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SMSF Weekly market update: Brexit, the Eurozone and the Federal election


Shane Oliver reviews the key political and economic developments over the last week and what these mean for financial markets.

 

Wariness returned to investment markets in the past week, led in part by worries about Eurozone banks – particularly Italian banks. Worries about Australian banks - on the back of global bank weakness, Australian Prudential Regulation authority (APRA) indications that further capital raising may be required, the chance of a royal commission into banks and the shift in Australia’s and banks’ credit rating outlook to “negative” by Standard and Poors - also weighed on the Australian share market. The rising US$ also weighed on oil and metal prices, and saw the Chinese renminbi fall to its lowest level since 2010.

Fears around a recession in the UK following the Brexit decision continue to build with business confidence falling sharply. Clearly, UK business is concerned about their continued access to European Union (EU) markets. These concerns have also hit the UK commercial property market, with several unlisted property funds halting redemptions, as investors sought to withdraw their funds in the face of a bleak outlook for the UK property market if businesses decide to relocate operations to Europe. While the Bank of England cut banks’ capital requirements and the continuing plunge in the value of the British pound should help, it’s doubtful this will be enough to stop a recession later this year. Bear in mind though that the UK economy makes up only 2.5% of global GDP. It’s also worth noting that the problem with British property funds is reflective of a specific problem in the UK post Brexit. It’s not indicative of a problem with global commercial property markets generally.

But will Brexit even happen? Given the Bregret and mayhem in the UK there is some chance that Article 50 of the Lisbon Treaty, which governs exits from the EU, will never be triggered. This could happen if, say, the new conservative leader waits till next year to trigger Article 50, by which time a recession could have moved popular opinion against Brexit, or alternatively, if a new election is called which becomes another defacto referendum on Brexit. It’s also possible that the UK does trigger Article 50, but then in negotiating with the rest of the EU concludes it doesn’t want to go. While once triggered, Article 50 means no going back, though it’s likely that in this circumstance the EU will find a way to keep the UK in.

Of course, the real issue for the global economy and investment markets is the impact on Europe and the risk of a domino effect of exiting Eurozone countries. If Britain ultimately doesn’t leave, or leaving is demonstrated to be more trouble than remaining, then the risk of a domino effect will be much reduced.

Back to the present, in the Eurozone the main focus regarding post Brexit risks in the past week relates to European – mostly Italian - banks. These have been weakened by years of slow growth, ultra low interest rates and tighter regulatory conditions. These risks preceded Brexit, but the Brexit scare has refocused attention on them by pushing down bank share prices, which in turn makes it harder for banks to raise capital. Italian banks are arguably most at risk with the Italian government wanting to recapitalise some of them, but the European Commission preferring a bail-in from creditors. Not recapitalising these banks risks slower bank lending, slower growth and higher unemployment and hence a greater risk of support for a move out of the Eurozone in countries like Italy. At this stage we are a long way from this, and some sort of muddle through solution will likely be found. Of course, it won't stop investors worrying about it in the interim.

On the positive side of the equation, it’s notable that Italian and Spanish bond yields remain around record lows, suggesting the threat of European Central Bank (ECB) intervention is working, the latest rise in the value of the US$ and associated fall in the Chinese renminbi has not been associated with the panic around capital outflows from China that we saw earlier this year, and commodity prices continue to hold up reasonably well, which may be a good sign for global growth. But again it’s early days yet, and one risk worth keeping an eye on is that of a further rise in the US$. Upward pressure on the US$ is a real risk given the ongoing risk of safe haven flows out of Europe, at the same time that the US economy looks to be doing okay, which suggests a much greater chance of a US Federal Reserve (Fed) hike this year than the 12% probability that the US money market is assigning. Another break higher in the US$ would be bad for oil and other commodities, the emerging world and the Chinese renminbi.

In Australia, it’s looking likely that the Coalition will attain a majority of seats following the Federal election or if not form government with independents like Bob Katter. The issue of course, is that the Senate is likely to be less friendly than over the last few years, which will mean that a Coalition Government will have little chance of passing key aspects of this year’s Federal Budget - including its company tax cuts (at least not for large companies), some of its superannuation changes and the still to be passed savings from the 2014 budget. The likelihood would be more slippage in the return to budget surplus. Serious economic reform looks off the agenda.

Reflecting the risk of yet more budget slippage, it’s little surprise to see the ratings agencies getting tetchy, with Standard and Poors (S&P) putting Australia’s sovereign rating -and flowing from this the major banks - on negative outlook. This of course does not mean a downgrade is inevitable, but with the new parliament “unlikely to legislate savings or revenue measures sufficient….for the budget deficit to narrow materially” [in the words of S&P] I would say that it’s probable. So far, financial markets have taken the move to negative outlook calmly, perhaps because it has long been talked about. In theory a ratings downgrade should mean higher interest rates, as foreigners demand a higher yield on federal debt and this flows through to state debt, banks, corporates and potentially to out of cycle mortgage rate hikes for households. In reality this impact may be muted. The US in 2011 and the UK last week actually saw bond yields fall after ratings downgrades and many lower-rated countries borrow more cheaply than Australia (eg, Italy and Spain). In any case the RBA can still offset higher mortgage rates with another interest rate cut.

The biggest implication from the threat to our AAA rating is what it tells us about policy making in Australia today. Australia worked hard reforming the economy after last being downgraded in 1986, and won its AAA rating back in 2002. Losing it again would signal we have become unable to control public spending, that we have lost our way to some degree after the hard work of the Hawke/Keating & Howard/Costello years.

About the author
Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.
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