The UK's triggering of Article 50 is like firing the starting pistol on the process of leaving the EU – but this race will be slow and tortuous, with many dangers along the way. Here is our view on what investors should expect and how they should prepare.
Triggering Article 50
In the immediate aftermath of the UK electorate's decision on June 23, 2016 to leave the European Union, Allianz Global Investors shared its house View on some of the implications of this landmark plebiscite. With the UK now readying itself to trigger Article 50 of the Lisbon Treaty, and thereby begin exit negotiations with the EU and its members, it is time to review how events have unfolded in the past eight months and offer our updated view on currencies, politics and economics, as well as implications for investors.
The full inflationary effects of the pound's devaluation are just now starting to materialize
As we and most others anticipated, the most immediate and pronounced effect of the referendum's outcome was on the value of the British pound sterling, which dropped by around 13.2% against the dollar and 10.7% against euro in the weeks following June 23, 2016. The currency was further dampened on two additional occasions:
We expect the FOMC to hike the fed funds rate at its next meeting, following strong US jobs numbers, rising inflation and a supportive economic backdrop. Franck Dixmier says not doing so would confound market expectations and risk a surge in volatility.
What the market expects from the Fed
We fully anticipate that the US Federal Reserve will announce a rate hike this month. If this is the case, the Fed will have skillfully succeeded in guiding market expectations toward its normalization scenario without any major hitches, albeit at the cost of a marginal increase in long-term rates. On the other hand, postponing the expected hike would send out a confused message to the markets and undoubtedly trigger a fresh surge in volatility.
The Federal Open Market Committee (FOMC) has actively prepared the markets for a hike in the fed funds rate. While the markets initially expressed a degree of skepticism toward the Fed's dot-plot chart (which reflects how the central bank expects it will shift interest rates), they now seem convinced and are pricing in an imminent hike, with implied probability of close to 100%.
The global growth outlook has been revised upward slightly, while market volatility remains at a low level
Underlying trends in the jobs market and inflation rate have provided the Fed with a solid case for justifying future rate hikes. This has been reinforced by a favorable macroeconomic and financial backdrop: The global growth outlook has been revised upward slightly, while an increase in risk appetite has maintained market volatility at a low level.
We expect the Fed will reiterate its resolution to continue normalizing monetary policy
In addition to the expected increase in the fed funds rate, the Fed's policy committee meeting should also provide the central bank with a platform to outline its latest macroeconomic forecasts and set the pace for further rate hikes. We expect the Fed will reiterate its resolution to continue normalizing monetary policy. However, it is too early to announce a reduction in the size of its balance sheet, which has now reached $4.5 trillion. The Fed probably plans to wait for the normalization process to advance further before doing so.