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Brexit: Risks, Realities and Perspectives

Brexit_TAblog The populace of Britain shocked the world on June 23 when in a national referendum the country voted to leave the European Union (EU).  While a book could be written as to why this turned out to be such a shock when all preceding polls indicated the election would be a tight one, and how in the days prior the markets and media could have been so wrong in their prognostications, the more important points to focus on now pertain to the aftermath of this decision and its potential impact on the markets.  In this regard we would like to stress the following:

Risk:  British Recession

As the implementation of the EU departure begins we believe recession in Britain is a real risk given the uncertainties this decision has created.  Global firms with operations based in the United Kingdom will most likely be curbing their presence with U.S. Banks probably being among the first to do this.  The unfortunate truth is that ongoing uncertainty and economic growth are not a match made in heaven.  In addition, a falling Pound could put Britain at risk of “stagflation”, the combination of recession and inflation, as a weaker home currency could make commodities and imports more expensive during a pending economic slowdown.  All of this being said, in our opinion, we don’t currently see a potential recession of the magnitude experienced in 2008 – 2009 simply because the terms and timing of the departure is within the control of both Britain and the EU.  Also the Bank of England and our Federal Reserve appear ready to provide liquidity during the transition.

Reality Check:  Britain’s departure from the EU will be at least a two year process.

Perhaps most important is the fact that there is expected to be about a two year process regarding Britain’s departure from the EU.  Certainly much will be determined and negotiated during this time, however England as we know it is not stopping on a dime and going a different direction tomorrow.  The referendum itself is a non-binding one and while clearly the UK will accept the will of their people and begin the process of leaving the Union, there will be ample time for rational paths taking economic and market conditions into account.  This is a shock event politically and socially but the implementation of this exit in economic and financial terms will be drawn out and deliberate, which we believe favors a smoother outcome than most may immediately recognize.

Risk:  More to follow

Perhaps the greatest systemic fear regarding Brexit would be the risk of other nations, perhaps Italy, France or Spain, taking up the notion of also separating from the EU.  While we do not view this as a high probability in the foreseeable future and the leadership of these countries are probably far less likely to go the referendum route given the dramatic result Britain has just experienced, the overhang as to if and when another shoe might drop is an unwelcome cloud on the European horizon.

Reality Check:  Impact to U.S. markets muted

We believe the overall economic impact to the U.S. is likely to be minimal as we do not see the business models of most American companies being materially impacted.  Probably the biggest risk in the short to intermediate term will be currency fluctuations and their effects on corporate profits, however bear in mind the Dollar against most currencies is still below beginning of the year levels.  It is also important to recognize that Britain only accounts for approximately 4% of the global economy, therefore the risk of a ripple effect moving overseas is unlikely in our opinion and we continue to believe that the U.S. is positioned for 2H16 improvement in both GDP and corporate earnings.

Risk: The Politics of Fear

Emotional sentiment in Britain could remain high for some time as “Remain” supporters took a hardline in their campaigning over the past several weeks as to how bad an outcome of an EU departure would be for Britain.  Much of this was probably campaign rhetoric, however Britain’s leadership must deal with the other side of it now.  The “Remain” contingent of the British political hierarchy must now make the case as to why the future will not be as bleak as they said it would be.  In addition, following Prime Minister Cameron’s resignation Friday morning, there could be more volatility as this leadership transition plays out.

Reality Check:  Putting market reaction in context

After stock futures plunged early Friday morning, U.S. equity markets closed down about 3.5% with the S&P 500® finishing the day just below 2040 which was basically flat on a year to date basis and approximately where it last traded during the middle weeks of May.   It is also important to remember that stocks had a strong run up going into Thursday’s referendum and closed just before the vote counting within 1% of their all-time highs.  This is not to say stocks won’t move lower in the days ahead however the market is clearly taking many things into account at this juncture, including a cheaper dollar versus the yen and the profile of higher dividend paying stocks in a revised interest rate environment.

Perspective:  Interest Rates once again “Lower for Longer”

When combining Brexit with the most recent May jobs report and the Fed’s renewed expression of caution at the recent June meeting, we now believe any rate increases for the rest of 2016 are probably off the table.  In fact, as of Friday’s trading, interest rate futures are now pricing in no action for either the July or September meeting and believe it or not, a slight chance of a rate cut between now and October.  While we do not consider a rate cut to be a strong probability in the upcoming months, it now appears as though sometime in 1Q17 would be the earliest point for the next hike.  The 10 year bond yield traded briefly below 1.5% on Friday morning and is challenging its multi-year low from the summer of 2012.  While this is all frustrating for those who believe we are in need of finally moving away from zero rates, such lower yields should help to buffer volatility in the short to intermediate term.   From a portfolio standpoint the quest for income will likely become front and center once more and this should favor dividend paying stocks and high yield bonds.

Perspective:  Comparisons of past disasters unwarranted

Comparisons of Brexit to the Lehman Brothers bankruptcy of 2008, the Asian Crises of 1998, or European debt crises of 2010, in our opinion are not fair ones at this point.  The biggest difference being those events were immediate in their economic impact with an unavoidable chain of events set in motion at their onset.  In this case the EU and British government still control a large degree of the eventual outcome.  Finally, it is also worth noting that while a member of the EU, Britain was not a part of the Euro currency itself, therefore making their departure more manageable than it would be for others in the Union.

On balance we view Brexit as a political, cultural and regional shock event as well as potentially a key turning point in intra-European relations.  We also view it as likely having a less than shocking impact upon the global markets and world economic landscape.  Britain faces change, Europe will have to adapt and investors throughout the rest of the world will have to do what they’ve always done – disregard fear and look for investment opportunities wherever they might be found.

 

 

 Tom Wald is responsible for overseeing the investment and mutual fund product development functions and sub-adviser selection process. He also actively publicizes Transamerica’s investment thought leadership and products to advisors, clients, and the media. Tom has more than 25 years of investment experience and has managed large mutual funds and sub-advised separate account portfolios. Tom holds a bachelor’s degree in political science from Tulane University and an MBA in finance from the Wharton School at the University of Pennsylvania. He has earned the right to use the Chartered Financial Analyst (CFA) designation.

 Investments are subject to market risk, including the loss of principal. Asset classes or investment strategies described may not be suitable for all investors.

The information included in this article should not be construed as investment advice or a recommendation for the purchase or sale of any security. This material contains general information only on investment matters; it should not be considered asa comprehensive statement on any matter and should not be relied upon as such. The information does not take into account any investor’s investment objectives, particular needs or financial situation. The value of any investment may fluctuate. This information has been developed by Transamerica Asset Management, Inc. and may incorporate third-party data, text, images, and other content to be deemed reliable.

Transamerica Funds are advised by Transamerica Asset Management, Inc. and distributed by Transamerica Capital, Inc.

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