When Brexit became a reality last week, we were just as stunned as most everyone else. As the markets struggle to process the enormity of the event, we believe it will be important to have cash on hand because politics have become an important market driver going forward.
Brexit is evidence that voters are seeking change — and change they will get. But I have reservations that they will get the growth, jobs and rising incomes they seek having elected a more inward route that limits opportunities and isolates Britain. I see two potential paths for the market right now:
Lower Growth Expectations in Europe
The first path is a lowering of growth expectations in Europe and, to a lesser degree, for the rest of the world. This is a continuation of a lower for longer rate environment and is supported by the world’s central banks. The results will likely lead to further stretched valuations as investors continue to reach for yield.
A More Prominent Role for Fiscal Policy
The second path would develop slowly in the months ahead but would be a response in opposition to the Brexit decision for the rest of the world. In this more optimistic scenario, both policymakers and voters would move more decisively towards growth initiatives including greater use of fiscal policy. This path is possible, but requires strong leadership, a strong credible message and a move away from populism.
I believe the following three things will influence which path the market ultimately takes:
- A further trend towards exiting the EU from other countries. So far, the Spanish elections do not indicate further contagion from Brexit as the establishment was voted back in. That’s a good sign, but bears will be watching in the weeks ahead.
- Whether fear builds or recedes and the impact on the U.S. dollar and rates in the developed markets. Dollar strength and negative rates will lead to market instability and will pressure China’s ability to maintain stability of the yuan. This would have broader negative implications for global markets, particularly emerging markets, which have been somewhat insulated from the Brexit fallout.
- The outcome of the U.S. election. Do we follow Britain and choose protectionism or does the political establishment move closer to the center to deliver necessary change to reduce inequality and polarization?
It’s a lot to ask for, but if we make it through the first two steps in the months ahead I will be more willing to use cash to buy the dips. For now we sit tight with our cash on hand with the flexibility to ride out this period of uncertainty.
Kathleen Gaffney is vice president and co-director of diversified fixed income at Eaton Vance Management.
