Beyond Brexit: An Update from Our Portfolio Managers Call Summary
On 28 June, Lazard Asset Management hosted a conference call on Brexit that included Michael Bennett, Portfolio Manager/Analyst of International Equity, James Donald, Head of Emerging Markets, and Ron Temple, Co-Head of Multi Asset and Head of US Equity. The call included a discussion of possible scenarios for the United Kingdom’s exit from the European Union (EU); the implications for the economy and markets; and the positioning and performance of our international and emerging markets strategies. In this paper, we summarize the observations and conclusions of the call. We believe that the Brexit result’s greatest impact will be to raise market uncertainty and it may threaten confidence at a time when investors are questioning global growth, the efficacy of central bank policies, and the ability of governments to address voter concerns. Periods of heightened volatility and uncertainty, however, may also benefit skilled active managers. While we were surprised by the Brexit result, we believe we were prepared. Lazard’s international and emerging markets strategies have been positioned defensively and focused on quality. At the same time, we continue to apply our relative value approach to markets, and we are looking for opportunities to make investments in what we determine to be strong companies at relatively cheap valuations. “Historically it has been wise for investors to stay the course,” said Michael Bennett, “and, quite possibly with some courage, buy.”
The Road Ahead The initial shock of the “leave” vote appears to be fading from the markets, and the short-term reaction by investors has largely been in line with our expectations. Over the medium and longer term, however, the implications of Brexit remain unclear and can be a source of significant investor uncertainty. A large part of this is due to the fact that the United Kingdom’s withdrawal from the EU is unprecedented. According to Ron Temple, the next steps for the United Kingdom include forming a government and deciding whether to challenge the referendum’s result. Thereafter, the new government will have to decide whether to invoke Article 50, in which case it would subsequently negotiate the exit with the EU and consequently be required to renegotiate trade agreements with the rest of the world. Each of these steps is fraught with potential complications. Both major political parties—Conservatives and Labour—are in turmoil. David Cameron will resign and the conservatives will select a new leader; Jeremy Corbyn has received a no confidence vote from his party. A new election could potentially seek to validate, or overturn, the referendum’s result. The formal process for leaving must be triggered by the United Kingdom via Article 50 in the Treaty of Lisbon, which will then lead to a negotiation period of up to two years. If the United Kingdom does leave the EU, it must then negotiate trade deals with more than 60 countries.
UK financial companies are most exposed to Brexit, since London’s status as a financial center is largely due to its “passport” status within the EU, which allows UK companies to operate in any EU country. Further uncertainty could come from secession movements in Scotland and Northern Ireland, which account for 11% of the United Kingdom’s population and 10% of its GDP. Another risk is a political contagion to the rest of the continent, where anti-Europe sentiment has been on the rise and has found expression in far-right political parties. Majorities in Italy and France favor a referendum on membership in the EU, and significant numbers say they would vote “leave.” A potential positive result of the referendum could be that it serves as a wake-up call for European, and American, leaders, who could respond with substantial investment programs that boost employment and productivity to address the anger and alienation that drove the “leave” vote. For investors, UK growth is likely to be reduced substantially, and the likelihood of a recession this year and in 2017 has increased. Growth in the EU will also be reduced (European Central Bank President Mario Draghi is reported to have estimated that euro zone GDP could decline by 50 basis points), though a recession is unlikely. While cautioning that Lazard does not have a house view on macro topics given our bottom-up approach to investing, Temple indicated that he expects interest rates will remain lower for longer. The US Federal Reserve likely won’t raise rates until 2017. Even then, the Fed is likely to only raise rates 2–3 more times before it ends the current tightening cycle. Even if the Fed were to raise rates more, long-duration yields are likely to stay low as more than half of euro zone sovereign debt yields negative rates. “We’re advising our investors within Lazard to be patient and thorough in their analysis before jumping to any conclusions,” said Temple. “Having said that, we knew the vote was coming and had prepared for different scenarios. In the global equity context US equities and emerging markets equities are arguably more insulated from the impact of the Brexit vote but even there it is important to recognize that some US companies have substantial exposure to the United Kingdom and that generally speaking, emerging markets equities in central and eastern Europe are probably more affected than those in other regions.”
International Equity The International Equity team understood that a “leave” vote was a very real possibility and aimed to be wellprepared by working within the team and with risk management to understand how portfolios would react to each scenario. We concluded that despite our overweight to the United Kingdom, our relative performance would likely not experience a major impact in either outcome. The strategies’ positioning leading up to the Brexit referendum was already moderately defensive because developed markets have been characterized by low growth and higher valuations for the past 12–18 months—a backdrop that can make stocks more vulnerable to macro or stock-specific events. As a result, our strategies were underweight European banks and European cyclicals. Consistent with our relative value investment philosophy, we owned what we view to be very high quality companies characterized by strong financial productivity, strong balance sheets, and proven management teams whose stock prices are inexpensive relative to the level of returns. We believe it is critical to focus on where our companies do business, not where they are domiciled, and thus we are comfortable with our UK overweight. Within the United Kingdom, we own mostly global companies, which are less affected by the Brexit outcome. Depending on the strategy, our revenue exposure to the United Kingdom and Continental Europe is roughly 25% less than our geographic exposure. Of that 25%, approximately 20% of the exposure is to North America and 5% to emerging markets. We expected UK domestic companies to underperform in the Brexit scenario, but they provided balance to the portfolio. After the “leave” result, many of our multinational holdings actually rose in local terms.
As of this writing, most of our International strategies have outperformed since the Brexit vote, and all of the International Equity platform strategies are outperforming year to date. We have and will make some changes in our strategies at the margin, but we had prepared for the Brexit event and believe we are well positioned for a period of uncertainty, consistent with our long-term record. Markets often quickly discount the worst-case scenarios during events such as Brexit—this time has been no different. While the market reaction has been severe, historically it has been wise for investors to stay the course and, quite possibly, buy. Volatile market dislocations are typically good for active managers and a risk-off environment plays to our strengths. Our job on the International Equity team is to calmly analyze companies and monitor the strategies to take advantage of stock dislocations.
Emerging Markets Lazard’s emerging markets strategies currently have relatively few positions in those regions with significant exposure to the United Kingdom, such as South Africa and parts of eastern and central Europe. The secondary effects of the “leave” vote—i.e., market or economic contagion—could have a greater impact on emerging markets through slower global economic growth, lower rates from central banks, and a longer recovery in commodities. Materials, energy, and industrials sectors could be most impacted, as well as countries with low reserves and large current account deficits—Russia, Brazil, Indonesia, South Africa, and potentially India. The emerging markets strategy has tracked the index recently but has outperformed month to date and in 2016. “Most of our companies have strong financial positions and should be able to weather a period of substantially lower economic growth relatively easily,” said Donald, “but the market’s effects may be significant as well.” Emerging markets relative valuations have not changed significantly due to the Brexit vote, and emerging markets equities are still relatively inexpensive compared to other global equities. In addition, emerging markets still have strong profitability levels, which have proved to be resilient. Unless the world has a significant recession, in our view, emerging markets are attractively priced.
Looking Ahead Overall, greater instability is likely to create appealing investment opportunities as some stocks are disproportionately discounted relative to fundamentals. In general terms, even while global markets are correlated, companies that are less directly exposed to UK and European growth rates should defend better—with the United States and emerging markets as obvious examples. In addition, debt has risen to such expensive levels that investors have been forced into riskier assets. Having said that, Lazard’s portfolio managers are not looking for specific signals in the markets to change how they approach investments. They are not market timers but employ fundamental, bottom up analysis one stock at a time. This focus on individual company characteristics can make volatile markets an opportunity for skilled and disciplined active management. This approach can deliver protection as markets decline while selecting undervalued companies that offer growth in the future.
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.
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