Pictet: Brexit unleashes turmoil in global markets

Alert to the need to contain the fallout from UK’s landmark decision, policymakers are sure to act, relaxing fiscal austerity and maintaining a loose monetary policy. For instance, we now expect the Fed to leave interest rates on hold at least until next year, offering substantial support to riskier asset classes. Moreover, Brexit may encourage governments in both Europe and elsewhere to push through economic stimulus to measures to insure against shocks. This, coupled with the fact that valuations for stocks are now at more attractive levels than they were a few weeks ago, has led us to upgrade equities to an overweight from neutral and to stay underweight bonds.

At the same time, however, and as an insurance policy against any further bouts of volatility, we keep our overweight stance in gold. According to our business cycle indicators, growth is slowing somewhat in the US because of weaker investment and manufacturing activity, and sluggish exports, which are suffering thanks to the strong US dollar. Labour market conditions are weakening too, with the economy adding only 38,000 jobs in May, the fewest since September 2010. 

However, the decline in non-farm payrolls growth does not point to a sharp slowdown, and recent consumption data shows more evidence of resilience. Following the Brexit vote, it now seems unlikely that the Fed will raise the cost of borrowing this year; the market is now implying that the next rate rise will not materialise until 2018. Easier-thanexpected US monetary policy should help underpin growth, in our view.

The euro zone economy, meanwhile, has been growing moderately, supported by European Central Bank stimulus measures, low oil prices and better labour market conditions. Also, the euro zone manufacturing PMI has risen to its highest level in six months. However, the fallout from Brexit is sure to weigh on business and consumer confidence as the year progresses. Political developments will have the biggest influence on business sentiment in the near term. We are closely watching Italy’s plans to recapitalise its banks, which are saddled with EUR 360 billion of bad loans – a third of the euro zone’s total. If Italian Prime Minister Matteo Renzi manages to convince EU partners to be more flexible on state aid for banks, this could give a strong positive signal. A gradual relaxation of fiscal deficit targest would also suggest that European governments are ready to do more do boost growth, building on the expansive monetary policies set in motion by the ECB. 

Japan’s growth momentum remains weak. A strong Japanese yen is weighing on exports and the manufacturing sector. While improving labour market conditions should support consumption, headline inflation is edging further into negative territory. Prime Minister Shinzo Abe postponed a proposed VAT hike until October 2019, while authorities are also likely to support the economy with fiscal and monetary easing. The government is expected to announce fiscal spending of up to JPY10 trillion and the Bank of Japan may purchase more exchange-traded funds to extend the scope of its quantitative easing.

In China, economic activity is stabilising, underpinned by Beijing’s recent fiscal and monetary stimulus measures. The housing market is accelerating further, especially in Tier 1 cities. Although the renminbi has depreciated in recent weeks and is near a five-year low against the dollar, capital outflows from China have so far remained muted. This is something we will be monitoring closely in the coming weeks.

Elsewhere in emerging economies, China’s renewed stability and expectations that the Fed will keep its monetary policy on hold should underpin growth in the near term. Some emerging economies are also increasing spending to support their economies, with South Korea planning a fiscal stimulus package of more than KRW20 trillion (USD17 billion).

In another positive development, India is looking to pass a key tax reform bill sooner than expected. Our liquidity conditions stand at a neutral level for a second consecutive month. Expectations that the Fed will remain on hold until at least the end of this year, and the likely expansion ofthe BOJ’s ETF buying programme, should lead to improved liquidity conditions in the coming months.

Our valuation signals show equities continue to be attractive relative to bonds. Our model indicates that Japanese shares are now approaching their cheapest levels on record, both in absolute terms and relative to other asset classes. European shares have also become much better value.

Our technical readings suggest riskier asset classes are now in oversold territory, raising the prospect of a bounce. Our indicators are also favourable for government bonds and credit, asset classes tend to do better than their riskier counterparts in the summer months. Seasonal factors also favour gold, even though the latest rally limits the scope for further gains in the precious metal.

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