Investors may be confused by what seems like a post-Brexit disconnect in global markets, with dread felt immediately after Brexit followed by record highs in US equities and more. However, the markets are not as disconnected as they seem and the post-Brexit story is not even close to being fully played out, writes Krishna Memani, Chief Investment Officer at global asset manager OppenheimerFunds
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Investors may be understandably confused by what seems like a post-Brexit disconnect in global markets. They can’t reconcile the dread they felt immediately after the Brexit vote with what’s happening now: US equities at record highs and a bull market in the UK, while Treasury yields head even lower and government bond yields in other parts of the world move deeper into negative territory.
In my view, however, the markets are not as disconnected as they seem. Furthermore, the post-Brexit story is not even close to being fully played out.
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By GlobalDataHere is my take on what is happening and what to expect.
First and foremost, Brexit is a bad economic outcome for the world. In a slow-growth world, such potential demand shocks take their toll. The real questions are the magnitude of the shock and where the impact will be felt. I expect global growth will slow by between 0.2% and 0.5%. That may not seem like a lot, but when the underlying growth rate is only around 3% to begin with, it is significant.
From a shorter term perspective, the regions likely to be impacted, in order of severity, are the UK, the Eurozone, the US, and emerging markets (EM). However, given the internal economic dynamics of the U.S. and EM, the impact on both is likely to be modest.
From a longer term perspective, the net impact on the rest of the world may also end up being modest due to central bank policy support; however, the impact on the UK and Eurozone is likely to be substantial for some time to come.
Second, the markets are correctly anticipating global central bank monetary support. Rates are rallying globally because central banks must try to cushion the impact of Brexit.
Even the Federal Reserve will have to delay tightening for the foreseeable future, otherwise the dollar will rally, financial conditions will tighten, and US economic growth will be much lower. Other developed market central banks were easing before Brexit and certainly have no reason to change direction now.
Credit may outperform equities
The reaction of global equity markets after the initial post-Brexit sell-off has been relief. While an equity relief rally may be justified on a cross-asset basis based on new lower rates, it is difficult to see how higher equity prices are justified if the economic outlook is likely to worsen.
Further, any buildup of risk premiums, as political and economic uncertainties persist, will probably move equity markets lower. It’s not a Lehman moment and we are not on the brink of a 2008-like global financial crisis, but a 5%-10% drawdown in US equities is quite possible.
While there are unlikely to be any absolute winners in equities, the relative loser markets for US dollar-based investors are obvious?the UK and EU, in that order. The US may prove to be a safe haven for equities, rates and currency.
The potential relative winner may be EM as lower global rates provide the policy cover they need to restructure their individual economies while market valuations are attractive. However, this EM view is contingent on global growth declining only modestly.
From a performance standpoint, credit may end up a surprising winner relative to equities. In an environment of low interest rates and flat yield curves, the extra income from credit risk will look extraordinarily attractive.
High levels of central bank monetary support?including direct bond purchases ?will probably keep investors pouring money into bonds. The flow story clearly helps credit markets but also raises the longer term credit market risk level.
Watch the Dollar
Interest-rate markets, at the moment, are all about policy support and therefore don’t foretell much. In my view, the only true indicator of market health is the dollar, which has behaved well since the Brexit vote. However, if it strengthens meaningfully, it will presage bad things to come for all markets.
I believe the dollar is the only metric for market health.
Krishna Memani serves as Chief Investment Officer of OppenheimerFunds overseeing all investment teams at the Firm. He is also currently the Head of Fixed Income. In addition to his investment leadership roles, Mr. Memani is currently a portfolio manager for Oppenheimer Core Bond Fund, Oppenheimer Corporate Bond Fund, Oppenheimer Global Strategic Income Fund and Oppenheimer Capital Income Fund. Mr. Memani has been with the Firm since 2009.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Eurozone investments may be subject to volatility and liquidity issues.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.
