- The United Kingdom (“UK”) held a European Union (“EU”) referendum on 23 June 2016 to let the British people to vote whether UK should exit or remain in the EU.
- The outcome: 52% voted to exit and 48% voted to remain; with majority of England and Wales voted for an exit, while majority of Scotland and Northern Ireland voted to remain.
- Markets were volatile going into the vote. On confirmation of an exit outcome, British Pound (“GBP”) slumped by 10% against US Dollar, its lowest level since 1985.
- Globally, financial markets reacted negatively. Stock markets and Emerging Markets (“EM”) declined.
General Market Implications and Politics
The short term impact on UK economy is likely to be negative. UK financial assets could weaken as a result of capital flight and uncertainty. The overall uncertainty hurts investments and consumer spending, potentially leading to an economic recession. This could be partially offset by a lower GBP and easier monetary policy, but the net effect should be weaker growth or an economic recession if the political uncertainty persists indefinitely.
Longer term, there is a great degree of uncertainty because the future state of the UK economy would be highly dependent on the outcome of negotiations with EU. Some political analysts have raised the possibility that subsequent to a Brexit outcome, EU could deliberately harden their negotiating stance with UK in order to make an example out of UK. This would be a strategic move by EU to deter other member countries from holding their own exit referendums.
We believe that Brexit might not be an isolated event and we expect at least some short-term turmoil in the global financial markets. The connection to the world is through financial and trade linkages. EU is already experiencing heightening degrees of populism and the rise of anti- establishment parties across the region. Brexit would only reinforce the resolve of these nationalistic populist parties whom seem to thrive on anti-EU rhetoric. The Euro dropped 3.3% immediately on the Brexit outcome (note that it has since recovered 50% of its losses at the time of this writing). Rising political uncertainty across the EU could further pressure the Euro, leading to broad US Dollar strength and hence weigh down on Asian currencies and Asian financial assets. Heightened EU political uncertainty could also dampen investments and private consumption across EU, leading to even slower growth and hence dragging down on global trade.
General Investment Strategy
The Brexit vote is unprecedented in history and although we believe that short-term financial market turmoil is likely, it is more difficult to gauge at this moment whether this could evolve into a prolonged period of negative growth across the EU region. However, central banks especially the European Central Bank (“ECB”) and the Bank of England (“BOE”) are expected to step up accommodative monetary policies should negative growth worsens in EU and UK.
In the US Federal Reserve’s case, they could delay rate hikes again. Governments could coordinate expansionary fiscal policies to boost growth. The key message here is that although we expect global growth to be subpar, which could imply modest or low investment returns, we are not ruling out global policy action that could support the markets and drive them higher.
We therefore take the prudent course of action of adopting a “wait and see” strategy. We have identified potential opportunities in advance. We have cashed up going into this Brexit vote and are ready to deploy cash if we are confident that negative spill-over effects have played out. We will continue to assess prevailing conditions to determine the best time to buy on value.
Equity markets and companies are evaluated from three aspects: Fundamentals, Valuations and Technicals (fund flows and positioning).
1. The Fundamental impact from the Brexit scenario is a weaker UK economy and weaker GBP and EUR. So fundamentally, companies with exports or have business operations in UK and Europe will be impacted. We have limited exposure to these names. The wider implication is slower global and trade growth.
2. Valuations for markets have not been cheap. MSCI Asia Ex Japan was at 12.3x (before today’s drop) and this is above the 5-year mean of 11.3x. Today’s drop of >3% will bring valuations closer to mean. Further sell down would make valuations more attractive.
3. From a technical view point:
a. USD strength is a headwind. USD is negatively
correlated with Asian equity markets. This relationship is due to tighter financial conditions and portfolio outflows as USD strengthens.
b. Global funds’ cash holdings are elevated and highest since November 2001. This is before the current tail risk event. The cash holdings will now go higher. But such high cash holdings is a good contrarian indicator.
Conclusion and Strategy
The fundamental impact to most Asian stocks is low. The short term technical impact due to fund flows and USD strength will be felt but this gives opportunity to buy into companies at lower valuations with fundamentals intact. Our funds generally have high cash levels. We have and will continue to identify companies to buy from this broad sell-off.
What we look out for are:
► Quality companies with sustainable growth, without excessive leverage and generating healthy free cash flows;
► Structural themes like internet and infrastructure; ► Dividend yielders (REITs).
Global Rates Strategy
We intend to remain long duration as we believe that the global growth environment will worsen over a longer period as rising political uncertainty in the EU dampens global growth prospects even more. The accommodative monetary policies of central banks globally should continue to support a long duration rates strategy. We do not intend to extend duration in the short term as we do not want to chase yields lower in the current risk-off environment in case the risk assets sell-off becomes extended and possibly lead to a short-term rates sell-off.
Asia Credit Strategy
The Asia credit universe will be affected by the general risk-off sentiment after Brexit in the coming weeks, although the immediate reaction to the extent that has been broadly well-contained with relatively good liquidity in the market. Investment Grade (“IG”) bonds, which are rated BBB- and higher, have seen spreads widen 10-25bps across the board. Surprisingly, there have been some bottom fishing in some of the benchmark names, which we view as too early as the Asia credit market is still digesting the UK’s next steps post-Brexit. As for the High Yield (“HY”) bond market, it is a touch weaker with orderly selling flows. China Property bonds were 0.25-0.75 cash points down on the back of Private Banking accounts selling while there are also some Chinese investors keen to buy selective bonds. In summary, we believe the sell-off in Asia credit is mitigated by its strong technicals whereby supply (bond issuances) year-to-date have been low compared to previous years and demand has been very strong due to lower-for-longer global yields which has created a hunt for yield in Asia-USD corporate bonds. This implies bond prices are to be relatively well-supported. Further, Asia credit investors in general have decent cash levels in their portfolios, thus, there is no impetus to force sell bonds should there be any fund redemptions. Our current holdings of predominantly IG bonds are relatively more resilient to the impact of Brexit on Asian corporate earnings and IG corporates have stronger balance sheet positions to withstand the volatility in Asian currencies and its impact on earnings. Our fixed income portfolios have relatively high cash levels of approximately 7%-10%, which places us in a strong position to add to our positions upon weakness when the dust settles. Meanwhile, our existing positions provide the portfolios with good coupon in defensive corporates at a duration of 4-5years. Malaysia Fixed Income Strategy
In Malaysia, the immediate impact towards the bond market was largely seen through government bonds as the Malaysia Government Securities (“MGS”) yield curve flattened with the 10-year moving higher by 3bps to 3.91% and the 5-year by 8bps to 3.50%. The latter was seen more vulnerable to the sell-off as it was initially a major outperformer on the curve, leading up to the UK referendum. The shorter end of the yield curve was relatively unaffected and remained well anchored despite the Ringgit being one of the highest beta currencies in Asia towards Brexit, weakening by 2.7% within the first half of the day.
Much of the resilience in the shorter end of the curve is owed to the potential of an overnight policy rate (“OPR”) cut by Bank Negara as the central bank may grow concerned towards the impact of UK leaving EU could have towards Malaysia’s growth outlook.
With that in view, we continue to think that the local bond market, especially the Private Debt Securities (“PDS”) segment remains well supported. Ample liquidity from yield hungry investors and a slowdown in private debt securities primary issuances, will see continued buying interest should pockets of relative value appear.
The potential risk lies more so in outflows from the government bond space with foreign holdings of MGS remaining close to 50%. However, with global yields remaining low for a prolonged period, MGS yields continue to appear attractive from a foreign perspective hence preventing a large scale sell-off from happening.
Moreover, much of the idiosyncratic concerns towards Malaysia as a country have somewhat abated lately. We thus continue to hold on to our strategy of remaining long duration for our portfolios invested in Ringgit-denominated bonds, whilst being slightly cautious towards the government bond space.