- The UK has voted to leave the European Union (EU)
- Long term effects uncertain at this juncture
- Financial markets likely to see a period of risk aversion as participants grapple with how to digest the result and its implications
- Heightened downside risks to the GBP, UK equities and corporate bonds
- 2.5 - Star "Neutral" rating on European equities maintained at this juncture, vigilant over downside and upside risks
- Good opportunity to enter the Indian market as it still looks attractive
What Just Rocked Markets
The United Kingdom (UK) has voted to leave the European Union (EU) after 43 years of membership in a historic referendum, with the leave camp securing 51.9% of the votes while the remain camp only managed to garner 48.1%. With the UK voting to leave the EU, markets have reacted and reacted via heavy selling of risk assets and buying of safe-haven assets.
Volatility has surged across all asset classes, as market participants attempt to assess the impact across several dimensions including politics, geopolitics, economic and financial markets. In our view, the departure of the UK from the EU has little if any positives. While we had warned investors to "brace themselves for volatility given that markets will begin to reprice the eventual outcome", we were not hoping for Brexit to happen given the huge uncertainties a Brexit result would have for both the UK's economy and financial markets.
As in the earlier article on a potential Brexit outcome (First There Was Grexit, Then There Was Brexit), we see a plethora of downside risks to the UK and risk assets. For financial markets as a whole, we continue to see a high probability of risk aversion with a flight to safety mentality likely to be adopted over the near term as market participants grapple with how to digest the result and its implications. Safe-haven assets such as the USD and government bonds, particularly US Treasurys are likely to benefit given that they should be relatively less affected by the uncertainty facing the European Union and Eurozone.
Heightened downside risks to the GBP, UK equities and corporate bonds from UK entities or corporate bonds that are denominated in GBP are also likely to materialise. With the UK economy likely to suffer from uncertainty at the very least, capital inflows might be found wanting with the prospects for capital outflows increased. A rise in the borrowing costs of UK borrowers is likely as well given that UK Gilts (government bonds) are expected to see their yields rise as markets demand a higher risk premium for holding UK government debt given that just today, ratings agency Standard & Poor's chief rating office Moritz Kraemer commented that the UK's "AAA-rating is untenable under the circumstances". As for GBP weakness, given that the economy is expected to weaken moving forward, the Bank of England is likely to have to cut rates or restart its quantitative easing programme, all of which are likely to add downward pressure to the GBP.
While it will take the UK a maximum of two years to fully exit the EU upon the issuance of a formal notice to leave by the British government, the gears have been set in motion and there lies a huge amount of interconnections and policies to be sorted out in the near future. Within the UK itself, potential problems could arise in the future, given the divided results of the referendum that saw Scotland voting to remain in the EU and Northern Ireland doing likewise. The two nations might seek to have their own referendum over their future in the UK given their preference for remaining in the EU.In the meantime, time is needed to see how the situation will unfold as well as for further clarity as to the effects Brexit will have on both the economies and financial markets of the UK and the Eurozone. A co-ordinated response from policy makers and central banks is possible; expect central bankers to attempt to assuage market fears.
How Should Investors React?
Don't panic. Even though markets have reacted in a knee-jerk manner to the entire episode, investors might not be best served to follow their emotions and dump their investments. We do not believe that Brexit will spell the end of the world for investors, as markets will eventually find their footing.
The market has been eagerly awaiting this event for some time now. We are not immune to any global uncertainties and Indian markets have also taken a beating today. The currency has been volatile throughout the day. Team RBI has been actively intervening in the currency market to prevent any disaster on that side.
We are of the view that Brexit will have an impact on companies that have significant exposure in the UK. However, we will have to wait and see how Britain will manage their exit from EU and the impact that it will have on India. Over a time period of 3 years we continue to remain positive on India. Improving macro-economic fundamentals, a reform oriented Government, a pro-active Central Bank and attractive valuations continue to give us confidence in recommending India to our investors.
Our suggestion is that our investors use this volatile phase to take exposure into our recommended funds on the basis of their risk profile.
iFAST Research Team is part of iFAST Financial Pte Ltd.
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