DAY 2 AFTER THE BREXIT

Lower volatility on financial markets this morning

After Friday’s high volatility that was generated by UK’s referendum, this morning sees markets opening rather calmly: slight decline in long bond yields, stability in the US dollar, yen and Swiss franc stronger and GBP weaker. Stock markets should open 1% lower approximately, the Nikkei is up 2%.

A heavy political calendar

Today’s Berlin summit is the first of several important meetings this week. It is well obvious that the political answers that the European Union brings will be crucial, both for Europe’s future and for financial markets. Several meetings are planned over coming days. Britain wants to take time to negotiate the Brexit, France prefers a speedy process, Germany favours staying calm and to ponder…

What adjustments on our fundamental scenario?

It is very difficult at this stage to see the economic implications for Europe. Downward growth forecasts for the UK, for the Pound Sterling and for yields have begun, going even to a UK recession forecast in the most extreme scenario. However, the Bank of England has ammunition at its disposal: it can lower official rates (currently at 0.50%), inject liquidity and even implement a new Quantitative Easing plan.

For Europe, consequences are less clear: probably somewhat weaker growth than previously forecast because of international trade, and bond yields that will stay lower and for longer than forecast. It has been well noticed that the reaction of bond markets has been marked.

The coming first week of July will see the release of the classical leading indicators (ISM in the US and PMI elsewhere). They will give hints on the strength of economic activity before the negative impact coming from the Brexit. Our scenario of moderate growth will once again be tested: this dichotomy between manufacturing which is in difficulty and services that are expanding better is now lasting since several quarters.

Spanish election: no clear winner but traditional parties resist well

The message from Spanish voters is ambiguous: on the one hand, the Popular Party comes first ahead of the PSOE, followed by Podemos, but it is not strong enough to form a new government alone. It is a repeat of last December’s results. On the other hand, protest parties are not making any noteworthy progression, including after the Brexit victory.

Negotiations between traditional parties will have to be followed closely. The most favourable scenario for markets would be a PP/PSOE coalition.

Spanish elections should thus not have a significant impact on spreads of bonds from peripheral countries, which had widened over the last few days and are stable this Monday.

Conclusions

It is too early to measure the implications of the Brexit, but financial markets have already reacted. The ball is now in the hands of politicians, and negotiations have begun. States and central banks have the capacity to react in front of these historic events. Depending on the news flow on this front, volatility could stay high in the short term.

This volatility provides opportunities for the longer term, because we keep unchanged our core arguments in favour of risky assets: moderate growth, unchanged corporate fundamentals, relatively attractive stock market valuations compared to bonds. These fundamental factors should sooner or later reassert themselves.