In Brexit’s Shadow, Diversification May be Best Bet

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August 05, 2016

The United Kingdom’s surprising decision to exit the European Union (EU) on June 23, 2016, has now left the world waiting for next steps — on both the economic and political fronts. As investors wait for politicians’ decisions, this event risk is likely to cause markets to experience increased volatility and drag on global economic growth. Individual investors as well are likely now struggling with their own responses to this crisis and elevated market volatility.


“In light of these developments, U.S. Bank believes the best course is to continue to use well-diversified portfolios of stocks, bonds, commodities and real estate to diversify the current event risks and to remain on track with long-term needs and goals,” says Robert Haworth, Senior Investment Strategist for U.S. Bank Wealth Management. 


New political leadership


The political issues will take time to unfold, Haworth says.

The first, most visible change is the emergence of fresh political leadership in the United Kingdom under the new prime minister, Theresa May, following the resignation of Prime Minister David Cameron. From here, the new government can decide if or when to initiate the withdrawal process from the EU.


Once the United Kingdom formally notifies the EU of its intent to withdraw, there is a two-year negotiation period, which can be extended by unanimous vote.

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August 05, 2016

“We generally expect the negotiations to result in a modified relationship between the United Kingdom and the EU,” Haworth says. “In our view, the chances are lower that negotiations will break down and lead to a total dissolution of the entities’ relationship, leaving the United Kingdom to negotiate bilateral agreements on trade and many other issues.”


Reactions from banks


Economic impacts from this political uncertainty are expected to be generally negative, with the biggest effects on the United Kingdom and the EU.


The political uncertainty is likely to suppress spending plans by both consumers and businesses in the United Kingdom, a decline large enough to potentially drop the United Kingdom into a recession over the next year.

“We believe, however, that the effects on other regional economies will be lower,” Haworth says. “The EU is likely to see a hit to growth due to reduced trade activity but should continue to muddle along at a very slow pace of expansion."


Haworth adds: “Other major global economies, such as the United States, Japan and China, may see only a fractional hit to economic data. For example, fundamentals for the United States remain relatively solid and should continue to power the economy at our current modest pace of growth.”


The combination of the ding to global economic growth and increased risk aversion by investors due to political uncertainty indicates that global central banks might remain cautious.

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August 05, 2016

Central banks already engaged in expansive easing programs, such as the European Central Bank and the Bank of Japan, are likely to expand quantitative easing programs and could even push short-term interest rates further negative.


The Bank of England is likely to cut interest rates to support the U.K.'s economy, and the U.S. Federal Reserve (Fed) might be more cautious in normalizing interest rates. “We may see only one rate increase from the Fed in 2016, most likely at the December meeting,” Haworth says.


Equity and currency markets have already seen significant volatility in the wake of the Brexit vote.


Haworth says that U.S. Bank believes volatility will remain elevated, given that political uncertainty is likely to continue for the next couple of years. This is a concern for investors, although low interest rates — including near-zero yields on cash — mean that waiting out the volatility in low-risk investments might damage one’s ability to meet long-term investment goals and needs.


“In our view, the appropriate solution is to use a diversified portfolio across global stocks, bonds, commodities and real estate,” Haworth says. “We believe portfolio diversification across a mix of growth and income investments is the best approach for investors to weather the long-term nature of this uncertainty while still continuing to earn some cash return in the near term.”

Diversification and asset allocation do not guarantee returns or protect against losses.


Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.  Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities.


There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).


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