June 27, 2016

Global Investment Team

Investment Implications of the Brexit Vote

  • The British vote to leave the European Union (EU) was a surprise.
  • We believe that investors should regard the surprise as a “speed bump” on the way to improving economic and earnings growth, not an impassable “brick wall.”

What it may mean for investors

  • If sentiment remains fragile but the U.S. economy continues its gradual improvement, we recommend looking for opportunities to take profits and reallocate into asset classes with upward potential.

1. What happens next in Great Britain, and is Europe ripe for further breakups?

  • The referendum itself does not take Great Britain out of the European Union (EU). For a binding decision, the British government must invoke a Lisbon Treaty provision (Article 50) for leaving the EU. After the vote, British Prime Minister Cameron announced his resignation, but he will stay on as a caretaker, pending elections in two or three months. We then expect a new government will begin a multi-year negotiating process.
  • Once the initial surprise of the result subsides, any ongoing concerns and market swings most likely will come from the risk that anti-establishment and separatist movements may feel encouraged to lead other countries out of the EU. Scotland may renew its bid to separate from Great Britain. These threats are significant and have seemed remote, until now. However, there is also much that can work against separatism, not least improving economic growth. Moreover, separatists may face a tougher challenge if the UK secures unfavorable terms for its departure. We believe that investors should avoid extrapolating the British result to the rest of Europe.

2. Are there opportunities from currency-rate movements, or in fixed-income markets?

  • Looking ahead, currency crosscurrents may keep the U.S. dollar trading within a band for the balance of the year. We expect the dollar to gain against the British pound and, to a lesser extent, vs. the euro and most emerging-market currencies. However, ongoing worries about the fallout from the referendum may reinforce buying of perceived risk havens, such as the Japanese yen.
  • Worries about European unity and questions about economic growth likely will lead Federal Reserve (Fed) interest-rate policy toward more caution. We also expect bond yields to move lower and the yield curve to flatten. While global growth could again slow, we see domestic credit remaining attractive, given the low-rate environment.
  • Given that an exit vote could improve the dollar’s prospects against European currencies, we prefer to maintain a developed-market fixed income underweight, despite the likelihood that yields could move further into negative territory.

3. Does Britain’s vote change our equity outlook?

  • The economic impact probably will be strongest in Great Britain, less so in the Eurozone, and marginal in the United States. Also, if the dollar’s value steadies within a band, U.S. firms should find less currency-related depreciation in their overseas earnings. International developed equities could experience the largest downward earnings revisions, but we expect little sustained referendum impact on emerging markets, which are already struggling with slow growth and economic reforms. For U.S. equities, we recommend large-capitalization issues, especially those that take support from improving growth—Consumer Discretionary, Industrials, Health Care, and Information Technology.

4. What are the implications for commodity prices?

  • Insofar as it supports the U.S. dollar’s value against many emerging-market currencies, the exit outcome should slow the broad industrial commodity price rally since the February low in oil prices. Gold could be an exception, if the yellow metal switches from tracking more with the U.S. dollar to tracking more with fear about the future of the EU. This tendency was already visible during late June, while polls were turning more to favor the exit outcome.
  • Lower oil prices should adversely affect Master Limited Partnership (MLP) values, but one offset could be that MLPs attract yield hunters should interest rates continue to slide. We view real estate investment trusts (REITs) as potentially one of the more stable real asset areas, especially if borrowing rates fall. The risk, however, is that REITs do not likely sidestep a global recession or perhaps even a slowdown—though such a slowdown is not our base case.

5. How can alternative investments help?

  • We did not anticipate a British “exit” vote, but the outcome supports our preference for strategies such as Equity Hedge and Relative Value that are balanced, opportunistic, carry low-net equity exposure, and are tactical. We believe that the diversification benefit of macro strategies is apparent today, and likely will continue in the aftermath of the referendum as those strategies are delivering positive returns from positions in fixed income, commodities, and currencies. In addition, we expect that the macro strategy will remain attractive in a gradual economic recovery.
  • We have confidence in our preference for low-net equity managers who can help investors both participate and reduce downside exposure in global equity markets. Finally, even though structured credit managers may see some mark-to-market losses given the risk-off move today, the fundamental support for sectors such as residential and commercial mortgage-backed securities remain sound and are less sensitive to macro influences than other areas of the credit market, like high yield.

6. What else should investors do about the British exit?

  • Our view is that the most important step investors can take today for their portfolios is to rebalance when markets are volatile, which means to take gains and reallocate the cash into asset classes that have upward potential. Bond prices broadly rose after the referendum, while global equity prices generally fell. In April, we recommended tactically reducing risk, specifically by cutting exposure to below long-term target allocations in U.S. small-capitalization equities and in emerging-market equities, but overweighting intermediate fixed income and REITs, for example. But even investors who are just following our long-term strategic recommendations may find opportunities to take profits in at least some fixed-income positions and reallocate cash into equities, starting with large-capitalization U.S. equities. A cautious investor might do this in stages, by adding cash at regular intervals.
  • At the base of our recommendation is the expectation that the surprise referendum result will only marginally affect the trajectory of 2016 growth outside of Great Britain and somewhat more in the Eurozone. The political implications of future European fractures are significant and bear watching but are likely to play out over years.

Risk Factors

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security.

Definitions

Alternative investments: Alternative investments are not suitable for all investors. Any offer to purchase or sell a specific alternative investment product will be made by the product's official offering documents. Investors could lose all or a substantial amount investing in these products. Equity Hedge strategies maintain positions both long and short in primarily equity and equity derivative securities. The use of derivatives may not be successful, resulting in losses, and the cost of such strategies may reduce returns and increase volatility. Investing in derivatives carries the risk of the underlying instrument as well as the derivative itself. Relative Value strategies seek to make profits by arbitrage opportunities between two related securities. These arbitrage opportunities might come in the way of pricing discrepancies between two securities or between securities and derivative instruments. Investing in distressed companies is speculative and subject to greater levels of credit, issuer and liquidity risks and the repayment of default obligations contains significant uncertainties such companies may be engaged in restructurings or bankruptcy proceedings.

Currency: Currency risk is the risk that foreign currencies will decline in value relative to that of the U.S. dollar. Exchange rate risk between the U.S. dollar and foreign currencies may cause the value of the portfolio's investments to decline.

Commodities: Investing in commodities is not suitable for all investors. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks.

Equities: Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.

Fixed Income: Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Foreign: Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

MLPs: Investment in Master Limited Partnerships (MLPs) involves certain risks which differ from an investment in the securities of a corporation. MLPs may be sensitive to price changes in oil, natural gas, etc., regulatory risk, and rising interest rates. A change in the current tax law regarding MLPs could result in the MLP being treated as a corporation for federal income tax purposes which would reduce the amount of cash flows distributed by the MLP. Other risks include the volatility associated with the use of leverage; volatility of the commodities markets; market risks; supply and demand; natural and man-made catastrophes; competition; liquidity; market price discount from Net Asset Value and other material risks.

REITs: There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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