- As the United Kingdom moves toward separating from the European Union, our chief concerns are risks surrounding the British pound and European politics.
- Policy responses both within and outside of Europe could generate new investment opportunities.
- Indiscriminate selling and currency moves have led to opportunities emerging for longer-term investors.
The U.K. economy could get worse if the pound plunges
One of our chief concerns related to Brexit is the vulnerability of the pound. The United Kingdom runs a current account deficit representing approximately 7% of gross domestic product (GDP), funded by foreign direct investment and by portfolio flows from abroad into British sovereign debt, or gilts.
In the wake of the referendum, however, foreign direct investment is likely to weaken as firms wait to see how the U.K.’s trading relationship with the EU is resolved. Portfolio flows have held up well so far, but may be at risk following recent rating agency downgrades.
The bottom line is that difficulty in funding the current account deficit could, in an adverse scenario, lead the Bank of England to raise rates to protect the pound and attract overseas flows. However, higher rates would hurt the already fragile British economy.
Political fragmentation within Europe
The example set by Brexit — both the vote itself and the political stances taken as leaders negotiate the separation terms — may strengthen other anti-EU parties across Europe. We believe that uncertainty regarding the terms of Brexit is likely to expand across the EU, which could restrict investment risk taking. In concrete terms, this means that factories may not be built, houses may not be purchased, and the brakes may be applied to economic growth. Also, we foresee that merger and acquisition (M&A) activity is likely to stall, and investors may shun equities for the perceived safety of bonds and gold.
Lower yields and policy responses could create opportunities and new risks
We have already seen bond yields fall, and there are scenarios in which they could fall further. While lower interest rates can be stimulative for economic growth, they are less so when rates begin where they currently sit: at negative levels in Europe and Japan, and at historic lows in the United States and the United Kingdom.
Low rates also spell trouble for banks. Major cracks are beginning to form in the European and Japanese banking sectors. Profits are under intense pressure and new loan demand is tepid. To add a positive note, we see potential opportunities in the United Kingdom and Europe but also in Japan, both among domestic businesses and exporters, notwithstanding the strengthening of the yen.