The markets after Brexit

Brexit is now seemingly a non-event for the global economy and its financial markets. A move to less quality in financial markets may be under way.

Brexit came as a large shock to the markets – but within two days of extra anxiety and an equity sell off – the Brexit effect came to be almost immediately reversed. Stock markets are now well ahead of where they ended on 24 June and are ahead of levels reached on 30 May. The benchmark MSCI Emerging Market Index on 14 July was 7.5% up on its 30 May level, fully accompanied by the JSE All Share that had lost over 12% per cent of its 30 May value (in US dollars) in the immediate aftermath of Brexit. The key S&P 500 Index has also recovered strongly. A feature of the equity markets in 2016 has been how unusually closely the developed and emerging stock market indexes have been correlated with each other when measured in US dollars (see figure 1 below).

 

The VIX Index that measures share price volatility on the S&P 500, simultaneously and consistently moved strongly in the opposite direction, while volatility on the JSE measured by the SAVI has remained elevated, consistent with the sideways move in the JSE when measured in rands rather than in US dollars. The volatility of the stronger USD/ZAR exchange rate has remained elevated as has, to a smaller degree, the realised volatility of the USD/EUR (see figures 2 and 3 below).

With renewed strength in emerging market equity and (especially) bond markets, emerging market currencies have shown strength against the US dollar, as we show below. We also show that the rand has performed better than the average emerging market currency, represented as an unweighted average of nine other emerging market currencies, excluding the rand and the Chinese yuan, as well as the Korean won and the Singapore dollar that enjoy a somewhat different status to the representative emerging market. The rand has gained about 10% against the US dollar and about 6% against the emerging market average since 30 May, as may be seen in figure 4.

 

A more risk-tolerant market place in the aftermath of Brexit has not only been helpful to emerging markets generally, but it has proved particularly helpful to the rand and the market in RSA bonds. As shown below, default risk spreads have receded for emerging market bonds, including RSA US dollar-denominated bonds. Judged by the spread between RSA yields and those of the high risk EM Bond Index, SA’s relative credit rating has improved recently as shown in figure 6.

 

A further important spread, that between RSA 10 year rand yields and US Treasury 10 year bond yields, has also narrowed as long term interest rates in developed markets and in emerging markets receded in the wake of Brexit. This spread represents the rate at which the rand is expected to weaken against the US dollar over the next 10 years (see figure 7 below).

The fact that most government long term bond yields declined further and immediately in the wake of Brexit – including gilt yields in the UK – indicated that Brexit was not regarded as a financial crisis, but rather as an indicator of slower global growth and less inflation to come. This conclusion was also evident in the decline in inflation-linked bond yields to very low levels.

This decline in the cost of funding government expenditure (especially in the form of negative costs of borrowing for up to 10 years for some governments) can be expected to encourage governments (not only the UK government) to borrow more to spend more and to attempt to reverse the austerity forced on them by the Global Financial Crisis of 2008 and the subsequent Euro bond crises, that were such a particularly expensive burden for European taxpayers. That burden of having to meet ever larger interest rate commitments has become something of a bonanza for European governments, faced as they are with a fractious electorate.

The sense that less austerity is now more firmly in prospect may have led investors to price in less risk when valuing equities. We have argued that a high equity risk premium is reflected in the value of the S&P 500 Index when valuation models that discount S&P earnings and especially dividends with prevailing very low interest rates. Still lower discount rates after Brexit may help explain the higher equity values. A search for yield in emerging bond markets, driving emerging market discount rates lower, may explain why more risky emerging market equities have also added value.

The very recent economic news moreover has been surprisingly good, rather than disappointing. The trends in the US economy have been particularly encouraging. The Citibank Economic Surprise Index for the US has moved significantly higher with the stronger S&P (revealing more data releases ahead of rather than behind consensus forecasts) (See figure 8 below).

The very recent news from China is that stimulus there has been working to stabilise GDP growth rates. Such more positive indicators of global growth will also have helped to modify what was already a high degree of global risk aversion before the UK referendum. Commodity prices, of particular importance for emerging economies and emerging equity markets, have recovered from depressed levels in January and have stabilised recently after Brexit (see figure 9 below).

This strength in emerging markets may be regarded as something of a reversal of the move to quality in equity markets that has so dominated equity market trends in recent years. A marked preference has been exercised for shares with bond-like qualities, revealed in the form of predictably defensive earnings flows, accompanied by relatively low share price volatility. These are qualities more easily found in developed markets but capable of adding to well above average price earnings multiples to favoured companies in emerging markets, including on the JSE. The JSE, by market value, has come to be dominated by relatively few companies with a global rather than a SA economy footprint. And the price-to-earnings ratios of these companies has risen markedly, dragging up the multiples for the JSE as a whole. We have described this class of shares that are well hedged against the rand and SA economy risks, as Global Consumer Plays.Chris Holdsworth in his Q3 Strategy Review for Investec Securities, published on 13 July has identified these trends – a preference for quality in response to lower interest rates that have left the average share price to earnings ratios well behind the elevated few (see figures from Investec Securities below).

Any further move away from quality will be very welcome to emerging market currencies, bonds and equities. It would be very helpful to the exchange value of the rand and the outlook for inflation and interest rates. It would be especially helpful to the SA economy plays that have so lagged the high quality Global Consumer Plays in recent years. Rand strength for global as well as SA-specific reasons could reverse such relative performance. Less quality may come to offer better value should global risk tolerance, even though justifiably elevated, continue to improve as it has done since Brexit.