Be wary of ‘over-simplified’ conclusions from UK’s vote to leave

24th June 2016

Steven Andrew, Fund Manager of the M&G Income Allocation Fund, on the market’s reaction to the UK’s vote to leave the EU and David Cameron’s resignation as prime minister:

There have been significant movements across global financial markets overnight and this morning – some of these moves seem rational, but others may be an over-reaction.

Confirmation of the referendum result removes some uncertainty and creates some other uncertainties. There is always uncertainty but markets tend to react most when we can put a name to it. We have to admit that at this stage, there is a lot that we do not know, so let’s focus on what we do know – how asset prices are moving and how that relates to a broad range of factors likely to influence the global economic outlook over meaningful time horizons.

As global investors, we have to step back from the enormous media attention on this topic here in the UK and Europe and ask whether our perspective has changed on the global outlook. So far, from that perspective, we can say that the ‘story’ – in terms of a narrative of broad political disaffection across many regions, not just the UK – has moved along a bit. Other than that, there is very little we can know.

Nobody likes political uncertainty but there is little sign that this represents a change in regime in that this is not about changing to anti-capital models. Therefore, we should question it when we see markets behaving as if that is what’s going on.

We have to think carefully about what market movements this ‘new’ news justifies. It might be sufficient to justify a 10% overnight move in sterling versus the US dollar, but does it justify a decline of 7-8% in Japanese banks or 6-7% in Portuguese bonds in a single day? Neither of these movements have taken pricing to levels outside of a range already seen year-to-date, but the speed of the moves looks like indiscriminate panic.

How much trade agreements between the UK and EU really have to do with the earnings of Japanese banks? And doesn’t this result make it seem more likely the ECB will do everything in its power to ensure peripheral sovereign bond yields do not spike to levels that could cause instability?

European stock markets have seen double-digit declines this morning. This is unsurprising give that the DAX fell 7% at one point in the run-up to the referendum, so we would not be surprised to see bigger moves than that now that the ‘Leave’ result is confirmed. However, declines of that magnitude may represent an opportunity.

We are watching carefully for buying opportunities in areas which are selling off too aggressively, away from the ‘epi-centre’ of events, if we believe markets are over-extending this news as a ‘negative’ for everything globally.

On the other hand, we would be likely to reduce any holdings in things which are rallying to unjustifiable levels, such as ‘safe-haven’ bonds. US Treasury yields have fallen sharply, but what will affect that more over the period ahead – Brexit or Fed policy in the long run? And will Fed policy be influenced more by Brexit or facts about the domestic economy, such as the employment rate being consistent with expansion?

In European bonds, spreads on core bonds are narrowing and peripheral bonds widening – indicating risk-off and potentially panicked sentiment.

In summary, while this is a significant development, we must be careful of drawing a straight line between this one event and saying that the world has changed in a singularly negative way. We have to be wary of over-simplified conclusions that do not seem well-considered and suggest that this development outstrips everything else in the global economic outlook. There will be many pushes and pulls for the global economy over the next few years – some of them will be about EU trade agreements, some will be about Spanish politics, but some will be about more durable things such as long-run US policy. We have to make sure we are always weighing up all of these things and being mindful of the different risks and opportunities they present in terms of how they affect asset prices.

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