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Opportunities amid market dislocations
THE United Kingdom's (UK) referendum which saw the vote going in favour of leaving the European Union (EU), marked the beginning of an uncertain and unprecedented road ahead. There will be a two-year negotiation period and early indications are that the UK will not start negotiations immediately. In fact, there are calls for a second referendum but the likelihood is low. The most probable scenario is a long-drawn and uncertain separation process over the next few years. Adding to the mix, Scotland and Northern Ireland could hold referendums of their own to leave the UK, so as to rejoin the EU as independent nations.
The impact of the referendum result on the UK will undoubtedly be negative. As uncertainty weighs on consumer and business sentiment, consumption and investment spending (which collectively add up to close to 80 per cent of its GDP) can be expected to slow. Brexit is likely to be negative for financial institutions and real estate firms, as well as domestically-oriented firms and cyclical sectors.
In contrast, firms which are more export-oriented or exposed to international prices could demonstrate greater resilience. The British pound can be expected to weaken and Gilt yields can be expected to drift lower. The UK's credit rating will also come under scrutiny, with Moody's putting it on negative watch following the referendum result. The ultimate impact will depend on the upcoming negotiations and a potential mitigating scenario could be the so-called "Norwegian" option where continued access to the single market is maintained.
What about the broader implications? Brexit is unlikely to morph into a global systemic crisis in the near-term. While banks will incur higher costs and face regulatory uncertainty, it is more of a threat to their profitability rather than to their solvency. On the economic front, the UK accounts for about 3.8 per cent of global GDP and absorbs about 3.9 per cent of global exports - not insignificant, but hardly earth-shaking.
The rest of Europe, however, will be relatively more affected as the UK is more significant within Europe than within the global economy. It accounts for about 17.6 per cent of EU GDP, absorbs about 7.4 per cent of Europe's exports and is the EU's third largest budget contributor. Beyond the economic impact, there is the prospect of other members following the UK's lead to hold referendums and possibly leave the EU.
Asia has limited direct exposure to the UK, but may nonetheless be affected by Brexit due to the accompanying slowdown across Europe. Small, trade-oriented economies would be vulnerable to this dynamic, as exports are typically large in comparison to GDP and exports to Europe make up a sizeable share of the total.
In particular, Hong Kong and Singapore have the largest export exposure to Europe (including the UK) as a share of GDP - about 14 per cent and 10 per cent respectively. Being financial centres, both economies also face headwinds from the higher volatility and lower transaction volumes likely to result in global markets following the referendum result. Domestically-oriented economies such as India, Indonesia and the Philippines are more insulated from weaker European demand.
Global monetary policy is likely to remain highly accommodative. Major central banks appear to be ready to ease monetary policy to combat economic weakness or currency strength, or at least to delay tightening moves. This will be positive for Asia.
The referendum result is likely to impact the pound the most, followed by the euro. Safe haven currencies such as the Swiss franc and Japanese yen are likely to remain well-supported, but are vulnerable to central bank intervention and easing. Emerging market currencies and commodity currencies are likely to weaken initially against the US dollar in line with the immediate risk-off sentiment, but subsequently strengthen in view of a lower US rate hike trajectory. To that end, investors should consider some allocation to gold in their portfolios, which may act as a hedge against unexpected event risks.
Consistent with risk aversion and highly accommodative global monetary policy, developed market sovereign bond yields are likely to fall and remain low. That said, we do not recommend long positions in these bonds, as the low (and in many cases, negative) yields present a poor value proposition.
We have been positive on credit, based on our view of low growth, low interest rates and non-recessionary conditions. The referendum result reinforces this view. Investment grade US-dollar-denominated bonds with little exposure to Europe should deliver decent risk-adjusted returns. High-yield bonds require a more selective approach.
We maintain an underweight allocation to equities, as risk aversion and low growth make sustained capital gains unlikely. Investors can consider rotating into defensive, domestically-oriented firms focused on delivering returns through income distribution. Within equities, we shift our allocation to Europe from overweight to underweight, in view of the uncertainty arising from the referendum result. We maintain an overweight allocation to Asia ex-Japan and a neutral allocation to the US. While Brexit is certainly a game changer for the UK and Europe, we believe that the impact will be mitigated by potential policy easing and, to a lesser extent, negotiations for a less drastic outcome. With this in mind, investors could look for buying opportunities in further market dislocations.
- The writer is managing director, chief investment officer and head of investment products and solutions, UOB Private Bank