June 24, 2016
We woke up this morning to news that U.K. voters had chosen to exit the European Union. Global markets are in risk-off mode, as expected, with the S&P 500® and the EURO STOXX 50® opening the day down significantly.
BMO Global Asset Management investment teams are focused on executing their philosophy and process within the context of elevated risk. Just as importantly, they are identifying opportunities that exist and that will likely arise as volatility persists.
Our U.S. investment team leaders have been aware of this potential result leading up to the vote and met earlier this morning to discuss events and our strategies. We will continue to closely monitor markets and risks in partnership with our investment colleagues in Europe. Please see our investment team insights below.
We caution investors about overreaction to this news. While the markets are down significantly today, some of this is unwinding gains from the past few days from speculation that “Remain” would win. We also recognize the implications of this vote will play out over a longer time period and urge investors to be moderate in their response.
Finally, we feel that BMO Global Asset Management is well positioned to help you through this volatility with our investment solutions that offer low volatility and good downside protection, along with opportunities to participate strongly in a market rebound.
We remain comfortable with our modest overweight in global equities. However, we consider there to be potential tail risks in Europe and Japan, warranting a lower exposure.
We see two risks not yet fully priced into the market: the uncertainty related to the future of the European Monetary Union and diminished central bank efficacy. In Japan, the yen is rallying to 102 versus the dollar, and the Bank of Japan appears more boxed in than before. While significant central bank stimulus could result in a risk-on rally, the downside risk of it not working could result in more selling pressure.
We see an increased probability of U.K. economic weakness worsening to recession, along with spillover effects to European and U.S. GDP. From the EU’s perspective, the biggest risk is the U.K. successfully detaching and contagion encouraging other anti-EU voices to follow a similar path. Within the U.K., we see an increased risk of a renewed effort by Scotland to push for independence, adding to U.K. economic uncertainty.
Within global equity markets, the U.S. is relatively attractive given its traditional role as a safe haven; it also has significantly lower economic exposure than Europe and emerging markets.
Similarly, we see the dollar strengthening as a safe haven. This may translate into an earnings headwind for S&P 500 stocks, particularly those with significant non-U.S. revenue.
BMO Disciplined Equity
The team manages global low volatility and global long-short portfolios that are well positioned for Brexit volatility. Other core U.S. large-cap, small-cap and international portfolios incorporate our process views that have suggested that defensive, high-quality stocks were relatively expensive compared to higher-risk cyclicals. In the short term, we expect these defensive names to continue to outperform despite this valuation difference. The team is reconsidering the medium-term implications of Brexit on our data.
BMO Fundamental International (Pyrford)
Pyrford has been defensively positioned for some time. U.K. holdings are focused on large-cap, defensive companies with global exposure that should benefit from the pound selloff and there is no exposure to U.K. or European banks on concerns over asset quality. We continue to monitor opportunities that arise should valuations in high-quality companies become attractive following market movements.
BMO Fixed Income
We see a continued flight to Treasurys and higher-quality credits with opportunities arising in select lower-quality areas of the market.
BMO Tax-Exempt Investment Grade
Municipal bonds continue to be a safe haven when volatility spikes abroad and tax-exempt yields are lower this morning by 15-20 basis points across the curve. If municipal yields settle in lower over the next few weeks, we would expect to see opportunities as refunding deals increase, pushing overall municipal supply higher.
BMO Short Duration Investment Grade
Liquidity remains high and short-term funding rates are attractive. We are anticipating inflows continuing from the sale of risk assets (i.e., equities). A flight to quality will also bring additional assets to government-backed products. We continue to anticipate opportunities in corporate and asset-backed securities.
BMO Taxable Investment Grade (TCH)
While the uncertainty around Brexit has generated a flight to safe havens like U.S. Treasurys, longer-term implications can only be fully assessed as details of the negotiation emerge. Policy makers in Europe have expressed their willingness to stand ready to provide liquidity if necessary. U.S. markets have opened in an orderly fashion and investors are likely to step back over the coming days and weeks to digest events.
TCH remains overweight spread duration, and maintains a constructive view of the intermediate-term opportunities within spread sectors following market dislocation over the last 12 months. Current positioning emphasizes U.S.-based entities and industrials, which we expect to outperform over the near term. In anticipation of the heightened uncertainty surrounding the Brexit vote, we reduced exposure to European financials. In addition, we have limited exposure to corporates, which derive material revenue from the U.K., the fulcrum of near-term growth pressures.
As evidenced by the substantial rally in U.S. Treasurys, we expect U.S. high-quality fixed income to remain a safe haven for global investors. Longer term, developments in Europe should support our thesis of a global interest rate substitution effect whereby global investors will increasingly look to U.S. bonds, including Treasurys, MBS and high-quality corporates, in an effort to benefit from the more attractive yields and simultaneously take advantage of the deepest, most liquid fixed income markets in the world.
We intend to reiterate to clients that despite low interest rates, fixed income continues to fulfill its role as the stable, defensive core of a diversified portfolio.
BMO High Yield (Monegy)
As an asset class, high yield has had a stellar return year to date, up 9.69% for the BofA Merrill Lynch US High Yield Index. We are not surprised to see the market pulling back following the surprise Brexit vote overnight, which has the broad high-yield index down 1.5%–2% in early morning trading, with higher beta names off approximately 4%. Anecdotally, the market appears to be functioning well, and our dealer contacts are telegraphing that there is a backlog of bidders looking to buy most issuers at these lower levels.
EURO STOXX 50® Index is Europe’s leading Blue-chip index for the Eurozone, provides a Blue-chip representation of super-sector leaders in the Eurozone. The index covers 50 stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain.
S&P 500® Index (S&P 500®) is an unmanaged index of large-cap common stocks.
BofA Merrill Lynch U.S. High Yield Index tracks the performance of below investment grade, but not in default, US dollar-denominated corporate bonds publicly issued in the US domestic market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P.