The Chief Investment Officer of Lombard Odier Asia, Jean-Louis Nakamura, has cautioned against extreme negative over-reaction to the news of the UK’s June 23 EU referendum results.
Global financial markets are currently experiencing extreme stress due to the decision of the British people to leave the European Union.
“The reaction by markets makes it clear that this was an unexpected shock, with cable falling to its lowest level since the mid-1980s, the 10 year US treasury yield registering a historic swing of more than 27 basis points to 1.48% over an 8 hour stretch, and various equity markets collapsing to circuit breaker levels or high single digit losses,” says Nakamura.
Nakamura says the decision is a blow to the British government which is paying for its dramatic mistake of submitting a referendum on such an emotional question, it is a blow to the UK economy that has been benefiting to a very large extent from EU trade integration and the pre-eminence of the City of London over the European financial industry while the UK authorities have always been in position to directly influence EU regulations.
“And finally it is a blow to the European integration process which is paying for decades of non-democratic functioning and, beyond that, its inability to put emotion at the forefront of the EU political agenda,” says Nakamura.
There is little doubt sentiment will remain fragile in the very near term, thus Nakamura cautions against extreme negative over-reaction to the news of the UK’s referendum for the following three reasons.
Referendum is not legally binding
First, the UK’s official exit from the European Union requires a few additional political and legal steps that are also associated with significant uncertainties. The referendum is not legally binding, and the result needs to be ratified by both Houses of the UK Parliament.
The formal process of exit (which is by itself an uncharted path) does not begin until the invocation of Article 50 of the Treaty on the European Union. It is thus entirely possible that the invocation of article 50 is delayed to pave the way for detailed interim negotiations between the UK and its EU counterparts on the details of the terms of the UK’s exit.
“We note that Boris Johnson, the leader of the Brexit campaign, made a suggestion in the past that the purpose of the “advisory” referendum was to jumpstart the negotiation with the EU for a second referendum on the terms. This means that basic political and economic realities will not change immediately on the ground as far as trade and financial links are concerned, at least for a few more years,” says Nakamura.
Global policy will shift decisively to contain shock
The incentive is now even stronger for the remaining EU members to address the risk of even more debilitating populist challenges in their midst.
"For this reason, we expect – and hope for - a robust and rapid response from Eurozone governments reaffirming their political unity and commitment to the integrity of the Eurozone, and the new EU summit on June 28-20 might be the occasion for this unified response," says Nakamura.
On the monetary policy side, the case is now clear for coordinated responses from major central banks in terms of liquidity provision and forward guidance. "We firmly expect the European Central Bank and the Bank of Japan to lead the effort as their economies have been subjected to multiple shocks this year," adds Nakamura.
Scheduled binary event
Nakamura says the referendum was a scheduled binary event that, while unexpected in terms of its ultimate outcome, already motivated many market participants to prepare for the worst scenario in advance.
Therefore, and spite of the recent rally experienced in markets ahead of the polls, there is still a significant portion of cash (or hedged positions) in many balanced portfolios and there is an increasingly likelihood that the rapid correction in markets will build a strong case for putting this cash to work (or reducing the hedges further).
“We do not believe that we are starting a structural liquidity crisis of the nature or the magnitude of the ones experienced in 2008 or 2011,” notes Nakamura. “In fact, aggressive policy intervention or political progress in the rest of the EU membership could lead to a material reversal of market sentiment quite rapidly.”