This note starts by providing a summary of London & Capital’s position. Then focuses on the implications on trade, workforce, the financial services industry and politics, then the financial markets and London & Capital portfolios.

What is London & Capital’s position? A summary

Equity exposure in London & Capital portfolios is mainly through high quality defensive large caps, which by nature will exhibit significantly more resilience than the market as a whole. We expect a small sell off in Financial Bonds, but we are still confident that the balance sheets of these institutions remain robust.

Overall, the characteristics that the markets are displaying play into London & Capital’s style of investing. In recent weeks, we have taken steps to factor this outcome into our strategy and as a result portfolios are well positioned.

What is the impact on trade?

EU is the UK’s largest trade partner by far (it accounts for 48% of UK exports and is the origin of 54% of UK imports). UK exports to the EU account for almost 10 % of UK GDP, and 2.3m jobs.

UK will need to renegotiate a new trade agreement to minimise tariff costs. There are three options open to the UK from this front:

1.Operate under World Trade Organisation (WTO) rules. If so, the UK would face so-called “Most Favoured Nation” import tariffs when exporting to the EU, just like the US. Similarly, the EU would have to pay these tariffs when exporting to the UK. These tariffs would harm trade, and the costs of tariffs make it unlikely that the UK would choose this option as it removes the advantages of free trade with the EU.
2.Join the European Free Trade Association (EFTA) along with Norway, Switzerland, Iceland and Liechtenstein, and sign up for the European Economic Area (EEA), which would allow the UK to participate in the single market with zero tariffs. At the same time, it would free itself from obligations related to the Common Agriculture Policy and the Common Fisheries Policy. However, the UK would still have to make a financial contribution to the EU and adopt all EU legislation relating to the single market without having a say on these laws. Being a member of the EEA would also mean that workers from other EU member states would continue to be able to live and work in the UK. This would make it an unlikely option.
3.Follow Switzerland (which is an EFTA member but did not sign up to the EEA). The UK would not have to adhere to EEA rules and would be able to negotiate its own immigration rules with other EU countries. However, the UK would still need to pay some contributions to the EU budget if wanted to enter into bilateral agreements with EU on trade.

Besides tariffs, the UK will have to deal with non-tariff barriers if leaving EU, like product standards, anti-dumping legislation and labelling standards.

While there is uncertainty around the nature of the deal, there is certainty around the following:

To prevent the Euro bloc from unravelling, EU countries will have a bias towards seeking to punish Britain, so others dare not follow its exit path.
The uncertainty of two year negotiations will weigh heavily on market sentiment. Foreign Direct Investment from EU countries is obviously at risk, but non-EU FDI will potentially be impacted. If, as a foreign (non-EU) company, your main objective is to sell into the EU market, then it would probably make more sense to place your factory or plant in a country that is actually a member of that economic zone and not one that is potentially subject to tariffs or some form of restrictions. FDI is less likely to be impacted in the near term, as it would be very expensive to shut down a factory and build a new one in an EU country. However, there may be a diminished prospect of that factory receiving ongoing investment.

What is the impact on workforce & immigration?

If Britain wants to retain full access to the single market, it would have to keep the free movement of labour* between the UK and EU. However, it is close to impossible that Britain will sign up to such a deal, given that concerns about migration were one of the main reasons for a vote to leave.

Nevertheless, even if the UK is free to impose restrictions, it is questionable how effective these would be in the near term. There would be a “rush for the border” ahead of the restrictions, resulting in a surge in migration in the short term. EU migrants already in Britain would almost certainly be given leave to stay, just as British citizens living in Europe could remain there. Furthermore, if EU migrants already in the UK knew that it would be hard to get back in if they left, they might stay longer than they otherwise would have. Emigration out of Britain could fall alongside a rise in immigration, perhaps leaving net migration little changed or even higher in the short term.

In the medium term, net migration from EU will fall outside the single market, reducing the growth rate of the British labour force. This may lead to upward pressure on wages and inflation, benefiting some workers but to the detriment of some employers. In any case, this would reduce potential supply due to a fall in the immigrant labour supply from the EU (which has largely complemented the domestic working population) and also a fall in productivity.

What is the impact on financial services sector?

Although there are no tariffs on financial services, leaving the EU could lose Britain its “passporting rights” (these allow British-based institutions to sell into the rest of the EU without having a branch there). The UK could still negotiate bilateral trade agreements (like Switzerland). But Swiss banks do not have passporting rights and so operate their European investment banking businesses through subsidiaries in London. It is unlikely that the UK will get a deal with the EU as good as Switzerland’s; the Swiss negotiated their deal when they were planning to join the EU; there will be much less goodwill for a country leaving it.

So, Britain’s financial services exports to the EU will be hit by Brexit. In addition, it would be wrong to assume that leaving the EU will result in less regulation on the City (British government has shown more zeal for regulation than its continental peers recently). Unlike those in other EU countries, Britain’s banks will be required to ring-fence their retail banks from their commercial banks from 2019.

Having said this, there is a decent chance that the City will still prosper in the medium-long term:
London’s pre-eminent position as a global financial centre predates the single market.
The City possesses intrinsic advantages, including Britain’s legal system, the English language, a convenient time zone perfectly placed between the working hours of Asia and New York, openness to immigrants, a large pool of skilled labour and a critical mass of expertise in support services such as accounting and law.
Overall, financial services has more to lose from Brexit than most other sectors of the economy, but it would not spell disaster. The City’s competitive advantage is founded on more than just free access to the single market.

Could this vote create political tremors?

Yes, both within the UK and abroad. This vote has been an opportunity for the electorate to give the establishment a bloody nose.

We have already seen, UK Prime Minister David Cameron resign this morning. The Chancellor of the Exchequer George Osborne may well be forced out as well.
The leader of the Scottish National Party, Nicola Sturgeon, has hinted the strong Scottish vote to Remain in the EU may well call for another Scottish referendum.
In Europe, the growing populist and anti-EU parties will be energised.

What now for risk markets?

The Brexit vote will prove to be the tipping point for initial market disruption:
UK ran a current account deficit of 5.2% of GDP in 2015, which requires a continued stream of capital inflows. As such inflows slow down, we could be facing a 10% weaker GBP rate (on trade-weighted basis) from yesterday’s levels.
UK yield curve should steepen: Yields on short-dated maturities should fall more than on long-dates with expectations of accommodative policies from BoE, while uncertainty over the UK’s relative creditworthiness in a lower-growth, post-Brexit environment could push yields higher on the long end.
Countries on the periphery of Europe might also see their yields rise with risk aversion setting in amid fears that more countries might look to leave the EU.
Core Europe (ie German bunds) yields will go lower.
EUR will weaken materially vs USD, as continued viability of the EU will be called into question.
Global inflation dynamics will be further restrained, which could renew downward pressure on commodity prices, resulting in possible spillovers into EM.

What about equity markets?

UK equities could plunge by up 10% (with European equities falling by a similar amount). With such a decline the market would approach the previous February lows. A decline of 10% is consistent with a spike in the risk premium similar in magnitude to the one experienced twice in 2015: during the Greek crises and the Chinese woes (summer 2015).

US indices will outperform UK & Europe as they are more defensive in nature (sector composition) and feature a lower beta.

After a few days of selling the market should become more discerning and companies that are less effected will bounce (like overseas earners).

Indeed, exporters will outperform massively. In an extreme case, bringing relative valuations back to 2008 lows implies exporters potentially outperforming by a further c. 15%.

The increase in uncertainty should see Quality outperform Value. Defensives will outperform Financials and other cyclical stocks.

Specifically, what are the most vulnerable sectors?
Financials (i.e. Banks): While UK banks’ capital position is far stronger than it was prior to the financial crisis, banks remain tied to the fortunes of the economies in which they operate.
Construction: real estate will be affected by both lower investment and weaker economic sentiment.
Leisure & Retail: UK consumer-facing companies will be hurt by falling consumer confidence and lower household expenditures owing to an uncertain post-Brexit environment, as well as the risk of higher labour costs because of some low-wage EU workers returning to the continent.

London & Capital’s equity position

Equity exposure in London & Capital portfolios are through high-quality defensive large caps, which by nature will exhibit significantly more resilience than the market as a whole. For the UK in particular, the bigger caps would enjoy a weaker pound which in time would sustain the earnings momentum through stronger exports and translation gains.

What this means is that equity portfolios will cushion the overall market downside and outperform competitors when it matters most (once again). We will be issuing flash performance estimates that will highlight this.

Should we reduce equity exposure from current levels?

No. The message is clear:
It’s too early to buy still (more on buying opportunities section below).
Do not panic as we are in defensive stocks whose earning streams will not be structurally impaired by British exit.
Ultimately, the fortunes of the companies we invest in will be determined by their strategic direction, investment choices and, ultimately, the strength and sustainability of their products.

Fixed Income markets

A flight to quality into government bonds and high grade corporate issuers will continue.

In the meantime, you could see a temporary flight out of financial CoCo bonds and to a lesser extent corporate high yield.

The message regarding Financials is crystal clear:

This will not be a re-run of 2008 (which was an existential threat to the banking system).
Banks have plentiful supply and access to capital.
Balance sheets are robust: Core Equity Tier 1 ratios are significantly higher, risk-weighted assets are much lower and ready liquidity much higher.
Major financial institutions in the Eurozone are safe from a liquidity event. They have access to unlimited funding from the ECB’s liquidity operations, and the central bank will be an eager provider in the current situation.
Should we expect for Financial Bond valuations to bounce back like they did in February?

Yes, but it will probably take longer for that to happen. As with other risk markets, you could see the following typical sequential pattern:

Market falls sharply as news breaks and people digest the immediate impact of news.
Short-lived bounce as “falling knife catchers” look to take advantage of lower valuations and policy makers line up to stand in support of markets.
Further correction as implications of continued volatility for year’s dawns on market participants, people start to panic as they look through screens and trends following strategies contribute to an overshoot. It is at that time that you might see capitulation and a buying opportunity is provided.

Will Brexit not create opportunities?

Absolutely. Big disruption brings big opportunities. There will be two types of opportunity:
Opportunity to look through the noise/volatility/panic and add to high conviction areas at improved valuations. This will be the case for areas like STAR stocks and Financial Bonds for London & Capital.
New opportunities will be generated by market overshooting. We are already setting up for a “Brexit Equity Theme” with names to buy on Brexit driven weakness (more to follow in next days).

Thanks to Paul Morilla-Giner, Chief Investment Officer, London & Capital for sharing his thoughts.

[* I  do believe that there is a difference between the ‘free movement of people‘ and the ‘ free movement of labour ‘and that while the former my not be acceptable for the UK, being a major issue in the referendum, the ‘free movement of labour’ may very well be a suitable compromise for the UK and the EU.]