What a Brexit Could Mean for Target Date Funds

Voters in Britain are set to decide this coming June if the United Kingdom (UK) will remain in the European Union (EU). The background surrounding Britain’s decision to potentially leave the EU is a complex issue and one that is swathed in decades of history. It’s also fair to say that Brexit–a British exit from the 28-nation politico-economic coalition–would be a significant event to say the least. In this blog post I’d like to discuss what a Brexit could mean for target date fund investors and how it could change the thinking of investment managers. Just a refresher: a target date fund is an asset allocation strategy that automatically resets the asset mix of stocks, bonds, cash equivalents, and other asset classes in a portfolio to a more conservative mix as the target date (retirement) approaches.

First, it’s important to note that the impact of a Brexit for target date fund investors and how it would change the thinking of investment managers are difficult questions since a member country exiting the EU would be an unprecedented event. Moreover, if Britain decides to exit the EU then one might worry what other countries (such as Germany and the Netherlands) could hold a vote of their own and be next in line to follow. This would certainly be a unique event and one with major financial repercussions for global financial markets at large. Before we address those questions, let’s take a look at how a Brexit would potentially impact the different asset-allocation elements of these particular products.

If Britain does indeed move to exit the EU, financial markets could react very negatively as the cost to the UK and the Eurozone in terms of GDP growth would be quite high. Given the financial markets currently have a low probability built into current valuations, risk assets such as equities and credit would also likely be impacted negatively. In particular, equities in the financial sector could enter a no-man’s land of very foggy earnings visibility. In addition, global financial firms would most likely look elsewhere in continental Europe to do business, and the benefit of having a UK franchise would greatly be diminished. Based on these beliefs as we near the Brexit vote, one may conclude that being light in financials in general could be a good option. Since the Brexit is a binary outcome, target date managers have to consider portfolio positioning that could potentially mitigate either outcome without taking too much risk.

On the other hand, global companies that rely heavily on business in UK for sales or distribution would probably not be the beneficiary, since earnings would be in doubt. Why? Because these global firms and UK distributors are the largest clients of the other, and upsetting that balance would require a significant amount of time to restore that balance. Lower immigration could also lead to a labor shortage in the near-term, driving wages higher and thus eroding corporate profits.

On the fixed income side, the likely outcome of a Brexit will be that investors favor safe-haven investments. The likely impact in the UK is a tightening of financial conditions, and a rise in bond yields.

If a Brexit occurs, it could create a lot of dislocation in the fixed income market. One of the beneficiaries of a Brexit would be Germany. The term “benefitting” is used rather loosely here because German rates are already negative, so a flight to those assets isn’t necessarily a good thing. The likely losers in the fixed income arena are the highly indebted nations, such as Spain, Italy, and Greece, who are being propped up by nations that are doing rather well. If indeed there is a Brexit, then again, one has to wonder what country will be next. This is a question that will play on the minds of investors and investment managers alike. For bond holders, where the upside is minimal, one option is to play relatively safe and look to areas like the United States where they could expect a positive yield without all of the EU drama.

Another area that would be impacted by a Brexit is cash equivalents. For instance, the British pound would most likely come under significant pressure. The uncertainty could cause a capital outflow, which would have the effect of causing the pound to depreciate. Interestingly, the beneficiary would probably not be the euro, since it too would face uncertainty and would likely also depreciate in value. The true beneficiaries would probably be the Japanese yen and the U.S. dollar, since they are viewed as “safe-haven” currencies.

In the coming months, the binary nature of the Brexit vote is likely to create market swings. For a target date fund, the impact of a Brexit would likely be a significant spike in uncertainty and volatility especially for non-U.S. assets. On the other hand, we would expect the impact of a “no vote,” would, over time, prove to be the opposite; that is, back to business as usual (eventually). This suggests that the negatives probably outweigh the positives, and warrant a cautious view toward risk in European markets. Today, it’s very difficult to handicap the June 23rd referendum vote. Based on recent polls, we would wager that the UK remains a member of the European Union, but it appears to be a close call. Time will tell if we’re right. In either case, we as target date fund managers will be closely monitoring the situation.

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About Target Date Funds

Target date portfolios are managed toward a particular target date, or the approximate date the investor is expected to start withdrawing money from the portfolio. As each target date portfolio approaches its target date, the investment mix becomes more conservative by increasing exposure to generally more conservative investments and reducing exposure to typically more aggressive investments. Neither the principal nor the underlying assets of target date portfolios are guaranteed at any time, including the target date. Investment risk remains at all times. Neither asset allocation nor diversification can ensure a profit or protect against a loss in down markets. Be sure to see the relevant prospectus or offering document for a full discussion of a target-date investment option including determination of when the portfolio achieves its most conservative allocation.

Investing involves risk, including possible loss of principal. Equity investments involve greater risk, including higher volatility, than fixed-income investments. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards

Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Principal Securities, Inc., 800-547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc., and Principal Securities are members of the Principal Financial Group®, Des Moines, IA 50392.