Mark Burgess, CIO EMEA and Global Head of Equities at Columbia Threadneedle Investments.
Investors around the world are unsettled by the forthcoming UK referendum on EU membership and what a ‘Leave’ vote for Britain might mean for markets. With that in mind we have been considering the following:
- A Leave vote and its implications
- How Europe reacts
- The US
The UK referendum on EU membership on 23 June is increasingly dominating global markets. Investors are now waking up to the fact that something that was once seen as a relatively peripheral, if not parochial, event, has the potential to slow global GDP and world trade, as well as place severe pressure on the European financial system and downward pressure on the euro and sterling, along with a number of associated risks that are slowly building.
We've seen increased volatility across asset classes, with people looking for safe havens where they can find them, and a general level of uncertainty exacerbated by more recent polls that have shown a marked swing towards a Leave vote. With the outcome far from certain, the rhetoric has been ramped up, with international central bankers and politicians joining the fray; not least Janet Yellen stating a Leave vote would have ‘significant economic repercussions' and European Council president Donald Tusk claiming that a vote to leave the EU could ‘threaten Western political civilisation' - though these comments are unlikely to sway voters.
Ultimately, we do not know what the future will hold for markets if we choose to leave the EU, beyond the fact that a Leave vote would undoubtedly be a very unpleasant experience for the UK and European economies and markets would be volatile for a period of time. We would likely see higher inflation expectations and lower growth expectations in the UK as well as a sharp fall in sterling. However, given the FTSE 100 is comprised of around 70% overseas earnings, the implications for the UK equity market may not be as great as some people fear.
As I have written before, there may be opportunities in UK domestic stocks that have been sold off aggressively, in particular those stocks that were in the various ‘Brexit Baskets' created by investment banks as they tried to exploit concerns about leaving the EU. Clearly, any exposure to overseas earnings is positive for investments as they benefit from a weaker sterling.
UK stocks (excluding financials) are also, to a degree, cushioned by the current market yield of 3.75%, which is three times that of gilts and attractive in a global context. Indeed gilt yields are already at their lowest level since records began in 1729: a Leave vote would see a steepening government bond curve as the front end prices-in greater policy easing, and rising inflation expectations call into question the relative wisdom of holding long-dated bonds.
A weak sterling would probably mean we would need to open up the spending taps again, putting pressure on the austerity programme and hampering the government's ability to reduce debt. Clearly, this debt overhang is the real issue facing Western economies, and is likely to be a constraint on growth for a very long time. This is why the referendum has come at a tricky time for the global economy, which remains haunted by the spectre of policy failure - globally, there has been an inability to get growth ticking up despite enormous stimulus packages. Other global concerns also remain as real as ever: not least, China's ongoing effort to rebalance its economy from an investment-led model to a consumption model while avoiding a hard landing.
So how are we positioned to deal with the referendum and these global concerns? We are modestly overweight on risk assets but have our lowest exposure to equities for five years. We are overweight credit and underweight core government bonds, and overweight UK commercial property. In portfolios that permit currency risk, we have no meaningful position in sterling and are slightly long the US dollar, a position we would expect to benefit under a Leave vote.
On a vote to Leave, we have a threshold at which we believe any equities sell-off represents a buying opportunity (and having reduced equities in recent quarters we have scope to build positions). By contrast, we have a ceiling on the back of any Remain-rally, at which we might wish to take some profits.
The earnings outlook for Europe is more favourable now than it has been, as its fragile recovery continues, albeit contingent on a Remain vote. We are seeing some upwards revisions to earnings coming through, and the macro-economic data looks reasonable, so we retain an overweight position in the region. Yet we are mindful that if Britain votes to leave the EU, investors might begin to question the sustainability of the euro as a currency and the eurozone as an entity itself. The risk premium attached to this will go up even if the European earnings outlook doesn't change. On the fixed income front, the European market is being underpinned by the ECB kick-starting its corporate bond-buying programme which, if it continues as it has done, equates to the ECB buying €7bn worth of bonds a month. Within that, there is a spread of variance, and sterling names are clearly underperforming - particularly banks - due to fears of a Leave vote.
Finally, there are parallels between how the polls have narrowed in the UK referendum and how Donald Trump has edged closer to becoming a realistic candidate for president of the United States. Trump has caught a wave that is at first glance difficult to understand - at least for non-US investors. He appears to have become a lightning rod for many of the US electorate's discontent with the way the world is and their desire for change. Clearly, Trump as president is no longer a contrarian view.
In the run-up to the US election, this could have a meaningful impact on US markets; for now, investors are concerned about when the Fed will tighten. There was a period of expectation when hawks thought there might be a chance to hike the US interest rate, but that was rapidly pushed away on the back of disappointing employment figures. The US is keeping a watchful eye on the UK referendum on EU membership and a rate rise could be pushed back further if Britain votes Leave, especially on the back of weak growth in the US. That said, we may see an upgrade in inflation expectations given the bounce-back in the oil price.
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