By Alexander Kalis, Managing Partner & Head of Manager Research at Milltrust International LLP, 30 June 2016

Unexpectedly, the United Kingdom (UK) voted to leave the European Union (EU), sending shockwaves across the world in the wake of the decision. We set out below our investment managers’ views for the respective markets: 

No Financial Crisis

We do not expect Brexit to cause a financial crisis in the global financial system.

Financial contagion risk is lower compared to the Eurozone crisis in June 2012, as European banks have largely deleveraged since then and the UK banking sector has consolidated in the hands of a few strong players after the global financial crisis.

The 10-year Spanish sovereign yield edged higher but remains low compared to 2012. The credit default swaps of major European banks are manageable while there is no evidence of higher counterparty risk in the interbank market. The European Central Bank (ECB) can be expected to join the Bank of England (BOE) in liquidity injections if needed.

Impact On Asia

Economic impact: By itself, a UK slowdown will not have a significant impact on Asia as value-added export to the UK is relatively small (about 2% of GDP for Singapore to less than 0.5% for Indonesia). Asia’s trade with the EU is higher; exports to Europe will be hit due to a combination of weaker economies and currencies (EUR and GBP). Asian economic growth could be downgraded in the coming weeks but the impact would not be material unless Europe slows significantly.

Within Asia, based on the value-add of exports to EU in Chart 1 below, Vietnam, Singapore, Malaysia, Thailand and HK will be more affected while Korea, China Indonesia, and the Philippines will be more insulated.

Chart 1: Value Added Exports

 

Picture1

Source: Credit Suisse, CEIC, Bloomberg, May 2016.

Financial impact: The secondary impact on Asia is via financial contagion and confidence. Renewed strength in the USD is the most serious channel of contagion to Asian markets. For China, the stronger USD will raise concerns on the stability of RMB and rekindle fears of capital outflows and falling foreign-exchange reserves.  Brexit should exert pressure on Asia financial assets as a result of the risk-off environment and heightened global volatility.

Market Outlook

While the direct economic impact on Asia is minimal, the combination of heightened macro uncertainties and higher risk premium should lead to greater volatilities for Asian markets.

However, valuations have become more attractive and Asian central banks have room to loosen monetary policy as policy rates in Asia remain high. In addition, the Fed can be expected to remain on hold if market volatilities continue. Countries expected to loosen monetary policy include Malaysia, Thailand, Indonesia, Korea, India and China.

Picture2

Source: Credit Suisse, CEIC, Bloomberg, May 2016.

For equity markets, we expect countries with higher domestic content to hold up better than the more open export-oriented economies.  Defensive and high dividend yield stocks should perform well.  With the Fed on hold and the potential of ECB expanding its QE program, we expect any sell-off in Asian credits to be short-lived. Overall, while Brexit has rocked investors’ confidence and the stronger dollar could pose serious challenges ahead, we caution against excessive pessimism as the economic linkages between Asia and the troubled economies are manageable.

In the medium term, the uncertainties in Europe can become beneficial to Asia and China in terms of fund flows as investors would look for relatively “safer havens”. Attractive valuations in Asia compared with developed markets such as the US would benefit the region.

Picture3

Impact on Latin America

Economic impact: With regard to the trade balance between Latam countries and UK/EU, one would conclude that the Brexit impacts are not to be neglected, but that they will not change the growth trends dramatically. A possible slowdown of global growth is a reasonable concern, but there is no reason to believe that international commerce will be completely halted, making the negotiation of trade agreements all the more important to understand the long term issues related to Brexit.

Financial impact: When it comes to financial conditions, currencies and assets around the world have been behaving in a “risk-off” movement, a negative development for countries that are seen as more fragile to a possible tightening of financial conditions. The unfolding of this risk aversion trend will be mainly felt in Mexico as the Mexican peso has suffered in the last trading days in a trend that is known to be uncomfortable for Banxico which is likely to lead the Central Bank to  raise rates this year, perhaps not in consonance with its North American counterpart. Even so, it is worth highlighting that countries that have unbalanced external accounts may also suffer – case of Colombia, with its 6.0% current account deficit.

Overall, it is fair to say that countries that are not as impacted by global financial conditions or that have a relatively small trade chain will probably not bear the brunt of the Brexit shock. This is not to say that such countries will not be affected, but that the magnitude of the shock will be much more related to the Brexit impact on overall global trade growth than in one specific partner.

Market Outlook

For equity markets, given that Latin American equities are still under-owned, we believe the implications of the expected lower rates in the developed countries will prevail over any risk aversion sentiment.

Another relevant side effect of the Brexit was the strengthening of the USD, which is usually bad for commodity prices. While difficult to predict the full extent of implications of such unprecedented event (Brexit), we believe the negative effects will be more limited to the UK and Europe, and should not make Latin American equity markets less attractive.

Sources: Lion Global Investors, Keywise Capital, Itau Asset Management

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