June 27, 2016

Brexit Aftermath: Here’s What Others are Thinking James Gauthier, CFA / (416) 350-3369 [email protected]

Denise Davids, MBA / (647) 428-8220 [email protected]

Joel Beriault, CIM / (416) 863-5912 [email protected]

To augment the Brexit-related commentary provided by the Global Portfolio Advisory Group, we have collected and consolidated the thoughts of various asset managers and product suppliers that are represented in our channel. All views have been taken verbatim from content that is available in the public domain American Century Investments    

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Positioning: Remaining underweight to U.K. banks. Our global and non-U.S. equity portfolios have maintained underweight positions to U.K. banks relative to their benchmarks, given the expectation that they would be among the hardest hit in the event of a “leave” vote. Minimizing exposure to U.K. economy.. For the large-cap portfolios with current overweight positions, exposure generally includes companies that are global in nature; therefore, in such cases our economic exposure to the local economy is much lower. Managing risk exposure in response to higher expected volatility. We have been managing our portfolios below tracking error targets in 2016, taking into account the potential risk events on the horizon. Therefore, we have planned risk positioning accordingly and are positioned to add risk exposure as we see opportunities. Opportunistically watching GBP. We anticipate minimal downside pressure to our global and international fixed income portfolios due to any correction in the pound sterling. We were underweight GBP earlier in the year, taking advantage of the currency’s decline as sentiment shifted leading up to the referendum. We have recently shifted to a neutral position, which reduces our exposure to whatever post-referendum moves occur. We will watch the expected post-vote decline closely in the event of any oversold opportunities. Maintaining our bank overweight. Our view is that the post-financial crisis regulatory environment to increase bank capital, improve liquidity, and reduce risk in financial institutions will improve their credit profile to the benefit of bondholders over time. Therefore, we are maintaining our positions in euro-denominated and GBP-denominated European bank bonds, with the currency hedged to the U.S. dollar. Hedging against expected euro weakness. With the potential for euro weakness post-referendum, we have maintained short positions

BMO   

The U.K. accounts for a modest 3% of total U.S. trade and an even lesser 2.5% of Canadian trade. Such small shares and the likely modest impact on total trade suggest the direct risk to the North American economy is minimal. A Brexit will be messy, and will act as a further dampener on North American growth. However, given the size of the U.K. economy (9th largest in the world, 2% of global GDP) and its small share of trade with Canada and the U.S., the uncertainty and its impact on financial markets may be the biggest negative at the moment. Indeed, the broad declines in equities, commodities and bond yields globally point to further downside in near-term global growth prospects. Ultimately, though, Brexit is about a trade deal and political arrangements, and the biggest loser from Brexit will be the U.K. itself.

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CIBC Economics     

Central banks will now move to damage-control mode. The Bank of England might cut rates and expansion of its quantitative easing program is a possibility. The ECB might cut again in July and the Bank of Japan might introduce another easing package. The Fed will probably shelf any plans to hike in September. In all likelihood the uncertainty will be large enough to damage economic activity in the UK, with a recession being a real possibility. A comprehensive study by Open Europe found that an exit without a replacement trade pact would trim UK GDP by 2% by 2030. But more likely outcomes involving replacement trade deals with the EU and/or other partners will leave the UK economy little affected by an exit, or even a small net winner under the best case scenario. We have doubts about the precision of such estimates, but their order of magnitude suggests that Brexit isn’t a make or break issue for the UK over the long-term. Markets tend to overestimate developments in the short term and underestimate them in a long term. That might be the case with the Brexit vote. The near-term damage might be less significant than currently assessed by the market, but the long-term consequences of the vote are significant. And those are mostly political, with rising demands for a referendum on EU membership in France, Italy and the Netherlands. Such demands may now be harder to resist. In the long term that can potentially impact the very existence of the euro.

DoubleLine Capital/Jeff Gundlach   

While Britain’s historic independence vote has shocked financial markets and political centers, the asset valuation and economic themes forming DoubleLine’s outlook remain in force. DoubleLine has been in a capital preservation posture, awaiting a time when sell-offs in risky assets such as credit and equities could open opportunities to take advantage of repricings in those asset classes. The Brexit outcome suggests the public mood for change is even greater than we had thought. While the referendum result triggered selling in U.S. stocks and widening in credit spreads, and much greater repricings in risk assets on the Continent, we continue to emphasize capital protection while looking to take advantage of dislocations in select markets, including in the aftermath of the Brexit vote as Brussels and London implement Britain’s Independence Day.

Dynamic/Myles Zyblock, Chief Investment Strategist    

In the following days and weeks, we expect a lot of noise to permeate from the news media surrounding this event. When events like these occur, big two-way daily volatility is typical in the days and weeks after the event. The complication with this event is that it is political and it will probably unfold over months and years. That said, investors will eventually adjust and realize the world is not ending after coping with the initial shock and then it'll move back to status quo behavior – be it the impact of more central bank interventionism or earnings delivery. Fasten seat belts and expect lots of two way risk over the next few days. Wait for news on any potential spillovers – like company pronouncements, Spanish politics, etc. Wait for any central bank reactions/announcements and see how the market absorbs the news. I don't feel I need to try to time the bottom here. Sometimes the best thing to do is to let the initial dust settle.

Industrial Alliance Investment Management  

We are now witnessing highly elevated volatility in Europe (measured by the VSTOXX index, Europe’s equivalent to the VIX), and the gap between Europe’s and the U.S.’ implied volatilities is sitting at a 5-year high. The spread between the valuation of the U.S. and European stock markets, measured by the forward P/E ratios, is also at a 5-year high (see right chart below). As returns in the months following heightened volatility are usually above normal and European equities are in themselves attractive on a relative basis, this could lead to interesting returns for the opportunistic investor.

iShares   

We expect the UK divorce to be messy, drawn out and costly. We expect potential losses in services exports and investment flows to overwhelm any benefits of lower payments to EU. We see a weaker euro over time and pressure on European shares, credit and peripheral bonds such as Italian government debt due to likely European job losses and lower growth. We expect limited pressure on government budgets, however, as high-quality government bonds are in demand in a low-rate world. The Bank of England’s first priority will be to provide ample liquidity to avoid any funding stresses, in our view. The magnitude and volatility of the British pound’s fall will likely dictate further responses. We expect the central bank to

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cut its 0.5% policy interest rate to zero soon, and see it returning to quantitative easing rather than pushing rates into negative territory. We expect credit rating agencies to quickly adopt negative outlooks for UK government bonds, with downgrades to follow. 

U.S. and Asia markets are only marginally affected by the UK’s exit from the EU, and are supported by a mix of easy monetary policy and economic growth. In the UK, we expect the large-cap FTSE 100 Index to outperform the more domestically focused FTSE 250 Index. A UK currency drop benefits large companies with overseas earnings, whereas domestic sectors such as homebuilders, retail and financials look vulnerable.

Mackenzie  

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Volatility is likely to remain elevated until markets better understand the next steps of the exit process and its implications for Europe. In the absence of an agreement, the UK will need to decide which of the almost 7,000 EU rules and regulations will remain in place. Since 45% of British exports go the EU, a key British priority will be to negotiate continued favourable access to the EU common market. In addition, the status of millions of British and EU citizens working abroad will also need to be decided. While volatility is likely to be high in the coming weeks, we expect a return to normalcy thereafter. The long-term economic impact of Brexit is likely to be limited outside the UK because the British economy accounts for just 3.5% of global GDP.

RBC Global Asset Management  

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The ongoing effect is that high policy uncertainty surrounding Brexit has already interfered with U.K. business investment over the last few quarters, undermining the rate of economic growth. This had been a key factor in our previously downgraded U.K. 2016 growth forecast from 2.5% to 2.0%. The short-term effect is that the U.K. is now at greater risk of a temporary recession (with a roughly 60% probability) as the recent abrupt financial market declines combined with increased risk aversion stall economic growth in the short run. Note that the U.K. will not actually leave the EU for several years, so this drag is not due to higher tariffs or diminished immigration but rather represents an anticipatory effect by businesses and households. The long-term effect is only moderate, but not insignificant. Overall, the impact should be somewhat negative due to higher tariffs, less immigration and the slight diminishment of London as a financial hub. However, the precise effect depends enormously on what sort of subsequent relationship the U.K. negotiates with the EU. We continue to operate on the assumption that markets will first overreact, and then reclaim some of their losses. Arguably this is already happening in most markets, though it is not entirely clear whether markets could again suffer lower lows before sustaining a more enduring rebound. Either way, there are certainly investment opportunities to be captured as all of this plays out. It is important to recognize that Brexit should not trigger opaque, cascading losses on the order of the 2008-2009 financial crisis. Banks do not appear set to be undermined, and the Bank of England is offering additional liquidity to ensure that this is avoided. Similarly, the scope for global contagion – while material – is not as dramatic as during the financial crisis.

RP Investment Advisors 

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RP Investment Advisors purposely positioned our portfolios conservatively given the binary nature of the outcome, reducing overall risk exposures and specific positions in UK credits. Importantly, as we hedge all of our foreign exchange exposures the volatile movements in currencies globally should have no meaningful impact on our portfolios. In respect of credit markets we are seeing a reasonably orderly repricing of credit risk. We would conclude that there remains much capital in the hands of fixed income investors to deploy into this market repricing. Importantly, while this can present an opportunity to add to high quality credits at good spread levels, we only intend to add to risk incrementally. Global growth will likely be constrained and this will serve to keep global interest rates lower for a longer period of time. The market now is pushing out the timing of further rate hikes by the U.S. Federal Reserve. At present the RPIA Portfolio Management team remains focused upon: 1) Assessing the risk that other European Union members may determine to leave the union, and the impact that this might have on the European Central Bank and its monetary system; 2) Analyzing the manner in which both the European Central Bank and Bank of England respond to the UK “leave” vote; and, 3) The impact of the “leave” vote on the new issue market for credit markets, where increased volatility will reduce new issue activity globally.

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Russell Investments  

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Expect more volatility: Bond yields have been heavily influenced by Brexit fears, sending the Canada 10-year yield on a roller-coaster ride over the last month. Yields declined from a high of around 1.4% in late May, to under 1.1% mid-June, rose back to 1.3% by June 23, and rallied on June 24th toward 1.1%. Manage risk dynamically: To invest in this environment, we continue to believe in a dynamic approach, reacting to market events to “sell the rallies” or, where appropriate, “buy the dips.” Identifying the signals in the noise requires a disciplined approach. After a multi-year bull market for equities and risk assets, risk management has been, and will continue to be, paramount in protecting returns. Across multi-asset portfolios, our belief is that this is achieved through diversification, particularly away from pure equity risk and through the use of options to structure a more attractive risk/reward payoff. Look for opportunities: Over the coming days and weeks, as markets turn their attention to other events, volatile market conditions are likely to remain. Our investment strategist and portfolio management teams continue to identify ways to both protect against risks, and, just as importantly, look for opportunities to add value, especially where market reactions are out of line with our fundamental expectations.

TD Economics        

In terms of the U.S. and Canada, trade linkages with the UK are small (5% and 3%, respectively). This is not the main driver or concern. Under a straight forward model simulation, financial and con¬fidence spillovers could shave real GDP estimates by 0.5 percentage point or more in the second half of this year. A new Prime Minister for the UK is certain and will be responsible for turning the referendum result into a formal request to leave the EU Looking beyond (June 24th and early this week), we foresee some stability returning to financial markets particularly as investors start to take advantage of buying opportunities, however we expect a prolonged period of market volatility. From the UK’s perspective, the Bank of England has announced enhanced liquidity provisions and will cut its policy rate by 50 bps by its August 4th meeting. Further easing measures, such as an asset purchase program, could possibly be on tap later this year if the domestic growth and inflation outlook continues to deteriorate. Outside of Europe, direct trade spillovers are relatively small: Canada sends about 3% of its annual goods exports to the UK, while the U.S. sends about 5%. The Canadian regions most likely to feel the brunt of reduced UK demand are Newfoundland & Labrador, which ships about 8% of its total annual goods exports to the UK, and Ontario, which sends about 6% of its annual goods exports to the UK. In addition, the UK is a popular destination for Canadian and U.S. firms investment, with about 9% of total annual Canadian foreign direct investment We estimate that confidence and financial spillovers from a leave result could shave about 0.5 to 1.0 percentage point off GDP growth for the U.S. and Canada in the second half of 2016, driven mainly by an expected reduction in business investment growth as a result of a rise in global economic uncertainty.

Vanguard 

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Bottom line: U.K. recession is possible, in our view, with potential contagion in Europe and Asia. Reduced prospects for domestic companies, capital outflows amid such uncertainty, and partial paralysis of the world’s fifthlargest economy could result in recession. It will almost certainly result in increased unemployment and GDP contraction. A weakened pound will make goods more expensive for domestic consumers. Uncertainty will only contribute to lower consumer and investor confidence. The rest of Europe will be similarly pressured in the immediate term. The euro is likely to decline relative to other major world currencies, which could undermine some of the recent improvement in economic results there. Any currency weakness that acts to strengthen the USD could also have ripple effects by further pressuring China and the yuan, raising the possibility of an impact on global economic growth.

WisdomTree  

Our central thesis is that the UK’s structural economic imbalance is likely to grow larger as a result of Brexit. Underpinned by a large current account deficit of 7% of GDP, the UK is going to have to rely ever more on the grace of foreign investors to finance a growing trade deficit. A devaluation of the pound, one likely fallout, may help make British goods more competitive and could offset some pressures from less favorable trade terms, while leading to price pressures for imported goods into the UK, thus hurting consumers.

Brexit Commentaries

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UK financial services are most at risk of trade barriers being erected in an attempt by the EU to reduce its trade deficit with the UK. Outside the services industry, in sectors such as cars, chemicals, clothing and footwear, and food, beverage and tobacco, where the UK has struggled to gain preferential trade agreements, a high-tariff regime against UK firms is likely to remain or become more punitive. Unfavorable for UK-Oriented European Small Caps. Most susceptible to such downside risks are smallercapitalization stocks whose business models are more focused in the UK or whose trade profile is more concentrated in Europe. Least susceptible to unfavorable trade agreements may be UK large caps. UK multinationals with a strong global footprint may benefit from improved exports and revenues if the pound weakens and investors hedge that currency exposure. Gilts: Short-term gain, long-term pain. A risk-off sentiment will potentially boost gilts in the short term. Further out, the UK’s large macro imbalance will be laid bare in anticipation of a volatile and debased currency—the pound sterling’s safe-haven status is undermined, and with it will be foreign investors’ gilt purchases. Bunds: Unassailable haven for safety. An already heavily crowded trade in German bunds may intensify if sentiment in risk assets, particularly within Eurozone banks, sours decisively. A negative yielding bund may not be a big enough deterrent any longer. Bearish Euro, Bullish Dollar. The dollar is expected to benefit from bullish sentiment relative to the euro, as U.S. domestic fundamentals are stronger. Banks have stronger balance sheets, the labor market remains resilient and business confidence is proving stable. A relative wide U.S. interest-rate differential over the Eurozone means the euro is structurally weak.

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