Brexit: 5 areas financial advisors should watch

June 26, 2016 at 08:00 AM
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Just like no one really knew how the Brexit vote would turn out — and many forecasters got it wrong — it's difficult to know now how Britain's vote to leave the EU will affect global economies and markets in the longer term, but today it's been a bloodbath.

At different points during Friday's trading day, the British pound was off 11 percent, major stock indexes in the U.K., Western Europe and Japan were all down 8percent and the Dow Jones industrial average was off 500 points. The Dow ended the trading day down 611 points, or 3.4 percent, at 17,400. On the flip side, so-called safe haven investments rallied. Gold surged as much as 8 percent before closing up 4.7 percent at $1,322 an ounce, and the yield on the 10-Year U.S. Treasury note plunged as low as 1.4 percent before rebounding to 1.57 percent by the end of the day.

Central banks, including the Bank of England, European Central Bank, the Federal Reserve and even the People's Bank of China, responded to the carnage by pledging to provide liquidity to global markets as needed.

What happens next to global markets and the global economy is still uncertain, and markets, as we hear continuously from strategists and analysts, hate uncertainty, so advisors should be prepared for a bumpy ride.

FSR chief Tim Pawlenty says investors "should seek the advice of professional investment advisors as they contemplate" Brexit implications.

Here are some of the developments that financial advisors should be watching for:

1. Continued volatility in financial markets.

"The next few days will certainly test investors' tolerance for risk," writes David Lafferty, chief market strategist at Natixis Global Asset Management. Jeffrey Kleintop, chief global investment strategist at Charles Schwab, expects the volatility "will remain a major characteristic of markets in 2016.  

"Longer-term investors may want to maintain their diversified asset allocations intended to weather volatility on the way to longer-term goals," writes Kleintop.

On the flip side, U.K. and European stocks are now cheaper for global investors and foreign buyers of European companies. "If European currencies and equities remain weak, "I would be very surprised if you did not see an increase in M&A, i.e., foreign buyers taking advantage of the weakness, when viewed from their own currency," writes Stephen Peak, director of international equities at Henderson Global, which is based in London but has a U.S. office.

Among the most vulnerable stocks: financials. "Financials are potentially the biggest victims of a Brexit because of both the financial and economic shocks," write BofA Merrill Lynch analysts. "We think further earnings downgrades are likely and we cut to underweight." They're favoring defensive stocks like utilities and health care.

2. A stronger dollar, which has implications for other markets.

Commodity prices, which tend to move in the opposite direction of the dollar, could fall and emerging market stocks, fueled by concerns about dollar-denominated debt plus tighter financial conditions, could weaken, according to Kleintop. But gold, unlike industrial commodities, should "gain firm support," according to Bank of America Merrill Lynch analysts. Gold prices surged above $1,300 an ounce on Friday to their highest level since March 2014.

A stronger dollar has implications for U.S. multinationals that export to Europe, which will "see more material weakness in overseas profits," notes Charles Lieberman, chief investment officer of Advisors Capital.

3. Recession in the U.K. and weakness in the Eurozone.

"Brexit is very bad news for the U.K. economy. It is bad news for the euro area as well." write Merrill analysts. "We expect the U.K. to quickly enter recession." They expect Brexit will shave 0.5 percent to 1 percent off European GDP.

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4. Rate cut by the Bank of England and continued low rates in developed markets.

The Bank of England is expected to cut rates at least 0.25 percent and could possibly renew bond purchases in an effort to avert recession, according to Merrill analysts. "Uncertainty will likely be prolonged. Downside economic risks are large, in our view."

The ECB and Federal Reserve are also expected to maintain low rates The Fed released a statement today noting it is "prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy."

Don't expect the Fed to raise rates in July, maybe not even this year, but do expect continued low interest rates and bond yields.

FSR chief Tim Pawlenty says investors "should seek the advice of professional investment advisors as they contemplate" Brexit implications.

5. Uncertainty about the U.S. economy.

The reaction of U.S. stocks, especially financials, could play a big role in the overall impact of Brexit on the U.S. economy, according to Carl Weinberg, chief economist at High Frequency Economics. "The keys to whether the U.S. economy is affected significantly will be whether equities tumble enough to have a major impact on business and consumer confidence and whether banks are affected such that they pull back on lending," writes Weinberg.

HFE Chief U.S. Economist Jim O'Sullivan notes that even a 4percent drop in U.S. stocks by day's end would just put the S&P 500 back to where it was in mid-May. As of around 2 p.m. ET, major U.S. stock market indexes were off less than 3percent.

What Happens Next?

Uncertainty about global markets and global economies triggered by the Brexit vote will continue for weeks, months, possibly for more than a year because the vote is just a first step in a process for the U.K. to separate from the European Union. There are many more steps that need to be taken, including notification under Article 50 of the Lisbon Treaty, the exit clause for withdrawing from the EU.

U.K. Prime Minister David Cameron, who initiated the Brexit referendum in order to address schisms within his Conservative Party, had indicated he would activate that provision without delay if Brexit "leave" votes prevailed. But on Friday, after he had announced his resignation, Cameron said that decision should rest with the next prime minister who is expected to be chosen by October (Cameron remains until then).  EU ministers may not want to wait that long, and, in either case, the process of leaving the EU is expected to take about two years.

The Brexit vote could also trigger more defections from the EU. First Minister Nicola Sturgeon of Scotland, whose referendum on independence from the U.K. was voted down in 2014, last said Friday that it is "highly likely" the country will have a second referendum. Sturgeon said it was "democratically unacceptable" that Scotland would now leave the EU against its will. (In the Brexit vote, Scotland voted to remain in the EU).

In the meantime, advisors should consider the time horizon for their clients' investments. Azzad Asset Management suggests that investors in need of cash within the next few months take some risk off the table and reallocate some assets to fixed income but that long-term investors stay the course.

Tim Clift, chief investment strategist at Envestnet, agrees with Azzad Asset Management but also suggests that advisors consider rebalancing portfolios and, for those clients with cash on the sidelines, possible buying opportunities.

Regarding those opportunities, Lieberman of Advisors Capital Management, warns that it's "almost certainly premature to move some capital into Europe" but not "too soon to begin digging into how we might hope to take advantage of the dislocations that are occurring."

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