Sunday 10 July 2016

Is Brexit Just Noise?

And so, Brexit fears went as quickly as they came. Within 4 trading days, the Straits Times Index had recovered all of its losses from news of the Brexit referendum, giving very little time for investors to either buy or sell. Does the speed at which Brexit fears came and went and the relatively limited damage to the stock market make Brexit a non-event and noise to be ignored by investors of all stripes?

First of all, whether Brexit is a noise or not depends a lot on the investor's investment strategy. For a passive investor, Brexit (and most other events) is just noise. Regardless of Brexit or not, an investor using Dollar Cost Averaging would continue to put in the same amount of money at the same fixed time intervals. Likewise, an investor relying on Portfolio Rebalancing would rebalance his portfolio at fixed intervals or when the asset allocation moves away from the target allocation by a pre-defined threshold. For a long-term active investor with an investment horizon of 5 years or more, Brexit is also irrelevant as UK would have completed its exit from EU and established new relationships with the EU and other trading partners. However, for active investors with a shorter investment horizon of 2-3 years, Brexit is not without impact. Just because the stock markets recovered rapidly after the Brexit news does not make it irrelevant and just a noise.

As news of the Brexit referendum results broke out on 24 Jun, Japan's Nikkei index crashed 7.9%, Germany's DAX index dropped 6.8%, France's CAC index fell 8.0% while UK's FTSE index declined by a much smaller 3.1%, despite being the protagonist of this episode. When I wrote my initial thoughts about Brexit in What's Next for Brexit?, I was still wondering why UK's FTSE index fell much less than the other European stock markets. It turns out that the answer lies with the forex markets.

Over the same period, British Pound (GBP) declined by 8.1%, from USD1.4877 to USD1.3679. EUR also declined, but by a smaller 2.4%, from USD1.1385 to USD1.1117. On the other hand, JPY rose by 3.9%, from JPY106.16 to JPY102.22 per USD, as investors fled from GBP to safe havens such as JPY. The implication of these currency fluctuations is that UK's goods have suddenly become 8% cheaper while Japanese goods have become 4% more expensive. It is no wonder then that Japan's (and other European) stock markets dropped more than the UK stock market! To a global investor, should Brexit be considered economically irrelevant and just noise to be ignored?

Now, 2 weeks after the Brexit referendum, GBP has declined further to USD1.2954, EUR stayed relatively flat at USD1.1051 while JPY rose further to JPY100.54. From just before the Brexit referendum till 8 Jul, GBP has declined by 12.9%, EUR by 2.9% while JPY rose by 5.6%. Over the same period, in the stock markets, UK's FTSE index has not only recovered all of its Brexit losses but also gained 4.0%, Germany's DAX index is still losing 6.1% while Japan's Nikkei index is still down by 7.0%. The economic effects of Brexit are just beginning.

A major reason why global stock markets did not fall off the cliff after the Brexit news was the realisation that central banks around the world would loosen monetary policies to stave off any economic fallout from Brexit. The impending US Fed interest rate hike went from near certainty in Jun/ Jul to being postponed at least until the end of the year. This has pushed up stocks that are sensitive to interest rates like REITs. On the other hand, bank shares have been relatively flat, ranging from -1.5% for DBS to 1.9% for OCBC during the 2-week period. If you think about it, if interest rate sensitive stocks are gaining from lower interest rate expectations, why are banks not suffering from it? Banks make money from the interest rate differential that they charge on the loans and pay on the deposits. Since the begining of this year, the 3-month Singapore Interbank Offered Rate (SIBOR) has declined from approximately 1.25% to 0.93% as at end Jun. They have also reduced the interest rate charged on housing loans recently. Coupled with lower loan growth and no improvement on Non Performing Loans from the Oil & Gas industry, banks are likely to see lower profitability moving forward, until US Fed decides to raise interest rates. To a local bank investor, should Brexit be considered a non-event and just noise?

If local banks are going to see reduced profitability from lower interest rates, imagine what would happen to European banks which had shown signs of stress even without the threat of Brexit in early this year, due to increased regulations, global economic slowdown, commodity price collapse, etc. (see Why investors are freaking out over European banks (again)). With Brexit, there is further economic slowdown in Europe, reduced cross-border business, forex losses at UK operations, and now, reduced profitability from lower interest rates. European banks are a major cause of concern (see Italy eyes €40bn bank rescue as first Brexit domino falls). Having said that, it is unlikely that there would be a repeat of the Lehman Brothers incident as central banks would step in to rescue any banks deemed as systematically important.

In conclusion, even though stock markets have recovered quickly from news of the Brexit referendum, it does not mean that Brexit is economically irrelevant and can be treated as noise and ignored, at least not by active investors with shorter investment horizons. It is akin to leaving the door unlocked and no thief came in. Does it mean that it is safe to leave the door unlocked? We might just be plain lucky.

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  1. UK out of Euro may mean a backdoor to iron curtain EU driving efficiency internally within the europeans. This maybe a plus to world economy to have more trades.

    1. Yes, let's hope the EU will learn from this episode and bring about a better EU.

  2. if ECB or any other central banks continue the negative interest rate policy, i'm wondering why depositors do not take the hard cash and keep them at home

    1. Actually, depositors are not affected by the negative interest rates. It is the banks who keep money with the central banks that are affected. The banks will not pass on the negative interest rates to depositors for fear of driving them away as you have rightly pointed out. You can refer to Will Bank Deposits Pay Negative Interest Rates? for more info.

  3. Hi CW,

    I agreed that Brexit is not just noise. It has structural impact. Most of the time people just use recent up down of stock market price to blow their trumpet w/o understanding the fundamentals impact on a bigger scale.

    Also "Brexit as noise" is also fav among investing firm to advocate u to stay invested all the time!

    1. Hi Rolf,

      I think a lot of people judge a decision based on the outcome of it. If the stock market doesn't collapse, Brexit becomes noise. If the stock market collapses, Brexit becomes crisis. How then are they going to learn how to differentiate noise from crisis?!