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Written by: Krishna Memani Chief Investment Officer, Portfolio Manager | OppenheimerFunds
With the June 23 referendum on whether Britain should exit the European Union (EU), the so-called Brexit, looming large over global markets, let me start by saying Federal Reserve (Fed) Chair Janet Yellen’s instinct on how it might play out has proven prescient.
Even when the probabilities of a Brexit were relatively low in the polls, Yellen and the members of the Federal Open Market Committee recognized that there was a chance the vote might end up being closer than everyone thought a few months ago. With that possibility in mind, she prepared the U.S. markets for the likelihood that the Fed would skip a tightening in June because it was too close to the Brexit vote date, and that is exactly how things are playing out. Of course, she probably didn’t count on the May U.S. payroll data being a massive whiff, which made Brexit irrelevant for the Fed’s June tightening purposes.
Brexit, however, is the most relevant thing for global markets at the moment. As the probability of a “Leave” vote has strengthened in the polls, the markets have taken a precarious risk-off turn. Equities are lower, credit spreads are wider, the British pound is down, the Japanese yen is up, and implied volatility has risen all around. The result is a classic risk-off scenario in the global markets.
The question is what to make of the increasing probability of a Leave vote?
I don’t have any special insight into whether the Leave campaign will carry the Brexit vote. I hope it doesn’t, primarily because the near-term impact on the global economy will be quite bad. Economic activity has been slowing on a global basis for quite some time and another shock to the system is the last thing the world needs. While we can debate the magnitude, if the Leave campaign wins it is fair to say that the impact on the global economy and global markets will be negative.
Portfolio Positioning Ahead of Brexit
That is the easy part of the analysis. The more difficult and pertinent question, however, is what am I supposed to do with that rudimentary insight for my portfolios ahead of the vote? Given the rise in risk, am I supposed to reduce risk and sit out the vote?
The challenge is further aggravated by the fact that the Brexit vote will be a binary outcome: the UK either stays in the EU or it leaves. If Brexit fails, the markets will breathe a sigh of relief and probably rally modestly. In other words, any portfolio de-risking may prove to be catastrophically bad. With the flash rally in February fresh in most investors’ minds, they may not be inclined to do that.
To answer these questions, I believe I need to go back to my original outlook, with or without Brexit.
Global Impact of a Brexit
The world is dealing with deflationary deleveraging issues. A British exit from the EU may compound those issues marginally, but at the end of the day does not materially change things. Growth has been and will remain modest, and global central bank policy support will remain in place with or without Brexit.
That said, this is unlikely to be a Lehman moment that tips the global economy into a crisis, in my view, for the simple reason that the overall leverage situation is more under control and investors’ tone and risk taking have been skeptical of the rally. Further, given the increased risk, I am quite sure that central banks worldwide are cooking up contingency plans to support the various economies, including a revival of quantitative easing programs in many countries.
In other words, there is a reasonable case to be made that while the impact of Brexit will undoubtedly be negative, after the initial drawdown the global economy may stabilize at a modestly lower level and markets will start recovering from that lower level.
Finally, there is a definite possibility that if the shock of Brexit proves to be too large, the developed world will enter a recession. However, given the state of the global economy-where capital expenditures have been low and consumer leverage is flat to lower on a global basis -such a recession may prove to be relatively shallow.
Against the backdrop of these possibilities, my outlook had been for low rates, modest returns, and high volatility, even before Brexit, and I structured my portfolios accordingly-modest overweight in risk.
Stay the Course
When I weigh the potential for a binary outcome in the Brexit against:
My bottom line is that I am leaving my portfolios unchanged.