Brexit is the black swan in the market

Investors are facing a barrage of risks at present. Chinese growth, the oil price, the failure of QE and the rise of populism are all raising their ugly heads. However, Brexit is undoubtedly the black swan in the market at the moment.

Nobody knows exactly what the short-term impact of an exit will be and so sentiment rather than fundamentals is likely to drive markets over the next few months. Consequently, investors really need to consider the level of risk they currently have within their portfolios.

We are undoubtedly entering into a very volatile period over the next couple of years. The risks I’ve mentioned – and the ongoing debate about the health of the banking system – are already creating a climate of uncertainty. Following the same good medicine after the crisis as the US, using a combination of monetary and fiscal stimulus, the UK has been enjoying a reasonable recovery.

However this is still very fragile. If we see a vote to leave, this will create enough additional uncertainty the economy does not need at this stage.  Sterling will in all likelihood depreciate markedly, reflecting the additional uncertainty about lack of competitiveness. Bond and equity markets in the UK will potentially be hit hard too. There will be a potential  spill over to Europe as conjecture increases about which other countries might opt to leave the EU. The US will not be immune either – the US Dollar will become more attractive and this ultimately will be a drag on their economy.

From an investment perspective, I think the best approach is to keep risk relatively low within portfolios at the moment. Fundamentals may be overlooked in the short term and so your decisions may be right but proven wrong by the market in the short term. That said it’s going to be a very good environment for active managers over the next few months and beyond. There are companies which are going to be directly impacted by a Brexit and that analysis isn’t hard to do. More significantly, a Brexit will lead to lots of herding in the market and this will open up lots of opportunities as companies could become mispriced.

Given this environment, I think investors should be looking more closely at absolute return and less-liquid strategies – in addition to active management more generally. I also believe it is a time for more diversified strategies such as those which take a smart beta approach. A region that will be less affected and has been neglected for years is emerging markets that offer more attractive opportunities for the next couple of years.

Jan Straatman, CIO at Lombard Odier Investment Managers

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