Brexit: When Emotions Run High, Uncertainty Runs Higher

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Includes: ADRU, DBEU, DBEZ, DBUK, DXPS, EEA, EPV, EURL, EWU, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEU, FKU, HEDJ, HEGE, HEWU, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, QGBR, RFEU, SBEU, UPV, VGK
by: Principal Financial Group

By Randy Woodbury, Portfolio Manager/Trader - Investment Grade Credit, Principal Global Fixed Income

It seems that there are times when financial markets and investors alike fall victim to a new buzzword ('the New Normal,' 'Lower for Longer,' etc.). Lately, the current buzz word has been "Brexit," or the exit of the United Kingdom from the European Union (EU). While the referendum on whether or not the UK stays or goes isn't until June 23, investment managers and investors alike have already begun hypothesizing what that could mean for financial markets and what the likelihood of an actual Brexit is.

And in the midst of the "Brexit debate," there are questions. Is this similar to the Scottish Referendum vote of 2014 that became much ado about nothing? Is this the next "Grexit," (Greece withdrawing from the Eurozone) threatening the EU's unity? Is Brexit even something investors should have on their radar? And with a variety of market factors, political sentiment, and opinions at play, and undoubtedly more to surface as the June vote draws near, is a potential Brexit being fueled by something even trickier to predict than the macroenvironment?

First, we would say that the outcome and ramifications of any financial investment-related event is difficult to predict and on that basis alone, this is no different. However, one must always examine the probability and magnitude of downside scenarios, and the magnitude in this scenario has the potential to be significant. Second, we would say that this is similar to "Grexit," in terms of impact; as an exit by the UK would have notable and broad reaching implications for investors and the global economy. However, we would not be dealing with an actual default on sovereign debt or a removal of a member that utilizes the euro as a currency. Third, we would say that a potential Brexit will be influenced by a confluence of economics, the migrant crisis from the Middle East/Africa and immigration, recent and feared terrorist attacks, the rise of nationalism/protectionism, and internal UK political maneuverings. All factors that make the likelihood of a Brexit difficult to predict.

But why? Couldn't an investor or manager reasonably hypothesize the likelihood of a Brexit? After all, the economics and internal political movements by the UK seem fairly transparent. Well, yes and no. While economics and internal politics are certainly tangible guideposts that often have historical track records, the recent migrant crisis, terrorist attacks in Europe, and the rise of nationalism/protectionism are hard to quantify in terms of influence. Additionally, often used data points, like polls, have shown to be quite incorrect in recent political events (see UK elections of 2015 or the U.S. primary process). Because of this, uncertainty is high, as emotional influences will move the vote away from a discussion of core economic and political realities to something much more intangible. An example of this is the recent Dutch referendum on the EU trade partnership with Ukraine - and in what would have normally been a low-key economic event focused on establishing a free trade zone, turned into a de-facto referendum on Dutch unhappiness with the EU. The result? The trade deal was rejected by 61% of voters. Muddying the Brexit waters even further, the recent volatility investors have experienced will likely continue to increase from late April until the vote, with the most volatile period likely being late May/early June. Pair emotions with financial stress and you have a vote that can go either way.

As this uncertainty runs high, it is understandable that you as a fixed income investor may feel unsure about what decisions to make. And while June is still a way off, we do have some insights as the market wrestles with a potential Brexit. First, it is important to understand the ways in which a potential Brexit would negatively impact the market, as this can be helpful when navigating the otherwise unknowns. A potential Brexit would negatively impact: currency markets, specifically the pound sterling, any UK or European corporates with significant UK revenue exposure (as UK GDP estimates would be reduced), and peripheral credit (as the long-term unity of the EU will be debated, increasing risk premium). Taking a closer look at the sector level, asset managers that have UCIT funds (Undertakings for Collective Investments in Transferable Securities) domiciled in the UK, domestically-focused banks, real estate, general retail, and leisure sectors are those we have identified to be at risk if there is a Brexit.

While there are many moving pieces, we believe that as June draws near the economic, political, and emotional undertones of a potential Brexit will become more defined. As to whether or not that definition will allow the market to better digest or better predict the likelihood of a Brexit is yet to be determined. But what we do know is that the days leading up to June 23 are shaping up to be unpredictable because when volatility and emotions run high, uncertainty runs higher.