WWW.KL-COMMUNICATIONS.COM JUNE 16

1

BREXIT!Equities suffer sharp fall and sterling plummets to a multi-decade low as the UK public votes to leave the European Union. Full analysis inside.

2

Arif Husain, Quentin FitzsimmonsT. Rowe Price

rif Husain, the head of international fixed income at T. Rowe Price,

believes there is a high probability of a global recession following the UK's vote to leave the EU.

"Those who believe Brexit is a UK problem are misunderstanding the impact it will have globally. They are forgetting the impact that Greece had – and Greece is much smaller than the UK, and not a financial centre,” Husain explains.

"The vote to leave could result in a global recession. It is likely that the chances of a global recession have risen above 50%. For investors, the money was to be made in the run-up to the referendum from all the volatility that was occurring. It will be harder to make money now."

T. Rowe Price senior fixed income portfolio manager Quentin Fitzsimmons says sterling is highly vulnerable, as UK business confidence is likely to fall and the country already has a large current account deficit.

However, he believes fears the pound could move toward parity with the US dollar are tenuous.

"Sterling is a reserve currency, is widely traded, and is a store of

value – when it falls to a certain point there will be buyers, and that will prompt a correction. It will certainly weaken, but fears that it will tumble endlessly down are unfounded," Fitzsimmons says.

"However, the prospects of a cut to UK interest rates have risen as a result of the vote to leave. We adopted some modest hedging positions ahead of the vote, but did not take a major bet on the outcome."

Fitzsimmons also expects divisive negotiations between the UK and the EU.

"The power of economic self-interest should not be underestimated,” he adds.

"France will probably want to make it very difficult for UK financial services firms to operate on the Continent. However, Germany might be inclined to be more flexible because its car industry is heavily reliant on exports to the UK and it would not want to lose that trade.

"Different countries in Europe have varying levels of trade-dependency with the UK, which could make negotiations within the EU very complicated. It could be divisive."

Chance of global recession is 50%

tuart Mitchell, manager of the SWMC European

Fund, expects UK and European authorities to 'do whatever it takes' to calm financial markets in the wake of the Brexit vote.

While Mitchell believes UK growth will be impacted, he is still positive on the ability of companies on the Continent to succeed.

"The UK accounts for just 6% of Eurozone exports – the direct economic impact on companies in the eurozone is, on average, likely to be limited. Of course, averages are only averages, and we are alert to potentially more adverse impacts for individual companies," Mitchell says.

"However, it is true Brexit could threaten, by contagion, the whole European project. But do not underestimate the willingness of the ECB and the Bank of England to 'do whatever it takes' to calm financial markets."

While the market is clearly unsettled, Mitchell remains bullish on many European corporates.

"There is no reason to think great growth companies – such as SAP, Essilor and Amadeus – will not continue to thrive. For example, we cannot see why VW or Rosenbauer should be directly affected by the vote. The pace of restructuring and the outlook for the Chinese market are more important issues," Mitchell adds.

S

EU corporates can still thrive despite Brexit shock

A

WWW.KL-COMMUNICATIONS.COM JUNE 16

"The vote to leave could result in a global recession. The chances of a global recession are above 50%"

Mitch ReznickHermes Credit

hile risk assets are all down, credit markets have generally

reacted surprisingly orderly given the significance of the result of EU referendum. In fact, while risk assets are meaningfully lower, they are off of the lows of Friday.

We think very little actually traded at those lows, but was more an act of price-discovery as shown by wide bid-offer spreads. If nothing else, we are even more convinced that to forsake illiquidity premia in a market like this makes sense, hence we retain our preference for issues with large capital structures and relatively good trading liquidity.

We expect to see pressure on areas most vulnerable – such as financials, sterling credit and European credit. We believe risks in financials and sterling risk will be mitigated by central banks protecting the banking sector with liquidity and stimulus. Indeed, the BoE has already come out with words and actions to

reassure markets. In addition, we have avoided exposure to the most vulnerable financials – like AT1s and US preferreds.

As we go forward, we believe a sustained period of uncertainty would render the path to recovery for the UK and Europe more challenging. It still makes sense to avoid companies relying on rapid economic expansion to grow into capital structures.

We remain calm and are not making major positioning changes. That said, we will be looking for dislocation of 'reverse Yankee' issuers as an opportunity, especially since the near-term outlook for supply is poor for HY, which is out-of-scope of the CSPP.

In addition, any significant widening of well-capitalised banks' legacy capital securities could be a buying opportunity. We remain vigilant on the momentum of the dollar, because it can compound existing pressure to the commodity-heavy areas of the market, such as US energy.

Time to remain calm and vigilant

ugh Yarrow, manager of the Evenlode Income

Fund, believes the UK’s Brexit vote will create both political and economic uncertainty in the short and medium term.

As an equity strategy consisting of primarily UK-listed shares, Evenlode is not immune, but Yarrow says the team always aims to insulate the portfolio from uncertainty – rather than predict it.

"Times like this are a reminder that investment is a marathon not a sprint, and controlling risk is very important for the long-term investor," he says.

"As a result of our cautious approach, our portfolio has several reassuring characteristics that give us confidence in the ability to continue generating healthy cash flows and dividends."

For example, roughly 80% of cash flows for companies in the Evenlode portfolio are generated outside the UK.

"For UK-based investors, the sharp fall in the pound represents a positive tailwind to reported cash flows and the ability of UK multinationals to pay and grow dividends in sterling. In some cases sterling weakness may improve competitiveness against global peers," Yarrow adds.

"Our process and preference for global cash flows also means we have little or no exposure to some of the sectors that may be most impacted by Brexit."

H

Brexit highlights importance of controlling risk

W

WWW.KL-COMMUNICATIONS.COM JUNE 16

"We have avoided exposure to the most vulnerable financials – like AT1s and US preferreds"

3

Chris RodgersSanlam FOUR

Robin HepworthEdenTree

arkets were badly wrong-footed by the referendum. The

sterling and equity market rally in the preceding days, most notably on polling day itself, makes the result seem more shocking. But this risk was a 'known unknown' and was hardly out of the blue.

The immediate sharp fall in sterling was predictable and highlights the market’s view this outcome is unlikely to be positive for the UK in the short or medium term. The slowdown prompted by the uncertainty in the run up to the vote will now intensify, with investment and spending likely to be at best postponed, and the risk of recession has increased.

The equity market reaction has been rapid and rational. Economically sensitive UK stocks

he vote to leave the EU represented a shock to markets. Global equities

fell sharply, along with the pound, in echoes of moves seen during the global financial crisis.

The next steps are unclear. How tough will Merkel and other EU leaders be? Who will lead the negotiations in this divided country? Will London’s status as a financial capital be eroded if it loses 'passporting' rights? What will be the impact on growth and inflation? The answers to these and many other questions are difficult to quantify until terms of the UK’s exit are negotiated.

While there will be challenges and risks, Brexit will not turn good companies into bad ones. With FTSE 100 constituents deriving the majority of sales

were hit hard, with many banks and housebuilders down more than 20% on Monday, while sharp falls in Central London office property companies reflect the likely risks to the City of London.

Despite the falls, sterling weakness mitigated the impact on the broader market. Many UK-listed stocks receive a boost on overseas earnings, so it was no real surprise to see the likes of ARM Holdings, Rolls Royce or AstraZeneca holding up.

Accompanying weakness in eurozone equity markets was also understandable. A return to some form of euro crisis is possible if peripheral bond yields in rise on any loss of confidence.

A further risk-off phase is now in prospect until some of these risks are better understood.

from outside of the UK, the sterling decline represents a large tailwind, making exports more competitive and boosting the value of overseas profits.

Though there may be short-term costs, these could well be exceeded over the longer term through reduced regulatory burden and with Britain re-establishing itself as a truly independent nation with connections to the world.

EdenTree invests for the long term in intrinsically sound and reasonably priced companies, with strong free cash flow and robust balance sheets. While we may enter a period of uncertainty, this philosophy will not change. The sell-off in risk assets may well create significant and attractive long-term opportunities.

Markets wrong-footed

Opportunities in sell-off

M

T

WWW.KL-COMMUNICATIONS.COM JUNE 16

Strong REITs can withstand the Brexit fallout

"A further risk-off phase is now in prospect until risks are better understood"

"While there will be risks, Brexit will not turn good companies into bad ones"

T he uncertainty surrounding the UK’s

Brexit vote will present continued challenges for listed real estate investors, Cohen & Steers' Rogier Quirijns says.

Quirijns believes the primary concern for investors is the impact on London, which is poised to suffer a more dramatic slowdown than the rest of the country.

However, while there are new risks to consider, Quirijns believes underlying fundamentals for many companies remain stronger compared to previous downturns. He cites stronger balance sheets and lower leverage, higher quality assets and a more robust sector focus, and an increased emphasis on income rather than developments.

"This current sell-off has created potential opportunities in REITs that have built up a strong long-term income and growth profile," Quirijns says.

"Average leases in many REITs are in excess of 10 years and we do not believe the UK faces a severe recession or a 'Lehman' event – therefore cash flows should remain robust over the long term.

"We prefer REITs offering dividend yields of between 4% and 6%, with 3-year growth rates of 10% to 30%. Many of these names should continue to deliver sustainable income and growth, despite the Brexit shock."

4

T: +44 (0) 203 137 7823www.kl-communications.cominfo@kl-communications.com

Joe Amato,Brad Tank, Erik KnutzenNeuberger Berman

his time the opinion polls got it right. The 'Remain’ and 'Leave' camps were

running neck-and-neck coming into the UK referendum on membership of the European Union and in the end a small majority of UK voters opted to reject the status quo and pull out.

Markets sold off in response, but we caution against reacting as though this were a second 'Lehman moment', as some commentators suggested.

Still, the UK has chosen the rockier of two paths. It is likely to prolong the period of low corporate investment we have seen leading up to the vote, both within the UK and in the form of foreign direct investment. This, together with the higher costs of trading, is what led mainstream economists to forecast a 3-7 percentage point negative long-term impact on UK GDP.

The pain may not be felt evenly. Many of the large FTSE 100 companies are global rather than UK businesses – 80% of the index's revenues come from overseas. This insulates them from any domestic downturn and potentially delivers a windfall from the weakened pound. Smaller, more domestically-focused companies are more vulnerable to a fall in consumer demand and higher import costs.

A more pessimistic reading of the vote would see it as one more crack in the edifice of international political and economic co-operation built over

the past 70 years. Anti-EU parties in countries like France, Germany and Italy will take heart from the result and further exploit the Euroscepticism increasingly evident on the Continent.

But this merely confirms globalisation is under siege, a trend already well-advanced and understood by markets. This vote will likely exert only a marginal effect on global economic fundamentals, which remain stable but weak. We still live in a slow-growth, low-inflation, low-interest rate environment, characterised by sluggish productivity and investment.

Brexit has been a tail risk stalking markets in the same way the oil price, strong dollar and China concerns created volatility back in January and February, but its implications are overstated. For that reason, we again counsel investors to look through the

This is not a 'Lehman' moment

T

5

noise and adjust portfolio risk to long-term fundamentals. That may mean taking opportunities to add to some positions in riskier assets once the worst of the initial volatility has passed.

Looking further out, many places in the world we still need structural reform and a more appropriate fiscal response to the current malaise if we are going to allow our economies to grow on a proper footing, and our companies to generate sustainable earnings growth.

Part of the progress will involve addressing the legitimate concerns of those who have failed to benefit from globalisation, but populism and political division is not the way. In this respect, the Brexit is hardly good news. But its effect will be marginal and the market’s initial response is likely to create opportunity for patient investors with cool heads.

WWW.KL-COMMUNICATIONS.COM JUNE 16

"Markets sold off, but we caution against reacting as though this were a second 'Lehman moment', as some commentators suggested"