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On June 23, 2016, the British will vote whether or not they want to remain a member of the European Union. In this article, three investors – Lukas Daalder, Mark Glazener and Kommer van Trigt - give their take on the consequences of a potential Brexit for, respectively, the main asset classes, global equities, and global bonds.
Asset allocation: a flight to safety
The latest polls (50/50) and bookmaker quotes (75/25 in favor of staying in the EU) clearly show that a Brexit outcome is far from certain. This means that markets certainly have not discounted the full impact yet. A Brexit outcome will therefore be seen as a negative surprise, which should trigger a flight to safety. This is generally considered as bad for stocks and positive for bonds. If Brexit were to materialize – which we do not deem likely - we expect the FTSE 100 index to plummet with, to a lesser extent, the Euro Stoxx 50 in its wake. On other equity markets trading will be volatile, but there we expect losses to remain limited.
We expect the safe haven bond markets of Germany and the US to benefit. The German 10-year yield is certain to drop below 0% in a Brexit scenario. The outlook for peripheral bonds and UK bonds is less certain. Peripheral bonds may come under pressure because of break-up speculation (which will probably trigger a reaction by the ECB before long). The reaction of UK bonds will depend on how hard pound sterling will be hit by the outcome: with a 25% depreciation of GBP versus its main trading partners, it is estimated that inflation could spike as high as 5%, which might trigger speculations of a reaction by the Bank of England of some sort. In addition to a general weakening of pound sterling, the euro is also likely to depreciate against all currencies but sterling. We expect the US dollar to appreciate. Again, we do not expect Brexit to materialize, so this is a what-if scenario to us.
Global equities: hedging Brexit risk
As the Global Equity team finds an above average amount of attractive stocks in the UK market, the global equity portfolio is overweight the UK. Holdings include British American Tobacco, Compass, Experian, Reckitt Benckiser, Rio Tinto and Vodafone. Besides that, the global equity strategy is invested in Hong Kong-listed HBSC and Royal Dutch Shell, which has a Dutch and UK listing.
The common denominator of these stocks is that the largest part of their revenues comes from overseas. In the event of a Brexit, which should have a dampening effect on British GBP, these companies will benefit, as they won’t be harmed by sterling weakness and have little exposure to the UK economy.
Despite the overweight resulting from stock selection, we have hedged the country exposure to the UK back to benchmark weight with FTSE 100 futures, in view of the Brexit risk. The position in pound sterling is also neutral versus the benchmark.
Furthermore, we are staying clear of real estate companies and banks, which have a large exposure to the UK economy and would suffer from weak sterling. Financial companies are also most likely to be impacted because they are major exporters of services. While the WTO sets international trade standards for goods, there are no such rules for services. This means that the UK will have to rearrange its trading relationships with the whole world anew.
Global fixed income: comfortable with UK banks
In the Global Fixed Income team, we also think that a win for the leave vote would be the surprise outcome and would therefore have the biggest market impact. Although sterling would be hit hard, we do not believe the Bank of England will tighten monetary policy to support the currency and dampen imported inflation. The Bank of England has shown before that it is willing to look through these temporary and transitory effects. Furthermore a weakening of the British pound – as long as it takes place orderly - might even be welcome to offset some of the negative economic consequences. A dovish stance is more likely, but probably the central bank will want to take some time to assess the situation before setting a new course.
In the case of a Brexit vote win, we do not expect severe funding problems for UK banks. However, would they arise, other central banks such as the Fed and the European Central Bank would immediately help out with swap arrangements to provide the necessary US dollars and euros. The potential impact on UK Gilts is more uncertain. With a budget deficit already more than 4% and a current account deficit running at 7%, long dated Gilts could face selling pressure from international investors.
Our base case scenario as of today is a win for the Bremain camp. Our holdings in UK government bonds are small. Within our corporate bond holdings a sizeable part consists of financial institutions. Amongst them are UK banks such as Barclays and Lloyds. At the start of the year these bonds underperformed other segments of the credit market in anticipation of a possible Brexit outcome. In relative terms, the fundamentals of UK banks are positive. Until now they recovered fastest in cleaning up their balance sheets. We expect these bonds to do well in case the stay vote would win. If the opposite occurs, some spread widening is to be expected, but current spreads have to some degree already factored in a negative outcome.
European politicians of the mainstream parties are terrified that a win for the Brexit camp will fuel Euroscepticism and support anti-EU parties throughout the continent. Which country will be next? Most likely the Euro system will be tested by investors and peripheral markets will come under pressure. As the ECB is already active in the market, we do not expect a replay of the 2011/2012 sovereign crisis, but we do sense that peripheral markets are too complacent. Political risk throughout the region is on the rise, debt dynamics remain worrisome to say the least and appetite for economic reforms is absent. In our fixed income portfolios we have scaled down exposure to these markets significantly.
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