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Moving To A More Defensive Strategy After The UK Referendum

Last month, we hedged our equities overweight position ahead of the UK vote. We believe the decision to leave the EU will hurt the UK’s growth and heighten global uncertainties for some time to come. As a result, we further derisk our positioning. We reduce our equities allocation to an underweight, while moving into cash and gold.

  • After almost completely pricing in a ‘Remain’ victory, markets have turned sharply to price in the ‘Leave’ result. Sharp corrections in currencies are hurting risk appetite in equities and other asset classes.
  • Looking forward, uncertainty is the main challenge for both economic fundamentals and markets. We believe that uncertainty may remain with us for some time.
  • How long global risk appetite is affected for, largely depends on the impact of Brexit on Eurozone growth and confidence. If Eurozone growth holds up, global risk appetite may gradually recover. But political turmoil could hurt Eurozone growth more significantly. In this scenario, the impact on the US and Emerging markets would be more significant as well.
  • We had already derisked our model portfolio in recent months, but we taken some further steps. For now, we are not buying on dips.

Principal calls in our model portfolio: Overall de-risking

1. Moving equities to underweight: We reduce equities for the benefit of cash and gold.

2. Within equities: We maintain our existing UK underweight and lower Europe to underweight. We also make a small reduction to EM Europe and EM Latin America. All of these changes are to the benefit of our US equity allocation.

3. Bonds: We expect to see continued volatility in GBP credit, but believe UK inflation-linked bonds could benefit from rising inflation expectations. As we foresee more EM currency volatility, we reduce EM local currency bonds to neutral.

4. The search for yield continues: as the US Fed may hike even more slowly, infrastructure and sustainable dividend strategies should benefit.

5. Currencies: our changes are in line with reduced global risk appetite. We upgrade JPY and USD, while we lower our GBP, EUR, NOK and CAD views.

Market reaction to the referendum vote: What a roller-coaster!

  • Last month, we pointed out that we thought markets were overly complacent, with global equity volatility being towards the bottom end of the 5-year range.
  • It was only in early June that markets seemed to pay attention to the potential global risks coming from rising odds of a ‘Leave’ vote, as a result of a poll going into that direction. Volatility spiked and GBP sold off.
  • However, in recent days, markets had again become increasingly confident of a victory for the ‘Remain’ camp. As the voting ended, a ‘Remain’ victory was rapidly being priced in almost completely, with GBP/USD rising to just above 1.50.
  • Overnight, this all changed. Although London, Scotland and Northern Ireland mostly voted to ‘Remain’, in many areas this was by a lower margin than expected. Conversely, in much of England, the victory for ‘Leave’ was higher than expected. As a result, markets are in a sharp ‘risk off’ mode.

Following the UK’s vote to leave the EU, we are seeing – or expect to see (as indicated) – the following market reactions:

  • Global risk appetite is hit hard, and markets are in sharp ‘risk off’ mode. Some of the moves are exceptional, as many markets move from almost pricing in ‘remain’ all the way to pricing in ‘leave’, just in a matter of hours. The speed of the correction by itself can cause illiquidity and the potential for markets to overshoot. The impact of unwinding of positions is hard to assess. The binary outcome had caused some investors to reduce bets in recent weeks, but the confident tone of markets going into the referendum may have caused investors to build positions that now need to be unwound.
  • The initial market reaction is probably most significant in currency markets. GBP had been the best barometer of the ups and downs in the referendum sentiment, and is therefore correcting sharply. EUR is the next to follow, with NOK and SEK also being hit, while the typical safe havens such as JPY and CHF/EUR are benefiting.
  • Equity markets are hit, with the UK and Europe in the focus, but the Japanese market also suffers from the strengthening of JPY, and most other global markets are down too. The UK has relatively low trade links with emerging markets, but the global hit to risk appetite, combined with the somewhat stronger USD are still hurting sentiment towards EM somewhat.
  • Bond markets are more mixed, with safe haven bonds benefiting, but credit markets generally weaker. While Treasuries are the main beneficiaries, UK gilts are up too, reflecting the likelihood that the UK government will remain a high rated credit. In credit markets, lower rated securities are mostly underperforming better rated ones, and financials are underperforming non-financials, especially in the UK and Europe. Peripheral markets such as Italy and Spain are underperforming the Eurozone’s core markets.

The medium term reaction: Looking at fundamentals and the new valuations

Economic growth

The first fundamental to look at is the economic growth in the UK and the Eurozone. In recent months, some spending or investment decisions in the UK had been delayed due to the uncertainty, and the question is now whether foreign CEOs will find the UK a less attractive place to invest. The second area of uncertainty is related to consumer confidence, with some consumers happy about the outcome, but others wary about the implications for them. Consumers may also be hit by the loss of buying power resulting from the weaker GBP, which should increase the cost of imported goods and boost inflation.

For the Eurozone, the impact on economic growth could be contained, given relatively low dependence on trade with the UK, the boost to competitiveness coming from EUR weakness, and continued intra-Eurozone trade in a market with 444million people. In fact, we expect only a -0.2% impact on 2017 Eurozone growth. However, the fear of political contagion and the hit to sentiment could be more damaging, and if serious, growth could drop more sharply (Spanish elections are held this weekend, and Italian constitutional reform is due by October). Economists typically find the impact of changes in confidence on growth very difficult to model. This point is critical, however: global risk appetite will be much more correlated to Eurozone growth than to UK growth, given the importance of the Eurozone economy.

Rates

The risk of weakness in global growth coming from a slowdown in the UK and the EU, together with the market turmoil we are observing currently should cause the Federal Reserve to  postpone rate hikes, if they continue to incorporate ‘global developments’ in their decision making process. This should, with time, help ease market tensions somewhat and help cap USD, even if it is unlikely to have a significant short term effect. Bond yields should remain lower for longer, and may focus the markets’ interest (which is likely to be lower than before) into relatively defensive strategies such as credit (with reasonable ratings) and equities with resilient dividend income.

As for the UK, we think the Bank of England will be on hold. Hiking rates to respond to higher inflation would hurt already weak growth, while cutting rates could make financing the UK’s substantial current account deficit even more difficult and cause a further fall in GBP.

Global central banks would likely act if there were any signs of developing stress in interbank markets. Both the Bank of England and the European Central Bank have announced that they stand ready to provide additional liquidity if required.

Currencies

Currency movements can have a significant effect on other assets’ prices. In the case of the UK and the Eurozone, we are already observing a break with the recent experience of a weaker GBP leading to support for UK stocks (except for exporters) . We believe that for the UK and the Eurozone, stocks and currencies will both move with risk appetite, and in the same direction. This is different in Japan, where JPY strength is leading to weakness in the Japanese market, in particular because the Bank of Japan has been hesitant to act against JPY strength in recent months and some investors believe it has become less effective in supporting economic growth.

USD strength tends to lead to some weakness in commodities, and this may be exacerbated by any downward revisions to Eurozone and UK growth and hence commodity demand. However, in the case of oil, impact on prices may be tempered, by reduced supply and declining US oil inventories. For emerging markets, USD strength and commodity price weakness are generally challenges, except for some oil importers. This may be somewhat offset by lower risks of US rate hikes.

Changes to our views and our model portfolio

Last month we hedged the small 3.5% overweight to equities in our model portfolio as we believed that markets insufficiently priced in the risk of a ‘Leave’ vote and potential of volatility ahead of the vote. We also believed that the upside for risk assets in case of a ‘Remain’ vote was smaller than the downside in case of a ‘Leave’ vote.

 

Jose A. Rasco is the Chief Investment Strategist for HSBC Private Bank-Americas. He is a member of the Global Private Bank Investment Committee. This column is for informational purposes only. It consists of general market commentary and should not be relied upon as investment advice.

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