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Global banks to respond to Brexit blues

David Bassanese
Wednesday, July 13, 2016

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By David Bassanese

One upshot from the Brexit decision is that central banks may well over react by easing already very loose global monetary conditions further. If so, this could be good news for equity investors over at least the short to medium-term, but it does add to the risks of a “valuation” blow-off down the track.

To my mind, there seems little reason why the UK decision to leave the European Union should pose major risks to the global economy, or risk markets in general. 

The UK has clearly shot itself in the foot, but it only accounts for 2.5% of global GDP. And while UK banks and property markets face of world of pain in the coming year, the type of uncertain “counter-party risk” seen during the 2008 global financial crisis doesn’t appear to exist.   

Yet by all accounts, many central banks around the world now feel the need to respond to “Brexit” through pre-emptive policy easing. 

The Bank of England, most understandably, seems likely to cut official interest rates from 0.5% at present, to probably zero by year-end, as the UK economy stumbles into recession as a result of an upsurge in business uncertainty.

Not to be outdone, the European Central bank under Mario Draghi has been itching to unleash more quantitative easing for some time, and Brexit now provides the ultimate rationale. The UK is small on the word stage these days, but still accounts for a chunky 15% of the EU economy. And a UK recession is the last thing Europe needs and may well unnerve business sentiment across the continent more broadly.

In Japan, the safe-haven capital repatriation is pushing up the Yen, which is likely to result in more easing by the Bank of Japan also – even though the direct impact of the Brexit decision on trade flows should be quite limited. 

The US Federal Reserve is also cautious and now seems unlikely to raise interest rates anytime soon – if only because it does not want monetary easing elsewhere to unduly push up the US dollar.

Last by not least, the Reserve Bank of Australia re-instated a mild easing bias in its post-meeting policy Statement earlier this month, setting us up for a probable rate cut in August if the June quarter consumer price index result later this month keeps annual underlying inflation at around 1.5%. Judging by the weakness in retail prices in recent National Australia Bank business surveys, chances are that the CPI will be low enough to goad the RBA in action.   

It’ no surprise therefore that a major outcome of the Brexit decision is a further notable decline in global bond yields. US 10-year yields have dropped from around 2% in February last year, to a recent low of 1.35%. In turn, this is encouraging even more capital inflow into equity markets, with America’s S&P 500 this past week flirting with new record highs.

So far so good, but to my mind a major concern remains that earnings growth globally still remains quite sluggish. Indeed, heading into the next US earnings report season this week, profits of companies in the S&P 500 index are expected to be 5% lower than the same quarter a year earlier. Even if US companies again “beat” expectations – as they conveniently manage to each reporting season – annual growth in earnings will still likely be negative for the fifth quarter in a row.

Meanwhile, America’s S&P 500 index is now trading at around 17 times forward earnings – near the same valuations levels that have kept the market constrained below current 2,100 point level for the past year. Of course, US 10-year bonds are now around 0.5% lower in yield than they were at the last market peak in early 2015. On a relative to interest rates valuation basis, the market could move higher. 

But I’m still feeling a little uncomfortable with the market at current levels. After all, if the global economy does manage to shake off the Brexit, the Fed will likely need to re-enter the picture soon with a rise in US interest rates. And it’s still hard to see a decent rebound in US earnings anytime soon given US profit margins are still quite high, business investment appears in retreat (particularly, but not only, in the oil and gas sector), and the labour market is tightening up.

Published: Wednesday, July 13, 2016

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