Heading into the third quarter, several of the biggest political concerns that have made markets jittery over the past year have been qualified, namely Brexit, with the United Kingdom voting to leave the European Union by 51.9 per cent, and the Spanish election, which has resulted in another hung parliament. 
In particular, the United Kingdom’s decision to leave the European Union creates a climate of political and economic uncertainty.
Breaking down the vote results regionally, the British electorate voted to remain within the EU in Scotland and Northern Ireland, while Wales and England voted to leave. Londoners also voted overwhelmingly to remain.
Given that 62 per cent of Scottish voters opted to remain, Nicola Sturgeon, the First Minister of Scotland, said a new referendum on independence from the rest of the United Kingdom was “highly likely”.
The vote can also be read as a negative sign for the future of the European Union. A recent Ipsos-Mori survey showed that more than 45 per cent of the population in nine European countries are in favour of their own European Union referendum.
Indeed, rising far right political parties in countries including France (National Front), Italy (Five Star Movement), Denmark, and Holland have all recently called either for a referendum of their own, or for a renegotiation of their country’s membership of the Union.
Brexit is likely to embolden these opponents further and, having been caught out as underestimating the Brexit risk, markets may now overreact to any inkling that other countries in the European Union could follow suit.
The timing of the United Kingdom’s departure is still unclear, and likely to remain that way for some time. Article 50 of the Lisbon Treaty states that, once notice has been given, the United Kingdom has two years to negotiate post-Brexit relations with the European Union (although this could be extended by unanimous agreement).
There is some concern that the United Kingdom is in a weaker negotiating position, given the relative importance of trade to each side. Additionally, there is little incentive for the European Union to be generous in these negotiations, as this could risk encouraging populist parties elsewhere in Europe calling for their own referenda.
Economically, the future is also uncertain.
Since joining the European Economic Community in 1972, the UK had outperformed all other major economies in the western world in terms of per capita GDP growth. However, the immediate reaction has been swift with the United Kingdom having already been stripped of its AAA rating by Standard and Poor’s and Fitch’s (Moody’s downgraded the United Kingdom in 2013) and a near-term recession is forecast by most economists.
For manufacturers already established in the United Kingdom, a lower exchange rate could mitigate the damage slightly.
But the United Kingdom may be viewed as a less attractive place to invest and create jobs, with the uncertainty around the timing of the United Kingdom’s departure likely to be negative for business and consumer confidence, and therefore decisions around hiring, investment, and significant purchases are likely to be postponed.
This could therefore have a detrimental effect on the domestic economy. Additionally, for United Kingdom-based providers of internationally tradable services, who need market access more than a competitive edge through the exchange rate, the outlook has become much murkier.
Relative performance of sterling in 2016
Source: FE Analytics
And although London will remain an international centre for financial and professional services, it could lose some of its business if it turns from an onshore to an offshore financial centre.
The Bank of England could cut rates, which currently stand at 50 basis points, and may introduce a quantitative easing program at its August monetary policy committee meeting. In Europe, the European Central Bank (ECB) could extend its asset purchase program even further.
However, such stimulus is unlikely to have much effect due to the fact that borrowing is so cheap to begin with. Some commentators have also noted that as this is a political crisis, as opposed to a financial one, monetary policy tools may have limited impact.
The other great uncertainty, the timing of the next United States Federal Reserve interest rate rise, was pushed out again in early June with Chair Janet Yellen voicing concerns over the impact of the United Kingdom’s exit from the European Union and worries about the effect the slowdown in China will have on US economic growth.
There has been some promising data from the United States - unemployment officially stands at 4.7 per cent and unemployment rates have fallen to very low levels in a third of US states.
At the same time, the median US worker is enjoying their highest wage growth since 2009, with a pay rise of 3.4 per cent year-over-year as of April according to the US Federal Reserve Bank of Atlanta’s wage growth tracker. However, the Fed is unlikely to ignore the results of the referendum so any rate rise is likely to be pushed out again – potentially to early 2018 - which will be supportive of commodity prices and emerging market economies as many of them are pegged to the dollar.
Given the domestic and global political uncertainty we have seen extreme moves in the bond markets as investors sought refuge in safe havens; the yield on the UK 10-year gilt has fallen from 1.96 per cent at the beginning of the year to 1.22 per cent mid-June and below 1 per cent in the wake of the referendum.
Ten-year UK gilt yields over 1yr
Source: FE Analytics
Additionally, the German 10-year bund went negative for the first time mid-June (and fell to a record low of -0.18 per cent post-Brexit) as did the 30-year Swiss bond.
In the wake of Brexit, government yields generally have experienced sharp drops with the flight to safer assets adding $380 billion to the pile of negative-yielding government bonds. We do not expect yields to return to previous levels in the near future.
Such low rates will have positive and negative implications.
On the plus side, the ECB has just extended its quantitative easing programme to investment grade corporate bonds; a fillip for corporates looking for cheap funding but rendering it even more difficult for pension schemes, insurance companies, and banks to make returns in the ultra-low yield environment.
Lower bond yields are particularly worrying for pension schemes as deficits continue to balloon; the UK’s pension funding deficit hit a record high of £900 billion after Brexit as sterling plunged to a 30-year low, global markets plummeted and bond yields dropped.
The extent of underfunding of corporate pensions in the United Kingdom, and Europe, and the potential impact this could have on financial stability represents a material risk.
Another negative implication is that considering the duration and extent of the monetary stimulus in place and its lack of appreciable effect, a parsimonious mind-set takes hold. This is evident in global capital expenditure (capex) figures; according to estimates from Standard and Poor’s spending on capital dropped 10 per cent in 2015 and could fall to 2006 levels by 2017.
Another indicator is the number of corporate profit warnings, which in the United Kingdom are running at their highest rate since the financial crisis. In total, 312 UK public companies warned analysts to lower forecasts in the 12 months to the end of March; the highest level since 2008.
In terms of markets, in the wake of the result, the UK stock market was down less than many expected and outperformed its European peers including the DAX in Frankfurt, the CAC in Paris, and Borsa Italiana in Milan.
The UK market was supported by the overseas earning power, and defensive characteristics, of many FTSE 100 constituents.
A number of consumer goods companies are markedly up in sterling terms, including Unilever and Diageo, as well as all of the major pharmaceutical companies. In the referendum aftermath sterling plunged to a 31-year low against the dollar; the weaker currency will make UK-listed companies with significant overseas earnings more attractive than those with predominantly domestic businesses.
Such businesses are also less reliant on UK growth. With a slower pace of growth, defensive sectors could outperform those with more cyclical exposure, particularly among those stocks with less exposure to the United Kingdom.
Performance of indices since Brexit vote
Source: FE Analytics
In terms of market capitalisation, UK-listed large caps, as represented by the FTSE 100 Index, derive just 21 per cent of revenues from within the United Kingdom (according to data from Thomson Reuters and Credit Suisse).
This suggests that these larger companies will outperform small- and mid-cap companies, which tend to be much more domestically exposed and therefore more vulnerable to any weakness in UK growth. Therefore, after the initial sell-off, which wiped $3 trillion from global stock markets, we believe that small- and mid-cap stocks will continue to underperform the large-cap FTSE 100 Index on a relative basis.
At the sector level, financials are likely to underperform given the potential loss of access to the Single Market through the EU’s passporting regime, which would affect both UK and European-listed financials.
In terms of mergers and acquisitions (M&A), now that the United Kingdom has voted to leave the European Union, we expect the pause in general activity that has taken place in the run up to the referendum to turn glacial.
The UK share of global M&A activity tumbled to a record low year-to-date, as deal making froze amid the referendum uncertainty. The volume of deals involving UK targets was down almost 70 per cent to June compared with the same period in 2015. In contrast, global M&A volumes have fallen just 20 per cent over the same period, according to Thomson Reuters data.
Although borrowing costs are falling we do not foresee it leading to an uptick in M&A activity, notwithstanding the recently announced takeover of ARM Holdings by SoftBank.
The next three months will bring increased volatility and uncertainty that will present both challenges and opportunities.
We will be focused on continuing our dialogue with company management teams and seeking to understand the impact on their businesses and any action they are taking to deal with this turn of events.
Alan Custis is head of UK equities at Lazard Asset Management and runs the likes of the Lazard UK Omega fund. All the views expressed above are his own and shouldn’t be taken as investment advice.
