Unsurprisingly we have witnessed significant volatility in the financial markets in the immediate aftermath of the UK referendum result which saw 52% vote in favour of Leave, deciding to end membership of the EU after over 40 years of membership. The vote is not legally binding and only becomes so when Article 50 of the Treaty of Lisbon is invoked by the government. However, with the majority of the electorate voting to leave the EU, it is difficult to see how ignoring the result would be practical. We believe it is most likely that it will be implemented.
We believe that the large swings in the markets are partly due to the positioning of participants ahead of the vote. Investors were largely complacent, expecting that the Remain campaign would be successful and were thus greatly surprised by the outcome. The pound crashed to its lowest level since 1985, although at the time of writing it has made a modest recovery from the low of $1.315. As we predicted, larger companies have outperformed due to higher levels of international exposure. Investment in overseas equities will also helped to have improved returns for diversified portfolios.
The financial and real estate sectors have borne the brunt of the selling pressure. However, certain defensive sectors, such as utilities and consumer goods, have been largely untouched by the sell off. This declining breadth is a cause for concern as the valuations of certain stocks which have been holding the index up do not reflect adequate potential for downside. Despite the significant decline in equity markets and the pound, there has been huge appetite for the security of UK Government bonds with the yield on the 10 year gilt dropping below 1.0%, indicating confidence in the UK from international investors.
In the immediate term, the UK has been plunged into political chaos. Following the resignation of David Cameron, the Conservative party is set to appoint a new Prime Minister who will take responsibility for handling the exit from the EU. Meanwhile the opposition Labour Party is in disarray. There has been a mass exodus from the shadow cabinet as ministers have lost faith in the leadership of Jeremy Corbyn. It is difficult to see who will benefit but we believe now is the time for a strong leader to emerge on either side of the political spectrum. In the absence of a strong leader coming to the fore, it is likely that the system will become yet more polarized.
We believe that Brexit itself could cause a technical recession in the short term due to the uncertainty which will doubtless arise and the potential for UK business, particularly in the City, to move abroad. The results depend very much on which type of trading model is established. For example, if the UK were to adopt a similar solution to one which Norway enjoys, it would have access to free movement of capital, labour, goods and services as a member of the European Economic Area. Whilst it is possible that Europe could take an aggressive attitude in order to make an example out of UK and deter other members from leaving, we view this as unlikely. The UK is the second largest customer of German goods. Realistically we believe that both sides will look for a mutually beneficient result. In the longer term, we see scope for impressive savings on welfare and the NHS with the potential for increased infrastructure spending. The UK will benefit from the ability to strike individual trade deals without reliance on Europe. In any case, we believe that the advantages to the City predate the EU meaning that many of the fears are overblown.
The main worry is the potential for a domino effect. There have been calls for similar votes on EU membership in eight different European countries since the UK vote: namely France, Holland, Italy, Austria, Finland, Hungary, Portugal and Slovakia. It would be particularly problematic if one of the countries that uses the euro were to vote to leave. Given rising levels of scepticism of the EU across the continent and increasing popularity of extreme political parties on the left and right, in part due to the weak economic performance and high levels of unemployment, one cannot rule out the potential for contagion.
We view the likely reaction from central banks across the world to be even lower interest rates and more Quantitative Easing in order to support asset prices. Whilst this may work in the short term, it cannot solve the underlying problems of dissatisfaction with government if it does not improve the real economy.
Our Asset Allocation Committee met today and decided to keep recommended weightings on hold at the moment. We retain a cautious bias with a modestly overweight cash position and believe that investors should continue to hold a diversified portfolio which will help reduce volatility but provide for long term growth.