Invesco Canada blog

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Scott Wolle | July 28, 2016

Diversification in a post-Brexit world

The basic principle that guides our portfolio construction is combining asset classes that we believe will perform well in at least one of the main economic environments. The goal of this approach is to have elements of the portfolio that are performing well in various scenarios – helping buoy results in more difficult times.

When we apply that principle to what has happened in the pre-, and now post-, Brexit referendum environment, the assets performed exactly as we expected.

Stocks, as the riskier assets, have had a rough go. But government bonds, which we’ve designated as the safe haven, performed well.

At the same time, commodities, which many people would put in the “risky asset” category, held up exceptionally well in many cases. While there were certainly some, such as energy, that struggled, others came through relatively unscathed, including gold and other precious metals. Even a number of agricultural commodities did quite well during the period around Brexit. In fact, industrial metals held up quite a bit better than most equity markets.

In short, the periods before and after the Brexit vote demonstrate the merits of the general approach that we use – preparing for different market outcomes by diversifying across asset classes.

What about commodities?

When it comes to commodities, I think it is very important to avoid viewing them as one homogenous group. We do this by thinking separately about energy, industrial metals like copper and aluminum, precious metals like gold and silver, and agricultural commodities like soybeans, wheat or sugar.

I believe that the Brexit result and uncertain aftermath will have a different effect on each of these.

Let’s look at a few examples.

Agricultural commodities are generally not as sensitive to macroeconomic shifts as other commodities. They are driven in large part by factors that are beyond the typical economic cycle. In this way, they can be a wonderful diversifying asset within a portfolio – as they often behave very differently than just about anything else.

Precious metals, on the other hand, could benefit from additional market turmoil. In periods of high geopolitical risk, investors tend to move toward assets deemed to be safe havens, like gold and silver. This is evidenced by some of the activity during the week following the Brexit vote.

The bigger question is around more industrially oriented commodities, including industrial growth in energy. We believe that, on balance, a Brexit would likely have both a dampening effect on global energy demand and a disinflationary effect. On the margin that would be negative. If that’s the demand side, what would happen from a supply perspective?

In this area, we’ve been encouraged by the response of many of the energy producers out there. There’s an old saying that the best cure for high prices is high prices. This simply means that when prices are exceptionally high, producers tend to invest more and bring out more marginal reserves while consumers start to pull back. The theory goes that all of these things combine to pull prices back down.

Well, the opposite works too – the best cure for low prices is low prices. And in this regard, we’re seeing positive behaviors from producers. We are seeing some going out of business, others partially shutting production and mergers occurring. A lot of those supply side factors are already occurring, so while we think that demand may be dented, there is still a nice tailwind from a lot of these supply-side factors.

Looking ahead

We don’t have a crystal ball and it remains to be seen whether these factors are powerful enough to overcome a shock. When faced with such uncertainty, we believe that it is critical to be prepared for whichever market environment emerges.

The first half of 2016 revealed how quickly asset-class performance can change and the benefits of diversification. This is precisely why we aim to better prepare our portfolios for an uncertain future by focusing on economic diversification – selecting a balance of assets that have historically outperformed in different types of environments. At the same time, we make monthly tactical adjustments that are designed to capitalize on timely market opportunities in these asset classes. Overall, we believe our approach leaves us well-positioned for any market shake-up that may occur.


More from Scott Wolle

Diversification in a post-Brexit world
July 28, 2016

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