Brexit – Implications for the Financial Markets

Economic Outlook | June 24, 2016

David Hussey, Head of European and EAFE (Europe, Australasia and Far East) Equities
Daniel Janis, Head of Global Multi-Sector Fixed Income
Paul Boyne, Lead Portfolio Manager, Global Equity Strategy
Thomas Goggins, Senior Portfolio Manager, Global Multi-Sector Fixed Income

Global markets have been roiled by the unexpected outcome of the UK Referendum on its membership in the European Union. Brexit has become a reality. While an initial knee-jerk is to be expected, what does the vote mean for investors from a more nuanced, longer term perspective? Manulife Asset Management’s managers share their views.

David Hussey, Head of European and EAFE (Europe, Australasia and Far East) Equities

This morning it became evident that the UK would leave the EU. Markets have underestimated the political shift in the UK. The assumption that the wider population were unwilling to rock the economic boat in the UK by voting 'remain' has been proved wrong. At least half the UK population, and specifically those living outside of urban areas are clearly dissatisfied with their lot and have staged a protest vote1. Many of these people have not benefitted from Quantitative Easing or London house prices inflated by foreign capital inflows.

This vote to leave the European Union may well be a game changer for the European economy and European project and possibly spill over to the global economy. In the short term, expectations of economic momentum across Europe will decline and businesses and consumers will react cautiously. Hence, we believe a recession is now a distinct possibility. Therefore, we will revisit our expectations of growth in our cashflow models and assess the impact on valuations. In the medium term, the more sinister spectre of the collapse of the European Union as another country considers exiting is a possible scenario we must now consider seriously.

However, it is important to note that not all UK firms will be adversely affected - for example, companies that earn foreign revenues with almost no exposure to the domestic UK economy and are most exposed to the wider global economy. We believe they will outperform in a scenario where investors question the sustainability of the European project. Secondly we have been nervous for some time on the UK domestic economy with or without a Brexit scenario and have been relatively cautious towards UK financials and consumer stocks. It is also worth mentioning that volatility episodes such as today’s offer good opportunities for active long term investors. This is what we are doing today in favored names exhibiting strong free cash flow yields with reinvestment opportunities and trading at a significant discount to their long term value.

On a final note, the rejection of the political status quo we've witnessed today by those left behind in recent years may well not be an isolated UK event and could spread to Europe and the USA. We have been warned.

Paul Boyne, Lead Portfolio Manager, Global Equity Strategy

We are bottom-up stock pickers and long term investors. While the macro environment is considered, it is not expected to be a driver of performance nor is it a driver of portfolio construction. Brexit has caused a tremendous amount of volatility and we believe that volatility will continue as the UK embarks on a two-year period of renegotiations. An anti-establishment tone has been set and volatility will also be caused by the political uncertainty of “who is next?” within Europe.

The British Pound would most likely stay weak for a sustained period of time and companies with a significant exposure to the domestic UK economy are likely to be affected. By the same token, UK firms that earn a significant portion of its revenue abroad would be better placed to navigate through the situation.

As we approached this event, we evaluated our UK holdings to determine the sensitivities both to a "Remain" as well as an "Exit" vote. We determined that some companies would benefit from the currency weakening that would result from an exit vote due to their large non-UK revenue streams.

In terms of positioning, we are staying the course and remain underweight commodity industries and European financials and retain big exposures to 'sustainable' quality franchises with areas such as healthcare and consumer staples. We remain wary of excess leverage and continue to focus on companies with what we believe to be sustainable cash flow streams. Given the uncertainty and volatility, we may see a flight to quality and we believe that companies with qualitative and valuation attributes of quality companies should navigate this transitional period successfully.

Daniel Janis, Senior Portfolio Manager and Head of Global Multi-Sector Fixed Income, and
Thomas Goggins, Senior Portfolio Manager, Global Multi-Sector Fixed Income

What drives the uncertainty stemming from the referendum results?

For the UK firstly there's the political impact; Prime Minister and leader of the Remain camp David Cameron has promptly tendered his resignation, saying that the country has made a 'clear decision to take a different path' from what he had supported in the referendum and as such the country needs fresh leadership 'to take it in this direction'2.

Second, and of more a medium term concern for the UK, is the economic impact from the referendum decision. The economic damage is widely expected to be real but the scale is unknown.

Lastly, and perhaps the largest concern from the referendum result, is around spillover effects, first within the EU but also for the global economy as a whole. Political leaders in many other countries have previously expressed interest in their own chance at a referendum on the EU, and the success of the UK's Leave vote will only embolden them (rhetoric from France, Italy, Denmark and Netherlands has already begun3).

On a global basis, in the immediate aftermath of the Brexit vote, we have heard some firm tones verbally from central banks about how they stand at the ready to act but we've seen limited actual action so far. Bank of England (BoE) Governor Mark Carney noted that it's expected that there will be volatility as developments unfold but that the Treasury and BoE have their contingency plans ready and that the BoE 'will not hesitate to take additional measures as required'4. The Bank will consider if any additional policy responses are needed 'in the coming weeks', which implies no emergency rate cut as some had expected, with the next MPC meeting July 14. We fully expect the response of each central bank around the world to be fluid over the coming days, weeks and months.

We have been maintaining a defensive posture based on the expectation that the volatility over the past 12+ months would continue as result of uncertainty in global growth, diverging central bank policies around the world (including the speed and path of rate hikes in the US) and targeted market events, such as the "Brexit". This meant we have been cautious towards non-investment grade assets and emerging markets debt over the past 2+ years. We also paid particular attention to the issue of duration, and took a conservative stance with regards to foreign currency risk. This posture served us well to protect on the downside in 2015 and should provide stability in light of today's market volatility and sell-off in risk assets.

We believe that a focus on high quality positions in government and supranational debt (e.g. Australia, Canada, US municipals) could help balance overall volatility due to exposures in US corporate bonds and emerging markets issues. One other way of managing volatility is to focus on more stable sectors and avoid lower quality debt. Similarly, within emerging markets, it makes sense to avoid lower quality and less liquid countries. Lastly, given the currency swings, hedging is important.

Looking forward, the team will continue to embrace a defensive posture in the short-term given the uncertainty of the immediate impact on the UK and Eurozone economies as well as the longer-term implications to the global economy and future changes to central bank policies (for example, the US Federal Reserve is more likely to postpone any near term rate hike and high quality government bonds should remain well-bid as investors look for safe havens). With many sectors and countries bond and currency valuations experiencing dislocations overnight, it could also create opportunities to add risk in both fixed income and currency markets, albeit on the margin, in the coming weeks and months, but we will be selective and patient in doing so.

1 Guardian: EU Referendum: Full Results and Analysis, June 24, 2016
2 UK Government: EU Referendum Outcome: Prime Minister’s Statement, June 24, 2016
3 Express: Brexit Spreads across Europe: Italy, France, Holland and Denmark All Call for Referendums, June 24, 2016
4 Bank of England: Statement from the Governor of the Bank of England following the EU Referendum Result, June 24
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About the Author

2016 Mar David Hussey David Hussey

Head of European and EAFE (Europe, Australasia and Far East) Equities

2016 Mar Daniel Janis Daniel Janis

Head of Global Multi-Sector Fixed Income

2015 March Boyne Paul Paul Boyne

Lead Portfolio Manager, Global Equity Strategy

2015 Apr Goggins Tom Thomas Goggins

Senior Portfolio Manager, Global Multi-Sector Fixed Income

The opinions expressed are those of Manulife Asset Management™ at the time of publication, and are subject to change based on market and other conditions. The information in this article including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Asset Management disclaims any responsibility to update such information. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife Financial, Manulife Asset Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Asset Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Asset Management.

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