Political and economic uncertainty following the outcome of the UK EU Referendum has significantly increased the chances of recession in the UK.
Any relief rallies in the markets are likely to be fairly short and limited in scope. Increased political uncertainties for the UK both domestically and with the EU will act as a drag on both economic growth and financial market performance. The team has downgraded growth expectations and estimates a 60%–70% chance of recession during the next 18 months.
In the UK, the fallout from Brexit has pulled our growth expectation for 2016 down from 1.5% to 1%, and for 2017 from 1.5% to 0%-0.5%. The drivers behind this downgrade include the direct impact from Brexit on trade and foreign investment, as well as the indirect impact on consumer and producer confidence. We expect the Bank of England to cut interest rates to support the economy at the margin.
Increased uncertainty to present buying opportunities
“Volatility however often creates opportunity, although the shakeout so far has not been large enough for our process to recommend taking on more risk. We have therefore kept a broadly neutral allocation between equities and bonds since the equity rebound.
Fixed income investors should continue to keep their expectations with respect to Gilt yields low, and our range for the 10-year Gilt yield at the end of 2016 is now 0.8%-1.4%, down from 1.5%-2.0%. There is little in terms of growth, inflation or monetary policy that is going to drive yields higher in a sustainable manner.
- Brexit impact to be contained in the Eurozone: the indirect impact of Brexit on consumer and producer confidence is expected to dominate the direct impact, given the relatively small size of the UK in trade and foreign investment. However, if contagion remains limited, as we expect, the overall drag from Brexit could end up being largely contained. Government bond yields will stay low but equities have upside potential.
- US assets remain expensive: Even after the volatility following the referendum outcome, the US market is not far from near record highs and long-term yields have trended lower. This mix of equity market optimism and bond market pessimism looks unsustainable, and a cautious investment strategy process is being taken.
- Cyclical risks remain for Asia-Pacific, despite recent growth: Asia-Pacific’s ongoing growth is also confounding the sceptics, with our central case of an orderly slowdown continuing to play out. Nonetheless, risks relating to housing, debt, and economic imbalances are rising. We like the value proposition of regional equity markets, but are cautious on cyclical vulnerabilities.
- Central banks have lost impact on currencies: Currency markets seem to have lost confidence in central banks’ ability to affect exchange rates to achieve their objectives. Policy divergence is less pronounced and less influential on G3 currencies – the U.S. dollar, yen, and euro – than in the last three years. In this environment, major currencies are expected to move within the ranges we have seen since the beginning of 2016 rather than establishing new trends.
Wouter Sturkenboom, senior investment strategist, EMEA, Russell Investments