Vanguard leaders discuss the implications of the United Kingdom’s decision to leave the European Union


Vanguard Global Chief Economist Joe Davis and Vanguard Chief European Economist Peter Westaway discuss the implications of the United Kingdom’s recent decision to leave the European Union.


TRANSCRIPT

Gary Gamma: The vote has been counted and cast, and the people of the United Kingdom have spoken. No doubt, the UK’s decision to leave the European Union makes for an uncertain future. Here with me to discuss Vanguard’s point of view on recent market events are Vanguard Global Chief Economist, Joe Davis, and Vanguard’s Chief European Economist, Peter Westaway. Peter, Joe, thanks for being here.

Joe Davis: Oh, thank you.

Peter Westaway: Thank you.

Gary Gamma: Gentlemen, what were your first thoughts when the votes came in?

Peter Westaway: Well, I have to admit, I was a little bit surprised. I think the markets generally had got themselves into a position where they were pretty sure that the vote was going to be for remain. Personally, I was always slightly skeptical about that but, in the end, it came as a big surprise to the market. And, as a result of that, we saw some pretty whippy price action last night in terms of currency movements and equity price movements since then. So, yeah, quite a night.

Gary Gamma: Right.

Joe Davis: Yeah, I mean, the other thing, Peter, you and I talked about it a lot, internally, as a team, we certainly knew this was going to be close. It’s something we’ve talked about, Gary, just more broadly the fragility of the world economy. And that, I think, what we saw recently, I think it’s just a confirmation of some longer term trends, some of which are economic in nature, which I think are leading to some change across the world.

Peter Westaway: Yeah, these sort of anti-establishment tendencies which, in Europe, has shown themselves up as anti-EU tendencies in other countries, not least here in the US, are showing themselves up in other ways. Very interesting.

Gary Gamma: So, Peter, what does this mean for UK assets, the UK economy, and more broadly, Europe in general?

Peter Westaway: Yes. I mean, there’s been a lot of debates about what the economic consequences of this. I think most economists think that the overall long-run effects are going to be negative for the UK economy, mainly because the implications for trade and for fund direct investment are likely to be negative. But I think almost everybody agrees that the most important short run effects are going to be because of the uncertainty. There’s just a lot of questions about how the UK are going to interact with the EU going forward and with the rest of the world. And markets hate uncertainty, and that’s one of the main reasons why we’ve seen so much weakness over the last 12-24 hours or so. As far as Europe’s concerned, I think it’s wrong to think of this just as a UK phenomenon, because what’s really important is because this has happened in the UK, the cat’s out of the bag. I think other countries in Europe are now maybe starting to think themselves about whether their presence in the EU is going to be continued.

Gary Gamma: Right. And that’s a big concern, right?

Peter Westaway: Yeah. And I think the impact that it’s going to have on the wider economy is very much—I mean, in the longer run—I think the most serious consequence would be if something happened in Europe that then had knock on consequences in the same way that we saw with the sovereign debt crisis a couple of years ago. It’s not the same as that crisis, but it might have similar consequences.

Gary Gamma: Joe, obviously, the big question is what’s the impact to the U.S. And maybe, specifically, to the Fed’s monetary policy plan?

Joe Davis: Sure. But this comes at a point, unfortunately, where we were already anticipating; and I think we’ve recently seen, a softness in U.S. economic fundamentals which, all else equal, is meaningful in a low growth world we’ve talked about for years and central to our outlook. So the U.S. has been among the bright spots relatively in a lower growth world. So I think what this certainly does in our minds, and I think the financial markets are anticipating this already, is that we went into the year saying that the Federal Reserve would be hard-pressed to raise rates materially over the next several years, although further rate increases this year could be possible. I think those expectations—to anticipate no rate hikes this year but, nevertheless, I think this underscores our longer-term view that for those investors that have been concerned about a rapid rise in rates just because they’re low, we respectfully said they’ve been somewhat misplaced, and our view has been one of a very low persistent interest rate environment globally, and not to hang too much on recent events in London. But I think this is just another reason why we won’t see any rapid rise in rates anytime soon.

Gary Gamma: Peter, what are the chances that the EU is heading for a larger breakup; any countries of concern in the near future?

Peter Westaway: I mean, I think that risk is now materially greater because of the vote last night. I don’t think it would have been absent if the UK had voted to stay in. There’s already an undercurrent of anti-EU sentiment in a number of countries. Some of the sort of the usual suspects, the Southern European countries that have been having to go through austerity measures and perhaps resent that. But it isn’t just those. Some of the richer countries, if you look at opinion polls in France, Italy, even Germany has a sizable minority probably of people who’ve expressed dissatisfaction about the EU. So, really, it could go one of two ways. Either it could actually lead to an unraveling of the EU and the Euro itself. That wouldn’t be my central case. The alternative might be that the EU has to start reforming itself. But part of the difficulty is for the Euro area to work most effectively, it probably needs to integrate more in terms of fiscal policy, banking union, political union, and these forces are tending to pull things in the opposite direction to that.

Gary Gamma: So I’m sure the big question, start with you, Joe, people are probably wondering, how does all of this affect our market outlook?

Joe Davis: Yeah, market outlook. Well, as our investors and clients know, we, and this has been Vanguard for several years, has been increasingly more guarded on the outlook for the financial market’s returns on portfolios. Ever since the end of the global financial crisis, where we actually had a somewhat decent outlook despite the somber economic backdrop. So with that as context of a somewhat guarded, not entirely bearish, but very guarded lower return expectation for the financial markets, recent events, and given what we’re likely to see continued at the margin, disinflationary pressure, which leads to, at the margin, somewhat lower interest rates in central banks which, again, I think was already our view regardless of what happened recently in London. I think it just reaffirms for us to have very modest return expectations. In the equity market in the mid-single digits as essential tendency for the next several years. And, obviously, for fixed income assets two things: One, we’ve been very consistent, and I think this is somewhat different from others we’ve heard in industry. Yes, the return on bond portfolios are going to be low, but the diversification value for high quality bonds is very important. I think we’re seeing that even as we sit here right now. The one flight to quality is US Treasury Bonds which, yeah, low yields, but trying to offset some of the volatility in the equity market. So we would anticipate those sort of dynamics persisting, and I think it’s also just important to address that the more volatility we may see going forward, I think is appropriate. Peter and I, we’ve talked about it right, the high volatility environment, particularly if you have potential for more political change. That it is important; it’s hard, but important for investors to be forward looking and not reacting in a rear view mirror, right? Because the more pessimistic the financial markets become at the margin, should that occur, you could potentially argue that the greater the expected return for those very assets, right, because there’s a greater risk premium that the market is assigning for it. So I think we’re going to have to be prepared for a more challenging investment environment just because our growth outlook and our return outlook is pretty low.

Peter Westaway: And I think the additional related point to make is that in a low return environment, investors are very often tempted to move along the risk spectrum to try and extract more yield. And if you like, this incident, this event that’s happened in the UK yesterday, is one particular example of the more general point that it is still a risky world out there.

Joe Davis: Yep.

Peter Westaway: And the risks have a way of kicking you in the teeth if you let them.

Gary Gamma: So you both touched on this, just in terms of closing thoughts, what would you suggest our clients do?

Peter Westaway: Well we’ve been talking a lot to clients over the last few weeks in the run up to this vote, and I think the most important advice that we think we can give them is not to try to be too clever by trying to look around corners, trying to time the market. At times like this, the importance of having a long-term horizon is absolutely critical. And, secondly, it’s a really good illustration of having a globally diverse type portfolio. Those investors in the UK who only hold UK assets will now be regretting that.  But they’ll be investors here in the U.S. who may think it’s best just to have domestic assets because that’s the safest thing to do, but that’s not always the best thing to do. So there are real benefits to having that globally diverse set of risks in your portfolio.

Gary Gamma: Excellent points. Gentlemen, thanks for your insight. Important times and I know it’s good to hear from you.

Peter Westaway: Thank you very much.

Joe Davis: Thank you.


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