JUNE 24, 2016 GMT
Cross-Asset Strategy
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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 CSPP-eligible 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.
For the economics view, see EU Referendum: Out into the Unknown.
Summary of key six-month target levels (mid)
Source: Bloomberg, Morgan Stanley Research forecasts
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