Following the Brexit - the United Kingdom's historic vote to leave the European Union after 43 years - I wanted to share my perspectives, as well as those of some of my colleagues, on what happened and what's next.
The good news: This outcome was not the unthinkable. More brainpower has been spent on this subject than any I can remember since the Greek crisis. Wellington Management's economists and strategists have been following this issue since the beginning of the year, and we have the white papers to prove it! Since a "Leave" vote was a potential outcome, a lot of hedging was in place and central banks had made liquidity provisions, so markets behaved in an orderly manner in the aftermath of the vote.
The bad news: What was perceived as a lower-probability event is what happened. As a consequence, the predictions of a lower British pound and falling equity prices in the UK and Europe came true. The day after the vote, the British pound (GBP) dropped by 4%, UK gilt yields fell by 0.30%, German bonds fell by 15%, and Italy, Spain, and Portugal government bonds rose by 0.20%. Equities fell across the board, with the UK markets dropping by 3%. In the United States, yields fell by 0.20%. Emerging market currencies fell by -1% to -3% as well. Gold rallied +5%, the US dollar (USD) rose +2%, and the yen rose +3.5%.
I'll frame my comments into two sections: What we know and what we don't know.
What we know:
As a result of the leave vote, there is a procedure in Article 50 in the EU treaty for a member to give notice of its intention to leave. That sets a clock on a 2-year window for negotiating its formal withdrawal. This time frame can be extended with a unanimous vote of EU members. The question is: When will Article 50 get triggered?
As stated in my May monthly commentary, "The only certainty is uncertainty." Uncertainty about government, growth, central bank policy, trade, and thus, markets. UK Prime Minister David Cameron resigned the day after the vote was held, and it will take at least a couple of months to form a new government. It will likely take many more months to craft a strategic direction for the UK and its approach to the EU. One of the major tasks will be to negotiate new trade agreements with the EU and with non-EU countries. The UK will need to establish a new migration framework, including determining how to treat EU citizens in the UK and UK citizens living in the EU. Financial services companies, which represent a major industry for the UK, could be at risk of relocating if their current rights to do business with the EU (called "passporting") no longer apply.
We believe this political shock will slow growth in the UK, and many believe it is likely to result in a recession. The uncertainty itself will delay purchases as well as depress business investment and foreign direct investment. This is bad news for a country with a sizeable current account deficit which was funded using foreign direct investment. Expect the GBP and UK assets tied to the economy to fall further. In a white paper I co-authored with our European economist, Jens Larsen, we predicted that the British pound would decline 10-20% further.
What we don't know:
The worst-case scenario is one in which the uncertainty in the UK spills over to Europe. This is a risk case I explored in my May monthly commentary. The leave vote could trigger political contagion across the continent, boosting non-centrist parties in Spain, Italy, France, and other countries. I also think political contagion could hit the US as its election season gets underway. A tilt toward anti-globalization and anti-immigration would be negative for global growth and would add a risk premium to many asset classes. Global recession risks are higher in this scenario. This scenario is "risk-off" and positive for safe-haven currencies and assets, including Treasuries, the USD, and gold.
A better and more likely scenario, in my view, is that there is a mild recession in the UK and possibly Europe. In this case, central banks ramp up interest rate cuts or quantitative easing, liquidity remains plentiful, and contagion does not cripple the financial system. In this scenario, I think US equities are the relative winner across equity markets, but US credit also does well. I think global fragility will keep US Federal Reserve tightening a distant prospect - which could be relatively good for China and emerging markets.
A more optimistic take is that this shock propels Europe to undertake structural reforms that ultimately boost growth. In this scenario, the EU becomes a true political union. This would ultimately propel European risk assets and global growth.
In the meantime, we are in the throes of high volatility. The Chicago Board Options Exchange Volatility Index (VIX)1 spiked up to 21 the day after the vote - almost twice the level of early June, but far from the 40s level seen last August during the yuan devaluation and at the height of the eurozone crisis. I'll be monitoring volatility as well as currencies, financial stocks, and credit indexes for signs of contagion.
Amid the uncertainty, I think portfolios should be tilted toward quality, which means credit and US equities, and even some gold. Our global industry analysts are cautious on European banks as interest rates fall, and on industrials, as slower growth and trade will be negatives. The UK is also a big market for autos, so auto companies' stock prices are vulnerable. With dislocations plentiful, I think there will be opportunities to add to sectors, companies, and countries with good fundamentals and cheaper prices. Our global industry analysts are looking at companies with little UK exposure, defensive sectors such as utilities and non-UK Real Estate Investment Trusts (REITs)2, and companies that will benefit from a lower British pound, such as some consumer companies.
Remember to stick to the facts, not the noise!
1 Chicago Board Options Exchange Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
2 Real Estate Investment Trusts (REITs) are a type of security that invests in real estate through property or mortgages and often trades on major exchanges like a stock.
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The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice or as the views of Hartford Funds. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management.
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