Stock markets are too complacent about Brexit aftermath

Stock markets are too complacent about the potential consequences of the UK’s historic vote to leave the EU, says Robeco’s Lukas Daalder.

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He believes that equities have not fully priced in an ‘either-way-you-lose’ scenario as to what happens next if the Brexit actually does occur. Stock markets at first plunged following the shock verdict in the 23 June referendum, but later rallied on there being no immediate threat to UK companies, some of whom may actually benefit from the weaker pound.

However, the fact that the Brexit trigger has not yet been pulled by a UK government awaiting the arrival of a new Prime Minister, and the minimum two-year timeframe for any exit to be negotiated, is giving markets a false sense of security, says Daalder, Chief Investment Officer of Robeco Investment Solutions.

Financial markets had bargained on a Bremain outcome, and the initial shock was therefore pretty severe: the MSCI World index lost 7% in two days, and European stocks declined by more than 11%, while European banks declined by 18%,” says Daalder. “But as sharp as the decline was, so was the rebound: the Bank of England indicated that new monetary stimulus was to be expected this summer, while the odds of a rate hike by the Fed were completely priced out of the market.

Added to this was the fact that as time progressed, the reality sunk in that the Brexit vote would not result in a sudden move or collapse, and that it would take at least two months before anything sensible could be said on what would happen next. Stocks rebounded with especially the FTSE 100 defying the odds by breaking above the pre-Brexit close, helped by the decline in the British pound.

So, now what?

So, now what, asks Daalder. “Although we are happy that the events have not resulted in a meltdown scenario, we clearly think that the stock market is currently too complacent with regard to the whole situation,” he warns. “Sure, the two-month outlook is pretty stable and is likely to be relatively uneventful, but that should not be mistaken to mean that business is back to basics. Taking our cue from the UK economy, we would say that we are much more on an either-way-you-lose outcome.

Either the UK economy escapes mostly unharmed, with UK and European earnings only marginally impacted, which gives a clear signal that the downside of leaving the EU is not as bad as it is made out to be, opening the way for other member states to organize and win exit referendums. This is the scenario in which the European market starts to disintegrate, which would ultimately mark the end of the Eurozone as well.

Stock markets’ reaction during and following the referendum. Source: Bloomberg, Robeco

However, the alternative scenario of a big economic slowdown caused by a UK recession is not very positive either. Although this would serve as a deterrent for other exiteers, the drop in demand from the UK would certainly come at the cost of lower growth in the Eurozone as well. The odds of a messy divorce between the UK and the EU would clearly increase in this scenario, which is certainly not good for overall confidence and stability in the European markets.

Also, although we see the logic that US stocks are not directly impacted by the events on this side of the pond, we expect a weaker Europe to have a ripple-through impact on the political situation across the globe. With US stocks still expensive and earnings still down, it is hard to see why this increase in underlying political risk should be disregarded altogether.

Taking risk off the table

Daalder says much will depend on who the new British PM will be, as well as on future UK economic data. “On both subjects, the jury is out until the end of August at the earliest, but it could easily transpire that we are in for a prolonged period of wait-and-see,” he says.

In the meantime, Robeco Investment Solutions is taking risk off the table in its multi-asset portfolio by removing a previous overweight to equities until the position becomes clearer either way. The team also has short positions against the pound, whereby derivatives are used to insulate against further drops in sterling, which has already hit 31-year lows against the US dollar and euro. ‘We have set up a short pound position versus the dollar

As such, we have been selling European stocks and are now on balance in the process of decreasing our equity exposure,” says Daalder. “Additionally, we have set up a short pound position versus the dollar, as we believe that sterling is the logical variable for the UK to ‘use’ to alleviate the economic pain. The UK runs a current account deficit of close to 6% of GDP, with the EU acting as its biggest trade partner.

Finally, we also have set up a short position in the euro versus the dollar, in the expectation that the greenback should strengthen on deviating fundamentals compared to the Eurozone.

Lukas Daalder July 2016

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