Brexit’s silver lining is emerging
Luca Paolini (pictured) is chief strategist at Pictet Asset Management.
The UK’s vote to leave the EU has sent shockwaves through financial markets but there are silver linings to the Brexit clouds.
We now expect the US Federal Reserve to leave interest rates on hold, at least until next year, offering substantial support to riskier asset classes.
Brexit may also encourage governments in both Europe and elsewhere to push through economic stimulus measures to better insure against shocks.
This, coupled with the fact that stock valuations are now at more attractive levels than they were a few weeks ago, has led us to upgrade equities to an overweight from neutral and to stay underweight bonds.
We have upgraded UK stocks within the globally-exposed FTSE 100 index to overweight. At the same time, however, and as an insurance policy against any further bouts of volatility, we keep our overweight stance in gold.
Fear over what Brexit might hold in store for the UK economy has seen a number of domestically-exposed companies such as banks, homebuilders and real estate punished by investors. On reflection, however, we believe the overall market is not as vulnerable to political turmoil as it would appear.
UK stocks are very diverse, and the government may look to enact some business-friendly reforms to reassure investors post-Brexit, including a potential cut in the corporate tax rate that would be an additional support for UK companies.
The turbulence triggered by the UK referendum has taken the valuations of Japanese and European stocks to levels that are at odds with fundamentals. Both markets stand to benefit from monetary and fiscal stimulus from the Japanese and European authorities.
The ECB has said it stands ready to provide additional liquidity to mitigate the impact of the vote and shore up the currency bloc. The strength of the Yen may force a policy response that will probably take the form of monetary and fiscal stimulus.
How central banks react to Brexit will have a major bearing on world bond markets and currencies over the coming months, with investors particularly focused on the Fed.
The markets had been pricing in two US rate increases for the second half of 2016. Following the referendum, investors started to discount no move until well into 2017 or even 2018. At the same time, the Fed’s forward guidance is likely to become more dovish.
Although the impact of any new measures in isolation would probably be modest, a coordinated policy response has the potential to trigger a strong rally in higher-yielding bonds.
For now, we expect the Fed’s dovish tilt to drive a further flattening of the yield curve as it feeds demand for long dated US government bonds. So we remain overweight US Treasuries and are extending the duration of our portfolio. We are less enthusiastic about other developed market sovereign debt.
A more dovish monetary policy, however, is supportive of credit, particularly corporate high yield. We are lifting our exposure to US high yield bonds and are also shifting to an overweight on European high yield debt from neutral.
On the other hand, European investment grade credit looks fully valued – investors are already long the market in response to the ECB’s corporate bond purchase programme.
The shift in the Fed’s thinking is likely to be positive for emerging market debt. While we remain overweight emerging market dollar bonds, for now we stick to our neutral stance on emerging market local currency debt, as developing world currencies could prove volatile in a shifting political landscape.