June 2016 Market Update

Political risk, uncertainty and volatility have been the key theme of the last month with Brexit, changing guidance from central banks and electoral uncertainty in Australia all driving markets.

By far the biggest factor driving this uncertainty has been Britons referendum to leave the European Union (Brexit). We flagged last month that the market was underestimating the risk, and the immediate market drops in the wake of the vote highlight just how much that was the case. Ironically however, the UK was the best performing of the major equity markets in June (up 4.4%) as the Bank of England (BoE) governor said it would not only provide liquidity support in the short term, but also was in a position to ease rates. The countenance to this was that the Pound fell over 10% to record lows.

Longer term, assuming the UK triggers Article 50 to commence the 2 year leaving negotiations, the loss or at least uncertainty around the rights of UK firms to trade into the common market will lead to deferment of investment decisions and capital movement out of the UK will likely lead to a UK recession.

The greater risk to the world economy comes not from a UK recession, but from a collapse of the European Union (EU) as other nations look to reassess their positions in the block. It is this risk that will force the EU to drive as hard a bargain as possible with the UK to make it a warning to other countries considering leaving.

Pre-Brexit Europe surprised on the upside, with Q1 GDP up 0.6% (1.6% yoy) as unemployment continued to improve (now 10.1%) and the EU saw some price growth in the quarter following zero growth or deflation in the previous 4 quarters. While this was a good result, we would expect some moderation of this as companies and investors, particularly those with business or clients in the UK, sit on their hands given the uncertainty. The risk remains around peripheral European bond rates, albeit the European Central Bank (ECB) bond buying should be able to contain rates in the short to medium term absent a move by any of those countries to leave the Euro or EU. The other risk factor is the promised referendum on political reform in Italy. Should it fail, and the Prime Minister resign, there is renewed risk of a credit crisis in that country. No date for the referendum has yet been set.

In Australia, the Reserve bank of Australia held rates at 1.75% and, despite the Brexit volatility, retained its neutral stance on rates as it awaits the Q2 inflation report later this month; and the likelihood of a low inflation number means that we would expect rates to be cut further later in the year. The uncertainty that a hung parliament in Australia and the ongoing instability that this could create would also increase the likelihood of further rate cuts. Even if we have a small majority or minority government, as we saw in 2010, combined with a fractured Senate means that whoever wins government, the inability to effectively pass legislation is likely to dampen business and consumer sentiment.

China growth continues to disappoint, with weaker than expected April and May economic data pointing to Q2 GDP in line with the Q1 level of 6.7% despite significant government stimulus over the past 12-18 moths, as a fall in manufacturing and exports, high corporate debt levels combined with high personal savings rates dampen the impact on the economy. Non-performing loans continues to increase the risk of a banking crisis in China, albeit we would expect the government to step in to recapitalise any struggling bank to avoid such a crisis.

In the US the Federal Reserve left rates on hold and stepped back from its hawkish bias following weaker than expected employment data and the uncertainty around Brexit. While housing construction and household consumption spending appear strong in Q2, the weakness in the labour market is likely to put off any rate rises before the end of the year.

The other central bank to surprise was the Bank of Japan (BoJ), which indicated it was reluctant to provide further stimulus. This led to Japan being the worst of the major equity markets in June, down 9.6%.

Overall, our view from the previous two months remains unchanged as uncertainty continues to weigh on business and consumer confidence across the developed world. The reflation trade that we previously flagged as extending into August appears to have gone into reverse already. Given the relatively high earning expectations built into prices we continue see risks to the downside in equity markets.