What now for Brexit punished markets?

We see GBP moving to 1.25-1.30 and 15-20% downside to European equities relative to Thursday’s levels. Corporate and sovereign credit present the best opportunities to buy on weakness

• Economic implications: The UK faces a prolonged period of uncertainty which should lead both investment and consumption to wane. Longer term, a less open economy could lower the UK’s rate of potential growth. Risks to the economy will likely lead the Bank of England to keep an easing bias – staying on hold through 2017-18, or a rate cut to 10bp with further QE depending on exit negotiations.
• What has furthest to fall: Negative implications extend beyond the UK. We see the most downside in GBP and EU equities, and would also be sellers of AUDJPY (target 70), USDJPY (90) and EURCHF (1.02) on a flight to safety. Gilt yields could rally 30-35bp to all-time lows, but breakeven inflation could ultimately rise, given weaker GBP. In EM FX and local rates, sell Poland and South Africa.
• Where to be brave: ECB support, both potential and existing, argues for buying corporate and sovereign credit into weakness. We discuss levels and our expected central bank response.
• FX: Poor fundamentals could support 10%+ downside in GBP. Higher global volatility favours JPY and CHF. Increased concerns over eurozone vulnerabilities make PLN the best short in EM.
• European equities: We expect significant downside for European stocks – SX5E at 2400-2550 and FTSE 100 at 5000-5300. Financials and Consumer Discretionary will likely lead the market lower, while Staples and Healthcare should outperform.
• Credit: We expect a strong response from the ECB – we’d add risk in CSPPeligible assets and ‘A’-rated ineligible non-fins on initial weakness. We’d also add bank credit selectively on what we expect will be materially lower prices today – UK banks’ LT2 and AT1s have best asymmetric returns.
• European rates: We reiterate our long duration recommendations and believe UK yields could rally 30-35bp. GBP depreciation should be a dominant force on inflationary pressures over the next two years – long Nov-18 UKTi breakevens. The decline in global yields could see 30y UK real yields return to all-time lows; we reiterate long Mar-46 UKTi real yield. BTP spreads moving more than 25bp would represent value to ‘buy on weakness’, in our view.
• EM fixed income: We expect risk-aversion to widen the impact beyond countries with direct UK links. We see Poland and South Africa most exposed in rates and FX, and South Africa and Turkey most exposed within EM credit.

Cross-asset implications: Bracing for volatility

It looks likely that the UK has voted to leave the EU. This result will come as a surprise to markets, based on Thursday’s pricing, and creates material political and economic uncertainty in Europe. Both are negative for risk premiums, and the question over the next several days is not whether prices fall, but by how much, and whether central banks respond.

What level of sell-off is warranted? A great deal of uncertainty hovers around all of our estimates in this scenario. Generally speaking, we see the most downside in European FX and equities. We think both European corporate and sovereign credit will be better insulated, given central bank support.

Specifically, we think GBPUSD could trade down to 1.25-1.30, as valuations need to adjust sharply before the currency is ‘cheap’, in our view. EURUSD could fall to 1.05 over the next six months as its correlation with risk flips, reverting back to the pattern seen in 2011-12, when EUR served as a proxy for European cohesion. JPY and CHF, in contrast, should be well-supported. We think European equities could sell off by 15-20%, on a ~5% hit to earnings and de-rating the P/E back to near historical averages. Within equities, we prefer to be defensive, favouring Staples and Healthcare, and our ‘Weaker EUR beneficiaries’ basket (MSSTWKEU).

While spreads should also widen, we think corporate and sovereign credit stand to outperform FX and equities significantly, given the ECB’s outstanding purchase programmes for both. We expect CDS to materially underperform cash, with XOver moving out towards 450bp.

What to watch for? All eyes are now on the ECB, and how aggressively it decides to intervene in order to protect its member states and deflect downside risks to inflation that could result from increased economic uncertainty. In the very short term, we think the ECB could reassure markets about liquidity provision (including via FX swap lines and emergency liquidity assistance) today. We would also watch MS GRDI* (STGRDI <Index>), our preferred sentiment measure, dropping below -3, for assessing if the sell-off has run its course. We see US assets across the spectrum – stocks, FX, credit and government bonds – becoming relative safe havens: We reinforce our preference for US versus ROW in equities. We think EM equities are more vulnerable to contagion risks from Europe than US equities.

We see US assets across the spectrum – stocks, FX, credit and government bonds – becoming relative safe havens: We reinforce our preference for US versus ROW in equities. We think EM equities are more vulnerable to contagion risks from Europe than US equities.

Statements and actions by central bankers

Elga Bartsch and Chetan Ahya, our global economists, think that in the immediate aftermath of a vote to leave key global central banks will make statements that they stand ready to support markets by providing liquidity and by reopening existing FX swap lines. Such statements could well be coordinated across the G7. Central banks with active QE programmes could make operational adjustments to their asset purchase programmes, if needed. Beyond these emergency measures, however, they do not expect changes in the monetary policy stance in the immediate aftermath of a vote to leave.