UOB Note Flash: UK walks out of the EU
On 23 June 2016, the United Kingdom (UK) voted by referendum to leave the European Union (EU). Financial markets have correspondingly reacted to the preliminary results, with the Sterling pound falling by about 10% against the US dollar to its weakest level in over 30 years. Asian equities also fell, with Japan Topix Index plunging 8% and Hong Kong’s Hang Seng Index dropping 5%. Closer to home, the Straits Times Index was down 3%.
With UK leaving the EU, expectations are that it will now invoke Article 50 of the 2007 Treaty of Lisbon, and begin a potential two-year negotiation period to set the terms by which the UK “withdraw(s) from the EU in accordance with its constitutional requirements”. The initial reaction by financial markets is expected to be sharply negative due to the uncertainties that could be unleashed by major changes to the structure of the EU, and the immediate impact on market confidence and economic behaviour.
In the aftermath of the UK’s “Leave” vote, EU leaders may take the unprecedented step of calling an emergency summit without UK representation. Nonetheless, an EU summit is already scheduled in Brussels on 28-29 June 2016. Cameron is still expected to represent the UK at the Brussels summit, although his position as Prime Minister is clearly in jeopardy. However, before that, investors will take heed of a Spanish general election on 26 June 2016. A strong showing by the left-leaning Podemos party may pressure EU leaders to re-examine the expansion of EU powers under the Lisbon Treaty.
The medium to long term effects of the UK vote are difficult to quantify. In the near term, we are more cautious on the outlook for risk assets, and equities in particular. We believe it will be increasingly difficult for risk assets to perform until the ongoing issues related to the exit are clarified and evidence shows limited spillover to the global economy.
While it is possible that market anxieties about Brexit will moderate by end of 2016, structural changes underlying UK-EU relations would need time to gestate. While immigration is likely to have little or no direct economic impact in the short run, trade and investment may be adversely impacted over the medium to long term. On balance we view the risks to the real economy and markets as being significant as the exit process means more uncertainty and friction on the horizon.
There will be headwinds along the way. First is the lack of clarity in trade and economic relations between UK and Europe. This uncertainty will persist for some time. Consequently, decisions on business investment may be placed on hold until there is visibility over the UK’s trading relationship with the EU. This will likely weigh on future business investment into the UK.
Another concern is the possibility of other EU member countries such as Holland, Sweden, and Italy calling for their own referendums. This could become the catalyst for a greater transition of the EU structure, again adding to uncertainty. Lastly, the UK is a significant contributor to the EU’s overall budgets and extricating the UK’s share and reallocating it accordingly is likely to be politically messy for the EU.
Asset allocation update
Given our concerns about the UK exit from the EU, we downgrade our recommended equity allocation to underweight and raise our fixed income allocation to overweight.
We continue to advocate lower beta positions within equities. We are overweight on the US, and underweight on the UK and Europe in our current asset allocation.
Within fixed income, we remain defensive. We are tactically overweight on duration. We prefer high quality corporate credit and remain cautious on high yield.
We remain underweight on commodities, with a preference for gold.
We are also overweight on cash. We expect gold, government bonds and the US dollar to benefit from this risk aversion.
The UK exit is likely to create a protracted period of uncertainty in financial markets, and will likely have negative implications on growth prospects for the UK and potentially elsewhere. We will look for evidence that market conditions are stabilising and that the global growth outlook improves before raising our risk positioning in our Tactical Asset Allocation (TAA).
Source: The Insiderstories
UOB Note Flash: UK walks out of the EU