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Week in Review: Brexit Rattles Markets

In Brief

  • Brexit is a credit negative for the UK, creating a sustained period of uncertainty. Downgrades could widen credit spreads.
  • Against a volatile post-Brexit backdrop, long-term inefficiencies may emerge, creating opportunity.
  • Brexit may be the first in a series of antiestablishment votes as increasing numbers of voters push back against the forces of globalisation

The United Kingdom's decision to leave the European Union has begun to reverberate around the world.

Prime Minister Cameron has announced he will resign in October, around the time of the next Conservative Party annual conference. Only after a new prime minister is in place will the UK trigger Article 50 of the Lisbon Treaty and start the two-year process of negotiating its exit from the E U.

From a credit perspective, the ratings agencies have made it known that the UK's sovereign credit rating will be downgraded as a result of the decision to leave the European Union. Standard and Poor's called the AAA credit rating 'no longer tenable under the circumstances'. Moody's called Brexit a credit negative for the UK and for other issuers in the country, citing a prolonged period of policy uncertainty that will likely dent investment flows and confidence. On an absolute basis, UK gilt yields may fall in the near term, but spreads could widen.

Central banks have made it clear that they stand ready to provide liquidity to financial institutions — and in some cases intervene in currency markets — amid volatile market conditions. Expect central banks to work together to suppress volatility. A rate cut by the Bank of England in July is increasingly likely, while the US Federal Reserve, as a result of the vote, is unlikely to hike short-term rates for the balance of the year.

Currency markets have borne the brunt of today's volatility, with the pound falling by a record 11% against the dollar in the wake of the vote before stabilizing. Equity markets were hit hard at the open of trading on 24 June, with the FTSE 100 Index falling nearly 9%, but those losses moderated significantly as the session wore on. The moves have been relatively sensible, with the sectors most at risk in the short term — financial services and cyclicals — bearing the brunt of the pressure thus far. Ten-year UK gilts fell to a record 1% before stabilizing near 1.10% toward Friday's close, while the 10-year US Treasury note tested record low yields, near 1.40%, this morning before rebounding to 1.57%.

This sort of environment can create opportunities for investors. We are long term in our focus, and we're very careful not to confuse the local economy and politics with markets. We invest in international and global businesses, and stock prices act as a discounting mechanism. Some of the impacts of the Brexit vote may already be reflected in prices. Against this more volatile backdrop, long-term inefficiencies may emerge. There are great businesses that have been hit hard in the short term, and there are others where risks have increased substantially. This is the type of environment where long-term active managers would be expected to add value. After all, volatility should be our friend over the long term.

In fixed income, we continue to look for opportunities where valuations have become dislocated. We're going through our names and sector exposures, deciding where we want to add or reduce risk. We're not rushing, as we're mindful of challenges around liquidity in the near term. We're largely taking a wait-and-see approach, awaiting improved liquidity. We have already identified specific credits and sectors, so we can move quickly when the environment is conducive to adjusting portfolios appropriately.

Politically, it's not over

As Michael Gove said during the Brexit campaign, many 'have had enough of experts'. That sentiment is being felt far beyond the UK's shores, notably within Europe and the United States. While the Brexit vote has brought a slight bit of clarity to the UK's future relationship with the EU, it opens the door for a potential domino effect across Europe as populist movements gather strength. Investors wonder which countries will be next in the queue for an EU referendum of their own.

The first test will be seen this coming Sunday as Spain heads to the polls for the second general election in less than a year. Italy has recently seen several mayoral elections, including last week's election in Rome, go in favor of the anti-EU, antiestablishment Five Star Movement, and the country is set for a referendum on constitutional reforms this fall. Should the referendum fail, Prime Minister Matteo Renzi would have to stand down, just as PM Cameron has done on the heels of Brexit. Next year, France and Germany head to the polls as well, so if antiestablishment sentiment builds, the effects could be quite significant if the EU's two largest states are swept up in the tide.

To sum up, it looks as though the UK's decision to leave the EU could be the beginning of a large, protracted process in which dissatisfaction with the effects of three decades of globalisation is being expressed in ever more impactful ways. It bears watching to see if the trend accelerates, and what lasting impacts, if any, these political forces will have on companies around the world. Geopolitical conditions are ever shifting, but great businesses always seem to find a way to adapt and prosper over time. We suspect they will be able to weather this storm.

Stay focused and diversified
In any market environment, we strongly believe that investors should stay diversified across a variety of asset classes. By working closely with your financial advisor, you can help ensure that your portfolio is properly diversified and that your financial plan supports your long-term goals, time horizon and tolerance for risk. Diversification does not guarantee a profit or protect against loss.

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Sources: MFS research; The Wall Street Journal; The Wall Street Journal Online; Bloomberg News; Financial Times; Forbes.com; CNNMoney.com; NBCNews.com.

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