Brexit: One Of Many Risks Around Us

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Volatility spikes on UK vote

The week begins with investors assessing the fallout of the Brexit vote, whose results came as a shock to most of the world - and to capital markets, which had not priced in this outcome.

The decision by the UK electorate to secede from the European Union (EU) triggered a global sell-off last Friday. The Dow dropped more than 600 points, and the yield on the 10-year US Treasury fell to a level it hasn't seen in several years. And, given that negotiations on the UK's extrication could take years - and that other important EU elections will occur in the meantime - this could result in bouts of significant volatility and downward pressure on risk assets for some time to come.

Risks are rising

Interestingly, Brexit is emblematic of the heightened risks we have been concerned about in recent months. In our 2016 RiskMonitor Survey of more than 750 institutional investors around the world, released just last week, our respondents indicated that the threat of equity market risk had escalated dramatically - to 45%, compared to 25% last year.

When we asked respondents about the biggest threats to their portfolio's performance in 2016, event risk was the third-most common response with 75% of respondents saying it was either a moderate threat or a considerable threat. That's up from just 53% identifying it as a moderate threat or a considerable threat in 2015.

Bigger risks than Brexit

Institutional investors rate the biggest risks to
investment performance over the next 12 months

Bigger Risks than Brexit

Source: AllianzGI 2016 RiskMonitor Survey

We even probed which events institutional investors were thinking about when they listed event risk as a significant risk.

Interestingly, a Brexit vote was mentioned by just 19% of total respondents globally - and 22% of respondents in Europe and the Middle East - when asked which specific events posed risks to their investment performance over the next 12 months. However, more investors listed a global economic slowdown, a slowdown in China, geopolitical tensions, a new banking crisis, oil price shocks and currency swings as events more likely to pose risks to their investment performance. In other words, a Brexit is arguably far from the worst thing that could happen to capital markets this year, at least in the minds of institutional investors.

Dollar strengthens, Fed likely to hold

But we can't minimize its importance - especially to the United States. While the UK has yet to formally invoke Article 50 and begin the separation process, markets have reacted. Perhaps most notably, the pound fell, affecting the value of currencies around the world including the dollar - which, as a 'safe haven' currency, is getting stronger.

A strong dollar can hurt an already weakened manufacturing sector, rendering exports more expensive to foreign buyers. In addition, a strong dollar imports deflationary pressures. Moreover, we need to recognize that the Brexit vote makes it far more unlikely that the Fed makes any changes to monetary policy at its July meeting - and it is far less likely to act at its September meeting as well.

Active investors look to take advantage

As we look ahead, we need to recognize that risks are all around us - not the least of which is the fallout from the Brexit vote.

While we don't know what will happen in the coming months and years as the UK negotiates its departure and future relationship with the EU, we can expect more volatility and some downside pressure. Rather than hide from risk, we need to seek opportunities presented by it. This is especially so for investors with a long term outlook, a healthy risk appetite and the latitude to invest actively and in an unconstrained fashion.

Interestingly, while the institutional investors in our RiskMonitor Survey recognized risks such as event risk were growing, they planned to increase their portfolio allocations to risk assets, most notably equities, in the coming year. They recognize the need to take risk in order to receive adequate return in this financially repressed environment.

This is a market where investors will benefit from paying closer attention to the shifting political realities associated with the ongoing financial repression dynamic, which has been the single largest force driving the markets since the global financial crisis began. While we don't know when and what these future opportunities will be, we know we must follow this situation closely, and be active to tactically allocate to new opportunities as they arise.