Daily Management Review

Did financial markets reconcile with Brexit?


The British pound is the most reliable indicator of sentiment towards Brexit. If the news headlines shout about a "hard" exit of the UK from the EU (the creation of trade barriers with Europe), the UK’s national currency declines. Once the information about the "soft" Brexit (what is close to current relations) appears, the currency strengthens.

But there is also a process of response. The sharp drop in the pound immediately after the referendum led to a gradual increase in imported inflation. Annual inflation in November reached 3.1%, which caused the head of the Bank of England, Mark Carney, to turn to Finance Minister Philip Hammond for a response on the reasons for exceeding the target level. The mega-regulator has already raised the interest rate.

Apparently, additional increases will follow, and these expectations are supported by the pound.

The need to tighten monetary policy is not simply a consequence of a higher import value, which may prove to be temporary. The most alarming is that the Bank of England believes that the trend growth of the British economy is slowing down (this point of view is shared by the Bureau of Budgetary Responsibility).

Partly, this can be explained by the fact that the UK is facing a more difficult future after Brexit, and also this is recognition that the economy’s productivity has suffered from the financial crisis of 2008.

If trend growth falls, then a tense labor market will provoke a rapid rise in wages and wider inflation. And this means that the central bank may have to raise the interest rate much faster.

Speaking about the bond market and the stock market, the effect of Brexit should be considered in the light of global trends: historically low bond yield and stock market boom. The yield of the ten-year-old gilt fell below 1% immediately after the referendum and is still less than in May 2016.

But the yield of bonds may fall for two reasons. An optimistic reason is that bonds look more attractive to investors, so prices are rising and yields are falling.

The pessimistic reason is that investors are less likely to believe in the positive outlook for the economy and go into bonds, since they are less risky, the British magazine The Economist writes.

Some want to believe that pessimists are mistaken: in the end, the stock market is growing, but it would not have been if it were believed that economic growth is under threat.

But the analysis is complicated by the presence of a large number of multinational companies in the FTSE 100 index. Their future does not depend very much on the British economy, and their foreign incomes stand much more in sterling terms after the pound falls.

In relative terms, British stocks are not very good. In the USD valuation, the FTSE 100 grew by only 6% since the referendum, compared to 23% for the MSCI World Index and 26% for the S&P 500. Both in dollar and sterling terms, the FTSE 100 shows the worst result among developed countries in 2017.

A survey of global fund managers conducted by Bank of America Merrill Lynch in November showed that 37% have a lower than usual presence in British stocks.

Despite this, there were no dramatic sell-offs in the stock market, and the pound strengthened in the aftermath of the referendum. Investors tend to ignore nationalist rhetoric and expect that a rational approach will eventually win. Trade relations between the UK and the EU are too important to risk.

In addition, this process is delayed. As the two-year transition period seems more likely, a critical moment for trading will not come before 2021. As a result, investors, when choosing the way of asset allocation in 2018, may not worry much about Brexit.

Some analysts expect that the process will turn into Brexit only by name (the UK will remain in a single market, which, in fact, is a member of the EU, but without affecting the legislative process). This is a logical consequence of the agreement that was reached over the Irish border.

But there can also be strong disappointment for investors when the British government tries to realize all its numerous and contradictory promises.

source: economist.com