Brexit shock:our first market thoughts

　　In a shock result versus yesterday’s market expectations, the UK has mostlikely voted to leave the EU. Here are our initial thoughts:1. We think the extreme market reaction in GBP is right. We haveconsistently argued that the implications of Brexit for the UK andsterling in particular are very negative given the country’s largecurrent account deficit financing needs. A period of exceptionaluncertainty now starts for the UK, including a potential leadershipbattle in the Conservative party, the timing of the trigger of the EU’sArticle 50, as well as potential Scottish referendum too. Oliver Harveywill provide a more detailed update in an upcoming note. OurGBP/USD forecast was

　　1.15 for 2017, we now think this will bereached this year. We think GBP/USD is likely to reach 1.30 today. theBoE is very likely to ease policy but the extent will depend on the FXmove.

　　2. It’s all about BTP’s and European banks on Friday open. For the rest ofthe world the transmission mechanism of Brexit works via Europe anda re-pricing of higher political risk premium. As a result, we think onlytwo key variables will matter as the world wakes up to Brexit:European financials and Italian bonds. The reaction of these assetswill be key for the broader market to assess global contagion risks andthe follow through in asset prices inclusive of the S&P and EmergingMarkets. Our prior is that a combination of resolute ECB action, largeand unquantifiable time lags in terms of the political risks and lightpositioning should mean that the market is more orderly than what istaking place in FX. But this remains to be seen, together with theoutcome of the Spanish election this Sunday.

　　3. We are bearish EUR/USD but are not changing our forecasts yet. TheBrexit outcome has clear negative medium-term implications forEUR/USD but our forecasts are already bearish and we are keepingthem unchanged for now. We expect a move to 1.05 by year-end and95cents next year. The reasons behind our cautiousness wereexpressed earlier this week but include a likely repricing of Fedexpectations as well as the tendency of the euro to benefit from riskaversion via the repatriation of foreign assets. We will be closelywatching the systemic implications of Brexit in coming days and willre-assess our EUR/USD forecasts accordingly.

　　4. Goodbye animal spirits. -Beyond the UK and Europe, the impact oftonight runs beyond the geopolitical implications: yesterday themarket was pricing a 90% probability of remain. The surprise of theresult and the unpredictability of the political process will impose a bigcost on the market’s self-confidence, ability and willingness to takerisk. In a world already pre-disposed to secular stagnation, the hit toanimal spirits and the market’s risk-taking capacity will be big.