Brexit impact on European equities

Having been cautious on markets all year, we went into the referendum with a defensive posture to our holdings with large weightings in healthcare as well as the recently built exposure to oil majors.

This positioning was based on fundamentals and not because of any prescience about the outcome of the vote.

I expect Brexit to be nothing like as bad for the world as the sensationalist media likes to portray, although the truth is we are in uncharted waters and nobody knows. We have therefore made no strategic changes to the portfolios since the result. This is because, if anything, the uncertainty fostered by the Brexit result aligns the market more closely with our thinking.

It would be damaging for British and EU negotiators to rush a solution when participants are emotionally charged. Markets, however, despise uncertainty and confidence more generally may be shaken as events drag on, leading to investments postponed, jobs withdrawn and consumption deferred. Our biggest concern at this stage, therefore, is that the vote catalyses a European recession.

If there is a recession, it need not affect markets in a uniform fashion. We would expect larger cap companies and non-cyclicals to do better. Similarly, sectors where valuations have already suffered a bear market are likely to be supported, such as the oil sector, where low oil prices are instilling capital discipline. We began buying the oil sector in Q3 2015 and with some shift towards these areas in recent weeks our portfolios have benefited.

It is telling that European markets suffered deeper falls in the initial panic than the UK market. A seemingly cruel irony of Brexit is that having retained its own currency, strain in the UK can be partially relieved through a weaker pound boosting exports and the translated overseas earnings of UK companies. No such relief valve exists for individual members of the Eurozone and this ties into our second concern – that Brexit precipitates a return to crisis in the Eurozone periphery.

I am less inclined to worry about the UK and to be more concerned about Greece, Portugal and Italy. Challenged economies means electorates in these countries are similarly disillusioned, with Italy confronting a referendum in October on political reform. Britain may not have the monopoly on political upsets. As for France, they are permanently disillusioned. Additionally, the banking sector in Europe, particularly in the periphery, is in no fit state to deal with recession: capital buffers in the sector are, in our view, insufficient. This has been the single biggest reason for our long-term caution towards banks.

Neither of these concerns need transpire. Central bankers may step in with additional stimulus measures, although I would argue that fiscal stimulus would be more useful given the stresses that negative interest rates and quantitative easing are creating in the financial sector. QE is suffocating the lives out of banks.

It is hard to believe that Europe’s economy can escape unscathed. Despite the initial market correction, equity valuations are at levels that make sense only if further turmoil or recession can be averted. This leaves them vulnerable. In these fast-moving markets we will be tactical but no strategic changes are being made to our broadly cautious positioning.

John Bennett – Director of European Equities – Henderson Global Investors