Brexit: How Quickly May The Surprise Wear Off?

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By Franklin Templeton Investments

As markets digest the shock decision of UK voters to leave the European Union (EU), Templeton Global Equity Group's Dylan Ball believes investors will want to focus on the fundamentals of stocks in their portfolio, while keeping an eye out for opportunities amid the volatility. Here, he also reveals why he will be closely monitoring the exit negotiations between the United Kingdom and the EU.

Dylan Ball
Executive Vice President
Templeton Global Equity Group

Markets have a problem pricing in political risk and events like the United Kingdom's European Union (EU) Referendum vote because of the binary nature of the outcome. After the initial shock of the decision, it seems to us as though the market is trying to find the bottom and reassess the situation. In fact, in mid-morning trading, the FTSE 100 Index was down just under 4%.1 So it looks to us as though the initial surprise effect may have started to wear off.

Now, we think longer-term issues will be key for investors like us, who focus on fundamentals. One of the macro implications of the United Kingdom's leave vote is that we'd anticipate UK gross domestic product (GDP) growth forecasts could be lowered, for 2017 and onward. That has already been reflected in the foreign exchange rates, with the pound declining versus the US dollar today; it probably means the Bank of England (BOE) could consider further easing, potentially restarting quantitative easing. We think that could help offset any upward pressure on UK bond yields from negative ratings actions such as potential credit rating downgrades.

From a European Central Bank (ECB) perspective, we could see further liquidity injected into bond markets in the coming weeks, and probably an extension of asset purchases beyond the target date of March 2017.

Volatility Can Provide Opportunities

As long-term global value investment managers, Templeton Global Equity Group has been through environments like this before, and will likely go through them again. What's good about having a 60-year track record, as we do, is that we recognize that volatility can provide opportunities. In such situations, our view is it's important to focus on the fundamentals of individual companies. We think it's a stock-picker's market, and there may be some attractive value opportunities opening up, although they may close rather rapidly.

It may be a good time for investors to take a step back and assess how this impacts the earnings of businesses. The two sectors that we think should be particularly interesting are financials - particularly banks - and also the energy sector, which seems to be showing some resilience amid the post-Brexit uncertainty, in spite of being a pariah of the market for the last 12 months. UK bank stocks also displayed resilience, with the sector rebounding to recover some of its sharp losses at the start of Friday's trading session.

Markets are concerned about two things for banks: first, the regulatory uncertainty as a result of the Brexit result, and second, what lower bond yields might mean for banks' earnings growth. At the banking sector price nadir during the early part of the UK trading day, these concerns were getting overly discounted, in our view. Stepping back from the near-term Brexit shock, we believe the banks are generally in a better position today than they were during the 2008-2009 global financial crisis. There have been a number of stress tests on their capital bases and liquidity positions, and we think both they and the regulators are better positioned to deal with an event like this.

We believe the big concern is the long-term trend for bond yields. That is ultimately likely to drive future earnings growth. Inevitably any increase in central bank intervention - whether that comes from the BOE, the ECB or the US Federal Reserve continuing to delay a rate rise - implies that a "lower for longer" interest rate environment is likely to be the message. That is likely to weigh on bank earnings, which is what the markets are trying to price in right now.

Political Implications High on Investors' Agenda

Attention is now likely to turn to the tone of negotiations between the EU and the United Kingdom, particularly whether those negotiations are going to be amicable or confrontational. We expect the EU wants to set an example and remain firm but is ultimately likely to offer up a "Plan B" fairly swiftly to prevent the risk of further disintegration if other countries jump on the referendum bandwagon.

There probably will be some scrutiny on the UK government and the method through which a change in its leadership takes place. That could dictate how the United Kingdom leaves the EU and adjusts its trading relationships with Europe. We believe these issues are going to be driving the fundamentals during the next couple of weeks, and the market is starting to focus its attention on that.

The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region, market or investment.

What Are the Risks?

All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Value securities may not increase in price as anticipated, or may decline further in value. To the extent a portfolio focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a portfolio that invests in a wider variety of countries, regions, industries, sectors or investments. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.

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1. The FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. Indexes are unmanaged, and one cannot directly invest in an index. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance.

Disclosure: None