Brexit matters, as both a signal and driver of negative events. The extent to which it leads to financial contagion and feedback loops remains to be seen, but the sociopolitical arena will be even more important.
Let's start with Brexit as a signal. It represents a long-festering wave of declining social mood, as characterized by Strauss & Howe in The Fourth Turning. During rising social mood, we think outwardly, hopeful about a utopian future, in a spirit of unification and integrative evolution. On the way down, we think internally, reminiscent about a picturesque past, in a spirit of division and individual protection. Brexit and Trump are both all about the latter.
How this drives events going forward is even more important. To an extent, there is an inverse relationship between the near-term effects of Brexit and the probability of sociopolitical contagion (eg. other EU/EZ exits, Trump victory). Path dependence is key: perhaps we need a crash/panic to prevent a Trump presidency or other European exits. But absent true tail shocks in response to Brexit, the latent centrifugal forces persist. Unemployment remains high while wages and deficits face internal devaluation; watch Spanish and Italian politics. Migrants get bottled up in ever smaller safe havens, which only worsens the anti-migrant sentiments in those countries; watch German nationalism and Turkish geopolitics. Global trade contracts while everyone fights for everyone else's share; watch French and Japanese protectionism. And blame is increasingly externalized; watch South China Sea tensions and American elections.
This may remind traders of the savings paradox: the more each individual increases his or her savings concurrently, the lower aggregate savings go. Indeed, this entire wave of deleveraging and deglobalization is basically one big fallacy of composition. Coordinated policy responses are the only thing that can short-circuit this process, but we unfortunately are living in an increasingly G-Zero world.
Looking at financial markets, it is disconcerting to see RMBUSD at its lows without Yellen hawkishness, as is seeing USDJPY at new lows without much left for the BoJ to try. Treasury's intervention rules are key in this light. They don't prevent opportunistic intervention in FX markets, which the BoJ probably engaged in to defend USDJPY 100 last night, but they do prevent the type of sustained intervention that could inject fear into (and squeeze) USDJPY spec shorts. Meanwhile, there's little to prevent upward pressure on the JPY with real yields rising despite QE, negative rates squeezing the banking system and challenging the BoJ's toolkit, PPP valuations still low, and the current account surplus persisting. What does the BoJ do if USDJPY sustains a break below 100?
The global trade environment saw a pickup in H1 from its recent lows, boosted by Chinese stimulus. But global political forces continue to put downward pressure on both real trade volume and cross-border investment sentiment. This does not bode well for East Asia's trade-driven economies, particularly as Chinese demand growth finds a choppy trend down.
But global trade risks take on a different level in a potential Trump presidency. Echoing the pre-Brexit experience, betting markets are discounting Trump's chances more than polling seems to suggest. Domestic financial markets are relatively calm and primarily focused on external risks. MNC and consumer staples stocks, which benefit greatly from global labor arbitrage and trade volume growth, are viewed as safe havens sectors. It appears to me that Trump risks won't really get discounted (possibly to the point of preempting his election) until risk aversion spreads into IG space, driven by large multinationals. Conor Sen has often commented that 2016 may be the year of a "political Lehman"; extending this analogy, Brexit could be BNP Paribas suspending ABS HF redemptions, with Trump being Lehman.
In sum, watch RMBJPY and US IG credit spreads to see if/how Brexit contagion spreads systemically. Brexit itself is not systemic to the global financial system or economy. Yes, we may yet see localized exits and shocking votes in specific European countries, but the extent of their globally systemic importance will be best reflected in the above indicators. Bank equity and credit, particularly in Europe, are showing dramatic declines post-Brexit, but the contagion risks to US banks are far lower and policymakers far more prepared this time around, versus 2007-2011. To the extent they do have a domino effect, it should show up in IG spreads and JPY.
My questions, in ascending order of importance, are:
- Do other countries exit the EU (and/or EZ)?
- What do the PBoC and Fed do if the RMB weakens in a more volatile way?
- What can the BoJ do if JPY keeps appreciating?
- Will Donald J. Trump be the 45th President of the United States?