Business & Money | Tuesday 12 July, 2016 7:18 am |

The Brexit decision came as a significant surprise as Sterling had appreciated and European equities rose prior to the referendum, leading to a precipitous sell-off following the ‘out’ vote. Short-term uncertainty, particularly around the legality of the United Kingdom’s formal departure from the European Union and the potential for subsequent countries to organise their own referendum, resulted in acute market anxiety. 

 

For Asian (ex-Japan) economies, the overall direct impact is somewhat limited. Gross exports to the EU account for about a third of GDP, with value added accounting for about 20% of GDP. With the world trade cycles already below trend growth, the Brexit outcome is unlikely to become the sole cause of a global recession. The immediate implications surround the extent to which central banks will coordinate their policies to ensure market liquidity while investors re-evaluate risk premiums that have traditionally been associated with emerging markets. 

 

In our opinion, the Federal Reserve is more likely to pause its current rate cycle, representing its second change when the US central bank suggested that the economy could now only withstand two hikes from an earlier expectation of four. Following weaker than expected jobs numbers in May and further USD strengthening from market volatility, Fed Chairwoman Yellen would probably prefer to maintain interest rates, with the earliest rate hike in December after the US Presidential election. The European Central Bank and the Bank of Japan are likely not only to expand their quantitative easing program, but also to have a greater tolerance for interest rates slipping further into negative territory. 

 

This accommodative policy backdrop should portend well for emerging markets that have traditionally traded at higher risks premiums relative to developed markets. Following the unexpected Brexit outcome, investors are likely to re-evaluate this tenet, particularly as emerging market equities are progressing away from nationalistic policies and towards pro-market reform, with this trend most evident in larger emerging Asian economies and Southeast Asian nations. Brexit not only reflects the opposite but highlights exactly why higher premiums are not justified in the current market environment.

 

Trade dynamics have altered significantly as Asian companies have shifted away from concentrated supply chains in preference for greater diversification that increases foreign content. This would partially explain the limited trade impact as most Asian currencies have depreciated this year against the USD, meaning the terms of trade advantage is offset by rising production costs in local currency terms. The rise of China as both a manufacturing and consumer of end demand means that most Asian exports remain within the region, with an estimated 51.1% of Asia Ex-Japan (AXJ) exports traded to other AXJ countries, rising from 46.3% only a decade earlier. 

 

Together, liquidity and falling discount spreads should make Asian equities an attractive asset class to hold. Valuations have priced in an unlikely global recession, while most of the region is driven domestically. The immediate beneficiaries in this environment include domestically focused economies, including India and ASEAN particularly the Philippines and Indonesia.  Southeast Asian economies are supported by low levels of debt, real rates and current account surpluses, which protect their values in both local and USD terms. To a certain extent, rising Chinese household consumption should remain resilient, as the bulk of debt is concentrated in the corporate sector while private debt remains low.