Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, John Bilton, Head of Global Multi Asset Strategy, JP Morgan Asset Management, asks what the EU referendum vote will mean for asset allocation.
We consider three key scenarios:
A clear vote to remain That is, a winning margin of 10 points or better with all the home nations agreeing to stay in the union: In this situation, we would expect a relief rally in sterling, with UK stocks outperforming Gilts and UK domestic sectors performing well.
A marginal vote to remain Anything less than around a 52% majority to remain and/or different outcomes in the vote across home nations: In this situation, we would expect only a short-lived relief rally in sterling, with risk premia in other UK assets remaining elevated and potential for some weakness in European assets.
A vote for exit This would lead us to expect a sharp sell-off in sterling, weak performance of UK stocks relative to safe haven Gilts, and underperformance of financials and related sectors.
Sterling Will Be the Focal Point of the Vote Impact
Historical patterns tend to show clusters of currency volatility around political events, such as the Brexit vote, with sterling acting as a lightning rod for the financial market reaction to any such event. To date, sterling has certainly been the most sensitive of UK assets to the Brexit debate – so much so that the Bank of England, in its May inflation report, adjusted the impact of currency on its growth and inflation forecasts. According to the Bank of England analysis, half of the 9% depreciation in sterling over the last six months is attributable to referendum uncertainty.
Broadly speaking, in the event of an exit vote, sterling would bear the brunt of the reaction. Relative to the USD we could see it dip 10%-15%. On the other hand, a vote to remain could spark a sterling rally.
Impact on Fixed Income Markets
More difficult to evaluate is the impact of the referendum on UK bonds, which will be influenced by several factors. First, the insatiable appetite of central banks around the globe to buy bonds – which supports all major government bond markets – is not going away, regardless of the vote outcome. Second, Gilts are sensitive to the domestic economic outlook, which could darken in the event of a vote to leave, creating further support for Gilts as investors dial down risk by switching from stocks to bonds. Third, the risk that the BoE restarts its quantitative easing program is also acting to cap yields. These factors would be supportive of Gilts in the event of an exit vote.
Impact on Equity Markets
And what of the equity market, the main area of concern for investors? Regardless of one’s personal view on the referendum, no one can dispute that stock markets dislike uncertainty. Thus in the immediate aftermath of the vote, we see UK equities rallying on a remain vote and sinking on an exit vote.
Once the initial currency volatility subsides, equity investors should look to sectors that benefit from a weakened pound. Industries that are less domestically focused, with significant non-sterling revenues, governed by global factors but listed in the UK, including health care, beverages, resources and energy, could ultimately outperform the broader market index. By contrast, domestic consumer discretionary and related sectors could underperform. Banks may also underperform, despite a reasonable share of international revenues, partly because of uncertainty about where inflation, growth and, in turn, base rates are headed.
If there is a marginal vote to remain, we would be likely to fade any relief rally in the UK equity index.
Conclusions
For asset allocators seeking to decode the Brexit puzzle, sterling should remain the main focus of attention. We emphasise one crucial fact: 38% of the UK’s exports go to the Europe. Whether the UK is in or out of the EU, Britain’s and Europe’s futures are inevitably intertwined. Thus, when we think about investment implications of the Brexit vote, we should bear in mind that the verdict could have a profound impact, short-term and long-term, on European as well as UK assets. The UK may be an island, but its financial markets are decidedly not.
Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com
