A brave new world post – Brexit?
The immediate pain of the Brexit vote was seen in headlines proclaiming that the UK’s pensions deficit has reached £1 trillion. Actually, the negative and positive implications of the Brexit vote will ricochet through the global economy and financial markets for years to come.
Starting with economic activity, an uncertainty shock of this size will cause the UK to slow materially, and Europe more modestly, into 2017, certainly requiring a central bank response – probably a fiscal response in due course too. Early, aggressive and co-ordinated easing would be a precondition for a better outcome - we hope to see rate cuts in July, and the Bank of England open the door to future QE if that is required. Other countries face their own triggers to ease policy. We consider that for the US and Japan in particular the degree of upward pressure on their currencies will be particularly influential.
How long will this market turmoil last? Sadly it largely depends on politics, but also the success of policy making, not just in the UK but especially the EU. This is both in terms of the pressures on political systems in other countries – such as the calls for referendum in some parts of Europe - but also how constructive and rapid the UK's negotiations are with its EU partners. We emphasise that ‘Brexit’ is a process, not an event, and it is an issue for the whole of Europe, rather than just the UK.
What is in the price? At the time of writing, the broader UK equity market is pricing in a modest recession. A number of stocks look very expensive, while this degree of market turmoil opens up possibilities for fund managers when stocks are hurt too much in an environment when macro factors dominate company specific characteristics. However, the timing of any recovery in share prices will depend on political and policy triggers rather than just valuations. What was seen as defensive in the past need not be in the new environment. Conversely, a serious bear market in the UK or indeed globally requires rather more financial contagion and stress than has currently been seen – again political or policy errors of judgement are sources of vulnerability.
We do expect global bond yields to remain lower for even longer, with flatter yield curves, with all that means for pension schemes. This trend is supported not just by safe haven flows and the impact of widespread negative interest rates but also the shock of slower UK & European growth. For some time the House View has favoured sustainable yield, such as credit and equity income, as its main investment theme. This view is clearly enhanced by recent developments – although the definition of sustainable yield will evolve as business models are forced to change.
Our focus on change analysis and our experience with scenario analysis comes into its own at times like these. For example, months ago we tested our absolute returns portfolios for the possibility of a Brexit shock. What are the next major triggers to focus on? They include the series of major central bank meetings held in July, and then the various elections in September-November. These events will provide waymarks for the future direction of economies, politics and therefore markets. Last of all, investors need to be watchful of disruption to capital flows into the UK and whether this creates undue pressure on sterling against the backdrop of a sizeable current account deficit. That could mark a much more dangerous situation for pension schemes in the UK and overseas.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Professional Pensions July 2016