Post-Brexit watch list

After the initial reaction to the Referendum result on Britain's proposed exit from the European Union begins to settle down and we enter the second full week after the vote, David Shairp, head of investment research, at Prudential Portfolio Management Group (PPMG) outlines the economic pressures to watch over the coming weeks.

Valuations are expensive

“The latest bout of “risk on” (where investors move to riskier, more volatile investments) has left several asset classes looking historically overvalued, according to our percentile framework. Equities look moderately overvalued, while our measure of government bonds suggests that they are expensive – all the more so given the dramatic recent declines in yields.

“The upshot of less favourable valuations is that prospective long-term returns will become less attractive, which has been a continuing refrain from the PPMG Long-Term Investment Strategy team over the past seven years. The medium to long term is likely to be a future of more meagre returns, where the generation of ’alpha’ (value added by outperforming specific benchmarks) becomes increasingly important as confidence in returns from ‘beta’ (broad exposure to asset classes) reduces.”

Policy makers’ response

“The rebound in markets towards the end of last week was from oversold levels. It owed itself in part to the repricing of monetary policy expectations, and markets have pushed out the next rise in US interest rates to the end of 2018. The Bank of England Governor Mark Carney stated that there is scope for interest rates to be cut over the summer, potentially with additional quantitative easing, and markets have responded by pricing in a 60 percent chance of a cut in rates at the July 14 Monetary Policy Committee meeting. A summer of more stable markets, that are underlined by easier policy from central banks, which boosts risk appetite may be the short-term prospect but will do relatively little to change the medium-term fundamental picture – barring evidence of a re-acceleration in global economic activity.

“The upshot is that UK equities have surprisingly moved to become very overbought vs global equities when measured in local currency terms. So, if the UK authorities are ready to support asset prices regardless, sterling could remain a vulnerable currency, despite its sizeable declines to date.”

A hard-Brexit Britain

“The Leave vote at the UK referendum represents a stagflationary shock for the UK - and a deflationary shock for the Eurozone, likely to lead to reduced activity. At this stage, PPMG’s tentative prediction is that we should plan for a ‘hard’ Brexit scenario, which could see growth fall sharply to between 0%-1% during the period of renegotiation, with a rise in consumer price inflation towards 3%-4% a year.

“In the post referendum environment, it has probably become harder for the UK to finance its current account deficit, which came in at 6.9% of GDP in Q1 2016, following a record deficit of 5.4% for the whole of 2015. While the 9% fall in sterling in effective terms, since the pre-referendum peak, should provide some short-term support to the economy, it is unlikely to lead to a rapid improvement in the current account. It is also notable that UK risk premiums (the compensation for taking on the risk of holding sterling assets) are lower than are probably needed at this stage of the adjustment cycle.”