Russell Investments’ Chief Investment Officers (CIOs) highlight key market and economic drivers impacting portfolio positioning and performance due to the recent Brexit decision.
As of June 24, 2016 Sources and indexes used to represent asset classes can be found in the disclosures.
1. Uncertainty reigns supreme
Europe has entered uncharted waters with the surprise vote by the United Kingdom (UK) in favor of Brexit. Uncertainty is clearly elevated, which adds risk to the economic outlook in the UK and also the rest of Europe, Japan, emerging markets, and the U.S.
2. Bank of Japan (BOJ) and Bank of England (BOE) are expected to act
The downside risks to the UK economy from Brexit are meaningful. We expect the BOE to preemptively cut rates to buffer growth. Meanwhile, the BOJ is likely to enhance its own stimulus program, but for different reasons. Yen appreciation has cast a shadow on the earnings outlook for Japanese businesses and will make it harder for the central bank to meet its inflation target.
3. Modest downward pressure on economic growth likely
Uncertainty will likely take its toll. Consumer and business confidence are likely to take a hit in Europe. Financial markets are also a watch point for contagion effects across global markets tied to concerns over European banks. This is not our central scenario, but if it were to become an eventuality it would likely lead to a downgrade of European equities.
1. Remain defensive in the midst of heightened volatility
While results of the vote may have been a surprise, the performance in many of our multi-asset portfolios was up for the week (ending June 24, 2016) in relative terms, because many portfolios were defensively positioned
(as measured by beta relative to market benchmarks) and remain so.
2. Europe ex-UK under the microscope
The immediate market sell-off in Europe as a result of Brexit was severe with Europe, Middle East and Africa excluding UK (EMEA-ex UK) equities selling off by 8%. The market gave up only slightly more return on June 24 than had been gained in the previous week, returning a net of -2% in local currency terms. We remain overweight in EMEA ex-UK equities relative to market-cap weights. However, we are watchful for negative impacts on earnings and sentiment as a result of Brexit and any political or monetary support to prevent further contagion.
3. Diversifiers and U.S. dollar hold up
Asset classes such as high yield, emerging markets equities, and fixed income held up more effectively than developed market equities over the past week (ending June 24, 2016). Each asset class ended the week in slightly positive territory in absolute terms (between 0% - 1%). We are currently neutral to slightly overweight in these diversifying exposures across multi-asset portfolios. Currencies were perhaps the most volatile area with British sterling the worst hit and having the potential to fall further. The slight U.S. dollar overweight position benefited overall performance in our portfolios.
1. Low volatility won the day
Low volatility factors played their role as uncertainty reigned following the unexpected UK referendum result. Interestingly, within the UK all factors, except low volatility, lagged the broad market. Value factors were hardest hit, while momentum was mixed across regions.
2. UK surprised on the upside, Japan on the downside
Although the result was a surprise, the broad market response (e.g., risk aversion, negative sentiment) was not. What was a surprise was the UK market. After falling almost 8% initially, the FTSE100 rallied to be down just 3.2% for the day. Given the downside risks and uncertainty facing the UK economy, this was an “under-reaction” in our view and presents a possible selling opportunity. Currency markets were volatile with the pound plummeting. The Japanese stock market plunged more than 8% as the strong yen casts a shadow on earnings outlook. Given the potential for further BOJ action, we believe this may have been an overreaction, which provides a buying opportunity in Japan. Many of our portfolios remain overweight Europe ex UK, emerging markets, and Japan. Meanwhile, we are underweight in the U.S., UK, Australia, and Canada. The Europe position is under close review, while the emerging markets position may be an opportunity for incremental capital in the near term.
3. Banks are under pressure
Banks sold off heavily in the U.S. and Europe. We are reviewing closely the bank positions in the portfolios with our strategists and our sub advisors and the risks posed by Brexit as well as any possible opportunities presented by the negative market reaction.
1. Don’t panic or call a bottom for yields or the pound
Markets have moved significantly with good cause. Political uncertainty is highly elevated, which does not lend itself to forming high-conviction predictions. For the pound and risk assets generally, there is potential for a technical rebound, though risks remain skewed to the downside. In our fixed income portfolios, we continue to favor U.S. over Europe, both currency and credit, given relative valuations and our economic outlook.
2. Neutral on U.S. duration
Since the market reaction has been in-line with fundamentals, we remain short-to-neutral with regard to U.S. duration. We continue to believe the market has somewhat underpriced the potential for further rate hikes in the U.S., given the domestic economy’s relative strengths. The sharp fall in rates post-Brexit has arguably pushed market expectations further below the Fed’s potential path of tightening. While we do not see the market as being unreasonable, with expectations so low, the “worst-case scenario” has worsened.
3. We continue to favor discipline and diversification in our strategies
Both our real yield and currency factor strategies have performed well during this period.
1. Gold reaps benefit
The bright spot among commodities continues to be metals -- gold in particular, which was up nearly 5% on Friday (June 24) and continues its run after the market reopened. Russell Investments’ Commodities portfolios have benefited from an overweight in gold. Grains have also held up well with corn and soybeans doing the best. Crude and West Texas Intermediate (WTI) continue to experience sell pressure due largely to a strong dollar.
2. Low net exposure is the place to be
Hedge fund managers fairing the best were those that had lowered the gross exposures (value of long plus short positions) and net exposures (difference between long and short positions) going into the referendum vote. Attractive entry points for risk-on trades will develop. However, patience and strong risk management will be key to navigating in the near term.
3. Financials and REITs hit hard
Perhaps the biggest toll has been on the financials, in particular banks across U.S. and Europe, as well as Real Estate Investment Trusts (REITs). UK REITs in particular were hit hard on June 24 (down more than 20%). The Russell REIT portfolios were slightly overweight in UK REITs going into the referendum vote. This had a negative impact on relative return. Since REITs are still largely categorized within the broader financials sector, this too had a negative consequence relative to their underlying fundamentals.