Wealth Strategies

Brexit And Beyond - The View From Bordier UK

Bordier Uk's Investment Team 10 September 2019

Brexit And Beyond - The View From Bordier UK

The UK investment team at Bordier considers how investors should approach the markets current Brexit uncertainties.

The following article comes from Bordier’s UK investment team. The subject, unsurprisingly, is about Brexit and how investors should position themselves, given the uncertainties and the manoeuvrings in Parliament. This publication is pleased to share these views and invites readers’ responses. The editors do not necessarily agree with all views of guest contributors. Email tom.burroughes@wealthbriefing.com or jackie.bennion@clearviewpublishing.com

The timetable for Brexit has seemingly shifted closer to the finishing line in recent weeks, with the UK’s new Prime Minister and his predominantly pro-Brexit support act upping the tempo and altering the rhetoric.

Whether this is all part of a deliberate hard-nosed tactic aimed at re-opening the negotiations with Brussels at the eleventh hour remains to be seen, but the apparent lurch, if one believes the political utterances and media talk, towards a “no-deal” Brexit has certainly brought everything into greater focus, causing a further decline in the pound and contributing to the uncertainty in financial markets.

UK economy already in a difficult place
It is very difficult to gauge the way the Brexit dice will fall in the coming weeks and months, and indeed what the UK political landscape will look like going forward. Whichever way the dice may fall, we have been quite clear that the ongoing uncertainty surrounding Brexit would, in all likelihood, cause a difficult period for the UK economy.

This has proven to be the case as shown by the latest quarterly estimate of gross domestic product (GDP) growth which shows the UK economy in decline and potentially heading for recession even before we get to Brexit’s October crunch date.

UK GDP growth

Source: Office for National Statistics (‘ONS’) as at August 2019.

Action taken already to reduce UK exposure
We have already taken steps to incorporate a gloomier outlook for the UK economy, and its relative position on the global stage, into our portfolio positioning. This is not something we started just after the European Union referendum, but rather it has been a progressive shift in recent years to provide exposure to the growth opportunities elsewhere in the world as the UK has lost economic momentum.

As the balance of probability and market expectations have seemingly shifted closer to a harder Brexit scenario, we have continued to assess the implications for our UK investment positioning, fundamentally ensuring we have good international diversification within client portfolios.

But this is not a straightforward exercise: trying to accurately translate what is going on at an economic and political level into the likely behaviour of the UK stock market is fraught with difficulty, not least because the UK stock market is a poor representation of how UK PLC is faring. Dominant and diverse UK stock market constituents such as Royal Dutch Shell, HSBC, Diageo and GlaxoSmithKline are really only UK in terms of their stock market listing and financial reporting – they are truly global businesses, and therefore influenced more by much broader economic trends than the specific vacillations over the UK economic and political scene.

It is estimated, for example, that over 70 per cent of the revenues from the UK’s largest companies are derived from overseas. This explains why UK large-cap stock market indices have held up so well since the EU referendum in the face of a weakening domestic economic outlook; the UK’s economic demise has weakened the pound, but in doing so it has increased the value of the overseas revenues once converted back into sterling. A weaker currency has also restrained more domestically-orientated businesses, including those reliant on importing raw materials or components which have become more expensive as the pound has fallen.

Active managers also playing their part
Repositioning has not so much been about abandoning the UK stock market altogether, but ensuring that the underlying exposure is tilted in a direction that can both take advantage of the opportunities that still exist, whilst also limiting exposure to those areas under stress.

A large part of this repositioning is delegated to the managers of the active funds we select, but we have also made changes in fund selection to alter the bias in our mix of UK funds. We have tilted our bias more towards managers that are fishing in the larger part of the UK stock market where international influences are greater, or towards those managers who are able to identify more domestically-orientated growth companies which are less affected by Brexit or the broader UK economic scene. Our regular research reviews with external active managers, which allow us to gain a deeper insight into their positioning, show that several have already taken active steps to invest for a more uncertain outlook that is aligned with our thinking.

Our response to the plight of the UK economy has been to ensure that we have good stock market allocations to regions which have better prospects (e.g. the US), but also to orientate the UK stock market exposure that we do have more towards international companies or businesses less affected by the troubles faced by the UK economy. In doing so, we have also been mindful that, for sterling investors, departing from the domestic market does introduce greater currency risk.

For a typical Bordier UK Balanced (sterling) portfolio, which is currently neutrally positioned with around 50% invested in stock markets, approximately two-thirds of this exposure is currently allocated to overseas stock markets. In reality, the economic exposure to areas outside the UK is much more than this, for the reasons aforementioned.

Split between UK and overseas equity exposure in Bordier UK's Balanced strategy – 10 years

 

Source: Bordier UK as at 30 June 2019.

The bigger picture adds another dimension
In our analysis, we need to be mindful that the current US/China trade war and central bank actions will, in all likelihood, have a greater influence on market sentiment/direction in the medium to longer term, and that trying to plan precisely for an exact Brexit outcome or future political landscape is likely to run into trouble.

As the results of the EU referendum and the last US election have proved, being completely aligned with the consensus view does carry some big risks. It is still possible, for instance, that a further delay to Brexit will be engineered, causing the pound to rally, or for softer interest rate policy in the US to lead to a similar outcome.

Placing all bets on one outcome is therefore a risky strategy, and is why we still retain some currency hedges on part of our non-UK exposure for sterling-based clients. It would not take much, for example, to see the pound rally sharply versus the US dollar if there were a nudge towards a softer Brexit and a simultaneous greater-than-expected reduction in interest rates by the US Federal Reserve.

Short-term pain for long-term gain?
Whether we get a soft or hard Brexit, or something in between, a lot of damage has already been done to the UK economy and its currency.

But whatever the outcome, or the future political landscape, there is every chance that the UK economy will rebuild, so it is important not to write off investment in the UK altogether.

Any kind of positive resolution is more likely to see a more immediate follow-through to business investment, a reversal of cutbacks (including hiring) and a revitalised property market. Boosting the economy is likely to lift inflation and would also potentially lead to interest rates rising at a faster pace than currently expected, and should see the value of sterling rise too. Oddly, even a “no deal” scenario might bring a temporary boost to inflation if it causes a sudden increase in stockpiling of essential goods before the drawbridge is raised. 

So a “no deal” might initially prove quite challenging for the Bank of England as it attempts to shore up a likely weaker pound and tackle a short-term rise in inflation, as it would come at a time when the economy is generally entering an even tougher period than it is at present. What a “no deal” would ultimately look like depends very much on the preparations made by businesses (the BoE has said that 90 per cent of firms have implemented some form of contingency plan), the actual tariffs imposed, the BoE’s policy response and the future relationship between the UK and the EU.

How much has already been factored into market prices is difficult to tell, but at a very high level a “no deal” Brexit is likely (in the near term) to further weaken those companies and sectors which are at or close to the UK economy’s coal face and which have already been adversely affected by the Brexit uncertainty. Thereafter, the scales are likely to tip back as the immediate issues are addressed by policy measures, and uncertainty is replaced by greater certainty in terms of the direction of travel.

Once the dust has settled – and admittedly this may take some time – markets should eventually start to anticipate an economy in recovery mode but with a potentially different subset of investment opportunities and trap doors to think about.

What about a change in government?
Turning to a potential change in UK government, this may require some further tactical shifts in allocation by us or underlying managers in the months ahead. A Labour government, for example, might bring a number of positives to the UK economy, such as higher public investment and spending (it might also delay or annul Brexit, unless it is already too late).

But a Labour government may also cause the UK economy to retreat into an even deeper decline, as higher taxes reduce profits and business investment, and public debt levels rise; talk of re-nationalising key utilities such as rail, energy and water companies, even though this would be met with significant regulatory obstacles, might be very damaging for key income-producing or defensive sectors of the market; meanwhile, the inevitable rise in public debt required to pay for manifesto promises may cause bond yields to rise and place additional strains on markets.

Everything may pan out very differently, particularly if the greater influence on markets and currencies is the bigger story on the current trade war, slowing global growth and the manner in which policymakers address these issues.

Without wishing to diminish the importance or relevance of what is going on domestically, and its potential to unsettle market and investor confidence, it is one piece of a very much larger global jigsaw that our general positioning is reflective of.

Staying active
Keeping an open mind and an active approach has always been part of our philosophy. If the UK economic, market or political landscape does change more decisively, one way or the other, in the coming weeks and we consider it warrants a further adjustment to our strategy, then we will take whatever action is appropriate at that time.

At this juncture, aligning portfolios for a specific Brexit or political scenario would carry risks outside the tolerances which we are prepared to accept. Furthermore, even though there is a theoretical map of the best paths to follow once the fog has lifted, the reality is that a broader and potentially bigger set of factors will also need to be thrown into the mix before any definitive action is taken.

Are we heading for a Halloween horror show or something less scary? Time will tell, but we do feel that we have taken the appropriate steps to mitigate some of the immediate risks of a further deterioration in the UK economy and slide in market confidence.

As noted, further action may be required, but in the meantime we feel that our current neutral bias towards stock markets generally, and our tilt away from the domestic economy and pound in particular, remains appropriate. This does not just reflect local issues but also acknowledges the complex interaction of differentials in economic activity around the world, the prospect of extended stimulus from central banks and a complicated geopolitical landscape, all of which continue to impact on different asset classes in varying ways and are likely to result in increased market volatility as the rest of the year unfolds.

Scenarios – the good, the bad and the ugly
Below is a summary of some of the likely high-level influences on the UK economy, market and currency in different Brexit scenarios; it also attempts to combine these scenarios with the different global trade outcomes and the expected impact on the global economy, US dollar and global stockmarkets.

Summary of our positioning and views
•    We are positioned more outside the UK than in it, and have been for some time.
•    Around one third of our stock market exposure is in the UK, but the economic exposure to the UK is significantly less due to the global nature of the UK stock market.
•    The mainstream UK market has been supported by a falling pound.
•    We have recently further reduced the domestic exposure within our UK allocations.
•    Underlying managers are playing the Brexit/political scenario with care, but some have taken deliberate action to reduce exposure to companies at risk of further UK economic weakness/increase international earnings.
•    The ultimate Brexit outcome remains highly uncertain and has various permutations and possibilities for both the UK stock market and the pound; the way this plays out may differ from what the textbooks say and will depend on wider forces at work.
•    International factors (e.g. the ongoing trade war, slowing global growth and central bank action on interest rates) are also playing a big role (and perhaps an even bigger role than Brexit), so knee-jerk reactions to different Brexit scenarios or political change may be unwise.
•    A US Federal Reserve softening policy at a more aggressive pace than the UK, for example, could see the US dollar weaken relative to sterling, limiting or offsetting further sterling weakness caused by a no-deal Brexit outcome or further political upheaval.
•    Care is therefore needed not to be skewed too far one way or the other, as the global political and economic backdrop, and impact on asset prices/currencies, could be much more impactful than domestic issues.
•    Heightened volatility is likely to be a feature of markets in the latter part of the year.

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