Perspectives. Brexit: Implications for Eurozone investors

Transcription

1 Perspectives Brexit: Implications for Eurozone investors Asset Research Team and Eurozone Advisory Portfolio Group July 2016

2 Brexit: Implications for Eurozone investors ART and Eurozone APG July 2016 Executive summary The UK has voted to leave the European Union (EU). The exact terms and timing of this exit are unclear. How investors respond to a world that is significantly less certain is of critical importance. The drivers of this world are as much political and diplomatic as they are economic or financial. Over the past weeks, we have seen sharp movements in yields, share prices and currencies in response to the UK vote to leave the EU. Although subsequently some of these movements have partially reversed, volatility remains with several key political events in the EU in the coming months/years (see Figure 1). Given these political events, we believe scenarios provide the mechanism to translate political pathways into financial ones. Our 5-year capital market outlook scenarios provide appropriate insight into the possible outcomes over the medium term for Eurozone investors. Of these scenarios, the downside risks scenario takes a worldwide recession into account, somewhere in the next five years. Our increased assessment of the chance of this scenario (we have increased it from 35% to 40% compared to 2015) reflects the increased volatility and possible triggers in today s markets. Our main Debt Overhang; Growth Moderation scenario is, given recent events, even more applicable since growth will be lower for (much) longer. Besides our scenario analysis, implications for Eurozone investors based on the market developments are in line with our key messages relating to the low-yielding environment and we urge Eurozone investors to rethink their fixed income portfolios, their exposure to the UK economy, European banking sector risk, and to consider the broader implications for hedging and possible downside protection. Figure 1. Political developments things to watch in the Eurozone Country Things to watch in the Eurozone UK New government s Brexit stance, possible snap elections, relations with Scotland Ireland Multifaceted coalition, possible snap elections; border and free movement of people issues arising Italy Referendum on Renzi s constitutional reforms in October 2016 Netherlands General election before March 2017 France Presidential election in April and May 2017 Germany Federal election in September and October willistowerswatson.com

3 Brexit: Implications for investors Key channels to consider Introduction The UK electorate has voted to leave the EU. For all EU citizens, this historic event leaves us in interesting times, both politically and economically. This note discusses how we believe pension funds should assess the investment implications of these events. Our approach can also be used as a basis for wider funding discussions. The challenge for investors is that the UK s exit from the EU (referred to as Brexit herein) is inherently political. Pension funds must make judgements based on unclear and sometimes erratic political and diplomatic developments, when often we are more comfortable basing investment decisions on economic or market fundamentals. In this note, we first link the politics to the economics to understand the impact on market fundamentals and explain the relevance of Brexit to Eurozone investors. We further provide practical considerations for a long-term portfolio and finally introduce our scenario modelling tool to provide insight into the funding ratio impact. Linking politics to economics There are several channels through which the politics flows through the economy and into market returns: Policy uncertainty The key near-term determinant of economic and market outcomes will be the impact of uncertainty, most notably for the UK but also for the Eurozone. The key drivers here include: Politics: political developments are key factors in future uncertainty. The pace at which clarity emerges over UK politics and policies, the diplomatic process and the stance of the EU will be key to outcomes. Figure 2 shows the range of options that will be the starting point of negotiations. Investment (foreign and domestic): the degree to which firms delay investment in the UK because of uncertainty is critical to growth. In turn, this is influenced by evolving consumer and business confidence. Employment and incomes: business confidence will affect jobs and wage growth in the UK. Prices: higher import price inflation for the UK will impact real incomes, while asset prices (house prices in particular) will be a key determinant of household wealth and spending. Monetary and fiscal policy: the decisions taken by the European Central Bank, Bank of England and the fiscal authorities are crucial to economic and asset market outcomes. Impact of Britain s exit on European businesses While the risk of direct trade disruption is limited, European companies may cut back on their operations in the UK if unrestricted access to the European labour market is no longer certain. European banks that have relied on the London hub for euro area-wide trading and capital market services will face legal complications, higher capital requirements, and possibly the fragmentation of FX and derivatives clearing services. Asset managers will also experience higher costs of servicing clients across borders. A significant number of jobs may have to be moved into the EU. Lost scale advantages combined with legal and relocation costs will increase the already intense margin pressures in Europe s financial industry. 3 Brexit: Implications for Eurozone investors

4 Figure 2. The evolving nature of the UK s trading relationships?? Standard World Trade Organization terms European Union Customs Union European Free Trade Association European Economic Area European Union Euro area Austria Latvia Bulgaria Iceland Switzerland Andorra Belgium Lithuania Croatia Liechtenstein Guernsey Cyprus Luxembourg Czech Republic Norway Isle of Man Estonia Malta Denmark Jersey Finland Netherlands Hungary Monaco France Portugal Poland San Marino Germany Slovakia Romania Turkey Greece Ireland Slovenia Spain Sweden Other (non-eu) countries with which the UK currently has trade deals via the EU that will need to be renegotiated include: Italy Australia, Canada, China, Hong Kong, India, Saudi Arabia, South Korea, United Arab Emirates, United States Source: LGIM, Willis Towers Watson 4 willistowerswatson.com

5 Things to watch from Eurozone perspective Brexit impact on Eurozone Although the direct impact of a Brexit on the Eurozone economy is assumed to be limited ECB President Draghi suggested a maximum impact of 0.5% of euro area GDP over three years it can be seen as part of an increased momentum for populist politics in Western countries. Disappointment about socially and regionally unbalanced income growth and stagnating real income levels at the lower end of the scale have reinforced scepticism about globalisation and migration. The resulting political tensions have made decision making within the EU less effective, hence in some countries EU-critical political movements have gathered strength on both ends of the political spectrum. Figure 3 provides an overview of the key drivers of immediate Brexit market reaction. Risk of political contagion Populist parties that are both anti-eu and anti-establishment have been on the rise in Europe for some time. While the political mainstream remains anchored to the EU, the emergence of populist fringe parties has made it difficult to form stable government coalitions and thus push ahead with much needed structural reforms. A look at the different countries: Germany: the next elections in Germany are going to be somewhere between September and October Although the current coalition is still the largest in the polls, their share has declined. According to the most recent polls they still have a slight majority. Alternative für Deutschland (a right-wing Eurosceptic party) has seen its share in the polls increase rapidly since mid-2015, to around 15%. France: Marine Le Pen (Front National) is a likely candidate for the presidency in France. Elections will be held in April and May Her primary opponent will most likely be from the French Republicans, which seems to be a race between Nicolas Sarkozy and Alain Juppé. Italy: although elections are some way off (2018), the constitutional referendum in October 2016 for the senate reform might result in Matteo Renzi stepping down, likely resulting in new elections. With the rise of the Five Star Movement (populist Eurosceptic party), the referendum seems to be one of the bigger political events in the Eurozone this year. Netherlands: Geert Wilders (leader of far-right PVV) has the largest party according to polls. He has no outright majority and there are no likely coalition partners to the PVV, but according to current polls other parties may similarly struggle to form a majority coalition, so the Netherlands might face a difficult political situation next year (similar to Spain). Spain: the most recent elections led to a victory for Mariano Rajoy (current prime minister and leader of right-wing people s party), but, similarly to the outcome of the vote in December 2015, not to a majority and therefore more political uncertainty. It is to be seen what Rajoy can accomplish. Figure 3. Things to watch from Eurozone perspective Asset class Key drivers of immediate Brexit market reaction Key drivers of medium-term outcomes Euro Concerns over economic growth Differences in economic growth and in interest rate developments Bund yields Periphery yield spreads European bank equity and credit spreads Short-term capital flows to safe haven Bunds Uncertainty over future of EU Profitability under pressure due to negative interest rates Future of ECB quantitative easing (QE) programme and measures to switch allocation of QE purchases to be in line with countries outstanding debt and alleviate issues with Bund liquidity Populist anti-eu political parties winning elections Measures to switch allocation of QE purchases to be in line with countries outstanding debt Capitalisation concerns Non-performing loan problems and bank rescues in Italy ECB credit measures to relax financial conditions 5 Brexit: Implications for Eurozone investors

6 Risk of European banks Besides a changing political landscape and possible fragmentation of the European financial services sector, there is another risk for the EU: its banks. The profitability of European banks is under pressure due to negative interest rates, higher than desired leverage levels and asset losses. The Brexit vote and recent stress tests have reminded us of these issues, with bank shares showing sharp declines in value. In particular, the non-performing loans and possible bank rescues in Italy are not improving the relationship between Italy and the EU. Stress tests by the European Banking Authority to be released on 29 of July (date of going to press) will bring more insight. Considerations for Eurozone investors Practical portfolio considerations Given the increased (political) uncertainty, the possible contagion from a Brexit vote and the issues in the Eurozone (see Figure 3), we provide three key messages for Eurozone Investors. These messages are similar to those set out in our paper on negative yields in the Eurozone (see Low interest rates and the challenges for long-term Eurozone investors ) and reflect recent market developments. Fixed income With the low to negative yields and compressed spreads in the Eurozone in mind, we advise investors to evolve portfolio positioning, with a primary focus on switches to global investment-grade credit, alternative credit and/or illiquid investment-grade credit in a risk-neutral manner. Eurozone banks Holdings of Eurozone banks equities and corporate debts should be sufficiently diversified and, additionally, we advise that these holdings are actively managed by skilled managers. We also advise investors to rethink their exposure to the UK economy and possible impact from further fragmentation of the financial services market. Hedging and downside protection With a continued downside skew to risks, modest risky asset premiums, and fragile economic and market sentiment, investors are advised to consider their hedging and downside protection strategies carefully. Increased insight with our scenario tool Besides our practical portfolio considerations, we believe scenarios can help Eurozone investors by providing the mechanism to translate economic and sometimes political pathways into financial ones. Our 5-year capital market outlook scenarios provide appropriate insight into the possible outcomes over the medium term for Eurozone investors. Using our economic assumptions (see Figure 5) for each scenario, we can provide path-dependent investors with insight into possible outcomes to cope better with future uncertainty. Our scenario tool projects an investor s balance sheet forward under the scenario in question and provides an estimate of how the various cross-currents associated with a scenario affect asset-liability values (see Figure 6). We believe this analysis is valuable. It brings clarity to an uncertain situation, allows schemes to determine which scenarios are most relevant, and gives a framework for monitoring and understanding key events as they unfold. Most importantly, this investor-specific framework provides a critical starting point for a discussion of what actions are appropriate in the face of uncertainty. Your usual contact is happy to discuss our key messages and scenario tool further. 6 willistowerswatson.com

7 Figure 4. Willis Towers Watson 5-year capital market outlook Probability Scenario Downside Risks 35% 40% 2. Debt Overhang; Growth Moderation 50% 50% 3. A Better World 15% 10% Figure 5. Economic assumptions Willis Towers Watson 5-year capital market outlook Scenario Equity 0.3% 3.2% 7.6% Core bonds -0.8% -1.1% -2.7% IG credits -1.1% -2.0% -2.3% HY and EMD 0.0% -0.5% -0.6% Commodities 0.1% 1.6% 3.8% Alternatives 0.4% 4.1% 9.4% Figure 6. Expected funding ratio * Start Debt overhang A better world Downside risks * Please note that this analysis is indicative and requires customisation to reflect the liability and asset allocation specifics. Further information For further information, please contact your Willis Towers Watson consultant or Joseph O Dea joseph.o dea@willistowerswatson.com Padraig Flanagan padraig.flanagan@willistowerswatson.com 7 Brexit: Implications for Eurozone investors

8 Disclaimer Willis Towers Watson has prepared this material for general information purposes only and it should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Willis Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this material should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This material is based on information available to Willis Towers Watson at the date of this document and takes no account of subsequent developments after that date. In preparing this material we have relied upon data supplied to us by third parties. Whilst reasonable care has been taken to gauge the reliability of this data, we provide no guarantee as to the accuracy or completeness of this data and Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any errors or misrepresentations in the data made by any third party. This material may not be reproduced or distributed to any other party, whether in whole or in part, without Willis Towers Watson s prior written permission, except as may be required by law. In the absence of our express written agreement to the contrary, Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on this material or the opinions we have expressed. About Willis Towers Watson Willis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 39,000 employees in more than 120 countries. We design and deliver solutions that manage risk, optimise benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com. Willis Towers Watson Trinity Point Leinster Street South Dublin 2 Ireland Towers Watson (Ireland) Limited is regulated by the Central Bank of Ireland. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. To unsubscribe, eu.unsubscribe@willistowerswatson.com with the publication name as the subject and include your name, title and company address. Copyright 2016 Willis Towers Watson. All rights reserved. WTW-EU-16-EML-3774h1 willistowerswatson.com