Britain will vote to stay in the European Union in June, Stephanie Flanders, chief market strategist at JP Morgan predicts this week – but uncertainty about the future will cast a shadow over UK equities, short term fixed income rates and the UK currency.
While Flanders said she doubted investors would cease all market activity, the referendum clearly “put a chill on investment” in UK stocks.
Costs and Benefits of Brexit “Overstated”
The economic consequences of leaving have been overstated by both sides of the debate according to Flanders, but she conceded there would be hugely different economic relationship between UK and the EU in the event of a Brexit vote. However she did not see major economic benefits “at the end of the road”, as well as in the short and medium term impact.
“If we voted to leave the EU, rather than growing at about 2% a year, the UK would probably only manage about 1% growth for a few years, as uncertainty around the eventual outcome of negotiations about the UK’s future relationship with the EU may discourage or delay investment and trade,” Flanders said.
Flanders also added that the looming referendum had made it harder for active fund managers to outperform the UK market – particularly those focused on large cap stocks. Although share prices for the UK’s largest companies have fallen in recent months, and would look attractive in a normal market cycle, uncertainty adds complication.
Investors Look to US to Lower Risk
It is not just equities that have felt the repercussions of the Brexit referendum. The short term yield curve of government bonds in the US and UK merged in February, as money flowed across the pond. Lack of demand means that UK gilts are now paying out a larger yield, to reward investors in the face of potential risk.
“There is definitely a big premium that markets are asking for in terms of UK money,” Flanders added.
Weakness in UK Currency Continues
The risk of a Brexit also put further pressure on sterling, causing intense volatility in the UK currency. Sterling has already fallen in value by 7% so far and it is expected to drop by as much as 15% in the event of a leave vote, according to HiFX, a UK international money transfer company.
“Likewise if the UK remains in the EU, sterling could very quickly strengthen by about 7% and make up for lost ground.” Chris Towner, chief economist at HiFX said.
But Flanders expected a continuous weakness, with a “fair” rebound in sterling. She said the assumption that the pound would go straight back up was probably wrong due to a massive UK current account deficit seen in the end of last year. The UK’s current account deficit increased to £32.7 billion in the fourth quarter of 2015, which was equivalent to 7% of GDP at current market prices.
It also depends on whether the European Central Bank would use the exchange rate as a tool to stimulate the economy would also put a main pressure on sterling, Flanders added.
Where Should Investors Look for Return in this Environment?
While fixed income yields look depressed, UK equity income does look “pretty favourably”, Flanders said. She said that the recent dividend cuts among large companies in the US and the UK did not hold back the outlook for UK stocks and dividend yields still offered an attractive income alternative to bonds.
For a lower risk option, investors could consider to include absolute return funds in their portfolio, Michelle McGrade, chief investment officer at TD Direct Investing recommended ahead of the Brexit referendum in June.
Data for the graphics in this story was provided by JP Morgan Asset Management, Bloomberg, Bank of America/Merrill Lynch
