Asset Allocation

Investment Outlook: 3Q-2016

Brexit: Brace for the Perfect Storm

Risk asset markets were already staring at darkened skies in early June, as a result of higher prices amidst deteriorating economic and earnings fundamentals. The United Kingdom’s decision to leave the European Union (EU) will turn this into a perfect storm.

Equities and risk assets were already facing selling pressures by the start of June. Price gains in stocks around the world from mid-February were unsustainable given a slowing world economy, falling corporate earnings, and a deep malaise in global monetary policy.

At last count, US and Euro Area quarter-on-quarter (qoq) growth figures had a “zero” in front of them. Japan continues to flit in and out of economic contraction. Growth in the Chinese economy continues to fall, with the 1Q-2016 figure down to only 1.1% qoq, from 2.5% in early 2011. Also at last count, global manufacturing activity had stopped growing again. And the recessionary-like conditions in global trade continue, with volumes dipping in and out of contraction and world trade prices continuing on the downtrend from mid- 2014.

Not surprisingly then, the corporate earnings recession has widened and deepened. The long-running decline in corporate earnings in Emerging Markets and Asia ex-Japan has gone global – with the US and Europe indisputably in the grip of falling company profits, too. Meanwhile, rising wages in the US, amidst a shrinking workforce and a cyclical decline in productivity, will put more downside pressure on corporate earnings.

So what can central banks do for encores amidst renewed slowing in economic growth after quantitative easing and negative interest rates? Well their answer, it would seem, is more quantitative easing and deeper negative rates. The danger is that instead of lifting economic growth, this would further inflate asset bubbles in stocks and bonds. And negative rates will likely undermine profitability and confidence in the banking sector. Perhaps the greatest risk is that this strategy of quantitative easing and negative rates – if successful – would encourage greater indebtedness in a world that is already suffering from dangerously high levels of debt.

Debt essentially borrows from future economic growth. And, with diminishing future growth prospects, a debt-driven strategy might ironically frighten households away from spending and companies away from investing for a more uncertain future. Lord Mervyn King, the former Governor of the Bank of England, recently warned: “After a point, monetary policy confronts diminishing returns. We have reached that point.”

“Brexit” will add a new – and very threatening – dimension. The UK faces a decline in economic activity as a result of its loss of previous trading privileges within the EU. The EU faces the threat of contagion and further stresses on the unity of the Union. And an aggravated “risk-off” will threaten the value of bank assets, potentially putting at risk bank capital.

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