Following on from the surprise outcome of the UK “Brexit” referendum, which resulted in sharp declines across global markets on Friday, we’ve taken a look at what the likely long term implications are for both investment markets and for your portfolio…
What’s in store for markets?
To start with, in addition to the moves on Friday, we are likely to see a sharp rise in market volatility in the short term, as investors try to work through the implications of what the referendum outcome actually means. Initially the main concerns will revolve around “systemic risks”. Will the financial system as a whole be ok? Will there be political instability or an immediate risk of “leave” contagion across a number of EU countries posing an imminent threat to the European Union? During this time fear and sentiment will be the main drivers. This period could be as short as a few days, or much longer if concerns prove to be founded. Once these initial fears moderate however markets should start to calm, and the focus will then turn to the implications for future economic growth. Are assets fairly priced based on the altered economic outlook? Which businesses will suffer, which ones may do better as a result of this? During this period overall market volatility will begin to subside, but the returns on individual asset classes and securities are likely to vary. Then finally, markets will adapt to the new environment, and the world will go on.
One thing that is important to point out, however, is that markets are made up of humans and just like humans they tend to over-react. Even the lead up to the referendum demonstrated that markets don’t always get things right, performing strongly right up to the end of polling day, mistakenly “pricing in” a Remain vote. It is therefore important to keep in mind that they are also likely to overshoot on the downside, something we are likely to experience in the coming days.
What are the likely implications of the “Brexit”?
While the UK may be the fifth largest economy, it is only of moderate importance on a global scale, making up just 4% of global GDP and just 2.7% of its growth in from 2010-2015. Although Britain does have an outsized influence on global markets due to its position as a financial trading hub, its underlying long term economic impact is far more limited. It is the knock-on effects of the Brexit on other European countries which are likely to have the greater impact than a change in UK economic performance or trade. For the rest of the world outside of Europe, analysts feel that the Brexit is likely to be a moderate adverse shock, but at this stage is unlikely to result in another GFC scenario.
In terms of the impact on Australia specifically, while cultural ties are strong, Australia’s economic relationship with the UK in recent years has diminished. In the short term in Australia, Brexit will likely result in higher demand for safe assets such as Bonds. Some direct impact through trade may also occur over time (perhaps a 0.8%-1.1% reduction in global exports, 2% when including impact on the EU, according to Citigroup). Direct investment from Australia into the UK accounted for 26% of the total Australian investment outflows in 2015. Again though, this is as a result of the UK being a trading hub, with only a fraction of that total being invested into the UK economy itself. Overall the general consensus is that the adverse effects of Brexit on Australia are likely to be noticeable but not large, unless global conditions deteriorate significantly. Also any material deterioration in domestic consumer confidence is likely to be addressed with further interest rate cuts by the RBA. Longer term there may even be some opportunities for Australia to capitalise on a potential refocus of the UK on its commonwealth partners.
As for the future of the UK itself, while uncertainty presently clouds the outlook, experts feel that an eventual new UK/EU arrangement will be forged, which will maintain the UK’s access to the EU Single Market, but with important limitations and concessions, such as a substantial reduction in the UK’s contribution to the EU budget and changes to the free movement of labour. Analysts forecast UK GDP to fall by 3-4pp over the next three years, with the pound to fall -15% and inflation to rise to 3-4% in 2017-18. EU and Eurozone GDP is expected to fall by less, 1-1.5pp. It is important to point out that neither of those scenarios involve a recession. Global GDP is only expected to fall by 0.1-0.2pp over the next three years. The bulk of the initial economic and financial effects are expected to be driven by uncertainty and sentiment, rather than any change in economic arrangements or trade.
What are the implications for your portfolio?
There is no doubt that the Brexit will have an impact on short term returns, and we may well see portfolios return a negative number for the 2016 financial year as a result. However should the analyst forecasts prove to be correct, it is unlikely that the Brexit will have a lasting impact on the mid to longer term performance of investment portfolios. In fact we may encounter some buying opportunities if markets over-react in the coming days and weeks, particularly given that the portfolios are currently positioned slightly “overweight” cash. In any event, Libero portfolios are currently well diversified across both asset classes and geographic regions, so should be positioned as well as possible to ride out the worst of the market volatility.
If you have any queries or concerns at all regarding your portfolio, or the markets in general, please don’t hesitate to call my direct office line, ph: 02 9119 3698.
Glen Holder, BCom, DipFP, CA, MAppFin
Director – Investment Management