May 2016

This publication is aimed at pension fund professional clients only, and is not aimed at retail clients.

Perceptions EU Referendum Special

To describe the UK’s referendum on European Union (“EU”) membership as a watershed moment is greatly understating its significance. What began as an attempt to lance the boil of internal disaffection within the Conservative party after its failure to achieve an absolute majority in the 2010 election has become a defining moment, challenging the foundations of international politics and diplomacy for the past 100 years and more. The reaction to the excesses of political and economic nationalism in the latter half of the 19th and first half of the 20th century that has driven the basic assumptions underlying international policy since at least 1945, is called into question. The consequences could be far-reaching indeed.

From a UK perspective the outcome of the referendum has the potential to fundamentally affect not only migration, trade, commerce and regulation, but also the role of sterling as an international currency, and London as a global financial centre.

The referendum is unlikely to be the end of the matter in the way that Prime Minister Cameron hopes. Politically, the cohesion of the United Kingdom could be stretched by pressure for further separation for Northern Ireland and Scotland. In the short term, Cameron’s survival could be in question, with the potential for a disorderly succession and the loss of the Government’s majority. As Harold Wilson found out after 1975, staging a public referendum on Europe to heal internal party rifts is a risky business. Although his Government won the referendum comfortably, the rift over Europe ultimately proved unbridgeable with the Labour party going down to defeat in 1979 to face 18 years out of power. Then, as now, the battle over the referendum was a proxy war for a wider ideological battleground within the governing party.

Uncertainty is the worst of all evils until the moment when reality makes us regret uncertainty.– Jean-Baptiste Alphonse Karr, French Journalist and Novelist (1849)

ObjectiveThis paper is an attempt to tease out the potential investment implications of the EU membership referendum, emphasising that investors need to consider many other factors at the same time. We understand the strength of arguments and emotions on both sides of the debate and we do not intend to convey a view as to which outcome would be the more desirable in the long term, either politically or economically.

The difficulty confronting investors ahead of the referendum is that an issue that is essentially political and largely domestic at that, as well as one of philosophical principles and emotions, also needs to be assessed in financial and economic terms.

This is not to imply that the decision reached on 23 June may not have far-reaching and fundamental economic and financial effects, as well as deeply important political and diplomatic consequences, merely that it will be hard to measure what those are with any certainty, and misrepresents the fundamental nature and purpose of the process.

However, for markets, whatever the outcome, once the dust has settled, for the next few years, the political and economic consequences may not be readily discernible, being masked by pre-existing and emerging fundamental forces not directly related to the EU referendum itself.

EU Referendum Special – Perceptions 2

The Impact of the DecisionAs so often in economics, because there is no ‘control’ case, it is hard to estimate with any precision the impact of the UK’s membership of the EU and its predecessors over the past 40 years. Most estimates are significantly positive but vary widely depending on the models and assumptions used. There can be little certainty that certain benefits or disbenefits might not have occurred anyway even without membership.

Even more so then, assessing the potential impacts of a decision to leave the EU must be essentially speculative, as the shape of trade relationship structures and the web of international relationships would have to evolve. The vast majority of analysis from credible economic institutions concludes that a decision to leave the EU would have a negative impact on economic growth, at least in the short to medium term. Whatever the actuality in the event, it is this expectation that will bear on investors, and drive market conditions in the run-up to, and aftermath of, the referendum vote.

Whatever the prognostications of the referendum result and its economic and financial impact, there are two over-arching considerations for investors to keep firmly at the front of their minds.

1. UncertaintyFirst, the outcome is subject to a high degree of uncertainty: opinion overall seems to be fairly evenly divided, varying between roughly 35-50% of the electorate in favour of leaving the EU, so the result could be close.

Markets for all assets are likely to be hamstrung by profound uncertainty, given the bi-polar risk profile, and vulnerable to bouts of considerable volatility until the result is known. Appropriate pricing of risk is barely realistic in these circumstances. There is some indication that markets are pricing in about half of a negative outcome, which seems a reasonably pragmatic response.

Even after the result of the referendum is known, the practical consequences are virtually impossible to predict, especially in the event of a ‘Leave’ vote. Basic questions concerning trade and commerce frameworks, access to markets, regulation, and even how these issues are to be taken forward are almost

completely unknown and will take time to develop. Even a ‘Remain’ vote, particularly if the vote is close, is unlikely to bring a return to the status quo given the severe challenges to the EU’s current model from migration, the still-rumbling Eurozone crisis, political separatism and populism, and the erosion of democratic support.

2. Global FactorsIt is also important to remember that investment markets, including UK assets, will continue to be driven by global factors while the EU referendum drama is playing. This makes it difficult to identify in isolation pure ‘Brexit’ factors which might either accelerate or reverse depending on the outcome of the referendum. For example, in early May, sterling rallied more because of weakness in the US dollar than because of any shift in market perceptions about the outcome of the referendum.

Underlying UK economic factors will also continue to play, and may be exacerbated by the referendum process. Any drag on the UK economy from this period of uncertainty will render the Government’s fiscal projections even flakier and very possibly worsen the UK’s deep-seated productivity and trade problems into the bargain.

To summarise, the key underlying global market drivers include:

• Continuing after-effects and prolonged balance sheet correction from the financial crisis

• Faltering economic growth momentum and deflationary pressure

• The profile of US interest rates

• The US Presidential election in November

• Central bank monetary policy in Europe, Japan and China

• The trajectory of the Chinese economy, and related adjustment problems

• Weakening global corporate profits cycle

• European political instability and Eurozone financial stress

• Potential debt market disruption

These factors will not only continue to affect most markets over the next few months, they will largely reassert themselves if the result of the vote is for the UK to remain in the EU.

Figure 1 The run-up to the referendum

Asset Likely Impact

Global Equities

Likely to be impacted more by global influences. Some relative weakness in European equities is possible. Emerging market equities may be largely insulated from EU referendum influences.

UK Equities

May move downwards on ‘Brexit’ concerns. Sterling weakness may support selective exporters and multinationals. Elevated volatility a distinct possibility as the referendum nears.

UK Property

Partial slowdown on the back of reduced demand from foreign investors. However property may be a relatively stable store of value in a volatile market environment for other assets.

Sterling Corporate Bonds

Issuance slows on uncertainty and lack of confidence. Yields may rise as demand falls.

Fixed Interest Gilts

Short-end yields pinned lower on reduced expectation of base interest rate rise. The belly of the curve (3-15 years’ maturity) would be principally determined by global macroeconomic factors. Long-end yields are likely to stay well-supported on insurance/pension fund demand so long yields are unlikely to rise substantially.

Index–Linked Gilts

Short term inflation expectations driven by commodity prices, but sterling weakness may start to exert upward pressure on inflation expectations.

Sterling Likely to weaken on uncertainty, particularly if polls tighten. Significant volatility in immediate run-up to election (in the fortnight before the vote).

Figure 2 The immediate aftermath (up to 3 months after the vote)

Asset Likely Impact (‘Remain’) Likely Impact (‘Leave’)

Global Equities

European equities, in particular rebound. May be affected by more global events.

European equities fall on the back of potential negative implications/uncertainty. Emerging markets least negatively affected.

UK Equities

Likely to rebound. Relief will be constrained by the closeness of the result and political repercussions from a divisive campaign.

Political and diplomatic upheaval will likely lead to sentiment-driven falls. Large-cap companies outperform smaller companies, though impacts very much sector and stock specific.

UK Property

Pricing infrequency means little immediate impact.

Pricing frequency means little immediate impact, but some erosion of value possible.

Sterling Corporate Bonds

Credit spreads may tighten. Credit spreads potentially widen. Long term issuance and liquidity impairment may hinder investors.

Fixed Interest Gilts

Uncertain – markets quickly return to being driven by UK interest rate expectations and global macro themes.

Change in shape of curve potentially as long-end may remain supported by demand and short-end yields fall. Middle part of curve may be affected by negative international sentiment with risk of significant yield rises.

Index–Linked Gilts

Uncertain – real yields may fall. Change in shape of curve possible as above. Inflation expectations likely to rise (subject to global factors). Real yields may fall.

Sterling Sterling rebounds but not all pre-referendum weakness may be recouped.

Severe sterling weakness.

EU Referendum Special – Perceptions 3

Investment ImplicationsIn order to tease out the implications for investment markets, we have divided the outlook into four phases:

1. The run-up to the referendum – Figure 1

2. The immediate aftermath (up to 3 months or so, possibly to the end of 2016) – Figure 2

3. The medium term (3-24 months) during which exit negotiations might be taking place – Figure 3

4. The long term (after a ‘Brexit’ might have taken place) – Figure 4

We have summarised our expectations for how asset classes might behave and discuss the rationale for some of these views in our Q&A section over the page. For the latter two stages, we have only considered the impact of exit, as the outcomes in the event of remaining within the EU should be indistinguishable in market terms from a referendum never having taken place.

Asset Likely Impact

Global Equities

Driven primarily by global factors – central bank policy, global economic outlook.

UK Equities

Potential change in listings. Heavily dependent on negotiation process and ‘post-Brexit’ framework and outlook.

UK Property

Property weakness exacerbates cyclical downturn.

Sterling Corporate Bonds

Bank/property spreads widen. Possible shrinkage of market.

Fixed Interest Gilts

Term premia increase; volatility caused by monetary policy conflicts between short term damage to trade performance and weak currency on the one hand, but action to re-stimulate economy on the other.

Index–Linked Gilts

Inflationary pressures from weak sterling.

Sterling Sterling weakness remains.

Figure 4 The long term (over 2 years) assuming a vote to leave the EU

Figure 3 The medium term (3-24 months) assuming a vote to leave the EU

Asset Likely Impact

Global Equities

European equities suffer as potential contagion (both political and financial) from the UK vote spreads to Europe. Driven primarily by global macro and political factors.

UK Equities

Probably negative – financial stocks could struggle in aftermath of vote. Lower economic growth could impact consumer stocks. Exporters could benefit from weaker sterling.

UK Property

Foreign investors may reduce UK property holdings. Commercial property weakens on falling demand. Yields rise. May accelerate cyclical downturn.

Sterling Corporate Bonds

Sterling issuance falls. Yields widen. Liquidity falls.

Fixed Interest Gilts

Short-end yields suppressed. Potential for further monetary policy easing (subject to currency pressures). International credit rating agencies may downgrade their view on the UK.

Index–Linked Gilts

Inflation expectations potentially pick up on sterling weakness. Real yields may remain suppressed.

Sterling Sterling weakness remains.

EU Referendum Special – Perceptions 4

Should we be taking a view on sterling in the run up to the election and what can pension schemes do to protect themselves?Sterling has weakened considerably since the start of the year and was the worst performing of the major currencies over the first quarter of 2016 (Figure 6). Despite strengthening slightly so far in the second quarter of 2016, it remains among the worst performing currencies this year.

Figure 6 Performance of Major Currencies Against the US Dollar over 2016 (to 18 May 2016)

Source: Bloomberg

11.6

7.4

7.0

5.7

4.9

4.5

4.5

1.4

-2.5

11.9

7.4

9.8

0.0

3.8

2.0

2.0

-1.1

-0.8

-4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%

BrazilianReal

CanadianDollar

JapaneseYen

AustralianDollar

Euro

SwissFranc

MexicanPeso

New ZealandDollar

PoundSterling

To 31 March 2016To 18 May 2016

Whilst some of sterling’s weakness can be attributed to the release of disappointing UK economic data (such as the continuing deterioration in the trade deficit), much of it can be attributed to the uncertainty surrounding the EU referendum, on both its outcome and the possible implications that a ‘Leave’ vote will have for UK and European economic growth, the relative attractiveness of UK assets, and UK interest rate policy.

Currency markets are volatile and are notoriously difficult to predict, particularly on a short term basis. In general, we would expect sterling to weaken if the polling data between the ‘Leave’ and ‘Remain’ campaigns tightens and the outcome becomes too close to call.

In the aftermath of the referendum, we believe that sterling could move sharply in one direction or the other, depending on the eventual outcome. A ‘Leave’ vote is likely to lead to further sterling weakness, with a recent report by Goldman Sachs stating that a fall of 15-20% could be a possibility. Conversely, a ‘Remain’ vote is likely to lead to a strengthening of sterling.

Given the wide range of outcomes for the value of sterling in the aftermath of the referendum, and the uncertainty surrounding the outcome of the referendum, we would not encourage investors to take a strong view on sterling prior to the referendum. However, if sterling overly weakens in the run-up to the election, clients may wish to use this opportunity to increase hedging positions against the possibility of strong sterling appreciation if the UK electorate opts to remain in the EU. This would, however, forego any upside of a weakening sterling on overseas asset holdings in the event of a ‘Brexit’.

Pension Scheme Considerations (Q&A)In this final section we try to answer some key questions from the point of view of UK pension scheme investors.

How could pension scheme investments be affected in the run-up to the EU referendum?As the EU referendum date draws closer (particularly in the two weeks before polling day), we anticipate that volatility in markets will rise. The scale of this volatility, however, is likely to be linked to how markets come to perceive the likelihood of the UK voting to leave the EU.

This volatility is likely to manifest itself in markets in many asset classes (as discussed earlier), though it is likely to be most visible in the behaviour of sterling. We expect the uncertainty surrounding the referendum to weaken sterling and if polling data indicates the result of the referendum is going to be close then that is likely to be exacerbated. Costs of some forms of hedging have already risen markedly. This would follow the pattern experienced by sterling in the run-up to the Scottish independence referendum in September 2014 (Figure 5). It is important to note that pension schemes with unhedged overseas currency exposures would benefit from higher asset values if sterling does weaken.

Figure 5 Movement in the Sterling Trade-Weighted Index over 2014

Source: Bank of England

Jan2014

Mar2014

May2014

Jul2014

Sep2014

Nov2014

99

100

101

102

103

104

105

Inde

x Va

lue

(Reb

ased

to 1

00 a

t 1 J

an 2

014)

18 September 2014: Scottish independence vote – sterling weakened in the two weeks prior to the referendum before strengthening after Scotland voted to remain part of the United Kingdom.

Elsewhere, the impact of the approaching EU referendum on broader asset classes is likely to be more complex as both UK equity and fixed income markets can be influenced as much by global factors as by domestic issues. A recent example of this was how gilt markets responded in the days following the 2015 UK general election. The unexpected outright majority achieved by the Conservative Party saw gilts perform strongly on the day after the election before giving up much of this gain the following day when gilts sold off on the back of an unrelated rout in European bond markets. Global factors, such as changing expectations for the pace of future US interest rate rises or wider economic or financial news, could have just as much of an influence on UK equity and fixed income markets as the possibility of a UK exit from the EU.

In broad terms, if expectations of a close result are sustained, it would be a reasonable rule of thumb to expect markets to be inclined to discount about half of the potential short term market adjustment ahead of the vote, and there is a reasonable amount of evidence that this is indeed happening.

Figure 7 Pre-Election Polling and the Outcome of the 2015 UK General Election (Based on Share of Seats)

Source: Guardian

Note: Pre-election polling is taken from the Guardian Poll of Polls data as at 6 May 2015

EU Referendum Special – Perceptions 5

the event of a ‘Remain’ vote. This would manifest itself in sterling appreciation and increased investment from UK and overseas investors in the UK property market, pushing up property valuations. Given the contrasting liquidity of currency and property markets though, we anticipate that the risk premia would unwind quickly in currency market but could take a number of months to come through in the property market.

Is now a good time to reduce equity risk ahead of June’s vote?In our latest edition of our quarterly Market Signals document, we noted that our view of global equity markets had deteriorated to ‘unattractive’ on the back of concerns regarding weakening fundamentals, stretched valuations and poor momentum signals. We also noted concerns regarding the tepid pace of global economic growth.

We believe that equity markets could fall in the coming months and note that there are a number of potential triggers ranging from the impact of US monetary policy on global markets, a further slowdown in China through to the outcome of the EU referendum.

As a result, we believe clients may wish to crystallise some of the gains experienced over recent months across equity markets, particularly if looking to satisfy shorter term income requirements.

However, we encourage investors to view the EU referendum through the lens of long term objectives and not to overreact to the volatility likely to be experienced within the market as the referendum draws nearer.

Can we rely on polling data to accurately predict the outcome of the vote?No. We believe that there is a strong possibility that current polling data is not providing a true reflection of the likely outcome of the referendum. Part of our scepticism is based on the recent poor track record of pollsters who wrongly predicted a tighter result in the 2014 Scottish independence referendum and a coalition government following the 2015 UK general election (Figure 7).

How will asset classes be impacted by a ‘Leave’ vote?A number of asset classes could be impacted significantly by a vote to leave the EU. Sterling is expected to fall markedly in the eventuality of a ‘Leave’ vote. We would also expect a ‘Leave’ vote to have a significant negative impact on both UK and European equities over the shorter term. The latter is likely to be particularly affected due to concerns that other countries within the EU, such as Greece, would question their involvement in the EU and euro. However, we note that a number of UK and European listed companies are global multinational companies with operations in multiple regions – this should subdue the impact of a ‘Brexit’ on their business operations somewhat. We anticipate that small-cap UK equities could also suffer given their high degree of sensitivity to the UK economy which could potentially slow following a ‘Leave’ vote.

We believe that the shape of the yield curve is likely to change as a result of a ‘Leave’ vote. Commentators have anticipated a slowdown in short term economic growth in the event of ‘Brexit’, which could lead to short term interest rate expectations falling and a flattening of the short-end of the yield curve. At the long-end of the yield curve (over 15 years), ‘Brexit’ may decrease the perceived credit worthiness of the UK economy, potentially leading to a rise in yields. This is likely to benefit pension scheme funding levels, though we note that the upward movement in yields could be countered by heightened demand from pension schemes for long-dated gilts. A fall in sterling is likely to cause a rise in inflation expectations over the medium term which could see index-linked gilts outperform conventional gilts.

From a UK property perspective, we have already seen demand for the asset class slow in recent months on the back of the changes to the buy-to-let regulations, the recent increase in stamp duty and uncertainty surrounding the EU referendum. The latter has particularly slowed investment from overseas investors. A recent survey of 25 global property investors suggested that Brexit would lead to less investment in the UK. This is a similar phenomenon to what happened in Scotland prior to their independence referendum in September 2014. Whilst the uncertainty surrounding a ‘Leave’ vote could further slow investment into the UK property market, we note that a weaker sterling may offset this somewhat by making the asset class more attractive for overseas investors from a valuation standpoint. It should be noted that the total returns of property are closely correlated with economic growth so any negative impact of ‘Brexit’ on the UK economy is likely to impact property returns.

Do we expect asset prices to normalise in the event of a ‘Remain’ vote?We believe it is difficult to identify the degree of risk premia (i.e. the discount placed on an asset class due to a foreseeable risk such as ‘Brexit’) that has been embedded into asset prices as a result of the EU referendum. Markets (both investment and betting) still believe that the UK is likely to remain in the EU and therefore it is likely that markets have not fully priced in the possibility of a ‘Brexit’.

That said we do believe that both sterling and UK property are currently pricing in a degree of risk premia that could unwind in

Pre-Election Polling Outcome

Conservative

Labour

Scottish National Party

Liberal Democrat

Other

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This publication is for information only and does not constitute legal, tax or investment advice; consult with legal, tax, investment and other advisors before applying this information to your specific situation.

Past investment performance is no indicator of future performance.

The sterling value of overseas assets in a fund may rise and fall as a result of exchange rate fluctuations.

The value of investments and the income from them may fall as well as rise and will be affected by changes in financial conditions.

Please note that investments involving property funds usually incur high transaction costs. They are also less liquid than the other asset classes discussed in this report so will trade less frequently, often monthly.

The views expressed in this document are general, and not specific to your circumstances. Please contact your investment consultant for further information and advice regarding the action that you should take in response to current investment market conditions.

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However, we also note that polls on the EU referendum appear to be quite divergent, particularly between those that are conducted online and those that are undertaken by phone. Phone polls suggest a solid lead for the ‘Remain’ camp whereas internet polls predict a much tighter vote. In general, polling experts suggest that phone polls are a better representative of the social attitudes and demographics of the electorate, though polling companies often struggle to gather truly representative samples.

On a somewhat related note, betting markets have typically had a strong track record of predicting referendum and election results and we therefore believe they could be a source of information, alongside selected polling data, for the likely outcome of the referendum.

Would a ‘Remain’ vote settle the matter for good?We believe that, as with the Scottish referendum, a vote to remain in the EU would not necessarily settle the matter for good. From a political perspective, there is likely to be repercussions on the leadership of the Conservative Party, a party that has been beset by in-fighting on the issue, and therefore the country, given that Prime Minister David Cameron has stated his intention to step down before the next election.

The events since the Scottish independence referendum have also shown that such emotive topics can continue to remain at the forefront of voters’ minds despite the wider electorate rejecting calls to change the existing status quo. Calls for a

follow-up referendum on the same issue could magnify if wider issues afflicting the EU, such as the migration crisis, continue to persist.

The UK is not the only country questioning the EU’s role within Europe. A number of non-traditional parties who oppose the EU and the notion of further political union within Europe have seen their share of votes increase in recent years. These include parties such as the National Front in France and the Danish People’s Party. We anticipate that over time, a number of countries may look to revisit their role within the EU in a similar manner to the UK.

That said, whilst political issues surrounding the EU may persist, we believe that markets will move on from the Brexit debate in the event of a ‘Remain’ vote and focus on more immediate (and more global) market events.

ConclusionRegardless of how the vote goes on 23 June, we anticipate that there will be significant moves in markets both prior to and after the referendum and sterling is particularly susceptible to these sharp moves. The repercussions of either a ‘Remain’ or ‘Leave’ vote are likely to be profound (both economically and politically), though we would encourage investors to continue to focus on longer term objectives rather than react disproportionately to shorter term market volatility.