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How to play Brexit

It has been quite some time since the global financial markets have faced such a widely-anticipated, major binary decision expected to propel securities prices sharply in one direction or another. I am, of course, referring to this week's ‘Brexit' vote. On Thursday, the United Kingdom decides whether to remain in the European Union or to begin pulling out and this landmark referendum has policymakers and investors on the edge of their seats.

If the majority of British citizens vote to remain in the EU, everyone can go back to working within a known framework which has arguably served Britain well over the past few decades. However, if the UK votes to exit the commonwealth, a series of somewhat unknowable events will then begin to unfold.

At a minimum, an exit vote will be disruptive, causing an extraordinary number of contracts to be rewritten. After that, possible outcomes range from a near term slump in trade to a severe downturn in the British economy potentially leading to a fundamental breakdown of the European Union if other member states follow suit and break with the pack.

Even taking the most draconian scenarios off the table, a “leave” vote creates immediate challenges. The British government would likely believe it necessary to calm the markets and move swiftly to invoke a policy response. Analysts believe the Bank of England would begin by cutting interest rates and increasing its quantitative easing programme to a larger amount. The Institute of Fiscal Studies predicts the British economy would contract by two to four per cent over the next few years with trade disruptions and labour supply challenges resulting in tens of billions of dollars in additional debt being added to the government balance sheet.

In the event of a leave vote, economic growth would not only be stunted, but other EU member nations could begin considering independence referendums of their own, thereby adding additional pressure on Europe's already fragile recovery. In recent years, forward progress in Europe has been bumpy at best, giving rise to a growing faction of “Eurosceptics.” The increasingly vocal anti-establishment proponents are fundamentally opposed to the EU structure believing many of the member countries would be better off on their own. Some think the regional authority has betrayed its constituents by allowing the southern states to break fiscal rules and creating open border policies which have contributed to an escalating immigration crisis. If Britain can successfully break free, other countries may be encouraged to do the same.

At this late hour, the outcome is still too close to call. The Brexit Poll Tracker poll of polls gives the “leave” camp an edge at 48 per cent versus 43 per cent for “remain” as of this writing. However, about eight per cent are still undecided. On a more positive note, the betting odds, where individuals stake real money, favour a ‘remain' vote by about a two-to-one ratio.

Market volatility has been increasing in front of the referendum. Global stock markets have been trending downward with European bourses declining the most. The British pound recently fell to a low of around $1.41. “Implied volatility”, a standard measure of daily price movement, for the pound recently soared to 21 per cent, a level not seen since the global credit crisis in 2008.

In the stock market, British and European-based companies have dramatically lagged their multinational counterparts. The British stock market, as measured by the FTSE 100, has underperformed the US-based S&P 500 by over ten per cent in the past month and portfolio managers have been tactically underweighting European risk assets in general.

The best way to play Brexit, depends on an investor's risk appetite. Since early last month, we have been encouraging more conservative investors to take profits in lower quality securities following the March and April risk rally. We suggested rotating towards higher quality securities and raising some cash (The Royal Gazette article Rotate Away in May May, 17 2016). Conservative investors with a shorter term time horizon should still consider adding to safe havens assets such as investment grade bonds or even UK gilts if they have existing Sterling currency exposure.

Initiating or increasing exposure to sterling at these levels may ultimately prove to be smart play longer term. The present Sterling/US dollar exchange rate represents an historically attractive level. The pound could take another leg down if Britain votes to leave, but that is not yet certain. Half positions are a safer bet here, buying some now with the idea of adding more on weakness.

Selectively, British and European equities are worth a look at these levels, especially those well diversified globally. In reality, the geographic revenue distribution of many large UK-domiciled companies does not look a whole lot different, than, for example, most large cap US multinationals. And yet, the FTSE 100 index is much cheaper than the S&P 500. A less aggressive strategy is to simply wait until just after the vote and play a rebound if “Bremain” prevails. A leave decision would likely require more time for markets to settle out.

Ultimately, Britain can survive on its own with or without membership in the EU as it had for the many centuries prior to joining European Economic Community in 1973. Compromise is a possibility, too. Norway pays into the EU budget and benefits from a portion of the bloc's trade policies without actually having to be a member. On a long-term basis, making big bets against sterling might be unwise. The British pound has existed for hundreds of years while the euro is only 17 years young. When the dust settles, as it always does, there will be opportunities. But investors should proceed gingerly and stay focused on their ultimate objectives.

Bryan Dooley is senior portfolio manager with LOM Asset Management. He can be contacted at Bryan.Dooley@lom.com. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

Risk appetite: British citizens will decide whether to remain with the EU or leave it in a referendum on Thursday. The uncertainty creates a number of opportunities for investors

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Published June 21, 2016 at 9:00 am (Updated June 21, 2016 at 12:59 am)

How to play Brexit

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