Brexit represents a potentially significant negative shock to a global economy that was already struggling for growth. Policy and political risks have risen following Brexit, and warrants a more cautious investment stance in the near term. The EU in particular needs to commit to protecting its still-tepid economic recovery and preventing any tightening of credit conditions via greater banking sector caution.
We expect such an outcome but are less clear about the timing and whether policymakers will act pre-emptively or only in reaction to significant financial market turbulence. One silver lining is that the Fed likely is now on hold indefinitely, which will help ease global financial conditions on the margin.
The UK and euro area financial sectors are especially vulnerable to heightened stress, given the former’s exposure to the UK economy and inflated housing market and the latter’s fragile capital base. A substantial deterioration in UK housing and/or tightening of bank lending standards would be ominous signs for the U.K. economy and indicate possible spillover effects elsewhere. The MRB Euro Area Financial Stress Indicator has risen modestly in the past two weeks, but is not yet signaling funding pressures. The ECB will need to act swiftly if stresses build meaningfully.
European leaders in particular will need to calm any fears about the fallout from Brexit if regional confidence and growth are to hold up. To this end, a continuing global economic expansion is contingent on the euro area contributing positively to growth.
The key risks would be financial contagion from the UK to the euro area (and subsequently to the rest of the world) and/or a gradual seizing up of corporate hiring and investment in light of political uncertainty. The former does not yet seem probable but could develop, while the latter will take time to become evident and materially intensify, but is increasingly possible.
Global growth risks have risen following the Brexit vote, but clear signs that policymakers are acting aggressively and in a concerted fashion, and the euro area is effectively ring-fencing any fallout from Brexit, would be signals that global economic growth and confidence is likely to improve. Until then, we recommend a defensive investment stance on a 0-3 month horizon. A prompt euro area policy offset and evidence of economic resilience are needed for MRB to shift back to a more pro-growth 6-12 month investment posture.
Peter Perkins, MRB Partners
MRB – The Macro Research Board (www.mrbpartners.com) is a partner-owned independent research firm, recognized as one of the world’s leading providers of well-researched and actionable theme-based macro strategy and investment ideas. Its chart of the week is a regular feature on Money Makers.