On June 23, voters cast their ballots to decide the U.K.’s future in the European Union. While many opinion polls leading up to the referendum were suggesting the race was too close to call, investors appeared increasingly confident that a “Remain” vote was all but assured. A few hours after the polling stations had closed, however, it was clear that the markets had gotten this badly wrong.
Though the “Leave” vote has set off the U.K.’s biggest political and constitutional upheaval in 70 years, our initial response was that fears of a “Lehman moment” were overblown. And, in fact, market reaction for the most part has been muted. While the announcement of the results sparked an immediate flight to quality, global markets in general have since recovered. The FTSE 100 Index powered back through its pre-Brexit level within a week, and the S&P 500 followed soon afterwards. The VIX Index of implied volatility in the S&P 500, often taken to be a measure of investor fear, moved back below its historical average after a brief spike. In credit markets the spread between BB and CCC rated high-yield bonds, often a herald of economic difficulties ahead, barely registered the event. Neither high-yield nor investment-grade spreads in the U.S. moved significantly, especially compared with the move at the beginning of the year when credit markets were genuinely pricing in concerns of a recession.
That’s not to say there haven’t been pockets of more lasting damage. Markets that are more exposed to the longer-term implications of Brexit have re-priced for weaker performance. The FTSE 250—which better represents the U.K. economy than the global, often U.S. dollar-earning companies in the FTSE 100—remains under its high-water mark, as do European stocks. And then of course there is the pound sterling: its 8% drop against the U.S. dollar on June 24 was the biggest one-day decline for more than 40 years. But even in the U.K. the credit market reaction has been tame; investment-grade spreads have widened 10 ‒ 20 basis points, but almost all of that has come from the financial sector.
If investors want to look for a broader impact, they should keep one eye on bond markets and the other on the way the political wind is blowing. Brexit hasn’t changed the slow-growth, low-inflation and low-interest rates dynamic we have endured since the financial crisis, but it may have amplified it. While it chose to sit tight at its July meeting, the Bank of England cut rates and announced a bond purchase program in early August. The market in Fed Funds futures, which represents expectations for the path of U.S. interest rates, now forecasts that the Federal Reserve will be on hold at least into next year. As the table shows, in the immediate aftermath of the Brexit vote low interest rates in most parts of the world were forecast to be even lower in a year's time.
The combined expectations for extended political uncertainty, slow growth, low inflation and further bond purchases by central banks spurred demand for safe haven government bonds, sending prices so high that the yields on those bonds went negative. The two-year U.K. government bond yield fell below zero for the first time ever in the week after the vote, the 10-year U.S. Treasury yield has hit historical lows and the German Bund yield has sunk to uncharted depths. Turn to the traditional safe haven of Swiss government bonds and it’s hard to get a positive yield even if you lend for 50 years.
Little Monetary Policy Tightening is Expected Worldwide
| Market-Implied Policy Rate | |||||
| Current Policy Rate | In 12 Months’ Time | In 2 Years’ Time | In 3 Years’ Time | Implied 1-Year Change in Policy Rate | |
|---|---|---|---|---|---|
| U.S. | 0.38% | 0.36% | 0.45% | 0.57% | -0.02% |
| Mexico | 4.25% | 4.98% | 5.32% | 5.64% | 0.73% |
| Eurozone | 0% | -0.20% | -0.24% | -0.21% | -0.20% |
| U.K. | 0.50% | 0.12% | 0.13% | 0.20% | -0.38% |
| Switzerland | -0.75% | -1.05% | -0.94% | -0.96% | -0.30% |
| Poland | 1.50% | 1.23% | 1.34% | 1.63% | -0.27% |
| Australia | 1.75% | 1.34% | 1.42% | 1.48% | -0.41% |
| Japan | -0.05% | -0.34% | -0.40% | -0.38% | -0.29% |
| China | 1.50% | 1.58% | 1.75% | 1.94% | 0.08% |
| India | 6.50% | 6.37% | 6.56% | 6.78% | -0.13% |
Source: Bloomberg. Data as of July 7, 2016. The implied policy rate is derived from interest rate futures contracts for each respective currency.
This can be a sign that investors are more concerned about the return of capital than the return on capital. However, while low long-term interest rates do put banking-sector profits under more pressure—and financial-sector equities and bonds have sustained longer-lasting damage since Brexit—we are not yet persuaded that this rush into bond markets forecasts similar gloom for non-financial corporate earnings. As we have seen so far, equity markets appear to agree.
When it comes to politics, Brexit is far from the last of the potential shocks coming our way. Despite fast progress putting together a new cabinet, there are still a lot of unanswered questions within the U.K. itself. Meanwhile, Spain’s general election at the end of June kicked off an 18-month cycle that will include Germany, France, Italy and the Netherlands, where anti-E.U. parties are taking heart from the U.K.’s vote. And of course the U.S. will choose its next president in November: as former Treasury Secretary Hank Paulson said at Neuberger Berman’s CIO Summit in June, neither candidate is promoting a positive view of global trade and investment.
If the U.K.’s vote turns out to be the blow that finally cracks the edifice of international political and economic cooperation built over the past 70 years, we could see more than a localized effect on growth prospects. That is not our base case, however. The world needs structural reform and a more appropriate fiscal response to the current malaise if its economies are going to grow on a proper footing and its companies are going to generate sustainable earnings growth. Part of that progress will involve addressing the legitimate concerns of those who have failed to benefit from globalization, but in our view, populism and political division are not the way to do it. In that respect, Brexit was hardly good news. Nevertheless, we believe its effect will likely be marginal, and the market’s initial response could create opportunity for patient investors with cool heads, who focus their attention on economic fundamentals rather than headlines.
Additional Thoughts from Benjamin Segal
Whatever else it may mean, the result of the U.K. referendum on leaving the European Union represents uncertainty. What will the new prime minister’s priorities be now that she is in office? When will the U.K. leave the E.U., and under what terms? Indeed, will the U.K. leave at all? What does that mean for trade between the U.K. and Europe and for investment in the U.K. itself? How might this result affect anti-EU factions across Europe? We are in uncharted territory, and market participants appear to be taking a cautious view until the way forward becomes clearer.
The initial sharp decline in equity markets and spike in volatility were a testament to that uncertainty. Markets sold off in the immediate aftermath of the vote, but recovered some of their losses as June came to a close, with many in July moving beyond pre-Brexit highs. The FTSE 100 Index, having declined by over 5%, was already 3% above its pre-referendum level on June 30—although adjusted for the 11% decline in the pound sterling the index was still down 8% by month’s end. The more domestically focused FTSE 250 Index was hit more severely, while the MSCI Eurozone Index was down 8% in U.S. dollars. European banks were impacted significantly: the EURO Stoxx Banks Index was down 19% in euros (21% in U.S. dollars) between June 23 (the day of the referendum) and the end of the month.
Near term, the U.K. holds the greatest concern, as consumers and corporations adopt a “wait and see” attitude to spending and investment. Longer term, however, we believe the prospect of a weaker pound and more pro-business policies offer great opportunities for U.K. companies and the economy overall. In continental Europe, the loss of an important EU member is a challenge to economies that—outside of Germany—are still operating below potential. The European Central Bank is likely to maintain interest rates at a very low level, which poses ongoing problems for the banking sector.
We remain focused on companies that appear well-positioned to withstand volatility: profitable, cash generative businesses with strong balance sheets. The U.S. and emerging economies should be less sensitive than Europe’s or Japan’s, and therefore companies with global revenues appear better positioned, implying a preference for large caps over smaller companies. Our conviction on quality is unshaken, as is our affinity for Swiss multinationals. We remain skeptical that Japan can manage with the sharply stronger yen. We have yet to conclude, however, whether the lower prices in the U.K. and euro zone represent a buying opportunity, or whether further downside risks remain.
