Brexit is not necessarily contagious

Two days before the UK voted on its European future, the world’s most powerful central banker warned Brexit would cause “significant economic repercussions”. Janet Yellen, chair of the Federal Reserve, was far from a lonely voice, yet neither markets nor economies have shown much stress beyond the few first days of frantic trading.

Swift action by the Bank of England and its European counterpart to support asset prices and encourage lending is one reason for the calm. “We have the confirmation that central banks are very bad at estimating one-off “tail” risks. Central banks got scared and thereby offered, once again, a safety net to markets”, says Didier Saint Georges, strategist for the French asset manager Carmignac, who adds: “when central banks panic, markets get brave.”

The eurozone may in time start to show the effects of protracted divorce negotiations — the UK is Germany’s third biggest export market — but for now Brexit concerns have been quarantined around perfidious Albion.

A knot of financial ties cannot be unpicked cheaply or easily

Many banks avoid offering advice to ministers. “It’s a political issue with financial regulation ramifications,” says Eric Litvack, head of regulatory strategy at Société Générale and chairman of the International Swaps and Derivatives Association.

Still, many bankers point out post-crisis rules designed to strengthen global markets assumed London, one of the world’s biggest financial centres, was inside the bloc.

One early flashpoint has been an EU threat to deprive London of the right to clear euro-denominated derivatives. The UK capital is the main European location for managing trades large companies use to protect themselves against adverse currency or interest rate moves.

Conducting this process in one jurisdiction simplifies the complexity and cost when billions of euros change hands every day. Bank executives and clearing houses warn splitting the market will push up costs and require thousands of derivative contracts to be rewritten.

“Moving the swaps clearing business would be a significant risk. Moving part or large part of that would be a non-trivial exercise,” says Mr Litvack. It is, however, just one of the ties that bind London to the EU’s financial system.

The market got sterling about right

For weeks, one part of financial markets was ahead of the pack in preparing for Brexit. While opinion polls pointed to a Remain victory, traders of currency option contracts, which give the right but not the obligation to trade at a set price in the future, were not so sure.

The cost to insure against a large fall in the value of the pound surpassed prices reached during the financial crisis. On the other hand, the foreign exchange spot market was happy to trade sterling in line with opinion poll movements, meaning the pound touched $1.50 shortly after polls closed on the day of the vote.

“The FX options market did get Brexit about right,” says Paul Lambert, head of currency at Insight Investment. “It told you there would be a significant depreciation of the pound if we voted to Brexit and that, had we stayed, the market pricing for a more modest appreciation I think would also have been correct. The price action after the vote when the markets thought we had voted to stay seems to me to confirm that.”

In the event, sterling dropped to a 31-year low, in line with a large number of forecasts. The options market continued to be heavily bearish towards sterling post-Brexit, until economic data in recent weeks forced a rethink.

Stock markets respond to profits

Gerard Lane, chief investment officer for the UK wealth manager Artorius, says what he has noticed since the referendum is “some very good numbers from some very good companies”.

For instance, he highlights JD Sports as a retailer that might be expected to suffer if fears for the future prompt consumers to spend less, but has so far proved resilient. “You are able to find things at the granular level which says it hasn’t stopped.”

This perhaps explains how UK stock markets powered through the panic that followed the vote itself. Profit warnings at individual companies have been more than offset by enthusiasm about those who do business overseas, profits now worth more when translated into sterling.

There are also warning signs, with shares of housebuilders still weaker. Colin Morton, head of Franklin Templeton’s UK equity team, says while the worst predictions of financial Armageddon have proven unfounded, “it’s unlikely that the situation today is representative of what will happen as the progress towards the United Kingdom’s eventual exit from the EU unfolds.”

Gilts are still in great demand

“The Bank of England has clearly been the exception”, says Cosimo Marasciulo, head of government bonds for Pioneer Investments. At a time when central banks are tweaking, or even beginning to reconsider existing monetary policy arrangements, the BoE has announced a new bond-buying programme and cut interest rates to 0.25 per cent, the lowest in its 322-year history.

Indeed, when the authorities first tried to buy long-dated gilts in August, too few willing sellers showed up at the auction. The desire for such safe securities has also allowed companies such as Vodafone to issue debt due to be repaid decades hence at record-low interest rates.

UK sovereign debt is also helped by an international environment where bond prices have not been volatile, although some investors are not comfortable.

“There is a lot of complacency”, says Alberto Gallo, head of macro strategies for the hedge fund Algebris. “The government could have to react to events with fiscal stimulus, which means higher inflation and interest rates.”

Additional reporting by Elaine Moore



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