This time the opinion polls got it right. The “Remain” and “Leave” camps were running neck-and-neck coming into Thursday’s U.K. referendum on membership of the European Union and in the event some 52% of U.K. voters opted to reject the status quo and pull out.
Markets have responded dramatically. U.K. equity index futures have slumped and the pound sterling has tumbled to 1980s levels. Safe havens such as gold, German Bunds and U.S. Treasuries are seeing substantial investor demand. The euro has also come under pressure.
Fears of ‘Lehman Moment’ Overblown
No doubt Friday's will be the first of many volatile trading sessions, and the major central banks may intervene if necessary. But we caution against reacting as though this were a second “Lehman moment,” as some commentators have suggested.
The likelihood of at least medium-term damage to the U.K. economy from a “Leave” vote, as well as pronounced market volatility on the back of political uncertainty for the U.K. and the EU as a whole, did lead our Multi-Asset Class (MAC) team to adopt a relatively neutral stance coming into the vote. But this stance was not only designed to try to buffer against volatility, but also to position the MAC team to take advantage, potentially by increasing allocations to riskier assets based on a longer-term view of fundamentals.
Still, the U.K. has chosen the rockier of two paths. It piles up the political distractions that have dogged the administration of U.K. Prime Minister David Cameron and his chancellor, George Osborne. The “Brexit” camp is clearly in the ascendant but the vote revealed a lack of national consensus. And even consensus would not wish away the complexity of this exit, a “monumental,” multi-year task in the words of one legal expert.
Economic Damage Likely to Be Contained
That complexity is likely to prolong the period of low corporate investment we have seen leading up to the vote, both within the U.K. and in the form of foreign direct investment. This, together with the higher costs of trading, is what led mainstream economists to forecast a 3-7 percentage point negative long-term impact on U.K. GDP.
The pain may not be felt evenly. Many of the large companies in the FTSE 100 Index are global rather than U.K. businesses—80% of the index’s revenues come from overseas. This should help insulate them from any domestic downturn and potentially deliver a windfall from the weakened pound. Smaller, more domestically-focused companies are more vulnerable to a fall in consumer demand and higher import costs. That could be a source of opportunity during a sell-off in U.K. assets, particularly if the U.K. makes its new status work over the longer term.
Elsewhere, the economic impact is likely to be felt most keenly in Europe and, in the words of one Federal Reserve Bank president, to have only “moderate direct effects on the U.S. economy in the near term.” Again, we expect an excessive market reaction to be a potential source of opportunity.
Another Blow for Globalization?
A more pessimistic reading of the vote would see it as one more crack in the edifice of international political and economic co-operation built over the past 70 years. Anti-EU parties in countries like France, Germany and Italy may take heart from the result and attempt to further exploit the euro-skepticism increasingly evident in opinion polls across the Continent.
But to us this merely confirms that globalization is under siege, a trend already well-advanced and understood by financial markets. Beyond Europe, a big effect on the outcome of the forthcoming presidential election is unlikely—and besides, as former Treasury Secretary Hank Paulson told Brad in an exclusive interview at our CIO Summit this week, neither the Republican nor the Democratic candidate is promoting a positive view of global trade and investment.
Look Through the Noise to Fundamentals
Most importantly, this vote will probably exert only a marginal effect on global economic fundamentals, which remain stable but weak. We still live in a slow-growth, low-inflation, low-interest rate environment, characterized by sluggish productivity and investment. “Brexit” has been a tail risk stalking markets in the same way that the oil price, the strong dollar and concerns about China created volatility back in January and February, but we think its implications are overstated. For that reason, we again stress the importance of looking through the noise to focus on fundamentals and watching for opportunities to add risk to portfolios. The market reaction may provide opportunities to add to some positions in riskier assets once the worst of the initial volatility has passed.
Looking further out, in a lot of places in the world we still need structural reform and a more appropriate fiscal response to the current malaise if we are going to allow our economies to grow on a proper footing, and our companies to generate sustainable earnings growth. Part of that progress will involve addressing the legitimate concerns of those who have failed to benefit from globalization, but populism and political division is not the way to do it. In that respect, today’s result is hardly good news. But we believe its effect will be marginal and the market’s initial response is likely to create opportunity for patient investors with cool heads.
Erik L. Knutzen, CFA, CAIA and Managing Director, joined the firm in May 2014 as Multi-Asset Class Chief Investment Officer. Erik will drive the asset allocation process on a firm-wide level, as well as engage with clients on strategic partnerships and multi-asset class solutions. Previously, Erik was with NEPC, LLC where he served as chief investment officer since 2008. He has 29 years of experience in the financial services industry, including nine years at Putnam Investments. Erik holds an MBA from Harvard Business School and a BA from Williams College.
Joseph V. Amato is President of Neuberger Berman Group LLC and Chief Investment Officer. He is also a member of the firm’s Board of Directors and its Audit Committee. Prior to this role, Joe served as Lehman Brothers’ Global Head of Asset Management and head of its Neuberger Berman subsidiary, a position he held from April 2006. From 1996 thru 2006, Joe held senior level positions within Lehman Brothers’ Capital Markets business serving as Global Head of Equity Research for the bulk of that time.
Brad Tank, Managing Director at Neuberger Berman, joined the firm in 2002 after 23 years of experience in trading and asset management. Brad is the Chief Investment Officer and Global Head of Fixed Income. He is a member of Neuberger Berman’s Operating, Investment Risk and Asset Allocation Committees and NBFI’s Senior Management Committee. He is a member of the firm’s Senior Management Committee and Asset Allocation Committee. From 1990 to 2002, Brad was director of fixed income for Strong Capital Management in Wisconsin.