July 1, 2016

Peter Donisanu, Global Research Analyst

Brexit: It’s Not Over Yet

  • The referendum vote in the United Kingdom (UK) last week unleashed historic levels of market volatility that transitioned to a recovery in asset prices earlier this week.
  • We believe that coming events resulting from the referendum vote (ultimately propelling the UK out of the European Union (EU)) will be a catalyst for reflating political risk premiums, likely weighing on global financial market sentiment in the coming weeks and months.

What it may mean for investors

  • Therefore, we encourage investors to not be complacent in light of this week’s market rally, but remain prepared for periods of heightened levels of financial market volatility. We reiterate our guidance on portfolio positioning (and rebalancing) during such periods of volatility.

The British electorate’s decision to leave the EU (Brexit) had come as a shock to financial markets and some UK watchers. In the days following the referendum vote, risk assets (including global stocks, corporate bonds, and oil) sold off sharply, only to rebound earlier this week. The coming events (following last week’s vote) are expected to be highly political, highly disruptive and highly uncertain as the stage is set for a UK divorce from the EU, an unprecedented event. In the near future, we expect a Brexit-related political risk premium to play a significant role in global financial market sentiment. As a result, we anticipate financial-market activity to ebb-and-flow around key Brexit milestones and suggest investors position their portfolios for uncertainty-related volatility.

Looking forward

We anticipate that the uncertainty surrounding Britain’s exit from the EU will likely come in two phases: First, a “pre-exit” phase, centered on the formation of a new government in the British Parliament, expected to conclude by early September. Second, an “active-exit” phase, encompassing a period of at least two years in which a new British government will trigger a mechanism (either Article 50 of the Lisbon treaty or unilateral legislative reforms by the British Parliament) that leads to a prolonged period of negotiations and potential political upheaval in the UK and the EU.

During both periods, we expect global financial markets to price in a political risk premium for global financial asset prices. We define the political risk premium as the discounting mechanism that market participants use to price financial assets during periods of uncertain outcomes (for example, following actions such as Brexit). The higher the level of uncertainty surrounding political decisions, the greater the likelihood that prices for risk-sensitive assets (such as stocks, corporate bonds, and crude oil) will fall and that prices for traditionally risk-averse assets (such as sovereign bonds, gold and the U.S. dollar) will rise. One need only look back to the events surrounding the Greek debt crisis to see the parallel themes and risks for Brexit.

Chart 1. Greece’s Debt Crisis Was Marked by Heighted Market VolatilityChart 1. Greece’s Debt Crisis Was Marked by Heighted Market VolatilitySource: Wells Fargo Investment Institute, Bloomberg; 6/29/16.

On March 9, 2012, the Greek government announced that a majority of its bondholders agreed to haircuts of roughly 75 percent on their holdings of Greek government bonds. This outcome came after years of financial support from, and political wrangling within, the EU to help support the struggling Greek government—a period fraught with heightened levels of global market volatility. Similarly, today, the UK’s path toward settlement with EU leadership is expected to be fraught with contentious negotiations, ultimately leading to the UK’s technical exit from the EU.

As noted, the events surrounding Greece’s debt crisis in 2012 triggered extended periods of market volatility, leading global stocks (as measured by the MSCI All Country World Index), to decline by 11.2 percent between March and June 2012. Indeed, the seemingly innocuous events unfolding in Greece during 2009-2012 (and the years thereafter) had some market watchers asking how such a small country could have such an outsized impact on global financial markets (Greece’s economy is slightly larger than the U.S. state of Oregon’s economy and has a population slightly larger than that of Ohio).

Indeed, market participants at the time were not necessarily focusing on the economic and financial impact on Greece, but rather on how the political events unfolding in that country could influence developments in other hard-hit Eurozone economies such as Spain and Portugal—and potentially threaten the unity of the currency bloc as a whole. The outcome of the UK’s referendum vote on the EU has likely encouraged other Euroskeptic parties, whose political influence in the coming weeks and months could increase the uncertainty surrounding political unity within the EU. In turn, we expect that this is likely to lead to an increase in the political risk premium for financial markets (not dissimilar to the experience during the Greek debt crisis).

Bottom Line

We believe that the political risks surrounding last week’s Brexit vote are not over and likely will increase (and not diminish) until Britain’s exit from the EU is complete. As a result, we expect financial-market activity surrounding the two phases of the Brexit vote, a “pre-exit” and “active-exit” phase to lead to heightened levels of market volatility into the coming weeks and months. Additionally, it is likely that the June 23 Brexit referendum vote has the potential to inflame independence movements in the UK and, more broadly, in the EU—further aggravating the political risk premium to which financial markets have been sensitive over the past week.

We reiterate our recent investment advice, as we fully expect equity-market volatility to remain elevated for at least the next few weeks, likely following the same path exhibited in January and February. Our ranking for equities remains biased toward U.S. stocks (particularly large-cap equities), while we remain evenweight on developed-market equities and underweight on emerging-market stocks.

For bonds, we continue to favor exposure in the U.S. with a bias toward investment-grade issues. We remain underweight international developed-market bonds given their low yields and U.S.-dollar strength. The dollar’s strength will likely leave unhedged international exposures vulnerable, particularly in emerging markets. We therefore recommend that investors maintain dollar-based exposure to emerging-market bonds.

We also advise investors to resist becoming complacent during periods of positive market performance and suggest that investors take action to prepare for periods of heightened volatility. Given the ongoing uncertainty regarding the referendum vote and resulting financial market volatility, we reiterate our belief that investors can benefit from the investment themes discussed in our “Disruptions and Volatility” report—and should consider positioning their portfolios accordingly.1 We suggest that investors employ prudent portfolio-management strategies that include aligning their strategic asset allocation with their long-term investment goals. We also recommend rebalancing by bringing portfolio allocations in line with strategic objectives, while also adding and trimming allocations as favorable market conditions present themselves.

As we pointed out in our “Disruptions and Volatility” report, uncertainty poses risks as well as opportunities for investors. We recommend that investors seek to exploit price drops in markets as entry points for favorable investments. We also suggest that investors avoid trying to time the equity markets, particularly as it relates to events surrounding Brexit—as being out of the markets at the wrong time can be costly. As such, we believe that it is important that investors look through the uncertainties related to UK’s upcoming negotiations with the EU and remain fully committed to and fully invested in their long-term investment plan.

1 “Disruptions and Volatility: Where to Invest When Markets are in Perpetual Motion,” Wells Fargo Investment Institute, May 17, 2016.

Risk Factors

Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors.

Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment. Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.

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.

In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement.

Investing in gold, silver or other precious metals involves special risk considerations such as severe price fluctuations and adverse economic and regulatory developments affecting the sector or industry.

Definitions

An index is unmanaged and not available for direct investment.

MSCI AC World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Index consists of 46 country indices comprising 23 developed and 23 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indices included are: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

MSCI Europe Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance in Europe. The index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe and consists of the following 15 developed market country indices: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

Global Investment Strategy (“GIS”) is a division of Wells Fargo Investment Institute, Inc. Wells Fargo Investment Institute 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 GIS division of Wells Fargo Investment Institute. Opinions represent GIS’ opinion as of the date of this report and are for general informational 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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