Where to now that we have a Brexit vote?

June 24, 2016 Categories: Market Updates, Markets

BREXIT-LEAVE-BANNER1

Later this morning, Jenny Watson, the Chair of the Electoral Commission, will conclude the UK referendum on EU membership by announcing the result in favour of a decision to leave the EU. This historic moment brings to an end the referendum process but simply heralds a new chapter of uncertainty for the UK and the EU.

Markets have reacted over the course of the early hours, as the leave vote has become increasingly likely. As anticipated, there has been a pronounced sell off in risk assets:

  • Sterling has suffered significantly, falling 10% against the US dollar and trading below 1.34 against the US dollar. Futures on global equity markets have fallen in overnight trading, with FTSE 100 futures falling over 8% and futures on the S&P500 falling around 5%.1
  • US Treasuries have rallied strongly, with the yield on the 10 Year bond falling by 30 basis points. We can expect a similar reaction in UK gilts as a result of a flight to safety and in anticipation of forceful response from the Bank of England.2
  • Further out along the yield curve, the full implications remain to be seen during the day’s trading and beyond. This risk off driven rally will likely drive yields down at the longer end of the curve. However, the potential inflationary pressure of sterling weakness may mitigate some of this impact.
  • In volatility markets, VIX futures are reacting to the news of Brexit with a strong rally; futures are currently trading at 25.25 an increase of more than 35% since last night’s close.3

The implications for investors
As we look forward, the implications of this decision are hard to predict. The political and economic landscape in the UK and further afield will alter dramatically over the coming days and weeks. The long process of negotiating an exit and subsequent international relations begins immediately but no one can be sure of the timetable or outcome.

Contagion into the rest of the EU?
On Sunday, the Spanish general election may provide some indications of the broader anti-EU voice. No doubt today’s result will increase calls for referendums in other EU states, including Denmark, Sweden and the Netherlands. To a large extent, the UK’s experience in negotiating an exit over coming months will continue to shape the future of the EU for some time.

The impact for UK investors
The biggest impact will be on sterling, UK equities, UK gilts and other domestic asset classes, including corporate bonds and less liquid investments. For pension funds, another significant risk will be any potential impact on their corporate sponsor and the strength of its covenant.

For more details, please read our note, ‘EU Referendum – Plan for either outcome’, June 2016.

The impact on global financial markets

At this point in time, the immediate sell-off in risk assets and the flight to safer investments is an understandable reaction, especially after markets rose over the last week as investors priced in a ‘Remain’ vote. Over recent years, financial markets have been driven by the expectations and reality of monetary policy, and today’s result will no doubt delay the path of monetary policy tightening in the US and the continuation of a more accommodative stance in the UK and Europe.

However, we should not over-read the impact of this event on global market volatility. Our global market outlook for 2016 has been dominated by expectations of heightened market volatility, triggered by events such as this. With the UK representing about 4% of global GDP, its ability to cause a major economic shock is limited.

For more details, please read our Global Market Outlook.

The uncertainty presents risks but also opportunities
In an environment which exhibits heightened volatility and where there is no clear direction for markets generally, we continue to advocate a dynamic approach, reacting to market events to “sell the rallies” or where appropriate “buy the dips”. Identifying the signals in the noise is a challenge requiring a disciplined approach. After a multi-year bull market for equities, the recent environment has been one where risk management has been, and will continue to be, paramount in protecting returns. Across multi-asset portfolios, this is achieved through diversification, particularly away from pure equity risk and through the use of options to structure a more attractive risk reward pay-off.

Over the coming days and weeks, the ramifications of the UK’s decision will continue to be felt both domestically and internationally. The resultant market disruption comes as no surprise and our investment strategist and portfolio management teams continue to identify ways to both protect against risks but importantly look for opportunities to add value where market reactions are out of line with our fundamental expectations.

1Source. Bloomberg LLP. As at 24 June 2016, 06:24 BST.
2Source. Bloomberg LLP. As at 24 June 2016, 06:24 BST.
3Source. Bloomberg LLP. As at 24 June 2016, 06:24 BST.

Summary
With the British public voting to exit the EU, we believe:

  • The implications for the UK and Eurozone will be prolonged and at this point hard to predict.
  • Unsurprisingly, this news will be a catalyst for further market disruption, however, there are many other significant issues driving global volatility too.
  • The ensuing volatility creates an opportunity for nimble investors to add value where market reactions are out of line with fundamentals.

David Rae – Head of Client Strategy & Research.

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