Navigating Brexit with your investments – Part 1

Markets can move quickly on news, so how is it possible to address ‘Brexit risk’ in a portfolio?

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  1. Rob Morgan

More than three years on from the referendum and we still don’t know what Brexit will look like. There may be further delay, and increasingly it appears a general election is required to break the deadlock.

While not exactly discounting Armageddon, UK shares have already got a significant amount of doom and gloom in their valuations as a result. With sentiment around politics driving markets at the moment rather than fundamentals, more uncertainty could have a negative effect. That’s because it not only increases the unpredictability of the Brexit outcome, but it adds another significant factor to the mix; a Jeremy Corbyn government.

In terms Brexit itself, a variety of outcomes are still possible, ranging from ‘no deal’ to a ‘softer’ Brexit, or even no Brexit at all. Markets can move quickly on news, and as investors this is outside our control – so how is it possible to address ‘Brexit risk’ in a portfolio? 

 

Market reaction depends on Brexit outcome

In any scenario, much of the immediate action takes place in currency markets. It is clear that the City generally fears a ‘no-deal’ exit, and in the event of a ‘no deal’ or ‘hard Brexit’ – sterling is expected to decline, as it has to a significant extent already. As well as causing an unwelcome rise in inflation this tends to mean overseas assets rise in value for UK investors, and UK companies with primarily international earnings benefit. In contrast, there would likely be a detrimental impact on the domestic economy overall and UK-focused equities would come under renewed pressure.

Diversification into overseas assets and currencies could assist the performance of an investment portfolio in this scenario. Gilts (UK government bonds) may also serve to protect with the Bank of England likely cutting base rate, looking through any rise in inflation and focusing instead on the downside risk to the UK economy. Gilt yields would likely fall and prices rise. Other ‘safe haven’ assets such as gold might also provide some shelter.

The behaviour of investments since the referendum result is relevant guidance here, and this clearly shows the short-term divergence of UK equities, especially smaller companies, from global assets as concerns about Brexit have mounted.

In a ‘soft Brexit’ scenario where the UK keeps a closer alignment with the EU, potentially remaining in the single market and/or customs union, there is likely to be less immediate disruption to the UK economy and it may avoid the need for a hard border with Ireland.  We would expect higher interest rates, higher gilt yields (and falling prices) and a substantial rally in sterling in this event.  It is possible that larger UK equities would underperform and many domestic UK equities would outperform – perhaps significantly so.

Interestingly, a soft or no Brexit poses as many risks, if not more, to the investor. Overseas assets would likely fall in currency terms and many FTSE heavyweights, as well as higher quality UK bonds, could be under pressure. The number of asset classes that would benefit is relatively small with UK smaller companies and commercial property the two probable stand outs. Shunning these areas to avoid hard-Brexit fallout, which fund flows suggest is what many investors are doing, means taking a fair amount of political risk in the opposite direction.

 

This article is part of a 3 part series. Click here to read Part 2.

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