Legg Mason : Full Implications of Brexit Vote Remain to be Seen, But Investors Should Not Surrender to Fear

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Alan Magleby Mary Athridge

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Full Implications of Brexit Vote Remain to be Seen, But Investors Should Not Surrender to Fear

Legg Mason Investment Managers Advise Caution and Diversification as the UK, Europe and Rest of the World Wait Anxiously

(London, England, July 5, 2016) - In a conference call on the post-referendum implications of Brexit, four Legg Mason senior investment professionals agreed that investors should be cautious, and for the most part stay true to their existing strategies. To them Brexit illustrates the need to ensure real diversification across countries and sectors. Yet it should also provide opportunities to smart investors with available capital who are willing take risks as others panic.

"We are underweight Europe as a whole," reported Jack McIntyre, senior portfolio manager of Global Fixed Income at Philadelphia-based Brandywine Global. "We got out of our Italian positions, but we need to see how the dust settles to make any changes to the portfolio."

"You need some things that are going to do a little bit better in a risk-off environment," Mr. McIntyre added. "But I wouldn't want to put the whole portfolio in those types of instruments. I want to get some yield in the portfolio as well."

"We'll be focused on earnings results and in particular in the next couple of weeks on warnings," said Michael Browne, Investment Manager for Scotland-based Martin Currie. "The real opportunity over the next 6-12 months will be on the short side. It's going to be in financials."

"Some banks offer prospective value going forward," agreed Andrew Belshaw, Head of Investment Management for Western Asset Management in London. "Certainly investment-grade corporate bonds in this environment offer very good value. They don't go anywhere."

Mike LaBella, portfolio manager with QS Investors in New York, said he made "no immediate changes. As a schematic shop, we try to keep to market discipline during events like this, making sure we're already prepared to weather unexpected storms. By focusing on diversification and volatility management in many of our strategies, we're pretty much staying the course."

According to Mr. Belshaw, the sharp fall in U.K. markets could lead to a quick bounce back.

"I'm optimistic," he said. "The economy tends to quickly rebound from that kind of fall. Let's be honest, the Bank of England has not covered itself in glory - but if the Bank does the right thing going forward, the

U.K. will have a couple of weak quarters, but it should be OK."

"One of the areas that has suffered the biggest outflows is the U.K. equity market," Legg Mason Investment Director and moderator Amanda Stitt said. "The last statistic I saw was 350 million pounds moving out of U.K. equities, probably going to the risk-off trade into sovereign bonds."

"The flow I'm concerned about is the impact of low or negative interest rates on the balance sheets of investors, most notably the insurance industry, who could well become forced sellers of a number of assets," said Mr. Browne. "There is a pervasive longer-term negative flow issue. The flip side is that will exacerbate the size of pension fund holes, and a number of corporates who will become basically pension funds with businesses attached, desperately trying to repay them. Very negative stuff, but that's this extraordinary world of deflation and very low interest rates."

Both Messrs. Browne and Belshaw agreed this is the start of very volatile months, or years.

"Probably say years," Mr. Belshaw amplified. "My view always was, post a Leave vote there will be a five to 10 year exit. I don't see any way to change that."

Brexit "certainly has made markets very volatile," observed Mr. LaBella. "But we are not seeing the kind of market panic we saw earlier this year or mid-way through last year. Brexit is a very important event for the

U.K. - two percent of the global economy - and has significant implications for Europe, but the further growth implications for emerging markets and the U.S. are less certain. Many emerging markets, particularly Latin America and Southeast Asia, are still quite robust and up well over double digits. Latin America is up 30 to 40 percent year to date."

"So there's going to be large opportunities out in the international space," Mr. LaBella noted, "but investors are going to have to deal with increased volatility."

Mr. Browne said Martin Currie's view was more pessimistic.

"The overall prognosis for the U.K. is obviously significantly worse than it is for the rest of Europe," Mr. Browne said. "You could argue it's joining some of the problems that the rest of Europe has already exhibited. But the rest of Europe could well see some opportunity sets, and some quite big opportunity sets if the currencies continue to depreciate as they are."

However, Mr. Browne noted, the state of U.K. and European banks is a "rebounding negative for the overall economic situation. We haven't actually answered the underlying question, which is how to make banks profitable in a world of negative interest rates? I don't think you can."

"I thought the market reaction was rational given the risk we've got," Mr. Belshaw observed. "It wasn't excessive. Opportunities have been created and I disagree on the impact of negative rates. I'm more optimistic on European growth. I have only revised it down .2 percent, to 1.8 percent from 2. If domestic demand holds up in Germany, which I think it will, Europe will be fine."

Mr. LaBella voiced special concern over market volatility and the need for global diversification.

"If you look at the longer term, the 1-year or even year-to-date numbers, global diversifications paid off pretty well," Mr. LaBella reported. "Europe is down significantly, but the U.S. is still relatively flat, and emerging markets are doing quite well. The dispersion between the best and worst performing sectors is well over 40 percent. There's been a flight to quality, where you see dividend paying sectors like telecoms and utilities holding up quite well, on a global basis up over 10 to 20 percent. That compares to financials, down anywhere from 7 to 15 percent based on region. So, the environment has been very different depending on how diversified you are."

"That goes to the bigger point of economic anxiety," he said. "This vote caught international markets by surprise, even though the polling was very close. The reason is a much bigger global trend: this is one of the first rejections of globalization, or economic integration in the post World War era. That has really rattled confidence. People see populist movements in Europe, Donald Trump in the U.S., and that's going to have implications on growth going forward. It's not going to be a Lehman-like panic situation, but anxiety is seeping into the markets right now."

"The commonality between Brexit and Trump's popularity are symptoms of the broader disease," Mr. McIntyre said. "We have been in a growth-challenged world for a very long time. Incomes are stagnant, people are getting frustrated. There are different forms of populism. Is it making Trump popular because he's playing this sort of anti-globalization, anti-immigration? We'll have to see how it plays out, but one of the points is: don't underestimate him. He keeps saying things you think would de-rail his campaign, yet he seems to be somewhat immune to it."

"The biggest risk with a Trump Presidency is he actually follows through with the things he says. That's a shift towards protectionism," Mr. McIntyre said. "Obviously in 1929 that just decimated global trades, so that would be a very risk-off environment."

Ms. Stitt pointed out that 71 percent of economists are now predicting a recession in the U.K.

"Most economists have been wrong in the last seven years anyway, so I'll take that with a pinch of salt," Mr. Belshaw observed. "Clearly, it's going to have a negative effect. It will depend on how investment reacts and how confidence holds up in the U.K. I think we'll see some slowdown in Q3, Q4, but ultimately just about avoid recession."

"We've had a huge profit warning from one midcap this morning, making the point that their business is falling off a cliff in earlier May and continues to decelerate," Mr. Browne said. "I would expect business investment to go into sharp negative and continue through that process in the third and fourth quarter. The consumer, with a savings rate of 3.1 percent, is over borrowed. Therefore, you've got to anticipate a much quicker, sharper slowdown in the U.K. economy."

"We are taking our numbers down for next year, which implies GDP must be negative in the first couple of quarters. I would not be at all surprised to see a similar figure for this year because of the negative sudden emotive reaction that is coming from both business and consumer."

"Where we go in 2018 is a really interesting question," Mr. Browne said. "You will have the banks facing significant cuts to their margins. You're then starting to ask questions about the overall prospect for house building and other areas. This could prolong a period of economic gloom through a recession. That may well be exactly what our European colleagues want to see so they can force us back to the negotiating table in 2018 with a tail very firmly between legs."

"Describing our view as sort of optimistic is probably being a little too generous," Mr. McIntyre said for Brandywine Global. "We're not looking for Europe to teeter into recession. Weakness in the currencies is going to go a long way towards preventing that. From the 40,000 foot level, because it's all inter-related, the two big influences are China and U.S. Federal Reserve policy. The unintended consequences of Brexit might be more global monetary stimulus."

From a political standpoint, Ms. Stitt asked the panelists, "Should we just move on at this point, with that having said is now done, we are going to leave the European Union?"

"That question is loaded with so many different issues," Mr. Browne answered from London. "The issues about Article 50, issues about whether we have an election in the autumn of this particular year, it's actually quite hard to make sense at this point in time. Just from a personal point of view, there is no point

having another referendum, even if you want it, until you got something to have a referendum about. And that could only be a conclusion of negotiations."

"It makes absolutely no sense, from a political or economic point, to go through the trauma - and it was traumatic - of another referendum until we get to that point," Mr. Browne said. "The question then is when and how are going to get to that point?"

"I certainly don't think another referendum will be forthcoming," Mr. Belshaw agreed. "In terms of the Remain camp and their reaction and the five stages of grief, in the first stage it was denial. And denial is clearly paramount here in their thinking. I mean it's very difficult."

"You don't want to invoke Article 50," Mr. Browne said. "It's not within the French and Germans interest to invoke Article 50. They have huge elections coming up in May and September next year. The one place you want going into that election is the U.K. on the naughty step. You want them firmly in everybody's bad book because it plays beautifully to your domestic politics."

"It's important that the listener knows there is more to this than meets the eye," Mr. Browne concluded. "The E.U. does have some ability to force the pace of this conversation on and has the ability to stop the British from disrupting business."

"Investors need to be prepared to expect the unexpected," Mr. LaBella summed up. In addition to Brexit,

"we look at the rate environment, whether it's when the Fed will start raising, or when rates may go further negative in Europe. We look at China's growth. We look at Japan with Abenomics, and rises in commodity prices. There is tremendous uncertainty right now. Quality is going to make a very big difference. We want to ensure that investors are utterly diversified across big macro factors, but making sure they own quality sectors. This is not a short-term environment. This is going to be a new normal. It's going to take place for a couple of years."

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Andrew J. Belshaw, PhD

As Legg Mason's Head of Investment Management, London, Andrew Belshaw has 24 years of experience. Prior to joining the Firm in 2009, Mr. Belshaw was Managing Director, Head of Sterling Fixed- Income at BlackRock Investment Management; Director of Institutional Fixed-Income at M&G Investment Management; and Director of Global Fixed-Income and Currency at Baring Asset Management.

Previously he was a Senior Investment Manager of Global Fixed-Income at Gartmore Investment Management, and an Economist and Investment Manager at Whittingdale Investment Management. Mr. Belshaw holds a Bachelor of Arts degree from Manchester Metropolitan University, and a PhD from the University of York.

About Michael Browne

An Investment Director and co-manager of European long/short strategies based in London, Michael Browne joined Martin Currie in 2010. Previously he co-managed the European hedge fund of Sofaer Capital, from 2001; was head of international equities at Chase Asset Management, where he had overall responsibility for all non-U.S. equity portfolios; and began his career in 1986 at BZW Investment Management, where he was responsible for a variety of European unit trusts and segregated funds. Mr. Browne received a degree in economic history from Brighton College, Durham University in 1981.

About Michael LaBella, CFA

A portfolio manager and member of the QS Investors portfolio management implementation group, Mike LaBella has been with the firm since 2010. He joined QS Investors from Deutsche Bank, where from 2005 to 2010 he served as a portfolio manager for the quantitative strategies group, and as an institutional