Three things we didn't learn this weekend
Investors hoping for greater clarity to emerge over the weekend will be disappointed. At least with regard to the UK, the weekend brought more questions than answers about how the UK will proceed:
1- (When) will the UK leave the EU?
The leaders of the Brexit campaign have been remarkably quiet over the weekend. Perhaps they are thinking about the difficult hand that Prime Minister Cameron has dealt his successor.
To leave the EU, the UK must exercise the so-called "Article 50" of the Lisbon Treaty, from which time the UK would have two years to negotiate an exit. Prime Minister Cameron has stated that the clause will only be exercised by his successor, which is unlikely to be determined until around September/October.
On the one hand, failing to exercise Article 50 would go against the wishes of the majority of voters. On the other, exercising would mean presiding over a possible recession and dissolution of the UK, should Scotland and/or Northern Ireland look to secede.
It remains far from clear who would seek to be Prime Minister, invoke Article 50 and risk the dubious honor of being the last UK prime minister in history - meaning we could face uncertainty over Article 50 for some time to come.
2- What kind of exit might the UK wish to pursue?
Assuming the UK does eventually exercise Article 50, it still isn't clear what kind of exit it might wish to negotiate, given the wide disparity of views within the Leave camp. The weekend saw no greater clarity over the policies of Brexit Britain. Major open questions remain over whether the future UK leadership would pursue an 'internationalist' or 'isolationist' vision of Brexit. For instance, it is not clear if the UK would be willing to accept freedom of movement in exchange for membership of the European Economic Area.
This uncertainty means that the future form of Brexit Britain might look quite different to that for which the Leave camp campaigned. As such, we shouldn't rule out the possibility of a second future referendum, even if it is unlikely.
3- What strategy will the EU pursue with the UK?
It also remains unclear the extent to which the EU will play hardball with the UK in exit negotiations. Over the weekend, German Chancellor Merkel stated "no need to be particularly nasty" in negotiations. EC head Juncker contrasted by stating "this will not be an amicable divorce."
Leaders are trying to balance the need to deter other countries from following Britain's path (implying harsh treatment of the UK), with the need to maintain stability and economic growth (implying a more constructive approach). Which path Europe will merge toward remains to be seen.
Policy responses: We remain confident that central banks will react in the event of disruptions in market function. The Bank of England has already made £250bn in liquidity available, and the Japanese ministry of finance drew up plans for a JPY10 trillion stimulus to be used if Brexit hits the Japanese economy. We also have no reason to doubt that the ECB would be prepared to step up its emergency measures, if necessary, to prevent damage to the banking system.
The Brexit vote also means we are likely to see an extension of looser-for-longer policy from all of the world's most prominent central banks. We expect to see rates cut to zero in the UK by the end of the year, and the Fed, ECB and Bank of Japan are all likely to become more dovish as a result of Brexit. All else equal, this should be broadly supportive of risky assets in the months ahead.
Risk appetite: While uncertainty levels have risen over the shorter term, markets functioned properly. Friday's liquidity was high - a record day on many exchanges for volume. Yet interbank lending rates rose only slightly and price action was relatively calm - markets fell and then stabilized, in contrast to the wild price action we have often seen on similar days in the past.
Political risk is evolving. Aside from the aforementioned Brexit-related news, the weekend saw elections in Spain, where exit polls (at the time of writing) saw the left-wing Podemos party becoming the second-biggest party for the first time. This again highlights the steady rise of populism in Europe. We will continue to monitor developments, and in particular the risk of follow-on EU referenda in other European countries.
Economic contagion: We believe that continued orderly market functioning will be key to avoid financial and economic contagion, and we will be monitoring a range of indicators of liquidity and funding stress in the weeks and months ahead. Bank credit spreads widened on Friday but the events of the weekend do not suggest that the risk of contagion has risen. In the absence of a Brexit-related financial shock, economic growth can support risky assets. We overweight US equities and US investment grade credit, and expect each to finish the year higher than today's levels.
US growth is generally on track and Eurozone growth was improving before the referendum. China also seems to have learned from past mistakes and should keep growth stable over the medium term. This week's consumer spending and income reports, the ISM manufacturing index, and S&P/Case-Shiller home price report should provide further clarity and confidence in the US recovery.