The U.K.’s vote to leave the EU surprised us and most investors as it roiled the market with significant implications from London to Washington DC to Tokyo. The British pound fell to its lowest level versus the dollar since 1985, stock markets fell sharply and government bond yields touched record lows.
In light of the Brexit vote and the current market environment, we elected to tactically transition from a modest overweight to a modest underweight in international developed-market equities. While we hold no unique insight into the coming events in Europe, the path forward appears skewed to the downside. According to a Financial Times poll prior to the Brexit vote, seven out of 10 U.S. businesses operating in the U.K. indicated that a departure from the EU would have a “negative or significantly negative impact” on future British investment. In the near term, the extent of this negative hit to capital expenditures remains highly uncertain, but the likeliest scenario involves the U.K. falling into a mild recession.
The most important medium-term risk lies outside of the U.K.: on the continent, Eurosceptic parties have gained momentum. The British referendum provided clear proof that European voters are angry, disillusioned and willing to express these emotions in the voting booth, despite overwhelming evidence of the negative economic implications. This inward bias will be tested in referendums and elections in Italy, France and Germany over the coming year; each will be closely watched by investors looking to gauge the health of the EU.
Whereas central banks have guided jittery investors through previous systemic shocks, we believe investors are right to question the efficacy of traditional central bank intervention at the moment. Policy rates are seemingly near their floor — although they could always go further negative — and central bank balance sheets are bloated from years of quantitative easing. Central banks will invariably intervene in a large-scale selloff, but the effect of such action is uncertain.
While the coming events seem purely political, they will echo throughout the financial markets as the strength of currencies, bonds and stocks hang in the balance. A further rise of nationalistic populist politics and any resulting disintegration of the EU could derail the European economy and potentially the global economy. While such a dire outcome is not our base case, we believe the uncertainty around this tail event will weigh down European growth and become the prominent driver of valuations for the foreseeable future. As a result, we believe it is prudent to cut our international equity exposure and redeploy into U.S. stocks, where fundamentals look more attractive.
We will continue to closely follow the policy developments in Europe and around the world over the coming months. While we have focused on the negative, there are still reasons to hold international developed-market equities in a diversified portfolio. With borrowing rates ranging from near 0% to negative in the developed world, we believe a coordinated fiscal stimulus program could prove highly beneficial and help pull economies out of their malaise. Such a program could start a virtuous cycle and allow these troubled economies to slowly recover and shift into a new growth phase. This could cause us to shift our portfolios into more bullish international equity positioning.
While we have reduced our international developed equity allocation in favor of U.S. equity, we remain modestly overweight to equities overall. The Brexit issue will weigh heavily on Europe, but it is unlikely to cause a global recession. Accordingly, global equities have recovered in the days following the Brexit vote after a sharp initial decline.