Voters in the United Kingdom (U.K.) have chosen to leave the European Union (EU). We believe this “Brexit” decision will have profound effects on the U.K. market as well as the rest of Europe and the broader global markets. American Century Investments Co-CIOs G. David MacEwen and Victor Zhang share their views on the impact of this decision and our response.
Markets abhor uncertainty the way nature abhors a vacuum. And uncertainty exists about the details and timetable for how the Brexit process will be carried out. First, note that this was only a popular referendum. The British Parliament must now enact a series of legislative moves to implement any changes in the U.K.’s status.
Per EU agreements, there is at least a two-year timeframe for execution of an exit. It will take protracted amounts of time for the U.K. to negotiate new trade agreements with the EU and other countries, including the U.S. Of course, as the world’s fifth-largest economy (see table), it will retain considerable ability to negotiate favorable trade agreements as a stand-alone nation. During any period of uncertainty, though, popular sentiment, economic conditions, and the probability of tariff wars could shift substantially, and the appetite for a “clean break” with the EU could be in flux.
|Rank||Country||2016 Projected Nominal GDP ($T)||% of World|
Source: StatisticsTimes.com. Gross domestic product (or GDP) is a measure of the total economic output in goods and services for an economy.
What are the implications of the vote to leave the EU?
Stocks to correct. We expect U.K.-based stocks to correct swiftly and to drag Europe- based stocks down with them, as a flight to safety intensifies. As with any risk event that adds to uncertainty, other global equities could suffer in the near term until more is known about how the split will be carried out.
We believe bond yields should remain at or near historical lows. Flows to perceived safe-haven credits, such as U.S. Treasuries and Japanese and German government bonds (JGBs and bunds), should further suppress yields. The exception may be U.K. government bonds (gilts), as investors lose their appetite for U.K. credit and prices decline.
Currencies may decline. We believe the British pound (GBP) should decline immediately versus the U.S. dollar (USD) and the yen. The Brexit vote was not fully priced into currency markets in our view, so a sharp correction is almost inevitable. Many currency traders expect an eventual turnaround, as asset managers who had built large underweights leading up to the referendum begin to buy back pounds.
Central banks may intervene. The Bank of England (BoE) and European Central Bank (ECB) may inject liquidity to shore up markets and support investor confidence. However, if flight of capital out of U.K. is significant, the BoE may hold off on easing to support the GBP. The volatility will likely convince the Federal Reserve (Fed) to delay additional rate hikes past their July 15 Federal Open Market Committee meeting and maintain their “data-dependent” stance on future moves.
U.K. domestic firms more at risk. A weaker GBP may be marginally positive for U.K. exporters, as it makes their goods less expensive to overseas buyers. Thus, while the effects of Brexit will play out on a company-by-company basis, we believe that more domestically focused companies will suffer more, at least initially. Large-cap internationals and industrials generally derive a lower percentage of revenues from the domestic economy and thus should be hurt less on a relative basis. However, the EU represents roughly half of the U.K.’s exports as a whole; therefore, it is necessary to consider companies on a case-by-case basis to assess exactly how they may be affected.
Exit will support immigration reforms. We expect a large impact on immigration policy. Anti-immigration, anti-migrant voices will likely become louder in ongoing debates and lead to closing the borders and/or reducing freedom of movement and employment from among EU states. Such moves are not likely to have a net positive effect on the U.K. economy or employment picture in the immediate term, as it may become difficult for companies to hire or retain needed human resources.
Spillover to Europe possible. The rest of Europe must now prepare a response to Euro-sceptic and isolationist voices within their ranks, which will likely be calling for some level of dissolution of the EU as it currently exists. Traction gained by any further dissolution will likely increase volatility in global markets.
Bottom line: U.K. recession is possible, in our view, with potential contagion in Europe and Asia. Reduced prospects for domestic companies, capital outflows amid such uncertainty, and partial paralysis of the world’s fifth-largest economy could result in recession. It will almost certainly result in increased unemployment and GDP contraction. A weakened pound will make goods more expensive for domestic consumers. Uncertainty will only contribute to lower consumer and investor confidence. The rest of Europe will be similarly pressured in the immediate term. The euro is likely to decline relative to other major world currencies, which could undermine some of the recent improvement in economic results there. Any currency weakness that acts to strengthen the USD could also have ripple effects by further pressuring China and the yuan, raising the possibility of an impact on global economic growth.
GLOBAL and NON-U.S. EQUITY
How are American Century Investments’ Global and Non-U.S. Equity portfolios responding to the Brexit vote?
Maintaining our bottom-up perspective. It is important to note that we manage our Global and Non-U.S. Equity portfolios from a bottom-up stock selection perspective and do not make top-down decisions to overweight or underweight any one sector or region in response to macroeconomic events. We evaluate stocks on a company-by-company basis and consider each company’s fundamentals in their entirety rather than in light of macroeconomic events such as this. As such, we will not be making wholesale changes to the portfolios based on the Brexit outcome, but will continue to rely on our bottom-up investment process to identify companies with the potential for positive earnings inflection.
Remaining underweight to U.K. banks. Our global and non-U.S. equity portfolios have maintained underweight positions to U.K. banks relative to their benchmarks, given the expectation that they would be among the hardest hit in the event of a “leave” vote.
Minimizing exposure to U.K. economy. Our small-cap and small-/mid-cap equity portfolios are underweight to the U.K. relative to their benchmarks according to country of domicile. We anticipate limited impact from the Brexit vote on those portfolios. For the large-cap portfolios with current overweight positions, exposure generally includes companies that are global in nature; therefore, in such cases our economic exposure to the local economy is much lower, and we expect the impact to be minimal.
GLOBAL FIXED INCOME
How are American Century Investments’ Global and Non-U.S. bond portfolios responding to the Brexit vote?
Managing risk exposure in response to higher expected volatility. We have been managing our portfolios below tracking error (the difference between a portfolio’s returns and its benchmark’s) targets in 2016, taking into account the potential risk events on the horizon (e.g., Brexit, Fed hikes, Brazil geopolitical issues, U.S. elections, etc.). Therefore, we have planned risk positioning accordingly and are positioned to add risk exposure as we see opportunities.
Opportunistically watching GBP. We anticipate minimal downside pressure to our global and international fixed income portfolios due to any correction in the pound sterling. We were underweight GBP earlier in the year, taking advantage of the currency’s decline as sentiment shifted leading up to the referendum. We have recently shifted to a neutral position, which reduces our exposure to whatever post-referendum moves occur. We will watch the expected post-vote decline closely in the event of any oversold opportunities. Most asset managers sharply underweighted GBP in the lead-up to the vote, and we would expect an eventual rally once they move to reduce or eliminate those underweights.
Maintaining our bank overweight. Our view is that the post-financial crisis regulatory environment to increase bank capital, improve liquidity, and reduce risk in financial institutions will improve their credit profile to the benefit of bondholders over time. Therefore, we are maintaining our positions in euro-denominated and GBP-denominated European bank bonds, with the currency hedged to the U.S. dollar. There will be a lengthy process of negotiating how this event will affect European banks operating in the U.K., and we will respond with any changes we may need to make. Critically, the U.K. is not part of the euro currency, which significantly reduces the potential disruptive nature of any changes. Both the U.K. and the EU have a vested interest in ensuring a smooth operation of the financial system through any transition.
Hedging against expected euro weakness. With the potential for euro weakness post-referendum, we have maintained short positions in select currencies correlated to the euro, particularly countries that are beneficiaries of EU aid. The U.K. is a major contributor of such aid.
The opinions expressed are those of G. David MacEwen and Victor Zhang and are no guarantee of the future performance of any American Century Investments portfolio. For educational use only. This information is not intended to serve as investment advice.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.
Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.