By Randy Woodbury, Portfolio Manager/Trader, Investment Grade Credit, Principal Global Fixed Income
"What now?" That is the question many investors and the general public are asking after Britain's decision to leave the European Union (EU) yesterday. And if the days leading up to the vote, characterized by uncertainty, displays of nationalism, and market volatility, were any indication of the future - many are curious what the road ahead will look like? Will it be more of the same? The short answer is yes. And the long answer is also yes, as the clock will soon officially start on years of negotiations that are likely to be influenced by nationalist sentiment and a bruised economy. So what now? What should investors expect as the exit of Britain reshapes the economic landscape of the U.K. and ultimately the EU?
The first thing to understand is that the vote to leave the EU yesterday isn't, in a technical sense, binding. In order for the vote to be binding, the U.K. government must give official notice of its intention to exit the EU, a decision that is most often communicated by the Prime Minister. Should notice be given, the EU's Article 50 of the Lisbon Treaty, stating that any member state wishing to withdraw must notify the European Council of its intention, will be enacted. Once enacted, the clock on an up to two-year time period of negotiations focused on the terms of exit and the future relationship with the EU will have started. And when these negotiations begin, we could see the political, economic, and nationalist landscape of Britain, and the EU as whole, change drastically. Changes that will likely come as a result of an already divided British government working to come to an agreement on the terms of an official exit, a fissure now deepened upon the announcement of current Prime Minister David Cameron's intent to resign in October. All while an anti-EU sentiment, present even before the vote, stands to gain momentum in the face of upcoming elections in Germany and France. Although there is no precedent for this type of vote, we do have a precedent regarding drastic change, and it is most often accompanied by a heightened sense of uncertainty and market volatility. But what is important to remember is that with change comes opportunity.
We believe the opportunity for investors' post-Brexit lies in U.S. companies with primarily U.S. dollar revenues; i.e. those that will not be influenced by the blows that are likely to occur to both the British pound sterling (GBP) and the euro as well as those companies which aren't reliant on European growth, but are instead exposed to a relatively stronger U.S. economic growth outlook. But if this is where the opportunity lies, what will happen if "all" investors flock to U.S. companies with a primarily U.S. dollar revenue base? Especially when we have already seen an appetite for U.S. dollar-backed bonds from investors within yield threatened countries, such as Japan in the face of negative interest rates. The theory is that with an increase in volatility, the market will cheapen and spreads will widen. As a result, investors will want to buy the names that have widened and those least affected by the change in underlying fundamentals. Based on this, we would expect the exit of Britain will only increase the already present global demand for bonds. As for supply, or issuance from U.S. companies with primarily U.S. dollar revenue, it will likely not increase. This is due to the fact that issuance plans are pretty laid out, with the only changes in issuance being timing-related (no one wants to issue in bad markets) rather than the ultimate amount.
While these are our initial predictions given yesterday's exit, the days, weeks, months, and years ahead will reveal a much different investing landscape than what we see before us today. Trade deals could reshape financial stability, currency decisions will influence the value of European-backed bonds, and nationalist sentiment will influence the strength of respective economies through immigration, migration, and the cultivation of a workforce. Nevertheless, these changes won't happen overnight, and investors should have time to insulate themselves from any shockwaves by avoiding the U.K. and the European Union until the dust from Brexit has settled.