On June 23, voters in the United Kingdom (UK) voted to withdraw from the European Union (EU), the outcome was 51.9% to 48.1% to exit the EU. Global capital markets felt the repercussions almost immediately. Global equity markets declined for a few days after the vote before the dust settled and investors scrambled for safety in less risky assets. Although the British exit (Brexit) from the 28-nation politico-economic coalition was indeed a watershed event for global financial markets, it didn’t turn out to be the end of the UK and Western Civilization as some had predicted and markets rebounded the following week.
As a result of the vote, British Prime Minister (PM) David Cameron announced his resignation, which was supposed to be effective in October of this year. His resignation came after failing to convince voters to vote in favor of staying in the EU. Mr. Cameron resigned somewhat unexpectedly today and earlier than initially projected, passing the job over to successor Theresa May. In order for the exit vote to be binding, the UK government must give official notice of their intention to leave the EU. When this notice is given by the PM, the EU’s Article 50 of the Lisbon Treaty is invoked. It states that any member of the EU wishing to withdraw must notify the European Council of its intention. Then the member wishing to exit has up to two years to negotiate terms of the exit and sort things out.
While the UK has two years to complete its exit, many EU officials are calling for them to speed up the process and leave sooner. If that happens there are many questions to be answered from a sovereign standpoint. For starters, could this mean an end to the UK as we know it today? Would Scotland and Northern Ireland decide to break away from the UK and decide to stay in the EU?
The unanswered questions as to how and when the exit will actually occur potentially sets the stage for continued volatility in the coming months, not only for the UK but also for Europe since the intermediate- and long-term outlook has changed. Let’s take a look at how Brexit could impact the different asset-allocation elements of target date funds (See related blog post: http://blog.principal.com/2016/05/19/what-a-brexit-could-mean-for-target-date-funds/).
Target date funds are based on risk and reward assumptions for the various asset classes they invest in, including equities, fixed income, and cash equivalents. These asset classes are also evaluated by their country of origin as well. Target date fund managers now have to separate the risk and reward assumptions of investing in the UK and Europe and develop appropriate strategies for both. For example, target date fund managers might have to look at their holdings in British and European equities and re-examine their risk/reward benefits and rework capital market assumptions to determine what might be appropriate allocations in the future. A couple of weeks ago, the outlook for British and European equities could be lumped together. As we move forward, there will probably be a need to create separate intermediate and long-term outlooks. Even if the reward outlook doesn’t change, there is a high probability for future volatility.
On the fixed income side, I mentioned a dislocation in the fixed income market with one of the beneficiaries being Germany. Investors are essentially paying the German government for safety since the yields on German Bonds are in negative territory. I use the term “benefitting” here rather loosely since rates are already negative, but a flight to these assets is a reflection of safety.
Cash equivalents were impacted by the vote and potentially will continue to be impacted. The British pound has depreciated since the vote, and the foreseeable future of its value could be uncertain. While the euro has a slightly broader base, there is also heighted uncertainty in its value. For now, the U.S. dollar will probably continue to be regarded as a safe-haven currency.
Brexit is not the end of the world and, the fact of the matter is, markets have experienced some short-term pain, but now it’s still business as usual. It is the same story as before the referendum, we believe target date fund managers should continue to monitor the situation and look for opportunities as they aim to combine a portfolio that balances risk and reward. Our assessment is that target date investors should try to focus on long-term retirement goals and let portfolio managers help guide them through this time of uncertainty.
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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 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.