As the U.K. and European Union move forward with their post-Brexit relationship, what may be the consequences, challenges and opportunities for investors? We asked portfolio manager Audrey Kaplan for her thoughts.
Q: How will Brexit affect the international markets? First is the potential for similar moves in other countries. Britain’s vote to exit the European Union (EU) may increase the risk of Prime Minister Matteo Renzi losing the Italian Constitutional Referendum in October and of the ultra-right National Front candidate Marine Le Pen to make headway in France’s elections next April. Several national leaders in the eurozone face elections over the next 18 months. A better-than-expected outcome for the U.K. short-term could embolden more moves by euroskeptics to exit. We believe this would lead to greater downside risks for Europe over the long term.
Second, despite hope in some corners that the U.K. government may never trigger Article 50—the step required to officially launch Brexit—the most likely scenario for the U.K. is withdrawal from the EU and the loss of single market access. We believe this will result in a prolonged period of uncertainty and sizeable costs to the U.K. economy over the medium to long term. The most recent Purchasing Managers’ Indexes for Britain’s services sector point to the most severe decline in seven years. We expect more market fallout once Article 50 is triggered.
Third, there’s been an inconsistent market response to Brexit. Although the reaction from equity, commodity and foreign exchange markets implies a relatively minor hit to global growth, the bond market is pricing for significantly looser policy from major central banks. While the Bank of England cut rates this morning, the Federal Reserve is still considering raising rates before year-end. Our view is that additional easing of monetary policies around the world may do little to boost the global economy—as evidenced by the limited impact of Japan’s efforts.
Q: What about investing in Europe? We believe this is no time to avoid European equities. They have already experienced a significant pullback and are trading on discounted valuation multiples relative to the U.S. last seen during the Greek crisis of 2011. That said, with the political risk rising in the eurozone, we are moving our equity weighting in the region from overweight to neutral. We are more concerned about Spain and Italy, which have a heavier skew to banks. Germany, Denmark and the Netherlands, however, will benefit more from a weaker euro and better domestic economies.
Q: In midst of this uncertainty, are there opportunities? In a global environment of slowing growth and continued accommodation from central banks, we expect high-quality companies with stable earnings streams will outperform along with investments that offer attractive yields. Markets are favoring certainty over cyclicality, so defensive sectors such as Consumer Staples, Spirits and Tobacco and Health Care are likely to prevail at the expense of Financials—especially given falling bond yields.
While we hold a neutral position for European equities, we see potentially attractive opportunities for long-term investors in emerging markets. These countries have received something of a flow “catch up” relative to the past several years, primarily driven by the unprecedented easing and accommodative policy of global central banks. Also, just 8% of emerging-market revenues (non-commodity related) are generated by developed markets, so they are relatively insulated from Brexit risks.
Importantly, China’s economic activity continues to show signs of stabilization following the large injection of credit at the start of 2016 and the measured depreciation of its currency. The deterioration in its industrial activity appears to have found a bottom while growth in consumer spending remains strong and the housing market is solid. We expect China’s latest round of stimulus to sustain the economy into 2017. Throughout Southeast Asia macro growth is relatively strong and valuations are cheaper than they have been in the past. As a result, we are looking toward Asia for opportunities should Brexit risks turn out to be overdone.
Thank you, Audrey.