There are times when the less expected outcome prevails, like on Friday, June 24, 2016 when the citizens of the United Kingdom voted to leave the European Union. Everyone is now left pondering what might happen next.
The comments below reflect Russell Investments’ strategist and multi-asset portfolio management teams’ thinking on June 24, as shared on a conference call hosted for our financial advisor clients, about the potential implications of Brexit on global markets and economies.
Four watch points going forward:
- Financial market reaction
Financial markets – including equity, currency and bond markets – are the most immediate barometer of the global impact of Brexit. Markets globally were hit hard with the UK, Eurozone and Japanese markets reacting most strongly so far. On a relative basis, the U.S. equity market has lagged to a lesser degree, while U.S. bond markets have rallied in a flight to safety. We see a broad contagion scenario as a possibility, but that is not our central scenario.
- Political consequences
As a result of the referendum outcome, current UK Prime Minister David Cameron announced his resignation. The UK leadership faces decisions about a new Prime Minister and whether to honor the referendum outcome and invoke Article 50, which officially starts the exit process from the European Union. There is uncertainty regarding the outcome of the negotiations between the UK and the EU and other trading partners – and any precedent these discussions might set for other EU member states contemplating a similar referendum. Questions also loom about potential independence referenda in Scotland and Northern Ireland, which had overwhelmingly voted to Remain part of the EU. These uncertainties are likely to drive continued volatility.
- Economic growth impact
There is no doubt that the uncertainty triggered by the Leave outcome will be felt in the real economy – consumer and business spending, producer confidence, housing market, foreign direct investment – of the UK. The question is how big will the impact be?
- Central Bank responses
Currency market movements on Friday suggest an expectation that the Bank of England and Bank of Japan will respond by increasing liquidity.
Potential investment opportunities
Our valuation, cycle, sentiment investment decision-making framework is currently guiding us to be risk managers rather than risk takers in navigating the volatility ensuing from Brexit. We see opportunity to buy the dips – capturing opportunities where risks and prices aren’t aligned.
In particular, we believe Eurozone equities represent good value now, even despite the Brexit risks, relative to U.S. equities. Brexit naturally introduces some risk into the Eurozone business cycle, but the U.S. business cycle is risky because of its advanced age.
Expectations of the Federal Reserve’s response
The Brexit outcome is unlikely to change the Fed’s plan of continuing to raise rates at a measured pace. It does, however, likely change the speed with which the Fed will implement that plan. As it has done in preceding months, the Fed will watch for signs that the U.S. market and economy are on solid footing before raising rates.
Potential implications for the U.S. economy
Our baseline view of 2% U.S. GDP growth in 2016 remains in place. We believe the U.S. economy will be resilient to global growth concerns, not least because the U.S. is a large, closed economy in the sense that trade accounts for only a small portion of GDP growth relative to the U.S. consumer which remains strong. The UK represents just 3% of U.S. trade – to put that in perspective, China represents 21% of U.S. trade. In the same way that the U.S. economy has been resilient to the slowdown in the Chinese economy, we expect the U.S. economy will be able to weather any potential UK growth slowdown resulting from Brexit.
The bottom line
The Brexit outcome was not widely expected and will undoubtedly continue to impact global markets, the UK economy, international politics and central bank responses. We believe volatility will persist but that opportunities exist for investors who stay invested and are nimble and broadly diversified in multi-asset portfolios.