Market Update – Special Edition (Brexit)

Russell Investments’ Chief Investment Officers (CIOs) highlight key market and economic drivers impacting portfolio positioning and performance due to the recent Brexit decision.

As of June 24, 2016 Sources and indexes used to represent asset classes can be found in the disclosures.

INVESTMENT STRATEGISTS

Erik Ristuben

1. Uncertainty reigns supreme

Europe has entered uncharted waters with the surprise vote by the United Kingdom (UK) in favor of Brexit. Uncertainty is clearly elevated, which adds risk to the economic outlook in the UK and also the rest of Europe, Japan, emerging markets, and the U.S.

2. Bank of Japan (BOJ) and Bank of England (BOE) are expected to act

The downside risks to the UK economy from Brexit are meaningful. We expect the BOE to preemptively cut rates to buffer growth. Meanwhile, the BOJ is likely to enhance its own stimulus program, but for different reasons. Yen appreciation has cast a shadow on the earnings outlook for Japanese businesses and will make it harder for the central bank to meet its inflation target.

3. Modest downward pressure on economic growth likely

Uncertainty will likely take its toll. Consumer and business confidence are likely to take a hit in Europe. Financial markets are also a watch point for contagion effects across global markets tied to concerns over European banks. This is not our central scenario, but if it were to become an eventuality it would likely lead to a downgrade of European equities.

MULTI-ASSET

Brian Meath

1. Remain defensive in the midst of heightened volatility

While results of the vote may have been a surprise, the performance in many of our multi-asset portfolios was up for the week (ending June 24, 2016) in relative terms, because many portfolios were defensively positioned (as measured by beta relative to market benchmarks) and remain so.

2. Europe ex-UK under the microscope

The immediate market sell-off in Europe as a result of Brexit was severe with Europe, Middle East and Africa excluding UK (EMEA-ex UK) equities selling off by 8%. The market gave up only slightly more return on June 24 than had been gained in the previous week, returning a net of -2% in local currency terms. We remain overweight in EMEA ex-UK equities relative to market-cap weights. However, we are watchful for negative impacts on earnings and sentiment as a result of Brexit and any political or monetary support to prevent further contagion.

3. Diversifiers and U.S. dollar hold up

Asset classes such as high yield, emerging markets equities, and fixed income held up more effectively than developed market equities over the past week (ending June 24, 2016). Each asset class ended the week in slightly positive territory in absolute terms (between 0% – 1%). We are currently neutral to slightly overweight in these diversifying exposures across multi-asset portfolios. Currencies were perhaps the most volatile area with British sterling the worst hit and having the potential to fall further. The slight U.S. dollar overweight position benefited overall performance in our portfolios.

EQUITIES

James Barber

1. Low volatility won the day

Low volatility factors played their role as uncertainty reigned following the unexpected UK referendum result. Interestingly, within the UK all factors, except low volatility, lagged the broad market. Value factors were hardest hit, while momentum was mixed across regions.

2. UK surprised on the upside, Japan on the downside

Although the result was a surprise, the broad market response (e.g., risk aversion, negative sentiment) was not. What was a surprise was the UK market. After falling almost 8% initially, the FTSE100 rallied to be down just 3.2% for the day. Given the downside risks and uncertainty facing the UK economy, this was an “under-reaction” in our view and presents a possible selling opportunity. Currency markets were volatile with the pound plummeting. The Japanese stock market plunged more than 8% as the strong yen casts a shadow on earnings outlook. Given the potential for further BOJ action, we believe this may have been an overreaction, which provides a buying opportunity in Japan. Many of our portfolios remain overweight Europe ex UK, emerging markets, and Japan. Meanwhile, we are underweight in the U.S., UK, Australia, and Canada. The Europe position is under close review, while the emerging markets position may be an opportunity for incremental capital in the near term.

3. Banks are under pressure

Banks sold off heavily in the U.S. and Europe. We are reviewing closely the bank positions in the portfolios with our strategists and our sub advisors and the risks posed by Brexit as well as any possible opportunities presented by the negative market reaction.

FIXED INCOME

Gerard Fitzpatrick

1. Don’t panic or call a bottom for yields or the pound

Markets have moved significantly with good cause. Political uncertainty is highly elevated, which does not lend itself to forming high-conviction predictions. For the pound and risk assets generally, there is potential for a technical rebound, though risks remain skewed to the downside. In our fixed income portfolios, we continue to favor U.S. over Europe, both currency and credit, given relative valuations and our economic outlook.

2. Neutral on U.S. duration

Since the market reaction has been in-line with fundamentals, we remain short-to-neutral with regard to U.S. duration. We continue to believe the market has somewhat underpriced the potential for further rate hikes in the U.S., given the domestic economy’s relative strengths. The sharp fall in rates post-Brexit has arguably pushed market expectations further below the Fed’s potential path of tightening. While we do not see the market as being unreasonable, with expectations so low, the “worst-case scenario” has worsened.

3. We continue to favor discipline and diversification in our strategies

Both our real yield and currency factor strategies have performed well during this period.

ALTERNATIVES

Vic Leverett

1. Gold reaps benefit

The bright spot among commodities continues to be metals — gold in particular, which was up nearly 5% on Friday (June 24) and continues its run after the market reopened. Russell Investments’ Commodities portfolios have benefited from an overweight in gold. Grains have also held up well with corn and soybeans doing the best. Crude and West Texas Intermediate (WTI) continue to experience sell pressure due largely to a strong dollar.

2. Low net exposure is the place to be

Hedge fund managers fairing the best were those that had lowered the gross exposures (value of long plus short positions) and net exposures (difference between long and short positions) going into the referendum vote. Attractive entry points for risk-on trades will develop. However, patience and strong risk management will be key to navigating in the near term.

3. Financials and REITs hit hard

Perhaps the biggest toll has been on the financials, in particular banks across U.S. and Europe, as well as Real Estate Investment Trusts (REITs). UK REITs in particular were hit hard on June 24 (down more than 20%). The Russell REIT portfolios were slightly overweight in UK REITs going into the referendum vote. This had a negative impact on relative return. Since REITs are still largely categorized within the broader financials sector, this too had a negative consequence relative to their underlying fundamentals.

All data is as of June 24, 2016.

Corresponding indexes/sources by section:

Multi-Asset

  • Global equities represented by Russell Global Index
  • EMEA ex UK equities represented by MSCI Europe ex-UK Index
  • Developed Europe represented by the Russell Developed Europe Large Cap Index
  • High yield represented by high yield sector of the Barclays U.S. Aggregate Bond Index
  • Emerging Markets represented by Russell Emerging Markets Index Local
  • Broad fixed income represented by the Barclays U.S. Aggregate Bond Index

Equities

  • UK represented by FTSE 100 Index
  • U.S. represented by Russell 1000® Index
  • Sectors represented by Russell 1000® Index sectors and Russell Developed ex US Large Cap sectors: Utilities, Consumer Staples, Banks Fixed Income
  • Broad fixed income represented by the Barclays U.S. Aggregate Bond Index

Alternatives

  • Commodities represented by Bloomberg Commodities Index Total Return: gold, metals, corn, soybeans, grains
  • Oil represented by WTI crude prices
  • REITs represented by FTSE EPRA/NAREIT Developed Real Estate Index
  • Hedge fund strategies data as observed across third party managers by Russell Investments.

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

Investing involves risk and principal loss is possible.

Bond investors should carefully consider risks such as interest rate, credit, default and duration risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage-backed securities, especially mortgage-backed securities with exposure to sub-prime mortgages. Generally, when interest rates rise, prices of fixed income securities fall. Interest rates in the United States are at, or near, historic lows, which may increase exposure to risks associated with rising rates. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.

In general, alternative investments involve a high degree of risk, including potential loss of principal; can be highly illiquid and can charge higher fees than other investments. Hedge strategies and private equity investments are not subject to the same regulatory requirements as registered investment products. Hedge strategies often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and to political systems which can be expected to have less stability than those of more developed countries. Securities may be less liquid and more volatile than US and longer-established non-US markets.

Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.

The Russell Global Index measures the performance of the global equity market based on all investable equity securities. The index includes approximately 10,000 securities in 63 countries and covers 98% of the investable global market. All securities in the Russell Global Index are classified according to size, region, country, and sector, as a result the Index can be segmented into more than 300 distinct benchmarks.

The Russell Global Large Cap Index measures the performance of the largest securities in the Russell Global Index, based on market capitalization. The index includes approximately 3,000 securities and covers 86% of the investable global market.

Barclays Emerging Market Bonds Index includes fixed-and floating-rate USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East Africa, and Asia. For the index, an emerging market is defined as any country that has a long term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below, using the middle rating of Moody’s, S&P, and Fitch.

Barclays U.S. Aggregate Bond Index is an index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Past performance does not guarantee future performance.

This material is not an offer, solicitation or recommendation to purchase any security.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Russell Investments is the owner of the trademarks, service marks and copyrights related to its indexes.

Russell Investments’ ownership is comprised of a majority stake held by TA Associates with minority stakes held by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

Copyright © Russell Investments 2016. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Financial Services, Inc., member FINRA (www.finra.org), part of Russell Investments.

First Use: June 2016

RFS: 17567

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