What could the EU referendum vote mean for asset allocation?
John Bilton, Head of Global Multi-Asset Strategy for J.P. Morgan Asset Management looks at what the EU referendum could mean for portfolios and what the implications could be for major asset classes
John Bilton, Head of Global Multi-Asset Strategy, J.P. Morgan Asset Management
What could the EU referendum mean for portfolios and what might the implications be for major asset classes?
We consider three key scenarios:
- A clear vote to remain–that is, a winning margin of 10 points or better with all the home nations agreeing to stay in the union: in this situation, we would expect a relief rally in sterling, with UK stocks outperforming Gilts and UK domestic sectors performing well.
- A marginal vote to remain–anything less than around a 52% majority to remain and/or different outcomes in the vote across home nations: in this situation, we would expect only a short-lived relief rally in sterling, with risk premia in other UK assets remaining elevated and potential for some weakness in European assets.
- A vote for exit: this would lead us to expect a sharp sell-off in sterling, weak performance of UK stocks relative to safe haven Gilts, and underperformance of financials and related sectors.
Some nuances should be noted at the asset class level:
Sterling will be the focal point of the vote impact
To date, sterling has been the most sensitive of UK assets to the Brexit debate—in its May inflation report, the Bank of England (BoE) said that half of the 9% depreciation in sterling over the last six months is attributable to referendum uncertainty.
In the event of an exit vote, we could see sterling dip 10%-15% against the US dollar, to trade at around 1.25; a vote to remain could spark a sterling rally that pulls the currency to the mid-1.50s. However, we’d expect any rebound to fade subsequently for fundamental rather than political reasons.
Impact on fixed income markets
UK bonds will be influenced by several factors. First, central banks’ appetite for bonds–which supports all major government bond markets–will remain, regardless of the vote outcome. Second, Gilts are sensitive to the domestic economic outlook, which could darken in the event of a vote to leave, creating further support for Gilts as investors switch from stocks to bonds. Third, the risk that the BoE restarts its quantitative easing programme is also acting to cap yields. These factors would also be supportive of Gilts in the event of an exit vote.
More concerning, however, is that non-domestic buyers now hold 25% of outstanding UK Gilts; should these investors sell after a vote to leave, Gilt yields could rise, though this would be offset by a domestic rotation from stocks to bonds. With a remain vote, any “risk-on” relief rally could see Gilt yields move marginally higher.
Impact on equity markets
In the immediate aftermath of the vote, we see UK equities rallying on a remain vote and sinking on an exit vote. But in the longer run, the situation becomes more complicated.
With a vote for exit, we expect the UK currency to bear the brunt of negative sentiment, as FTSE companies source their revenues in roughly equal measure from emerging markets, the US, Europe and the UK. Once the initial currency volatility subsides, equity investors should expect outperformance from UK-listed sectors with significant non-sterling revenues (including healthcare, beverages, resources and energy), while domestic consumer discretionary and related sectors could underperform. Banks may also underperform, partly because of uncertainty about where inflation, growth and base rates are headed.
If there is a marginal vote to remain, any relief rally in the UK equity index would likely fade and rotate towards higher-quality sectors. Persistent political uncertainty that would accompany such an outcome would probably cause UK large cap firms to outperform mid-caps, due to their higher-quality and lower-beta characteristics.
With a vote to remain in the EU, we would see reduced political uncertainty, a little more optimism about earnings and rising consumer confidence, and UK stocks would find a sweet spot in the second half of the year.
For asset allocators, sterling should remain the main focus of attention. In the UK Gilt market, we expect to see volatility in the most liquid part of the curve (10-year)–and particularly in Gilt futures–but we anticipate that the short (2-year) and long (30-year) ends of the curve will remain relatively well-anchored. In the equity market, on weakness we would look for opportunities at the sector level, taking into consideration the impact of sterling.
We emphasise one crucial fact: 38% of the UK’s exports go to the Europe. Whether the UK is in or out of the EU, Britain’s and Europe’s futures are inevitably intertwined. The verdict could therefore have a profound impact, short-term and long-term, on European as well as UK assets. The UK may be an island, but its financial markets are decidedly not.
John Bilton is Head of the Global Multi-Asset Strategy team at J.P. Morgan Asset Management.
 Haver, JPMorgan Multi-Asset Solutions
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