A Game of Two Halves

It’s not been a good couple of weeks for anything Euro. A ‘Leave’ result was followed last week by an ignominious England exit from the Euro 2016 football championships.  As a long-standing Crystal Palace fan, I have found that with two starters in the Welsh team and a third Palace player who regularly comes on as a substitute, I can justifiably point to a tenuous link to supporting the Welsh on Wednesday night when they take on Portugal in the semi-finals.
By now your inbox will be clogged up with Brexit references and conference call invitations to discuss the outcome and its consequences. Of course nobody really knows what’s next – it’s conjecture.  Much like the current political landscape.
Sterling has taken a big hit against all major currencies endorsing our non-sterling allocations as a hedge to risk assets such as equities which also suffered initially but perhaps not as much as some feared. Bonds, especially government bonds have seen their yields fall in reaction to being a safer place to be and in the face of potential changes in monetary policy in the UK and abroad.  As they were unattractive before, they are even more so now.  Imported inflation could rise, at least in the short term and ten year gilts well below 1% are behaving like a commodity.  Fortunately for the UK economy, Mark Carney, our Canadian Bank of England Governor has taken pre-emptive measures to ensure ample liquidity and won’t raise interest rates like others have done in the past.  Indeed, a rate cut is expected later this summer.
Yellow card?
Talk of a plunge into recession looks like many of the pre-referendum headlines – a scare story. We’ll find out eventually but the more sensible projections that have crossed our desks point to GDP (gross domestic product) growth of around 1% in 2017, down from over 2% a week ago.
Equities have staged a meaningful recovery since June 23rd and are generally above those levels seen in February this year while sterling continues to bear the brunt of our impending departure from the EU.  Sterling’s precipitous fall may partially deal with the UK’s chronic current account deficit.
In and Out
Following the EU referendum result and in the ensuing days, the tendency is to look inwardly and then towards the rest of Europe. Not much time is spent on how others perceive the UK and how others perceive themselves.  It’s a worthy exercise especially when considering how the Chinese look at the rest of the world rather than vice versa.
Back to the UK and Europe. It is clear that a negative interest rate policy (NIRP) makes little sense.  When you have to talk about taking the largest denomination note out of circulation to stop people from putting quantities in their safes rather than negative rates at the bank, something’s wrong.  It highlights that monetary policy has reached its limits and the protest vote that seems to be gaining momentum in Europe spurred on by the ‘Brexit’ outcome, may well lead to a relaxation of tight fiscal policies as it has already done in the UK with the abandonment of a balanced budget by 2020.
Policy Mismatch
What the ‘Brexit’ result might achieve in Europe is a change in attitude to fiscal policy by the stewards of fiscal propriety – the Germans. Such an emphasis on zero or near zero interest rates or even NIRP inflates asset prices from stocks to bonds to houses.  If you don’t possess any of those assets, you may feel marginalised and tempted to use any opportunity to voice your protest about that inequality.  This isn’t a political statement but it does offer the would-be incoming UK Prime Minister the opportunity to be more inclusive of society and slacken the fiscal rules previously in force and that would seem to be happening.  The key will be if such a shift is reflected in the rest of the EU.
As we enter the second half of 2016, a key event and one where a shift of policy may occur is in Italy where Prime minister Matteo Renzi has staked his political future on a constitutional referendum to be held in October.
The leader of the European movement is Germany. It has benefited from a cheap Euro and built up a huge current account surplus.  The UK was Angela Merkel’s offset to the intransigent French.  The loss of her key sovereign ally in a couple of years’ time may prompt a shift in German policy towards its EU neighbours as Angela also seeks to repel the surge in support for the right-wing AFD, the German equivalent of UKIP.  After all, as we have noted before, negative rates are pointless, Mario Draghi and the European Central Bank have done enough.  Time for a German-led fiscal initiative across Europe.
Bonds may reset to higher yields, equities will be supported, currencies shouldn’t alter too much and electorates may feel more included.
Dod ar chi Wales!
16-07-05 A game of two halves

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