praised “the courage of the free citizens of Great Britain” and called for an Italian referendum next. For European leaders, the most pressing question is how to deter this contagion. That means making Britain’s exit look like an unattractive option, and preventing it from enjoying the benefits of EU membership once it has left. The idea, as one French minister said before the result, is “not to punish” Britain, but to send a strong signal to others. But most German politicians have been less confrontational, hoping that the panicked reactions of financial markets and business leaders to Brexit will be enough to scare off others.
Australia & New Zealand
On Friday close to $50 billion was wiped off the ASX200, which dropped 3.2%, while the NZX feared slightly better down 2.5%. The ASX’s revenue exposure to UK and Developed Europe is fairly minimal at 1.8% and 2.0%, respectively. The NZX is estimated to have a similar exposure. From a trade perspective, Australia has limited exposure with total merchandise exports to UK being 2.5% and Euro Area 3.5%, and total imports being 3% (UK) and 13% (Euro Area). New Zealand is slightly higher with total merchandise exports to UK being 3% and Euro Area 11%, and total imports being 5% (UK) and 13% (Euro Area). Trade focus for both AU & NZ has become much more focused on emerging markets and Asia of recent years and therefore both countries will be insulated to some degree to the fallout.
The worst effected sectors on the domestic share markets will be those with revenue linkages to UK and EU. These are likely to be Diversified financials, Health-care, Insurance and Real Estate. In a broader picture, a loss of investor confidence is likely to see AU/NZ company valuations come under pressure. Tighter financial conditions are likely to be a negative for markets in general and may see pressure on credit markets. Both the AUD and NZD came under pressure on Friday and are likely to stay under pressure as investors repatriate and de-risk their portfolios in light of further market turmoil. This is likely to be a slight positive for the Australasian economies. The negative sentiment and general turmoil is likely to be factored into both the RBA and RBNZ’s next rate decisions as they assess the impact on domestic trade and growth.
The UK Brexit is likely to be supportive for the Turnbull Liberal government’s election campaign as the economy and economic security will come into focus in Australia. Voters are likely to want stability and elect to “keep things the same” in wake of global market volatility.