To the surprise of most observers the Brexit happened. The most immediate impact has been a sharp drop of the British pound which lost 11%, an exceptionally brutal move. The impact on the stock markets has been very limited. European markets initially lost 6% and have recovered half of the loss while the S&P 500 has recovered all of the losses. Interestingly the UK market achieved the best returns and is trading 3% above its pre-Brexit level. This is because its constituents are big exporters which benefit from a weaker pound.
There were two further noteworthy developments in the financial markets.
Firstly, UK 10-year interest rates fell below 1% for the first time as the Bank of England will need to follow an expansionary monetary policy as the economy adjusts. This shows that the dynamic of zero interest rates in the world is far from over.
Secondly the Japanese yen appreciated 4% as investors fled to “safe-haven assets”. It is to some degree illustrative of investors’ struggle to identify safe assets that the yen is still considered a “haven” as Japan faces its own set of problems both in the short and in the long terms.
We expect the consequences of the Brexit to remain limited. The drop in UK interest rates illustrates the market’s confidence in the solidity of the Bank of England and in this respect it is essential to keep in mind that the UK has always maintained its own currency. This is a crucial difference for example with the situation that was faced by the EU at the time when there were market fears about a possible exit of Greece from the EU.
The possible exit of Britain from the EU will only happen as the result of a long negotiation process which will be started by the next British government. Further unpredictable developments are possible including possibly the negotiation of improved EU membership terms for Britain and a new referendum. While nobody can forecast what the end result will be one thing is clear: there is major trade between the EU and the UK and it is in the best interest of all parties to reach a balanced solution. One possibility might be a set of agreements between an independent UK and the EU that would from an economic point of view be very similar to the current situation. As shown by the cases of Switzerland and Norway, two independent countries with their own currencies, this is realistic.
In terms of investment policy the recent events only emphasize further the degree of uncertainty in our world and the necessity to prepare for extreme scenarios.
Particularly essential is currency hedging as in the current environment currencies are particularly exposed to seismic shocks. Every investor must clearly define his reference currency or currencies and ensure the protection of his purchase power in
consequence. While the clients of Rosetta Investments have substantial exposure to the UK they have generally been hedged very effectively for the currency risk.
More general market hedging remains as important as ever and has to be achieved using multiple levers, including:
- True diversification across asset classes, industries and geographies
- Inclusion of investments with low correlation to financial markets
- Top-quality in the choice of investments and of external investment managers
- Risk-mitigation of directional bets including the use of shorting strategies to
counter possible market downturns using long-short managers and systematic managers.
For investors willing to take in a higher degree of short-term volatility European banks are trading at historical lows similar or even lower than 2008 and might offer good long-term upside potential. The share prices of some quality UK retailers were also beaten up following the drop in the pound and can represent good value.
More generally, high-quality private equity investments, directly or through selected funds, can provide investors with the benefits of quality, reduced correlation as well as the advantage of the illiquidity premium.