The Referendum is almost on us, but what happens post the vote? This outlook aims to provide a view on how we see events unfolding and what our response as portfolio managers may be.
It is virtually impossible for markets to focus on the global economy when faced with an imminent political risk event like the UK’s EU referendum. The opposing outcomes are so different, and the potential for market reaction so severe if the result is ‘Leave’, that the politics trumps all, and forces near-term caution on all the prudent investors; even those who – like us – see an improving outlook for the global economy and corporate profits. But the political event risk will pass, one way or another, in a few days.
Assuming we ‘Remain’, the threat of uncertainty will fade and investors can refocus on the improving economic cycle. Europe continues its gradual recovery, and looks set to benefit from stronger global trade this year; fiscal stimulus and targeted measures to support housing markets; stabilised growth will pervade in China; and perennial concerns over Chinese debt can fade into the background. And – despite one month’s data showing a slower pace of job creation in America – most indicators for the US point to continued employment growth, higher wages and a sustained improvement in consumers’ spending power, which is still receiving a boost from low energy prices. That’s good news for global exporters. Corporate earnings should be able to grow in this environment.
Assuming we ‘Remain’, the threat of uncertainty will fade.
Yet, investors are cautiously positioned and holding near-record amounts of cash: if the BREXIT risk recedes and the global economy remains on track, investors are likely to be tempted back into assets with greater return potential, and that can support better stock market returns through the remainder of the year. Inflation pressures continue to build too, as commodity prices have stabilised, rents continue to rise and wages (a big driver of services price inflation) continue to grind higher in tighter labour markets: global bond yields are close to record lows, but this surely reflects investor risk aversion rather than a realistic near-term outlook for inflation. Bond yields can push higher if investor focus shifts back from near-term fear to medium-term inflation pressures.
If it’s ‘Leave’, the uncertainty will intensify. We can be pretty confident of significant weakness in the Pound: the UK’s huge current account deficit requires substantial capital inflows to the UK, and we suspect that those capital flows would at the very least be disrupted by uncertainty over the UK’s future trading relationships with Europe. Other impacts are less certain, but most independent economists project a meaningful negative impact on GDP growth, capital investment, jobs and housing in the UK, with negative implications for UK corporate profits. Of course, this affects domestic mid-cap companies more than the globally-oriented large caps of the FTSE 100, but investors may not make the distinction in an immediate knee-jerk aftermath. We suspect there would also be significant near-term implications for other assets, especially European equities, peripheral bonds and the Euro, as investors speculate on the possibility of other EU members leaving. Under some scenarios, the vote could become a significant risk-off event for most global markets.
So this is the near-term challenge we face: construct portfolios for the medium-term world post-referendum in the most likely scenario (which is still, despite the recent shift in polling, Remain) but ensure we have some near-term protection both against volatility in the lead-up to the vote and against the shifting probability of a Leave result. We are ready to shift exposures rapidly if polling indicators break one way or the other; and ready to act quickly in the aftermath.
We retain favoured equity positions, with an emphasis on Europe and Asia – where stocks look cheap versus history and where earnings growth potential is strongest; but we also have substantial risk buffers – as at the end of May cash and short-term bonds are over 18% of the portfolio, with a further 16% in government and public sector bonds (including US Treasuries) and 4% in Gold. We also have well over a third of the portfolio allocated to currencies outside Sterling – substantially more than our long-term norms for our portfolios – mostly in the US Dollar and Euro. This could help shield investors from volatility if the Pound does indeed come under more pressure around the referendum.
Deputy Chief Investment Officer
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