Brexit and the Long Term

The June 23 vote by the U.K. to leave the European Union touched off a volatile few days in capital markets ranging from stocks to bonds and currencies. In the time since, markets — and investors — have settled down but big questions remain. While the resulting uncertainty is keeping investors on edge, investment professionals point out that longer-term trends remain in place and opportunities are still available.

In this roundtable discussion, Adrian Helfert, head of global fixed income USA at Amundi Smith Breeden, Arnab Das, head of emerging market sovereign and macro research at Invesco Fixed Income, and Ellen Gaske, principal and lead economist for G-10 economies at Prudential Fixed Income, explore the impact of the Brexit vote, what investors need to know now and where long-term investment opportunities lie.

Adrian Helfert: Financial markets are certainly opining that the economic implications are going to be more limited outside the U.K., and somewhat even within the U.K. Looking at something like the FTSE 250 [stock index], it's not far off from where it was since the Brexit event. Consumer sentiment has dropped significantly in the U.K., but if you look at the broad event affecting eurozone economies, it hasn't been as heavily impacted.

Arnab Das: The market has recovered so strongly partly because it is primarily a domestic U.K. shock — at least so far, though we are concerned that there will eventually be some spillover from the UK slowdown to the eurozone. The financial sector, in particular the weakest links in the sector, such as the Italian banks, lagged the recovery in risky assets as the Brexit shock dissipated on expectations of new monetary policy stimulus.

The combination of a strong rally in risky assets in general, and some bank stocks being left behind suggest that this expectation of yet more liquidity from central banks is another boost for risky assets, at least where solvency or business model risks and economic growth risks are not that prevalent.

Ellen Gaske: Political uncertainty in the U.K. is being resolved faster than we initially anticipated. It's a reminder of one of the U.K.'s huge strengths: Its institutions work. We also now know the Bank of England's initial response and the extent to which interest rates have rallied and sterling has depreciated, all of which should help cushion downside economic risks. But it's very early in the Brexit process, so there is significant uncertainty how it will all play out — whether U.K. trading arrangements will stay focused on the European Union or whether they'll turn more outside the EU and, in the process, what the balance of benefits and costs are as a result for the U.K.

Ms. Gaske: Emotions played a large role in the run up to the Brexit vote; they are playing less of a role in the aftermath. Investors are sorting through which sectors and companies are likely to be affected by potential changes in the U.K.'s global trading arrangements and which ones will be more immune to the process.

An added dimension to the analysis is separating which companies and industries are likely to benefit or be hurt by the now lower value of sterling and lower interest rates. So I think the market is getting on with the business of rationally sorting through the aftermath of the vote.

Mr. Das: It's pretty unclear what Brexit actually means and how long it will take to play out. The analytical process is fraught with a lot of scenario analysis and a lot of imponderables and intangibles that people are now trying to get their hands around to see what the specific scenarios might be and what the trade-offs are.

The time line for triggering Article 50 and therefore the actual EU exit two years later has shifted from just after the referendum, to some six months down the line, to now possibly late 2017, which would result in a mid-2018 to late-2019 exit.

Mr. Helfert: Emotions on how much central banks will do to support valuations and support the risk environment have gotten a little outsized. On the other side of the question of how are fundamental valuations looking regardless of expected stimulus, very few benefit from Brexit and mostly would expect lower consumer and corporate spending and weaker global trade. Fundamental valuations have been supported — and in some cases stretched — almost purely on the back of expected central bank activity. This expectation has overly depressed implied volatility as well. Emotion is driving the bus.

Mr. Helfert: The probability is still low that we're going to see another singular country exit or another major problem country, but the risk is rising and market risk premia should reflect this political concern, not just in the eurozone, but in other markets such as emerging markets and even the U.S., where populism/anti-establishment is on the rise. Italy is the most important upcoming country to follow with their Five Star Movement and the upcoming vote on constitutional reform.

Mr. Das: There is some risk of a knock-on demonstration effect, some risk of political contagion. In the wake of the Brexit referendum itself, there have been some 34 referendums tabled across the remaining 27 members of the EU. Some of these are also in-out referenda and others are about the specific issue of immigration, coming from existing or incumbent governments or by opposition parties across various countries.

It's hard to say categorically whether this will lead to a breakup or to countries leaving the EU or leaving the eurozone even, but the risk of it will certainly be there. The worse the U.K. does and the relatively better the rest of the European Union and the eurozone do, the less strong those flare-ups are likely to be, and vice versa. So these are issues that we will have to monitor carefully.

Ms. Gaske: Near-term, it's not our base case. But anti-EU parties have gained support in a number of countries, so it is a risk over time that cannot be ruled out. The most disruptive case would be if a member of the eurozone were to exit, but there are factors that could help dissuade them. In the eurozone periphery, for example, government bond prices have rallied massively as a consequence of being part of the ECB's purchase program, so those countries are benefitting from much lower borrowing costs as a result of being part of the system. But we've also seen that economics is not necessarily the overriding issue for voters.

The U.K.'s vote to exit the EU reflects a broader trend in many countries where populations have just become more anti-establishment and multilateral trading arrangements and their attendant rules are being met with a lot more opposition. Regaining a sense of control, regaining sovereignty, have become overriding issues for many voters.

But each country has its own story, so it's something we definitely have to monitor. We'll also be watching Scotland, as its pro-EU stance poses the risk of another independence referendum down the road, and monitoring the extent to which conciliations may be offered to Scotland as the U.K. negotiates its EU exit.

Mr. Das: The financial market movements were very short-term responses to the surprise results. You experienced a very quick and quite sharp adjustment in the immediate aftermath of Brexit. Once that had more or less stabilized and then recovered, the markets found a temporary, somewhat sustainable equilibrium. And now we're in the mode where the short termism is giving way to more longer-term thinking about the implications in the real sector for direct investment and the allocation of resources in the financial sector in the U.K., versus the eurozone overall.

Market participants are still processing the trade-offs that might have to be made, especially the trade-off between immigration and participation in the single market.

Mr. Helfert: There was a short termism right around the referendum results that tactical and super-tactical traders took advantage of (and contagion risk fears drove some assets outside fair values), but strategically and for longer-term investment themes, what changed was the central bank outlook. It drove the majority of asset pricing. The [British] pound is still significantly off, and that's got its own idiosyncratic reasons.

But otherwise I'd say that before Brexit, the market almost looked as if it was pricing with a long-term vision past Brexit. When the vote happened, we saw that short-term volatility, but then the market went back to pricing strong asset prices, with the exception, of course, that yields are lower and the GBP is lower.

Ms. Gaske: What we're left with this at this point is significant uncertainty as to how Brexit will play out in coming years. But we also now have a lower value of sterling, lower interest rates and, in sectors that have the most uncertainty associated with them such as the financial industry, some repricing in equities and credit spreads. From a foreign investor's point of view, the lower value of sterling makes sterling assets in general now look more attractive and we think worth a fresh look.

Ms. Gaske: We are likely to see a pullback in spending while the exact arrangements of the U.K's exit are hammered out and also perhaps during the process of negotiating new trade arrangements with both the EU and countries outside the EU. In fact, some business and investment activities were already slowing ahead of the vote.

But we're also watching for policies designed to cushion the downside effects of that uncertainty on economic activity. The Bank of England reacted fairly quickly by providing support for liquidity and credit, fiscal consolidation efforts are expected to be loosened, and a potential cut in the corporate tax rate is now on the table.

Mr. Das: Everyone is worried that globalization might be at risk, and that there's an element of protectionism here with regard to the Republican candidate for U.S. president, Donald Trump. It's important to make a very clear distinction that this is not what the general idea of Brexit is supposed to be about. There is an element of that because the campaign became about immigration rather than about opening up to the rest of the world, as opposed to being integrated with the European Union, or about deregulation compared to regulation that's supposedly coming out of Brussels.

The philosophical ethos was not about closure but actually about opening. That got changed during the heat of the campaign. That is a danger that everyone has to be watching, and that includes businesses, investors and indeed politicians and governments and civil services around the world.

Mr. Helfert: Business spending and negotiated policies are two of the biggest ones, and consumer sentiment and jobs will be the things that are headlined, with volatility driven by the passporting issue on the policy side. Market volatility will drive new policies and regulations coming out of the eurozone, and we're watching what the direction those policies take as far as strengthening or weakening the whole euro project.

Secondarily, we will watch for rising populism and negative election outcomes in countries like Italy, France and even Germany. I would expect that the European Union may be dampening some of its harsh rhetoric and thinking how they can make the European Union a stronger place. What will move it that direction will be the solutions that are adopted for this and other crises.

Mr. Helfert: Given so many outstanding questions remain, I would expect a higher volatility compensation for the uncertainty in the market. People should be looking for ways to expose themselves to increased volatility. When markets calm down, you can expect to see greater dispersion.

So you want to pick your places where you have some decent transparency and understand valuations, and where it's been mispriced, because a singular factor is leading to mispricings and excess (or lack of) compensation for risk in certain areas, like emerging markets.

Positioning in financials/banks is right now a key area for investors to right-size their portfolio. I like European banks over U.K. banks for several reasons, but as a medium-term thesis, I expect the Europeans are going to be supportive of their banks via regulation and, if needed, capital. Subordinated positions in the capital structure in Europe are looking more attractive than they have in the past. Corporates are still an attractive area for excess compensation, as well as sectors that have U.K. economic exposure.

Mr. Das: We're likely to see the eurozone move from above-trend growth to somewhat below-trend growth over the course of the next year-and-a-half to two years, but not as sharply and not as far as the U.K. All of that pressure on growth will further suppress inflation, which has already been quite low in the eurozone. As the risk-aversion factor comes out of bond yields, we'll still be left with bond yields that are somewhat higher than they are now, but still significantly lower than they were before the Brexit event. So all of this points to a general environment of low yields and continued yield-seeking amid these occasional shocks.

Ms. Gaske: Volatility is likely to ebb and flow as the Brexit process unfolds, particularly when individual industries come into the crosshairs of negotiations and hit headlines. The treatment of financial services is an important issue, given its large share of the U.K. economy and its exports. We could also see volatility around particular deadlines in the negotiation process.

But given there's a global ongoing need for yield at a time when yield is scarce, bouts of volatility can potentially provide important opportunities, particularly if you look at solid credits and credits immune to the Brexit process. So during bouts in volatility, investors could do well to take advantage of them.

Mr. Das: I think the short-term effect, following the initial risk-off response, has been quite favorable for emerging markets, primarily because beforehand the interpretation was that there would be more divergence among the major central banks, which in turn would release volatility; instead, we have more volatility-suppressing QE flowing from the central banks, and less divergence.

Longer term, the big danger here is trade. If the ideas of the Brexiteers and others continue trade integration and eventually create the conditions for another round of trade [negotiations], and if worldwide trade integration increases or the status quo is maintained, then that will turn out to be a good thing. But global trade has already taken a hit, both in value terms, because of the strengthening of the dollar over a period of years, and also to some degree in volume terms. Further declines in the growth of global trade, or setbacks in trade integration would be quite bad news. The main beneficiaries of trade integration and financial and economic globalization have been, primarily, the emerging market countries.

Ms. Gaske: I'd watch the extent to which emerging markets benefit from G-4 central banks maintaining a more dovish stance than previously expected. I'd also watch over the medium term for the possibility of trade deals between the U.K. and some of the emerging market countries.

Mr. Helfert: The primary immediate consideration in emerging markets is the positive effect from the lower developed market interest rates. Given the flow effects from yield-seeking investors, this helps financial conditions in EM. Medium term, the direct trade (and subsequently growth) impact is muted given low terms of trade exposures.

Longer term, we could see a significant rebalancing of the terms of trade across the emerging world to developed markets. On this note, the U.K. exit gave a little bit of a lift to Donald Trump's U.S. presidential bid, which subsequently led to a negative impact on the value of the Mexico peso. So we're seeing dynamics happen elsewhere in the world that are related in a very ancillary way to Brexit. The central and eastern European countries are the most directly exposed to U.K.-related vulnerability, places like the Czech Republic as well as Poland and Hungary.

Ms. Gaske: Being short sterling is a crowded trade at the moment, which cushions its downside risks, at least in the near term. But we're just now starting to see post-referendum economic data…as actual data is released confirming a slowdown in activity and Brexit uncertainty persists, sterling could come under further pressure. Longer term, though, as more of the Brexit uncertainty is resolved and investors continue to look through the rubble for opportunities, sterling could potentially start to perform better.

Mr. Helfert: The cable (the U.K. pound) has room to fall farther from this base level, based on fundamentals such as the current account readjustment, and is still pricing in the possibility of an ending such as a Brexit-lite and a more limited economic impact. The most directly observable impact will be in the emerging market countries gaining value as flows go to higher yield differentials. Effectively, it supports the carry trade. The impact on the other G-4 countries' exchange rates is more dependent on their own central bank reactions looking forward.

Ms. Gaske: It was an area of risk the Bank of England's Financial Policy Committee identified in advance of the referendum. The problem was partly the nature of the assets, given increased uncertainty about the demand for commercial real estate as trading arrangements with the EU — particularly the issue of passporting in the financial services industry — need to be resolved. Added to this increased uncertainty was a classic case of asset-liability maturity mismatch given the short-term nature of the funding. So, yes, I think it was specific, although other instances may also crop up as Brexit negotiations unfold.

It does point to a broader issue, though, which is the U.K.'s large current account deficit and the foreign financing that it requires. Before the referendum, the deficit was widely recognized as a vulnerability and a reason to expect sterling would likely decline in the event of a vote to leave the EU, and that's what we saw. But the drop in sterling could help improve the current account deficit over time, mitigating this source of risk to some degree.

Mr. Helfert: One positive, in light of Brexit, is the possibility that it actually leads to a stronger eurozone.

A hope is that this is just as it's headlined, a nonbinding referendum, which over 1,000 lawyers in the U.K. said was nothing more than consultative. This could then simply push the EU into making broad adjustments in areas such as immigration, so that the eurozone is more attractive for all of its members. This is certainly needed as the eurozone is currently at an unstable equilibrium.

On one side, if we have a strong U.K. exit, and if things go awry, we could see the entire European Union project fall apart. On the other side, a stronger EU would be something that would alleviate it from the more frequent crises that are being seen in the eurozone.