The U.K.’s decision to leave the EU has sent shockwaves through global markets. How worried should you be?
Florian Ielpo, head of macroeconomic research at Unigestion in Geneva, Switzerland, told Advisor.ca the market stress we’re experiencing is episodic. “What the market is saying is, ‘We are entering terra incognita. We’ve never experienced anything like this—no country has ever left the […] European Union. We don’t really know the extent of the consequences.’ ”
Relief from the temporary jolt could come from a “natural stabilization” that stems from markets simply focusing on something else, says Ielpo. And central banks will act to mitigate negative fallout. “We’ve been told by central banks that they will be fighting this […] actively. And we know central bank coordination is actually very effective at stabilizing market stress episodes.”
After the shock
Gloom and doom scenarios for the U.K. are off the mark, suggests Nick Mustoe, chief investment officer, Invesco Perpetual, in a blog post. “Longer term, we believe the U.K. economy will not only be able to handle the decision to leave the EU, but continue to thrive, as we remain optimistic about the U.K.’s growth outlook. Having experienced some of the strongest growth among the G7 nations over the past four years, we believe the economy is well-positioned to handle what lies ahead.”
Ielpo says economic self-interest will help sweep aside the turmoil. “There is a natural interest for the U.K. and the EU to keep trading. They will find an agreement, and we know Angela Merkel is in favour of finding a suitable way of interacting with the U.K.”
But that won’t be easy. Ielpo notes this is the first vote-of-confidence referendum with actual consequences for the EU. In 2005, France rejected a vote to ratify the proposed EU constitution; the result was effectively bypassed—or, perhaps more accurately, ignored. It’s highly unlikely the Brexit vote will share that fate.
So Ielpo says political risk, in the form of rising anti-EU sentiment, will be “the number one macro risk in the coming months,” with potential to “recreate market stress periods” similar to what we’ve seen today.
Ultimately, the Brexit vote will affect the EU and the eurozone more than the U.K., predicts Ielpo. “The fall in the pound has been the best friend of the U.K. economy. The trade disruption [the U.K. experiences] should be partially offset by the fall in the British pound.”
Frank Maeba, managing partner at Breton Hill Capital in Toronto, is less optimistic that economic self-interest will produce a tidy transition. “Worst-case scenario is the negotiation with the EU […] doesn’t go well. Right now everyone is putting on their best face and saying, ‘We’re going to pull up our socks and try and get this done so it’s an orderly exit,’ but things will probably be a little more contentious and as those tensions are broadcasted through the media, the market in general is […] going to start pricing in even worse outcomes.”
If EU authorities “don’t say the right things […] and conduct an orderly exit, then I think it could be a messy risk sell-off,” adds Maeba. In that scenario, “Europe probably goes down the most—back to January lows, maybe even further.”
Maeba says we could see two to five more Brexit-style votes in the next couple years. “That forces you to take a defensive posture and have very low conviction, at least in the European market.” This means sticking to “boring, low-vol stocks” such as consumer staples and utilities.
Watch the buying and selling behaviour of money managers around the end of the month and into early next, because this is when they tend to make their tactical asset allocation shifts. This activity, Maeba says, will speak volumes about whether these managers think the authorities have the transition under control.
One unintended consequence of the vote is the strengthening of the U.S. dollar, and Ielpo says this is a potential risk. In particular, the greenback’s rise could be a trigger for China to devalue its currency again. Ielpo adds that gold prices, which understandably rose in the aftermath of the vote, will likely stabilize and even fall as the immediate impact of the vote dissipates.
A research note released by National Bank Financial suggests that while gold ETFs “have already reacted to [Brexit] with large price surges, […] there may be further upside potential as asset managers reset their positions in the days to come.” The note also suggests “selected currency-hedged Europe, Japan and Broad International Developed ETFs [as] potential candidates for capturing the short-term market rebounds if investors view equity market impacts as showing evidence of initial over-reaction.”