"The UK becomes a posterchild for something to avoid at all costs"

The UK's decision to vote for "Brexit" in the recent referendum created shock waves across global financial markets. London-based active equity investment boutique J O Hambro Capital Management (JOHCM) does not have a house view on "Brexit", or indeed on market and economic matters in general. But, almost two weeks on and with time to reflect on this dramatic event, Paul Wild, JOHCM Continental European Fund has provided his initial thoughts.

Reflecting on the ramifications of the UK electorate's decision to exit the European Union, the one certainty is the significant rise in uncertainty. Ultimately, markets are priced off risk premiums and confidence in the future outlook for growth and profits. This confidence has unquestionably taken a severe knock in recent days, but the nebulous nature of confidence becomes critical once it starts affecting business investment intentions and delaying investment decisions. And it is this which is the focus of our thoughts as regards Continental Europe.

The recent macro trends within Continental Europe have been pretty good, with above historic trend growth and a resurgence of domestic demand. In the near term, Paul Wild would expect the outlook for gross fixed capital investment (20% of eurozone GDP) and inventories to worsen, whilst consumption (55% of eurozone GDP) may well stay pretty resilient. Economists are rushing to cut their 2017 GDP forecasts, typically by around 40-50 bps for next year. Understandably, this is a highly inexact science at the moment, with the negatives of industrial confidence and trade (the UK accounts for c.13% of Continental Europe's exports) on one side, and possible tailwinds from a cheaper euro and fiscal policy mitigation on the other. The UK has traditionally absorbed a disproportionately high amount of inward foreign direct investment (FDI) into Europe. This would seem highly unlikely to be sustained ahead, which may well benefit the Continent in the longer term.

Financials: little systemic threat but bank stocks to remain unloved
Naturally, the central banks have been out in force. In the European context, one can expect more front-loading of quantitative easing, which will have further depressing effects upon bond yield curves. Financials in this environment become problematic given a worse earnings outlook and higher cost of equity. We must, however, remind ourselves that this is not a Lehman Brothers moment and that European banks' balance sheets are in pretty good shape. Additionally, unlimited liquidity is available on a full allotment basis, so the systemic risk that the banking sector poses is really not comparable to that witnessed during the global financial crisis. If absolutely necessary, the further headwinds from regulation will be delayed, with the European Central Bank as the ultimate supervisor. Bank valuations are close to their lowest ever levels, which mirrors both real and nominal yields. Until yields rise again, the financials sector will inevitably stay in the doldrums.

Politics: Europe will play hardball with the UK
In order to suppress any calls for referendums in other parts of the region, it is clearly in Europe’s interests to maintain an extremely hard line in its short-term rhetoric and future deliberations over Article 50 with the UK. The hope that the UK can maintain all the advantages of the single market without being in the European Union currently seems fanciful at best. Indeed, when one thinks of the proverbial opening of Pandora’s Box, it is difficult to see a sharp slowdown in UK growth, currency devaluation and political chaos as offering many attractions for Europe's dissolution parties. Certainly the Spanish general election (held after the UK's EU referendum) was a modest positive, and in some respects a vote for Europe, with the incumbent conservative party, Partido Popular, slightly increasing its number of seats versus Unidos Podemos, which polled worse than expected.

Looking ahead, one should focus on the Italian referendum on electoral reform in October. The importance here is that Prime Minister Renzi has rather nailed his fortunes to a victory. Later in 2016, we have the French primaries, the precursor to the presidential election in April/May 2017. Additionally in 2017, there is a general election in the Netherlands in Q1 and a general election in Germany at the end of the year. We must also remain attuned to the development of the alternative parties now present in the European political system. In the medium term, it is rather a case of the EU having to grow closer together, and we will obviously monitor the success or failure of the European project closely.

In the near term, Paul Wild is concerned by the Italian electoral referendum as a potential risk event. But he is much less concerned about the possibility of dissolution of the monetary union, which, in his opinion, is highly unlikely to happen. Indeed, it may well be the case that the UK, as a case study in domestic macro collapse courtesy of a national referendum, becomes the posterchild for something to avoid at all costs.