After Brexit: top 10 least preferred asset classes

Close to one week on from the UK's vote to leave the EU and the markets remain volatile. But in the recent recovery there are at least signs that the event is being treated as a more of a local issue than a global crisis. 

Nonetheless, there are various asset classes we expect to underperform over the next three to six months, due to Brexit or related flows. I list our top 10 in this note. Not losing money is the first part of making it, but finding the right assets remains challenging; cash isn't necessarily the answer in today's low or even negative rate world. 

For investors seeking short-term investment opportunities please see my note – "After Brexit – top 10 opportunities" – that I published earlier this week. It contains our top three-to-six month opportunities in the wake of Brexit. 

For investors seeking to protect and grow wealth over the long term, we continue to stress the importance of a multi-asset portfolio, well-diversified across regions, sectors, and asset classes. Our global credit opportunities strategy seems well positioned in a time of a renewed hunt for yield, and our systematic allocation strategy seeks to sharply limit exposure to equities in times of stress, which could materialize in the months ahead. 

For non-US investors, I list our view on the top least preferred asset classes.

Equities

Avoid UK–exposed companies in former UK colonies

An equal-weighted basket of UK-exposed corporates listed in South Africa, Australia, Singapore, India and Hong Kong has outperformed the FTSE 250 by c. 10% since Brexit in USD terms, despite having a similar exposure to the UK (of around 50% of revenues/assets). The companies in the basket boast a big local shareholder base (either controlling shareholders or institutional investors), some of which might move to reduce their UK exposure over time. For these investors the British pound is not their reference/functional currency, so ongoing uncertainty in the UK could lead to a rotation to more domestic-focused stocks. 

S&P 500 downside volatility

S&P 500 downside volatility is used to price put options and related structured derivatives. It is also currently very high. Relative to last year, three-month at-the-money S&P 500 implied volatility is in the 79th percentile. Volatility for lower strikes is, in relative terms, even higher – the difference between 90% volatility and at-the-money volatility is in the 87th percentile. Therefore, selling S&P 500 downside volatility for yield could be attractive. We are overweight US equities in its tactical asset allocation. 

Taiwan equities

We had expected the electronics-heavy Taiwan market to report its worst earnings figures in Asia and EM this year – a 5% y/y decline due to weak external demand and, more importantly, muted consumer electronics product cycles. Brexit is likely to make matters worse for Taiwan, since it has the highest revenue exposure (15%) to Europe among Asian countries, resulting in further earnings downside risks. Trading at a premium to regional markets, the valuation is unattractive, which together with rising political risks under the new government increases the vulnerability of the Taiwanese market, as we see a potential downside rate in the mid to high single digits till the end of year.

Selected overpriced Eurozone equities (vs MSCI EMU) 

Since the Brexit vote, investors have rushed into some familiar stocks, even though they might be overpriced. The stocks described in our "Selling expensive stocks with cloudy outlook" publication exhibit more expensive valuations than average, despite decreasing cash flow generation, above-average debt leverage, higher dividend payout ratios, and lower earnings momentum. We expect the median free cash flow generation of our selection of companies to drop by almost 20% this year, compared to an increase of 8% for the MSCI EMU index, and for these stocks to underperform the wider market.

MSCI Poland (vs MSCI EM)

Poland has the highest UK exposure among EM countries. The sell-off in the Polish zloty in the aftermath of Brexit raises the burden of CHF mortgage loan book conversion for Polish banks, which make up half of the MSCI Poland index, adding to the regulatory difficulties they already face. We think the underperformance of MSCI Poland is likely to continue.

Fixed income

High grade bonds (vs Euro HY, US IG, and US equities)

Following the recent risk-off move, the yield curves in CHF and EUR are broadly negative, and the market has priced out any rate hike in the US for the next 12 months. We find HG bonds relatively unattractive at these levels, with expected rising yields and, in particular, negative carry in EUR and CHF affecting total returns. In a moderate growth environment and with monetary policy remaining loose for the foreseeable future, we prefer EUR HY bonds and US IG bonds, which benefit from an attractive yield pickup, and US equities, which should benefit from improving US earnings growth. 

Within the high grade curve we see a Short Term Investment Opportunity to sell 10-Yr T-notes and buy T-bonds. After the Brexit vote, Fed funds futures are pricing the Fed to remaining on hold for almost the next two years, with a slight probability of an ease in 2016. However, a continued improvement in the economy could well lead to market expectations of Fed action sooner, leading to a bear flattening (curve narrows in a selloff). The long end, on the other hand, is relatively anchored due to structural buying from pension funds, safety flows, and the Fed could be forced to do QE to fight even a vanilla recession. 

Limit exposure to Central and Eastern European (CEE) credits 

Due to their tight links to the UK and the Eurozone, CEE economies are likely to be affected by the Brexit vote, whether through fewer exports to the UK/Eurozone, lower remittances, declining EU structural fund flows, or rising political risks. This adds to negative developments already seen in the region recently. We expect spread volatility to remain high and the scope for spread tightening to be limited amid political uncertainty, unlike with EM credit overall, whose spreads we expect to narrow as investors' search for yield continues in the current low rate environment. Default risk for CEE credits remains contained, in our view, but we expect them to underperform on a risk-adjusted basis. 

FX / Commodities

Australian dollar (vs USD)

Weaker signals from China have gone under the radar amid all the noise from Brexit. But there are signs of a renewed slowdown in the Chinese economy, and we anticipate any deceleration weakening Australian growth drivers further, with increased global uncertainty creating additional impediments to Australia's transition away from mining-led growth. We expect the Reserve Bank of Australia to cut interest rates by 25 bps in August, and the risk of further adjustments remains skewed to the downside. 

Euro (vs NOK) 

The greater uncertainty about the future of the EU, further calls for disintegration, and potential economic hiccups leave us cautious on the euro, which was already expected to underperform given the European Central Bank's exceptionally loose monetary policy. We are more positive on the Norwegian krone: although it fell in the aftermath of the Brexit vote, it does not suffer the structural concerns of the euro, and the direct trade links between Norway and the UK are relatively small. 

Japanese yen (vs gold)

The Japanese yen has performed strongly in the aftermath of the Brexit vote thanks to safe haven flows. Yet it is now approaching levels at which the Ministry of Finance or Bank of Japan could act to prevent further appreciation that could damage the Japanese economy. Likewise, Prime Minister Abe may propose a large ( up to 20 Tln Yen)) fiscal stimulus package. We suggest selling the Japanese yen, partially hedged with long gold to help avoid exposure to ongoing systematic risk (gold also tends to rally in times of global political risk aversion or sell off in times of relative calm.

The price and value of investments and income derived from them can go down as well as up. You may not get back the amount originally invested.

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