To tide through, investors can build a diversified portfolio with focus on highly rated bonds and equities
The unthinkable has happened. Britain voted to leave the European Union.
This outcome has had a negative impact on markets. It will create a shock, such as fears of a British recession, with significant knock-on effects on the EU.
This could trigger a risk-off phase and may justify a more defensive posture in asset allocation. Even if Britain's economic fallout is modest and temporary, investors are in a "sell first, and assess later" mode.
In the next few days, markets will enter into a short-term risk-off phase, characterised by higher volatility. Sterling and British assets will bear the brunt of the sell-off and European equities will not be spared.
There will likely be a flight to safety to the greenback and US dollar-denominated assets, especially Treasuries. We expect US 10-year bond yields to test recent lows and remain low in the near term.
As with all risk-off phases, markets tend to overreact before finding a bottom, once valuations and fundamentals become compelling. Meanwhile, we expect volatility, particularly British assets, to be heightened.
The pound will take centre stage as the mechanism of Britain's exit unfolds. The currency would experience wide moves and could continue its downward spiral towards the long-term support level of 1.30 against the US dollar.
The euro will not be spared either, given Europe's close economic ties with Britain. The US dollar would likely rally and there would be a heightened demand for other safe-haven currencies such as the Japanese yen and, to a lesser extent, the Swiss franc, as well as gold.
Over the past few months, we have been advising clients to de-risk their portfolios. For those who followed our advice, this sell-off will soon present many attractive investment opportunities.
The appreciation of the Swiss franc may force the Swiss National Bank to step up currency intervention and, in the extreme, introduce a hard peg, while the Bank of Japan may embark on more drastic policy easing to curb the unwanted strength of the yen.
We can expect central banks to react to Brexit. The European Central Bank and Bank of England would inject market liquidity to ensure the banking system has sufficient funding in pounds and euros, while the Federal Reserve in the United States may consider pushing back its interest rate hiking cycle.
Policymakers around the world will assess if the market fallout from a Brexit were to weigh on the global economy, before embarking on any coordinated monetary easing. Any major central bank actions would uplift markets.
British equities will face the bulk of the global stock market correction. British equities could face further de-rating as EU-British trade negotiations drag on. The current price-to-earnings of 15.4 times for British equities is above its long-run average and may face further downside pressure.
Global equities will be hit but British and European equities will endure the brunt of the sell-off as investors pull back from British and European assets in the face of rising political and economic uncertainty.
Singapore equities will not go unscathed either. We could see British and European equity markets falling, possibly to levels that would take them back to the February lows. The weaker sterling will take a while to lift British equities, which will likely remain under pressure over the short term.
Over the past few months, we have been advising clients to de-risk their portfolios. For those who followed our advice, this sell-off will soon present many attractive investment opportunities. However, for investors who had not de-risked, it is perhaps too late now. At this point, especially over the next few days, we advise those investors not to panic sell.
On asset allocation, we had advised our clients to be on a tactically neutral stance for both global and European equities. Our current neutral asset allocation position puts us in a strong position. If the market sell-off becomes overly unjustified, we could turn overweight on equities.
But if Brexit has deeper ramifications for the world economy, we can reduce our risk exposure meaningfully, for example, by tactically raising our cash position to overweight and reducing our equities position further to underweight.
Now is not the time to panic.
We would advocate that investors remain vigilant, as we foresee market conditions to be very uncertain over the short term. Panic selling is often not a good investment strategy.
To tide themselves through the year, we would encourage investors to build a diversified portfolio with a focus on income from highly rated bonds and equities. Investors should build a US dollar-biased currency hedge around portfolios to protect from adverse currency fluctuations.
•The writer is Bank of Singapore's investment strategist.
A version of this article appeared in the print edition of The Sunday Times on June 26, 2016, with the headline 'Don't panic sell on Brexit'. Print Edition | Subscribe
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