Calm down, it’s only Brexit

Bretigue (n): The feeling one has after discussing, for the hundredth time, the likely outcome in October and whether everything will carry on as normal, or if we will be rationing fresh food supplies.

Firstly, I would like to apologise for another article on Brexit. However, it is by far the most popular topic we have when out on the road with advisers. We are usually asked two questions.

  1. What do you think will happen?
  2. How are you positioning the portfolios?

The first question has a short answer and a long answer.

The longer answer is that in a negotiation between two developed political blocs, one would expect a compromise to be found. The situation is akin to the famous game theory puzzle, ‘the prisoners’ dilemma’. It is in the interests of both sides to reach a compromise as a solution – as this will cause the least disruption to both sides in the short term. However, like the prisoners in the puzzle, people do not always act rationally. People often do not cooperate even though it is in their best interests to do so.

Therefore, if sense prevails we would expect to see a ‘softer’ Brexit – an orderly exit by the UK from the EU. The difficulty is understanding how we will get to this position. Clearly the arithmetic no longer stacks up in the current government, but through the process of a general election we still see it possible for a solution to be found to some of the key issues such as the backstop. This was our position back in March, and despite the political turbulence, we still see this as our central outcome, but are not foolish enough to rule out other possible scenarios.

The short answer is, I don’t know.

The second question is far more interesting to me as a portfolio manager, but before I attempt to answer, it is useful to put some context around multi-asset investing for a UK-based investor.

The UK is no longer a global investment superpower

The UK economy still ranks as the fifth biggest in the world, however we are now a long way behind the likes of the US, India and China.

Over time, the size of stock markets is said to converge with the size of the economy. As economic growth internationally has outstripped the UK over the past twenty years, UK-listed companies are now a much smaller part of global markets.

Looking back to the start of the millennium, the total value of the FTSE All-Share – all the UK main-market listed companies – was £1.48 trillion. The MSCI All Country World Index, a measure of both developed and emerging nation stock markets had a total size of £13.69 trillion back in 2002, meaning the UK represented just short of 11% of global stock markets.

Fast-forward to 2019 and the market size of the UK has grown by two-thirds to £2.48 trillion, a much slower rate than that seen in world markets, which have seen a 250% increase in sterling terms to £48.58 trillion. As such, the UK’s share of markets has more than halved to 5.1%.

UK stock market as a percentage of global stock markets

Source: Bloomberg September 2019

In addition to the overall fall in the UK’s share of global markets, it is also worth considering how and where the UK-listed companies generate their earnings.

The original composition of the FTSE 100 back in 1984 had a heavy leaning towards British companies. In fact, eleven had ‘British’ in their titles and another eight hinted at a UK heritage. Today only six ‘B’s remain, and their reliance on the UK as an income stream has fallen. For example, BAE’s percentage of revenues generated from the UK has fallen from 37% in 1984 to 21% at the end of 2018. It’s a similar story for other UK businesses. In fact, it is estimated that around three quarters of the revenue generated by FTSE 100 companies is from overseas. As the FTSE 100 represents the majority of the UK stock market by size, it is therefore fair to say that the 5% weighting of the UK in global stock markets significantly overstates the relevance of the UK economy when it comes to global stock market performance.

That being said, international companies will earn revenue from the UK. In addition, a significant part of the UK stock market’s revenues are generated from Europe. It is therefore almost impossible to ascertain the exact effects of Brexit on global markets but, on balance, it is fair to conclude that stock market falls due to Brexit alone are actually likely to be fairly muted.

The most relevant period to use as a potential indicator is the immediate aftermath of the referendum vote on the 23 June 2016. In the week following this, the MSCI World Index was up over 9% in sterling terms, boosted by a fall in the pound. When measured in dollars, it was down a relatively benign 2%.

Put simply, the effects of Brexit on the UK and European economies are not necessarily heavily linked to the performance of global stock markets.

A falling pound: the good, the bad and the ugly

Like company performance, it is important to disaggregate the effects of a falling pound to the UK economy from the performance of a UK investor’s multi-asset portfolio.

For the UK economy, a falling pound, in general, is bad.

UK exporters benefit from a fall in the pound, as their goods are relatively cheaper and – save for additional tariffs – this makes the UK more competitive in global trade. In 2017, the UK exported $395 billion of goods, making us the 10th largest exporter worldwide. The largest export was cars, representing 11% of total exports.

On the other hand, we are the fifth largest importer, bringing in goods with a total value of $617 billion in 2017, leading to a net trade deficit (the difference between imports and exports) of $222 billion. Put into context, this represents around 8% of the UK’s economy.

For imports the opposite is true: a falling pound leads to rising prices. Again, the period after the referendum vote in June 2016 is a good indication of this effect. Sterling fell by nearly 20% against the dollar, and we saw inflation rise. In June 2016, just before the referendum, the annual CPI change, a common measure of inflation, was 0.5%, significantly below the Bank of England’s 2% target. By November the following year, CPI had peaked at 3.1%. The Bank of England’s own analysis concluded the majority of this was due to ‘imported’ inflation from the fall in the pound.

Therefore, a further fall in the pound would likely lead to another bout of higher inflation. If this is combined with a period of low economic growth, it is often called stagflation, hindering the spending power of the UK consumer.

Alongside a rise in inflation, a fall in sterling has other negative effects on the UK economy.

When net imports of goods are combined with the net import or export of services, alongside any income the UK makes from foreign investments, and any monetary transfers into the UK from abroad (for example from UK workers sending money home), it is categorised as the UK current account balance.

When a country has a negative current account, it is the equivalent of an individual holding an overdraft – at some point it needs to be funded. The UK has a large current account deficit and is currently funded predominantly by foreign investments. A fall in the pound is therefore negative on two counts. In the first instance, it increases the current account deficit as the value of imports rise when measured in sterling. The second effect is uncertainty of foreign investors. If they have suffered a loss in investments due to a fall in sterling, and uncertainty remains, they are less likely to continue to fund the UK’s current account deficit. This could lead to lower demand for UK investment assets, such as UK property, which in turn may lead to falling prices, lowering the wealth of UK homeowners and domestic investors.

However, set against the doom and gloom of the effect of a falling pound on the UK economy, the opposite is true for a UK investor, especially one with an international portfolio of equities and bonds. As the pound falls, the value of international holdings rises. In addition, as already discussed, the UK stock market derives the majority of earnings from overseas; as sterling falls, revenues rise. As such, even UK-based companies may benefit from a falling pound.

Therefore, although it may seem counterintuitive, a fall in sterling is actually likely to be a positive for any investor with a significant portfolio invested mainly in international companies.

Rates on a tightrope

Conventional wisdom (or at least history) shows that high inflation can be controlled by increasing interest rates. With the spectre of higher inflation if sterling falls significantly, it is conceivable that the Bank of England would be forced to increase rates to temper inflation.

On the contrary, lowering rates, or engaging in Quantitative Easing, can be used to boost economic growth, as they encourage savers to spend. This was the approach taken back in 2016 when rates were cut to 0.25%, despite inflation running above the 2% target.

Over the long term, our belief is that rates will rise, as they are unsustainable at such low levels. In the shorter term the outlook for UK rates is uncertain in the case of a ‘no-deal’ departure from the EU. In the instance of an orderly Brexit, a normalisation in rates is more likely.

However, alongside monetary policy action from the Bank of England, we would also expect to see the Government use the tools available to it to try and boost the economy (more than likely funded by borrowing), although the amount depends on the Government in charge at the time. Therefore, the resultant fiscal and monetary policy actions taken after the 31 October deadline are almost impossible to predict.

Portfolio positioning

The outcome of Brexit is a moving feast. At present it appears that 31 October is the cliff edge, where the UK will either leave with ‘no deal’, or a ‘renegotiated deal’ will be struck. But, as they say, a week is a long time in politics. By the time this article is disseminated, we could already be in the midst of a general election campaign, with possibilities of an extension, or indeed no Brexit it all.

Whatever the final outcome, it is likely we will see large moves in financial markets, especially the currency markets. The pound has fallen 20% from its peak before the referendum in 2016, with many predicting a further fall of 20% in a stress scenario. On the other hand, a softer exit could see the pound rally back to pre-referendum levels.

We are in the business of long-term investing, rather than short-term speculation. As the outcome is uncertain, and likely to lead to large market moves, we feel it is important to have positions in the portfolio that will help in different scenarios, offsetting losses in other positions. In the longer term, we feel the UK economic situation will have little bearing on the performance of a UK investor’s diversified multi-asset portfolio, therefore placing more value in our long-term capital market assumptions.

A key difference between market moves now and back in 2016 is the signposting. The vote to leave was a surprise to the markets (despite polls indicating this was the likely outcome). As such, the markets reacted sharply to the news. This time around, the situation is more fluid, with news emerging on a daily basis. Therefore we do not envisage a scenario where markets change in a single day by the same amounts as 2016, although the aggregate move may end up being a similar amount over a series of days or weeks. This gives us the chance to react to any large market moves that we feel are overreactions.

The following is our assessment as to how we think the market will perform under different scenarios in the immediate aftermath.

The only difference we see in the short term between a ‘renegotiated deal’ and ‘no Brexit’ is the political landscape under which this is achieved. A ‘renegotiated deal’ is likely to lead to uncertainty until the eleventh hour but will ultimately lead to a relief rally in sterling and a focus on a Conservative legislative programme, likely to include (promises of) corporate and personal tax rate cuts. On the other hand, ‘no Brexit’ will only be achieved through a general election and the formation of a new government. We categorise ‘no Brexit’ as either an extension or the revocation of Article 50.

Our current leaning is towards a general election, the re-electing of Boris Johnson and then a toss-up between ’no deal’ and a ‘renegotiated deal’. As highlighted above, the market moves here are binary, so it is important to be positioned for either scenario.

A couple of other scenarios are possible, such as a general election resulting in a hung parliament. If this spans the 31 October deadline, we will leave the EU in a disorderly fashion, with similar moves, but perhaps larger in quantum.

Using the same scale as above, we outline areas of the market that we feel will perform particularly well or badly under the above macro moves.

The one asset class we see doing well in most scenarios is UK large cap equities. On one hand, the majority of earnings from this market are derived from overseas, and would benefit from a further fall in sterling. On the other hand, the valuation of the FTSE 100 versus other major indices is at a significant discount. The FTSE 100 trades at a 27% discount compared to the S&P 500 when measured by the price/earnings ratio. This is larger than the average discount over the last decade of 16%.

UK large caps make up between 20% and 30% of our total equity holdings across our growth funds and MPS.

In addition, we invest a significant part of the portfolios overseas, in both equities and fixed income. Crucially, the majority of this is pointed away from European markets towards the US, Asia and emerging nations. In fixed income, we have introduced asset classes such as emerging market debt and US treasuries over the last couple of years to further diversify our holdings.

In general, we actually expect the portfolios to perform fairly well in the event of ‘no deal’ due to the international bias. Our MPS launched in August 2016, so didn’t exist at the time of the referendum vote in June 2016, however back-testing our strategic asset allocation for the month of June 2016 for our Balanced/MPS 3 portfolio shows a positive performance of 4.5% (gross of any fees). We feel this is a good guide for short-term portfolio performance under a ‘no-deal’ scenario.

However, as we have already outlined, it is important to have balancers in the portfolio given the uncertainty of the outcome. All the growth portfolios have an allocation to UK mid-cap equities, which we feel would outperform in either a ‘renegotiated-deal’ or ‘no-deal’ scenario. In addition, the passive portfolios have an allocation to UK REITs, which currently trade at a large discount to marked book value.

Ironically, in the short term, a ‘renegotiated deal’ or ‘no Brexit’ could lead to negative performance of portfolios, however in the longer term the removal of Brexit uncertainty may lead to strong performance of equity markets, especially in the UK. As such it is best to keep calm and carry on investing!

So, to finally answer the question:

How are we positioning portfolios?

Sometimes the best thing to do is nothing.

Given the lack of a clear outcome, making radical changes to our portfolios will generate significant trading costs, but will not necessarily generate higher returns.

Having already positioned portfolios for some sort of compromise back in March, whilst also making sure we have some risk balancers in the case of a different outcome, we see no reason to make significant changes.

The central pillar to our investment philosophy is to be long-term in nature and valuation driven. The economic fall-out does little to change our long-term capital market assumptions, in particular for international markets.

Instead, our bigger concern is the low level of government bond yields globally and the liquidity risk contained in open-ended property investments in the UK. We therefore continue to favour international equity investments and shorter maturity bonds.

Past performance is not indicative of future performance. The value of investments may go down as well as up and the income generated by investments is not guaranteed and may fluctuate. You may receive back less than the amount that you invested.

This information is for indicative purposes only and is not intended, and should not be construed, as investment advice. The information contained in this document has been taken from the sources stated and is believed to be reliable and accurate, but without further investigation cannot be warranted or guaranteed to be wholly correct. The views and opinions expressed in this document are not forecasts or recommendations in relation to investment decisions.

The information and data presented in this document were believed to be correct at the time of writing and we are not liable for any subsequent changes.

Head of Passive Portfolios AJ Bell Investments

Matt is responsible for the day-to-day running of the AJ Bell Funds, working with our investment team to further grow the range of investment options. He joined us with over six years’ experience in financial services, having previously worked at a leading provider of wealth management services as a Senior Fund Manager and Head of Fixed Income Research, with specific responsibility for managing a discretionary fixed income fund. He also formed part of a four-person fund management team that ran the company’s multi-asset funds. Matt graduated from the University of York with a first class Masters degree in Mathematics, and is a CFA Charter holder.