Investment Vlog: David Eiswert on Brexit

June 2016
David J. Eiswert , Portfolio Manager


Hello, my name is David Eiswert and I am Portfolio Manager for the Global Focused Growth Strategy at T. Rowe Price and this is a virtual PM session where we try to get our clients and potential clients closer to our current thinking, especially in times of volatility.


So, the last few days we have had the UK vote in a referendum to exit the European Union. This was a surprise to us in that we believed the momentum behind Stay was strong enough for the referendum to go the other way. Now that was driven by polls, that was driven by betting odds, that was driven by our own research on the ground. Our portfolio wasn’t designed for Stay or for Leave of course, but there is an element of risk on risk off that goes with each outcome.


Maybe the bigger surprise following the referendum was how unprepared politicians were to deal with this. Several surprises followed the referendum; Prime Minister David Cameron resigning, the Labour party really suffering a crisis of leadership and much of the shadow cabinet resigning, Scotland and Norther Ireland responding in a very pro Stay stance with Scotland even threatening to veto the results of the referendum, and finally the Leave campaign who won the referendum but then appeared to have no plan to execute any kind of smooth exit. Really they seemed surprised by the victory. To a large extent this has left UK politics rudderless and global markets have responded to that uncertainty.


It’s really amazing how such a small group of people could cause such strife in global markets. About 35% of the registered voters voted to leave the EU. What’s interesting is almost the same number of people, registered voters, didn’t vote in the election. So approximately 1.5 million people swung the end result of this and really led to about US$3 trillion of price changes in global markets. It’s amazing.


But I think that represents a lot of the different risks that we experience today as investors and the rise of populism. No just in the UK, but in the US and parts of Continental Europe. And we really think there’s three drivers to that rise of populism. One is a slow growth environment, which it’s harder to lift all boats in that slow growth environment. Two is really a push back against globalisation because globalisation has not delivered for the average person what politicians and policymakers have promised. And finally, three, the area that’s probably most overlooked by investors is how technological disruption has put pressure on existing industries, on existing labour forces. All of that is leading to a push back against the establishment and we’re seeing that in the UK today.


I think in the UK there’s also a dichotomy between the countryside, the rural areas and the City of London, and again that is just a glaring example of how globalisation has benefitted one part of the country in an epic way, London, and how it’s left much of the other part of especially England out of the prosperity of globalisation.


So what has this change done, what has this referendum, this rudderless political situation in the UK? It’s introduced a lot of uncertainty and risk aversion in markets and that has led to price dislocations and price movements. And probably, perhaps the thing we’re most concerned about right now is how price movements and uncertainty can lead to a lack of confidence both from the consumer and from corporates which can lead to a lack of spending and can lead to a slowdown in economic growth and potentially even a mild recession.


Now we are not as concerned about a financial crisis mainly because we think the financial system is much more regulated, much more controlled than it was in 2007/2008 but we are concerned we could be heading into a recession. That’s not our base case but it is a concern.


Now, if you’ve followed a lot of the work that we’ve done, our framework, there is a tool we use called CRIC. And we didn’t develop CRIC but we use it and it’s very valuable to us. CRIC is a paradigm for crisis. CRIC stands for crisis, response, improvement and complacency and over the last 7 or 8 years we’ve had a number of different crises, whether it was Greece I or II, or Spain, or Italy, or China, or the US debt downgrade or the US debt ceiling, these have all been crises that we’ve experienced that have caused a lot volatility in financial markets. Ultimately following the crisis we’ve gotten a response really in relatively quick order, 1, 2, 3 months we’ve had a response. In general, it’s been from central bankers which has led to stability and then has led to improvement and then complacency and then we find ourselves back in crisis unfortunately.


In the case of the Brexit it’s a little more challenging because it’s not clear how you resolve the Brexit in a short period of time. What I mean by that is that there is no central banker that can stand up and say everything is OK. What has to happen is a complicated political process. I mean first of all the UK needs a new Prime Minister to lead it into a Brexit negotiation. Second of all, that leader needs to present to Parliament this Article 50 for separation from the EU and Parliament has to vote on that. The referendum is not legally binding, actually we need a vote from Parliament.


The issue there though is that a significant majority of MPs are pro Stay in the EU and so this is going to create an interesting dynamic between the MPs and their constituents. Now it’s not clear that the majority of constituents are pro Leave and so there’s a process here we are going to have to go through to figure out how we are going to enter into the exit. Now, in that process there’s going to be a number of opportunities for negotiation and compromise and it’s going to be very interesting to see how that plays out.


So, from our perspective we don’t see any quick resolution, which is bad for financial markets. But we also think that there’s still the opportunity for some compromise that would lead to a less draconian separation. Time will tell.


In the meantime we are not fooling ourselves about the pressure that Brexit and uncertainty could have on global markets, certainly have on the UK, also have in the EU, and that by extension will lead to a stronger US dollar and put pressure on US exporters. So it’s impossible not to be linked.


Our first response to the Brexit in terms of our portfolio last Friday was to take down beta and we did that mainly through financial holdings that we had. In general, we’ve owned financials because, in general, we believed the valuations were very attractive, the likelihood of slow interest rate increases was high and industry structure around the world in many financial markets have improved dramatically. With Brexit, with more uncertainty, this is less likely. We remaining to bet in some of these areas, but we’ve taken down some of the weights, just, you know, recognising that the world has changed.


The next thing we’ve done with the portfolio is really just focus on the high quality insights we have in the portfolio. And so adding, adding to those names, where prices have come down and we feel very confident about our insight, about why returns are going to rise and about why stocks are going to work. And we’re really relying on our research platform and the resources of T. Rowe Price to have conviction in those bets.


Second of all we’ve looked for some dislocations and the most glaring being companies with US free cash flow for some reason listed in the UK and taking advantage of a price disparity there. So a lot of those names were down significantly in the last two or three days and yet the free cash flow profile is very US dollar-based and there’s really no reason for that price dislocation other than quant or index selling in that market. So we’ve found a number of those that we’ve added to the portfolio that we think will add value as we reach a more normal environment.


And finally, there’s one or two UK companies that we’ve look at, local UK companies, who we think are premier assets; premier, low risk, long-term durable growth assets that have just been really knocked around in the last few days and we’ve started relatively small positions in those names, managing risk, not running into a burning building in terms of chasing them but trying to be carefully contrarian and add to some of those names.


In general, our positioning, we’re less optimistic about US Fed hikes, we’re less optimistic about some of our financial holdings but we’re not moving completely out of these names because we think there are good fundamental theses here but we’re still slightly less optimistic that we’re going to get the same pattern that we thought, or maybe another way of saying it is it’s delayed, the investment theses are delayed, perhaps beyond the US general election. So we continue to own some of these, we continue to work on them but we’ve lessened our bets in some of these names.


Secondly, we think our EM focussed holdings probably have a little more tailwind now with a lack of US rate increases and so we feel a little bit better about the names we own, we really aren’t adding any names in EM but we’re continuing to maintain the positions we have and we’re really overweight floating currency emerging markets now, which hasn’t been the case for a lot of the time that we’ve run the portfolio.


And finally we’re the most underweight in energy that we’ve been since I’ve run the portfolio and really we’ve been trimming energy into the rally. We were underweight to begin with, but we’ve been trimming into this rally because we fundamentally think that US inventories or in general, energy inventories are going to turn up again later this summer into the second half and that this trading rally that’s happened in energy doesn’t reflect the fundamentals. And the fundamentals are there’s too much oil in the world and that’s driven by technological change, not by demand, and so as that becomes again apparent as rig counts bottom and begin to grow energy will trade off. Natural gas is slightly different, where we think natural gas prices actually could have a tailwind in the second half, again just based on their inventory dynamic.


So in general there’s no change in the way that we run Global Focused Growth. I mean we’re focused on quality companies where we have insight about improving economic returns in the future and we don’t pay too much. We’re leveraging all of our global research resources to identify those names, to confirm our conviction in those names and that’s status quo, we continue to do that.


We do think that stock picking and identifying the best ideas is going to be critical in this time of uncertainty. We’re not going to understand what it means for the UK to exit the EU for six months, a year, maybe longer and so it’s going to be critical to be able to pick stocks where drivers come through and where theses play out and deliver value for us.


So that’s nothing new, it just again raises the bar of having great research resources like we do and that’s going to be critical in us outperforming going forward. In the end, we want to have a better portfolio exiting a time of crisis than when we went in. We want to have better potential for alpha going forward than when we went into the crisis. I feel very confident about our ability to do that.


So hopefully I’ll see you soon in my travels, I hope you’re well and thank you very much for listening.




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