Of the sectors, we believe UK financials would stand to lose the most. The City of London’s economy is dominated by financial services, some of which may have to move outside of the UK post-Brexit (e.g., currency trading, international settlement). The Economist quotes CityUK data that suggests London has around 70% of the entire market for euro-denominated interest-rate derivatives and 90% of European prime brokerage (The Economist, May 28, 2016). Under Brexit, banks may be forced to move staff and comply with two separate sets of rules or lose business to Irish, German or French banks. One specific example is the statement in February from a large UK-based bank, HSBC, in which they suggested Brexit could cause them to shift 1,000 workers from London to Paris. These legal and operational issues add to an already unappetizing earnings profile for UK banks, in our opinion.
Likely Currency Effect: GBP down a lot, EUR by less: We believe that Brexit will be negative for the pound sterling (GBP) relative to the USD. In our view, the market would likely be forced to bake in greater uncertainty in the near-term, as well as a negative shock in terms of trade. It’s also possible that the euro would suffer in sympathy with the British pound, though probably not to the same extent as the pound. Additionally, we think currency markets would start to again question the sanctity of the Eurozone as a construct, which would also negatively impact the euro.
How much could the GBP drop? Goldman Sachs and other currency analysts have suggested a meaningful immediate drop, predicting that GBP/USD could reach 1.15-1.30 under Brexit (10-20% downside from current levels) over an intermediate timeframe, similar to the GBP’s performance during the credit crisis. This range is based on the principle that it represents the equilibrium rate needed to balance the current trade account, which strikes us as perhaps an overly pessimistic forecast given that the UK consistently runs trade deficits.
Some Important Counterpoints: Weakness in the British pound may eventually hold a silver lining for UK exporters. While exporters would be damaged initially by the lack of certainty around future European trade deals, it’s possible that a major drop in the sterling may eventually sow the seeds of their own recovery; this is because a cheap currency would make UK exporters more competitive. This is in part what happened during the “black Wednesday” episode in 1992, when the Bank of England was forced by currency speculators to exit the European ERM (exchange rate mechanism), driving the pound down. While the incident was embarrassing and costly to the UK initially, it may have also helped usher in a long period of economic growth and strong stock market returns, though the economic dynamic then was admittedly different from today.
We would also note that in the event of Brexit, we expect a central bank response not only in the UK and the Eurozone, but also perhaps from the Federal Reserve, where tightening of financial conditions in the aftermath of Brexit may make the Fed less likely to raise interest rates. It’s also worth noting that even if Brits vote in favor a Brexit, it would not happen immediately. Post-vote, there would be a 2-year negotiation period for exit terms, during which terms of trade would not likely change dramatically.
Broadly speaking, in the midst of hysteria we do think a deep breath is warranted – while Brexit would be disruptive, we do not think it necessarily spells the end of the Eurozone, as many have posited. Markets often overreact in the short-term to uncertainty, assuming the worst case scenario, but investors who have the ability to remain calm and focus on time horizons longer than a few weeks or months can often benefit from such emotional volatility.
HOW IS RIVERFRONT POSITIONING THE PORTFOLIOS FOR THE POTENTIAL OF BREXIT?
- Underweight to UK stocks relative to our strategic and baseline benchmarks. Despite an overall constructive view on European stocks at current levels, we have chosen to make the UK one of our largest country underweights. It is important to note that our underweight to UK stocks is not just because of Brexit risk; we also view the UK index’s sector composition and earnings trajectory as unattractive.
- Tilt away from UK and European financials. European indices tend to be banking-heavy, and our belief is that these banks represent poor risk-reward potential at current levels. We believe that a combination of future capital raises, low/negative interest rates, and dislocation in the advent of Brexit make British and European banks unappealing.
- Hedging European currency exposure. Due to our underweight positioning in UK stocks, we therefore also have an underweight exposure to the pound. However, we also believe that in the aftermath of Brexit, the euro is likely to come under pressure for reasons presented above. We are currently hedging over 70% of our exposure to the euro in our portfolios, in part to help compensate for this risk.
- Risk plan in place in the event of Brexit. The uncertainty and binary risk associated with something like a referendum vote is one of the most difficult and complex risks for a portfolio manager to plan for, and we believe one has to be humble and prepared to act decisively if things turn out differently than expected, either with the outcome of the vote itself or the market reaction to it. Those familiar with Riverfront’s portfolio management philosophy know that we have a disciplined risk management process in place for events like Brexit, and that we have predetermined risk trades set to execute in the event that particular triggers are hit.
Important Disclosure Information
Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability.
High-yield securities (including junk bonds) are subject to greater risk of loss of principal and interest, including default risk, than higher-rated securities. In a rising interest rate environment, the value of fixed-income securities generally declines.
Investing in foreign companies poses additional risks since political and economic events unique to a country or region may affect those markets and their issuers. In addition to such general international risks, the portfolio may also be exposed to currency fluctuation risks and emerging markets risks as described further below.
Using a currency hedge or a currency hedged product does not insulate the portfolio against losses.
Changes in the value of foreign currencies compared to the U.S. dollar may affect (positively or negatively) the value of the portfolio’s investments. Such currency movements may occur separately from, and/or in response to, events that do not otherwise affect the value of the security in the issuer’s home country. Also, the value of the portfolio may be influenced by currency exchange control regulations. The currencies of emerging market countries may experience significant declines against the U.S. dollar, and devaluation may occur subsequent to investments in these currencies by the portfolio.
ETFs are subject to substantially the same risks as those associated with the direct ownership of the securities comprising the index on which the ETF is based. Additionally, the value of the investment will fluctuate in response to the performance of the underlying index. ETFs typically incur fees that are separate from those fees charged by RiverFront. Therefore, investments in ETFs will result in the layering of expenses.
RiverFront Investment Group, LLC, is an investment advisor registered with the Securities Exchange Commission under the Investment Advisors Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations.