08Sep 2016

Mike Brooks,
Head of Diversified Multi-Asset Strategies,
Investment Solutions

Diversification in a post-Brexit world

First came talk of Grexit, and then came Brexit.

Political risk has certainly risen in Europe, but the same sentiment that prompted the Brexit vote can be felt across much of the world. The policies being followed by established political parties have led to feelings of greater inequality in a number of countries. A large section of the populous feel disenfranchised and are desperately seeking change

This feeling has fuelled the rise of populist politicians such as Donald Trump, the Republican candidate for the US presidency, and Marine Le Pen, leader of France’s National Front, who are promoting attractive narratives for a more prosperous future. These politicians typically support trade barriers as a bulwark against foreign competition; and portray immigration as a key problem.

This anti-globalisation agenda has huge implications for financial markets. Immigration has boosted corporate earnings in many countries by providing an ample supply of labour. The advance of free trade has accelerated global economic growth, which is good for stocks too. We can expect volatility in stocks and many other asset classes with every advance and setback to the electoral prospects of populist politicians, and with every policy prescription they devise if they gain power. This raises the risks for equity markets and potentially reduces prospective returns.

At the same time the prospective returns from government bonds are extremely low. Brexit has pushed down yields on 10-year gilts to record lows under 1%. This is largely because of an expectation that the Bank of England will ease monetary policy yet further because the post-Brexit mood of uncertainty is hitting economic growth.

But the implications of Brexit spread far beyond the UK markets. Janet Yellen, Chair of the Federal Reserve, warned before the referendum result that Brexit could “negatively affect financial conditions and the US economic outlook” – keeping Treasury yields down. More generally, if populism reduces global growth, bond yields across the world will remain lower for longer. This is evidenced by Germany joining Japan in having negative bond yields. These low government bond yields also drag down the prospective returns from investment grade corporate bonds as well.

So, if the risk-return trade-off from equities has deteriorated and government bonds offer very low returns then where do investors go for consistent growth?

One answer is diversification.

There is an increasing array of investment opportunities away from traditional asset classes that offer the potential for attractive returns but with different return drivers. This approach is perfect for a turbulent era because it has an impressive record of producing good returns but with lower volatility than other strategies – improving the risk-reward outlook once more.

These diversifying asset classes include infrastructure, offering relatively stable long-run cashflows with little economic exposure. It also includes various forms of higher returning credit opportunities including high-yield bonds, asset-backed securities, loans and peer-to-peer lending, subject to careful due diligence. Emerging market bonds have also regained favour this year as a prolonged lower interest rate environment favours emerging economies.

However, Brexit might also make some investments more attractive especially off the back of the fall in sterling. For example, high-end student accommodation targeting international students may well receive a boost as Britain may see more rather than fewer foreign students in the wake of Brexit. Their cost of living in the country will be lower because of the fall in sterling; the UK government may welcome them with redoubled enthusiasm if immigration policy becomes more focused on skills, as many Conservative politicians who voted for Brexit want. This would increase the demand for relatively scarce high quality student accommodation , supporting rental growth in the sector.

We do not yet know whether 2016 marks the beginning of the end of the long period of economic neo-liberalism that began in the 1980s; until we do know this for sure one way or the other, we should expect volatility. When markets are volatile, the case for a diversified approach is all the greater.

Image credit: ImageZoo / Alamy Stock Photo

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