Where to Find Opportunities in a Post-Brexit World

Magnifying Glass

Last week’s British vote to exit the European Union (EU) has spurred a flight to perceived safety and left many investors asking where to find opportunities amid indiscriminate selling of global risk assets. This week’s chart helps explains where to potentially find attractive value in a post-Brexit world.

Prior to the Brexit vote, there was a wide range of valuations but few cheap assets globally, as shown in the chart below. With most asset valuations still looking fair to expensive, it’s important to focus on relative valuations.

Modest economic growth, low inflation expectations and easy central bank policies have sent yields lower, intensifying flows into income-oriented assets. This partly explains extreme valuation differences between equities and government bonds. Political concerns in Europe have exacerbated other extreme differences, such as that seen between international stocks and U.S. equities.

Asset Valuations

Valuations tell us little about short-term returns but can potentially shed light on medium-term returns. Starting valuations explain roughly 10% of U.S. equity market returns over the following year but 87% of returns over the next 10 years, according to our analysis back to 1988.

Valuations also show the risk of owning bonds (and bond proxies) could rise further, as market uncertainty and easy monetary policy potentially drive valuations of interest-rate sensitive assets higher. Some assets may be cheap for a reason, reflecting structurally challenged businesses, for instance.

The big takeaway for investors

The big takeaway for those seeking to buy into market weakness: Be wary of buying notionally cheap assets that face challenges (e.g. domestically-focused European assets like U.K. real estate and European banks), and instead focus on assets with relatively attractive valuations and positive fundamental drivers, such as quality stocks, dividend-growth stocks and investment-grade bonds. Indiscriminate selling of risk assets could translate into buying opportunities in these assets, including in U.K.-listed stocks that benefit from pound depreciation (72% of FTSE 100 revenues are earned abroad).

Selectivity and caution are key

Bottom line: Post Brexit, selectivity and caution are key. Read more market insights in my weekly commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. There is no guarantee that stocks will continue to pay dividends.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

The Big Bad Brexit

Brexit

Late Thursday night it became apparent that, despite earlier polls, the British people had voted in favor of leaving the European Union (“The Brexit”).  Unfortunately, this has led many people, especially in the media, to fear the worst.  Although there is some justification in being alarmed, I always find it useful in situations like these to take a step back and first understand what is happening from a macro level and then decipher what that means for our future.

From a very high level, I see the Brexit decision as a continuation of the anti-globalization and anti-establishment movement that has been gaining steam in most of the western developed world.  This is evident in the fact that the vote in England was almost eerily split up between urban and more educated individuals (some might define as the establishment) who voted for “Bremain” and middle and working class individuals living in more rural areas voting for Brexit.  Not surprisingly, this latter group has been very concerned by the influx of immigrants into Britain, which they see as resulting from the European Union’s open border policies.  So what does this mean for us?

In the short term, this event will increase the perception of political and economic uncertainty.  In general, markets dislike uncertainty and that is one of the reasons that the markets reacted negatively to the unexpected result of the British vote.  From the political sphere, we are already seeing additional increases in uncertainty with British Prime Minister David Cameron signaling his resignation and the Scottish threatening to hold their own referendum to split from Britain and United Kingdom.  This does not necessarily mean the world is ending, however.  Great Britain is still a dominant economic force and will most likely be able to reinitiate trade agreements with Europe to ensure stability, which is in the best interest of every party involved.  From an economic standpoint, I don’t believe doom is coming either.  While we are in our seventh year of a United States bull market and market indicators are generally mixed, the US market is not about to enter into a full-fledged recession with characteristics of the financial crisis.  This is due to the fact that the balance sheets of corporations are relatively healthy, and the Federal Reserve under Janet Yellen is committed to trying to manage monetary policy in a manner that is likely to avoid a recession in the near-term. The low interest rate monetary policy pursued by the Federal Reserve continues to act as a tailwind for companies, who can borrow at extremely low costs of capital.

Finally, and arguably most importantly in the context of the “Brexit”, the US market as a whole will continue to be seen as the best house in a bad neighborhood. International markets, whether in China, Brazil, or elsewhere have been underperforming in our latest economic cycle.  This new European development will only increase this trend which will continue the flow of foreign capital into the “safety” of the US market.  This does not mean that we are immune to outside volatility and overall market malaise but it does tell us that we will not necessarily feel the brunt of any outside negative market impacts.  Currently, our view is that from a long-term perspective, Brexit will be viewed as an important event, but not one that in itself will lead to market catastrophe.  However, we will continue to monitor this and other market events as summer progresses.

Susan McGlory Michel is the CEO of Glen Eagle Advisors, LLC. For additional information regarding Susan or Glen Eagle, visit www.gleneagleadv.com. If you are interested in scheduling a free portfolio review call 609-631-8231 or email info@gleneagleadv.com.

 

Disclosure: This commentary is furnished for the use of Glen Eagle Advisors, LLC, Glen Eagle Wealth, LLC and their clients. It does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific objectives, financial situation or particular needs of any specific person. Investors reading this commentary should consult with their Glen Eagle representative regarding the appropriateness of investing in any securities or adapting any investment strategies discussed or recommended in this commentary.

The Big Bad Brexit

Brexit

Late Thursday night it became apparent that, despite earlier polls, the British people had voted in favor of leaving the European Union (“The Brexit”).  Unfortunately, this has led many people, especially in the media, to fear the worst.  Although there is some justification in being alarmed, I always find it useful in situations like these to take a step back and first understand what is happening from a macro level and then decipher what that means for our future.

From a very high level, I see the Brexit decision as a continuation of the anti-globalization and anti-establishment movement that has been gaining steam in most of the western developed world.  This is evident in the fact that the vote in England was almost eerily split up between urban and more educated individuals (some might define as the establishment) who voted for “Bremain” and middle and working class individuals living in more rural areas voting for Brexit.  Not surprisingly, this latter group has been very concerned by the influx of immigrants into Britain, which they see as resulting from the European Union’s open border policies.  So what does this mean for us?

In the short term, this event will increase the perception of political and economic uncertainty.  In general, markets dislike uncertainty and that is one of the reasons that the markets reacted negatively to the unexpected result of the British vote.  From the political sphere, we are already seeing additional increases in uncertainty with British Prime Minister David Cameron signaling his resignation and the Scottish threatening to hold their own referendum to split from Britain and United Kingdom.  This does not necessarily mean the world is ending, however.  Great Britain is still a dominant economic force and will most likely be able to reinitiate trade agreements with Europe to ensure stability, which is in the best interest of every party involved.  From an economic standpoint, I don’t believe doom is coming either.  While we are in our seventh year of a United States bull market and market indicators are generally mixed, the US market is not about to enter into a full-fledged recession with characteristics of the financial crisis.  This is due to the fact that the balance sheets of corporations are relatively healthy, and the Federal Reserve under Janet Yellen is committed to trying to manage monetary policy in a manner that is likely to avoid a recession in the near-term. The low interest rate monetary policy pursued by the Federal Reserve continues to act as a tailwind for companies, who can borrow at extremely low costs of capital.

Finally, and arguably most importantly in the context of the “Brexit”, the US market as a whole will continue to be seen as the best house in a bad neighborhood. International markets, whether in China, Brazil, or elsewhere have been underperforming in our latest economic cycle.  This new European development will only increase this trend which will continue the flow of foreign capital into the “safety” of the US market.  This does not mean that we are immune to outside volatility and overall market malaise but it does tell us that we will not necessarily feel the brunt of any outside negative market impacts.  Currently, our view is that from a long-term perspective, Brexit will be viewed as an important event, but not one that in itself will lead to market catastrophe.  However, we will continue to monitor this and other market events as summer progresses.

Wishing you a safe and restful summer.

Susan McGlory Michel

 

Disclosure: This commentary is furnished for the use of Glen Eagle Advisors, LLC, Glen Eagle Wealth, LLC and their clients. It does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific objectives, financial situation or particular needs of any specific person. Investors reading this commentary should consult with their Glen Eagle representative regarding the appropriateness of investing in any securities or adapting any investment strategies discussed or recommended in this commentary.

5 Key Takeaways From the Brexit Vote

London

The UK’s 52% to 48% vote to break with the European Union (EU) has lasting consequences for the UK, Europe and the world at large. With UK Prime Minister David Cameron set to leave his post by October, we believe other European leaders will be focused on fending off populist movements throughout the continent, spurring further political and economic uncertainty. We see five key takeaways from this historic decision.

The exit process won’t be an easy one. We believe the UK’s departure from the EU will be a long and complicated process as officials sort through UK and EU laws. The UK will have to strike new trade deals with the now-spurned EU and with the rest of the world. The resulting potential losses in services exports and investment flows will likely overwhelm any benefits of lower payments to the EU.

Scottish independence is back on the table. Prime Minister Cameron’s departure sets the stage for a Conservative leadership election, dominated by Leave supporters, this summer. This could make for volatile EU exit negotiations and set the stage for another independence attempt by Scotland.

A weaker euro is likely over time. We also see pressure on European shares, credit and peripheral bonds. We believe pressure on government budgets will be limited as high-quality government bonds are very much in demand in today’s low-rate world.

The Bank of England (BoE) will react accordingly. We believe its first priority will be to provide the liquidity necessary to prevent any funding stresses. The magnitude and volatility of the British pound’s decline will likely dictate further responses. What’s more, we expect the BoE to cut its 0.5% policy interest rate to zero soon, choosing to return to quantitative easing instead of pushing rates into negative territory.

Global implications vary. While the vote will likely lead to declines in global shares and other risk assets, we do see indiscriminate selling potentially paving the way for opportunities. U.S. and Asia markets are only marginally affected by the British exit from the EU and are supported by a mix of easy monetary policy and economic growth. A UK currency drop will benefit large companies with overseas earnings, but domestic sectors such as homebuilders, retail and financials do look vulnerable.

For more on this, read my full report, UK Vote: Out of Europe.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

International Bonds Are Worth Another Look

Books Glasses

Historically, American investors have displayed a strong home country bias when it comes to fixed income, investing more in U.S. bonds than international bonds. According to data on U.S.-based ETFs and open-end mutual funds from Morningstar Direct, $200.3 billion was invested in international bond categories, while $3.6 trillion was in U.S. bond categories, as of year-end in 2015.

Why is there such a big difference? Some investors are just more comfortable investing in markets that they know better. Others may shy away from international bonds because currency fluctuations between the U.S. dollar and foreign currencies can lead to higher return volatility. Many of us buy bonds as a potential source of portfolio diversification—e.g., to offset dramatic price swings from equity markets—and hesitate to add foreign currency risk.

A rising rate environment is a challenge for U.S. bonds

Looking ahead, it will likely not be easy for U.S. bonds to deliver good returns after the recent multi-year rally. Bond investors today are faced with low yields. There is also the prospect of price loss as the Federal Reserve (Fed) has started raising its benchmark lending rate amid a stronger U.S. economy (a bond’s yield moves in the opposite direction of its price). Although U.S. interest rates could stay lower than in previous rate cycles as Fed policy very slowly normalizes, investors remain concerned about the impact of rate increases on their fixed income returns. As a result, future bond returns are likely to be driven more by income and less by price appreciation.

It’s a big world out there

Overseas, the fixed income market may offer a wider opportunity set, which is important considering how hard it is to source income today. As I travel from country to country this summer, I am getting an on-the-ground view of this low yield world and seeing first-hand the variety of economic and monetary policies at work that may differ from those of the United States. For example, while the United States is tightening its monetary policy, the central banks of Europe and Japan both have launched aggressive stimulus measures since 2014 to jumpstart economic growth. These stimulus measures have driven bond yields in Europe and Japan lower and bond prices there higher, and could continue to do so (source: Bloomberg).

Central Bank Map

At any given time, different countries are experiencing different levels of economic growth. In response, these countries may implement different economic and monetary policies. As a result, their bonds may offer a mixture of potential income and capital appreciation opportunities that may differ from those in the United States.

More than one flavor

If a portfolio’s fixed income allocation is entirely made up of U.S.-only bonds, it likely means that if U.S. bonds have had a bad year, so has the portfolio’s fixed income exposure. But if a portfolio holds a basket of bonds from different countries, bond prices of one country may be rising while bond prices of another may be falling. This way, price movements of bonds from different countries can help offset one another. While diversification does not fully protect against market risk, it can potentially make a portfolio less prone to dramatic swings.

For investors worried about foreign currency risk, currency hedging could be the answer. Currency impact can be managed by hedging local currencies back into U.S. dollar, allowing investors to potentially earn local market yields and take advantage of potential local bond price appreciation, with less currency fluctuations. And perhaps more importantly, some hedged international bond exposure can potentially reduce a portfolio’s overall volatility amid rocky markets.

Expand your fixed income opportunity

Investing in international bonds, especially currency hedged bonds, could provide additional income opportunities and could also lower overall portfolio risk. Investors may want to think about taking a percentage of their U.S. core bond fund exposure and allocating it to a hedged international bond market index fund, such as the iShares Core International Aggregate Bond ETF (IAGG).

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Diversification may not protect against market risk or loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.

A fund’s use of derivatives may reduce a fund’s returns and/or increase volatility and subject the fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. A fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited.There can be no assurance that any fund’s hedging transactions will be effective.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

Least-Loved Cycle Looks Less Lovely

MFS Risky Assets

We are now more than six years into one of the longest-lived — though least-loved — business cycles in history. Markets have shown a much greater ability than the public to shake off the effects of the global  financial crisis. Why is this? If you listened to the pundits, you’d think they have been held aloft by nothing but a combination of hot air and central bank liquidity. But that couldn’t be further from the truth. It has been profits, not punditry, that have driven markets to new highs. Since the market bottom in early 2009, the value of the S&P 500 has tripled. Not coincidently, S&P 500 company profits have tripled as well.

Earnings of large multinational corporations — like those in the S&P — have been propelled by the productive use of labor and capital, rapid asset turnover, low energy costs and, yes, the historically low cost of capital, thanks to accommodative central bank policies.

In recent months, however, profits have begun to flag, and with them my confidence in the market’s upward trajectory.  The drag on profits and earnings seems to be coming from two sources. The first is excess global manufacturing capacity, particularly in China. In the developed markets, production is quick to respond to changes in demand. Demand in China does not respond as quickly, given the political realities there. This leaves excess capacity in the global economy, which tends to depress pricing power, not just for Chinese companies but worldwide.

A second factor that has weakened profits is tepid consumer demand. I had expected the “energy dividend” from spending less on gas and home heating to translate into greater demand from consumers in developed markets. But we’ve actually seen a significant percentage of that energy dividend going into savings rather than back into the economy. At the same time, energy costs have begun to rise, suggesting more downward pressure on consumer demand down the road. That could further crimp topline growth for many companies.

That lack of topline growth has translated into weak capital expenditures at big global companies. That’s a worrisome sign, since in my view, capex is the main driver of jobs and profits.

Here are the conditions I’d need to see before venturing back into riskier assets:

1. A return of pricing power

2. A reversal in global disinflation

3. Improved consumer demand

4. A revival in capital expenditures

While we wait to see if these occur, I’d advise investors to be cautious with new money. My concern is not that recession is imminent in 2016, but that we’re facing a prolonged profits drought which could disrupt margins and returns. This could become the new theme for the final years of a market cycle that, while remarkable, could become even less loved.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

 

 

High Yield Plays a Supporting Role

Escalator

In a recent post my colleague Russ Koesterich talked about the role of fixed income in a portfolio. It was a good reminder of why most of us invest in bonds: to help provide diversification against our equity holdings. Historically, when equities are down, Treasury bonds are often up. And when equities are up, Treasuries are often down. This creates diversification in a portfolio. The value of your investment doesn’t move around as much, which gives you a better idea of how much it’d be worth in the future. The fewer surprises, the better, so to speak.

Part bond, part stock?

Russ’s comments were focused on U.S. Treasury securities. But I want to extend the conversation and talk about another fixed income sector, high yield bonds. High yield bonds are interesting because they have some properties of Treasury bonds, and some properties of equities. They are typically structured like other bonds with regular coupon payments and a return of principal at maturity. They also have sensitivity to interest rates, so as interest rates rise, the value of a high yield bond can decline, and vice versa.

Of course, the coupons paid by high yield bonds are generally higher than what Treasury bonds of similar maturity would pay. The extra yield is compensation for taking on credit risk when you lend your money to the bond issuer. Like equity, the value of a high yield bond is tied to the fate of its corporate issuer. When a bond issuer is doing well, generally its stocks and bonds go up in value. But when hard times hit an issuer, its stock and bond values tend to decline. So in many ways, high yield is somewhat of a hybrid of Treasuries and equities: It has properties of both but isn’t exactly like one or the other.

High Yield Graph

The graph shows the performance of Treasuries, equities and high yield over the past year. I normalized the returns to start at 100 for an easy comparison.

As you can see, the Treasury market just jogged along, rising slightly but not fluctuating too much. This is a reflection of the lower volatility of Treasuries. Equities moved around the most, whipping down and then back up in response to market sentiment. High yield was somewhere in the middle. For the most part it tracked equities down, but without the same level of volatility.

The trends are more obvious if you look at a longer horizon, as Bloomberg data shows. For longer time periods, we find that Treasuries and equities have a low to negative correlation to each other, meaning when one is up, the other tends to be down. With high yield, we find a low level of correlation with Treasuries, and a medium level of correlation with equities. High yield hasn’t given you quite the diversification against equities that Treasuries have, but it also hasn’t moved in lockstep with stocks either.

A supporting role

High yield can be a source of income and diversification in a portfolio, but don’t expect it to be your ballast against equities. Always keep moderation and diversification in mind. High yield in my opinion is used more effectively as a complement to a core bond position: A potential yield tilt that can help boost income without compromising that diversification benefit investors look for in bonds.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting www.iShares.com or www.blackrock.com. For standardized performance, click here.

Index returns are for illustrative purposes only.Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Diversification may not protect against market risk or loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Markit Indices Limited, nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with Market Indices Limited.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

How Investors Should Think About the Brexit Vote

UK EU Flags

On June 23rd British voters will decide whether their country should remain a member of the European Union. A vote in favor of leaving the EU—commonly called “Brexit”—would alter European economics and politics. It would also affect investors, although the exact implications of Brexit are shrouded in uncertainty.

The United Kingdom is the world’s fifth-largest economy and the second-biggest net contributor to the EU budget, so a divorce from the EU would certainly reverberate throughout the European economy and global financial markets. Yet since no country has left the EU before (and the EU is fairly unique in terms of its economic heft as a multinational political body), there’s no exact precedent that could help predict the economic implications of a Brexit vote. The novelty of the situation has allowed both sides of the debate to claim that their position would lead to better results for the British economy.

Most evidence, however, suggests that Brexit would be a net negative for the UK and the global economies, at least in the short term. The UK would have to negotiate new trade deals with the EU and countries around the world. Many companies would likely move jobs—and in some cases their whole firms—out of the UK so they could more easily do business internationally. A report by the British government projected that a vote for Brexit would lead to a year-long recession.

Financial markets could be further affected by prolonged uncertainty created by a vote for Brexit. It’s unclear how long it would take for the UK to actually leave the EU and how long it would take to negotiate trade deals. A vote for Brexit would likely lead to the resignation of Prime Minister David Cameron, creating additional political uncertainty. And Brexit could prompt Scotland to break away from the UK to become an independent country, leading to another round of economic upheaval.

For US investors watching the Brexit drama unfold from a distance, there are a couple key points to keep in mind. While some of the fallout from a Brexit vote would be felt in financial markets around the globe, much of it would likely be concentrated in the UK itself. Some potential effects of Brexit, such as companies shifting their operations to continental Europe, could even provide a small economic boost to other countries. Having diversified exposure to countries around Europe and throughout the world could therefore help moderate the potential negative impact of a Brexit vote on British stocks.

It’s also important for investors thinking about how the vote will affect their portfolio to note that some probability of either outcome has already been “priced in” to financial markets. Polls indicate the vote will likely be close, with polling averages suggesting that the pro-Brexit side has gained ground recently and is currently only slightly behind the “remain” side. Yet betting odds suggest that the likelihood of the UK voting to remain in the EU is still over 75%. These numbers will continue to bounce around until the vote actually occurs, but the betting odds suggest that markets would respond much more dramatically to a vote for Brexit than a vote for the UK to remain in the EU.

What Price to Pay for Yield?

Tags

Price is often a function of circumstances. Just ask anyone who has ever arrived at their hotel at 1:00 a.m. and paid $6 for a candy bar from the minibar.

Investors appear to be adopting a similar approach when it comes to stocks, particularly those with a healthy dividend yield. With bonds, the traditional income source, providing little actual income, investors are increasingly willing to pay a premium for any alternative. The question now is: how much is too much?

Dividend stocks, particularly those in more defensive industries, are and have been expensive for some time. This is a function of several trends: a preference for safe, stable companies, the growing popularity of minimum volatility funds and the quest for yield. The last one here should come as no surprise given central banks have anchored short-term interest rates at zero and long-term rates continue to be suppressed by massive asset-purchase programs and the generally sluggish nature of the global recovery.

One expensive example

Utility stocks provide a good illustration of this phenomenon. Historically, utilities, a regulated sector with a low return on equity (ROE), have traded at a significant discount to the broader market. Between 1995 and the financial crisis, the average price-to-earnings (P/E) ratio of the S&P 500 utilities sector was roughly 25 percent below the P/E of the broader market, as Bloomberg data indicates. However, since 2010 the utility sector has traded at less than a 10 percent average discount. There have even been brief periods during which the sector has traded at a premium.

This is difficult to explain in terms of fundamentals. Not only is the sector less profitable than the broader market, but today profitability is especially low. According to Bloomberg data, the ROE on the S&P 500 Utilities Index has fallen from nearly 10 percent last summer to roughly 6 percent today.

Instead, the rise in the relative valuation of utility companies, along with other yield plays, can largely be attributed to investors’ quest for increasingly scarce yield. The utility sector’s current yield is roughly 3.5 percent, not particularly generous by historical standards, but is about twice the level available from a 10-year Treasury bond, as data from Bloomberg shows.

This is important as the relative value of dividend plays is more and more being driven by the level of long-term rates. In recent years this relationship—yield vs. valuation—has come to dominate how many of these stocks trade. According to my analysis, since the financial crisis the yield on a 10-year U.S. Treasury note explains roughly 65 percent of the variation in the relative value of the utility sector.

Where does this leave investors?

First, when considering the valuations on yield names, it is necessary to take into account the overall yield environment. As long as yields remain near historical lows, relative valuations are likely to stay elevated relative to the pre-crisis norm.

Second, certain sectors are more reasonably priced than others. For example, many of the dividend payers in Europe currently look much cheaper than their U.S. counterparts.

Bottom line: given the expectation that yield will remain low for long, the question of what price to pay for yield will be vexing investors for some time to come.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

 

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