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Volatility to remain at elevated levels for some time in wake of Brexit outcome

27 June 2016 Rian le Roux, Old Mutual Investment Group
Rian le Roux, Chief Economist at Old Mutual Investment Group.

Rian le Roux, Chief Economist at Old Mutual Investment Group.

The surprise outcome of the UK Brexit referendum had an immediate adverse impact on global financial markets, with stock markets coming off sharply and investors rushing into safe-haven assets.

Director of Investments, Hywel George

The surprise outcome of the UK Brexit referendum had an immediate adverse impact on global financial markets, with stock markets coming off sharply and investors rushing into safe-haven assets.

Given the global significance of the decision, investors can expect considerable volatility in the short-term; at least until the medium- to longer-term consequences of the UK leaving the European Union (EU) become clear. As an emerging market, South Africa is likely to be caught in the cross winds of this risk-off investment environment.

I am confident, however, that within a context of extreme volatility, opportunities will arise and, as long as investors do not panic and stay the course, our fund managers will be able to navigate these precarious market conditions, given the experience they have in negotiating similarly seismic crises in the past.

We asked our chief economist Rian le Roux to interpret what the decision means for the global macro-economy and South Africa. Graham Tucker, portfolio manager of the Old Mutual Balanced Fund, shares their current asset allocation positioning and what impact – both positive and negative − these events could have on the portfolios the MacroSolutions team manages.

Potential macroeconomic fallout of the UK’s decision to leave the EU, Chief Economist, Rian le Roux

The UK vote to leave the EU came as a shock, even though polls showed the decision to be a very close one.

Immediate market reactions have been largely as expected: equity markets are down sharply, the US dollar and Japanese yen have surged, the euro and, especially, the British pound, have slumped and bond yields outside of Europe fell in the rush to safe haven assets.

Looking at the global macroeconomic impact, the decision by British voters constitutes nothing short of a shock to the already slow growing and fragile global economy. The immediate transmission mechanism from the vote to the world economy will mostly be through global financial markets, with falling equity markets and a stronger US dollar implying a tightening in global financial conditions. The stronger US dollar will likely also pressure emerging market currencies, including the rand, and, as concerns over the global economy mount, capital flows to the developing world will likely also come under pressure. The US, itself will not escape any weakening in the global economy and the stronger US dollar will also act as a brake on the economic activity in the world’s biggest economy.

Central banks to extend life lines

As to how bad the impact on the world economy might be, considerable uncertainty exists, so the actions of global policy makers will be key. In this regard, one would expect central banks to provide considerable liquidity lines to the global banking system in the short term − so as to support global financial markets − and to lean towards an even more accommodative policy stance than is already the case over the medium term. Easier fiscal policy is also a possibility, especially in countries where scope for easing exists. Fiscal support could also come through lower taxes and/or increased government spending, especially on infrastructure.

Eurozone breakup and global recession risks rise

The longer-term concern for the world economy, and the issue markets will fret about the most in the short to medium term is what the UK’s decision means for Europe. If the UK’s decision leads to renewed concerns about a Eurozone breakup, global economic and market uncertainty and confidence, in general, will be more negatively affected, and likely over a more extended period, too.

With the above considerations in mind, the impact on the world economy is likely to be negative, although the extent of the hit is clearly hard to quantify, due to all the uncertainties − and estimates vary widely. In a worst-case scenario, global growth (currently running at an already slow 3% pace) could slow sharply to 2.5% or lower, the typical threshold for a global recession. Other estimates put the impact as very moderate, assuming policy makers are successful at stabilising financial markets relatively quickly and that fears of a Eurozone break-up do not become a major concern again.

SA will have to find its own drivers of growth

South Africa will not escape the market or economic fallout of Brexit, although the full impact will likely only become clear over time. While our financial markets will pretty much echo global markets in the short term, the medium-term impact on SA will be determined by the extent to which commodity prices, SA’s export volumes and capital flows to SA are affected. Still, SA’s already poor growth prospects will be further undermined, although the extent of which remain uncertain at this stage.

As far as the outlook for local interest rates is concerned, in the worst-case global scenario described above, the South African Reserve Bank (SARB) may be left with little choice but to raise rates further, should the rand take a major hit.

In a milder global outcome, with relatively little impact on commodity prices, capital flows and the rand, we think the SARB will keep rates unchanged for an extended period.

As far as the direct impact of a likely recession in the UK will have on SA, we estimate it to be relatively small, as the UK ‘takes’ only about 4% of SA’s exports. However, one area that might be negatively affected is tourism, as the UK is responsible for about 18% of tourist arrivals from outside Africa. A much weaker pound and a UK recession might negatively influence tourist arrivals from the UK.

On a more fundamental level, the current global turmoil and likely negative impact on the world economy highlights the fact that South Africa cannot rely on the world economy to drag us out of our slow growth trap and that the urgency to speed up growth-enhancing structural reforms has just ratcheted up another notch.

Investment ramifications of Brexit vote and our positioning, Old Mutual Balanced Fund portfolio manager, Graham Tucker

While the results of the referendum have sent shock waves through financial markets, we would expect our clients’ portfolios to be somewhat protected against these movements. Within our asset allocation funds, we have been positioned lighter than usual in South African equity and listed property (collectively known as growth assets), holding significantly more cash than normal in this volatile environment. For example, the Old Mutual Balanced Fund holds nearly 25% in cash and money market instruments at the beginning of this historic day. Within local equity, we hold meaningful positions in defensive shares such as British American Tobacco, Reinet and AngloGold. We prefer global equity to local equity, but remain less exposed to equity, and growth assets, in aggregate.

While we have been positioned more defensively of late, we have holdings in counters that are attractively priced and have good fundamentals, but are exposed to Brexit risk. Within the Old Mutual Balanced Fund, these include Old Mutual, Investec and, more recently, UK property company, Intu. We remain comfortable with these positions on a longer-term view, but there is clearly downside risk in the short term as investors grapple with the implications of the Brexit referendum outcome.

The fund holds about 12% in South African government bonds. These offer an attractive real yield and in our view should provide good medium term returns. However, they could be impacted by a selloff in emerging market assets and currencies. The initial reaction of the bond market has however been relatively muted.

Looking forward, this result reinforces our view that we are in a low growth and uncertain world. As such, we reiterate Rian’s comments of expecting policymakers to provide considerable liquidity lines to the global banking system in the short term, so as to support global financial markets. We would therefore view this as an opportunity to put your cash to work and gain exposure to quality assets that are indiscriminately sold off in the panic.

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