Stay alert as investors may start fearing Brexit and lock-in multiyear profit
By Peter Rosenstreich
A very ordinary Monday with market sentiment skews towards risk-off. With the ECB meeting Thursday, investors are taking time to re-examine strategies. Asia equity markets are broadly in the red, highlighting the negative macro view. The conversation over the stock markets' reversal point continues to gain traction. Our overall thought is that the fate of stocks markets will be determined more by financial conditions than the business cycle. Global growth has been riding the wave of accommodative monetary policy and fiscal stimulus which allowed investors to overlook negative macro developments - sending asset prices to clear bubble territory. But in the face of expected tightening in financial / credit conditions, a slowing China and trade tensions, geopolitical stress is now taking a toll on investors' psyches. Not to mention the real strategy of locking in a positive return a year before a broader correction wipes out 9 months of hard work. It’s hard to imagine another alternative to a significant equity correction - although slow deflation is preferable to a sudden pop. JPY and CHF continued to gain growth in the FX space, highlighting investor concerns. Both USDCHF and USDJPY are nearing the near-term range support. Higher US bond yields and stronger labor market reports will keep the USD in demand, despite Trump's threats of more tariffs on imports from China. The Fed is likely to increase rates on September 26th and debate a further hike in December, currently priced as a near-70% probability.
EM Crisis.. not likely
EM currency remains under pressure despite the heavy devaluation of the past month. Investors have been focused on foreign debt holding to pick winner and losers. Foreign debt in EM has risen significantly in the past few years after a long period of decline. With funding costs expected to rise further, countries such as Turkey and Argentina are in an extremely delicate situation while Mexico, Russia and South Africa are in a lower emergencystat but still worrisome. Yet overall, it's unlikely that the situation will spiral towards a currency crisis. We anticipate the extended volatility in EM countries to further decelerate, proving a short-term opportunity to short vol.
Place your bets on Brexit
According to The FT, the EU is instructing Michel Barnier to reach an agreement with the UK on Brexit which should give PM May support amid political chaos. It's time to place your bets on the outcome of Brexit. From our view markets are playing it overly safe. Investors are pricing in an 80% probability of seeing a Brexit deal, with a 60% chance of a market neutral 'soft' Brexit. This will make our next few words appear exaggerated and far-fetched. Gone are our expectations of a 'soft' Brexit. We don’t expect a realistic deal to be reached in time to meet the October deadline. Potentially, a headline-grabbing deal will be proposed so as to lessen the impact of that missed date, but that is likely to fall apart under scrutiny. Agreement on a 21-month 'transition' period to smoothen the way to post-Brexit relations will not provide comfort when the October deadline is missed.
Even a loose form of custom union for goods and services will be challenging to reach. And even more difficult to pass. News of the German government abandoning key demands (accepting fewer details) and British willingness to postpone key decisions until after Brexit day has failed to ease the path to an EU / UK deal. A day earlier for instance, one EU official described May’s Brexit plan as dead. This should drive GBP significantly lower and volatility higher as any normalization of elevated political volatility fail to materialize.
While the three key 'divorce' issues have in theory been settled, the devil lies in the detail. Judging from the hostility off the coast of France neither side is ready to give up the details.
Key Dates
18th October 2018: EU summit. Submitted outline of future relationship to permit time for the UK parliament and EU members to ratify a deal by Brexit day.
13th December 2018: EU summit. Safety.
29th March 2019: “Deal” or “No Deal”, Brexit is expected to take place 23:00 UK time.
The uncertainty surrounding the Brexit process is increasing, driving volatility in the GBP. GBP/USD has marginally rallied and is consolidating at the 50 DMA at 1.3010. We suspect this is more a function of closing profitable short than shifting positive expectations around the Brexit outlook.