The prospect of a potential Brexit has been the key issue for the relative performance of UK assets since the start of the year. Initially considered peripheral, markets have started to wake up to the legal and economic ramifications of a vote to leave the European Union. Should investors simply wait it out? Or should they be taking steps to “Brexit-proof” their portfolios?
Fund Strategy and Money Marketing convened a roundtable of industry experts to discuss the impact of Brexit on markets, and how portfolios can be best positioned to protect against any market falls, and benefit from market gains.
It may already be too late to insulate a portfolio fully against the damage. Paul Hollingsworth, UK economist at Capital Economics, pointed out that the referendum is already weighing on economic data. He said: “We have seen some weakness in some of the business surveys. The PMIs are pointing to growth of just 0.1 per cent in the second quarter, which represents a slowdown, so there is some effect on real economy.
“This may not entirely be to do with Brexit. Equally, while we are worried about company investment intentions, they don’t point to a very sharp slowdown. So Brexit is weighting on the economy, but not seriously.”
Stephanie Flanders, chief market strategist for the UK and Europe at JP Morgan Asset Management, agreed: “There has been a falling off in investment and investor expectations, but identifying how much is tied to the referendum and how much to negative mood, is a challenge.”
Nevertheless, the referendum effect has been notable in the performance of some parts of the stock market over others. Flanders said: “You can see some referendum effect in the performance of the FTSE All Share relative to small and mid cap. Part of this is a commodity rebound, but it pre-dates that.”
She also pointed out that some specific sectors have taken a hit, such as housebuilders – adding: “While there is no massive smoking gun, there is some weakening. On consumer confidence, the concrete things haven’t changed – how people feel about wages and so on – but the more ephemeral and non-specific feeling is more negative.”
Equally, it should be said that choosing the winners will be difficult. For example, the big externally-oriented exporters may do well with a weaker pound, but will be operating in a completely different trading environment should the UK vote to leave. The service sector may see a more difficult environment, as existing trade deals suggest that it would not emerge well from a Brexit scenario. Flanders says: “There aren’t many clear plays. In the near-term it may be better to focus on micro-factors.”
“The FTSE is a difficult one: if you think there’s going to be a bigger short-term hit to the pound, then the short-term effect on a lot of the FTSE 100 is an improvement in foreign earnings and foreign dividends. That may change afterwards, but it argues against a significant sell-off in the stock market after a Brexit vote.”
Nevertheless, there are opportunities, as valuations have been hit by concerns over a potential Brexit. Adrian Lowcock, head of investing at Axa Wealth, says:
“At the moment the market isn’t factoring in the benefit from a weaker sterling on increased earnings. They are waiting to see what happens.”
Alan Custis, head of UK equities at Lazard Asset Management, said: “It’s a cloudy picture. The retailers have also been impacted by the weather and the timing of Easter, for example. From a stockmarket standpoint, domestic sectors are trading at a one standard deviation discount to their long-term trend. There are housebuilders and retailers trading on single-digit multiples. The international staples companies, in contrast, are trading on 15-year relative highs. We see this persisting until 23 June – people don’t know what to do and want to see the result before committing capital.”
This view is supported by the most recent Bank of America Merrill Lynch survey, which showed UK equity allocations at their lowest level since 2008. Global fund managers have cut their UK equity allocation from an average underweight of 20 per cent last month to an average underweight of 36 per cent today.
Custis said: “There is huge value in some domestic sectors, but when will it be realised? Only on 24 June and after. Certainly, we could buy some, but if there is a Brexit vote, we would expect them to underperform.”
There are some highly competitive sectors that may see considerable disruption in the event of a vote to exit. Flanders points to financial services: “There are a few companies that won’t wait to set up elsewhere, particularly in financial services. They are all competing and there is a chance a competitor will relocate, based on the assumption that the deal won’t be great because other companies haven’t managed to get a good services deal.”
Commercial property is another vulnerable area. Lowcock pointed out that the sector has also started to see some Brexit-associated weakness. He added: “The property market is probably peaking anyway and Brexit may be that peak. We may see a bit of a slowdown.”
Nevertheless, Jason Broomer, head of investment at Square Mile Investment Consulting and Research, cautioned against being too pessimistic: “The expertise in London is not going to disappear overnight. There will be a move to set up elsewhere in Europe, but companies are unlikely to close down in London. The Eurobond market, for example, has largely come about as a result of London’s independent position.”
With this in mind, how are fund managers and strategists positioning their portfolios ahead of the vote in June? Custis pointed out that it is dangerous to skew a portfolio too strongly either way.
“We don’t bet on a binary outcome, particularly where we have very little insight. There are clearly a lot of domestic stocks are looking over-sold and there is an argument for selective purchase in the run-up to 23 June. However, to make a significant bet for or against would be foolhardy.”
While he suggests that it would be easy to find well-valued stocks to buy in the event of a ‘remain’ vote, finding stocks to buy in the event of a vote to leave would be a lot more difficult and would probably only come down to a handful of names.
However, he believes a “remain” vote could prompt a rally: “If we stay, there would be a general sense of relief in the market and the market would perform well versus Europe for the rest of the year. Looking at the valuations – with a 4.1 per cent prospective yield on the FTSE 100 – it appears to be offering an attractive return versus other investment opportunities.
If sterling doesn’t do anything crazy and there is some inflation with commodities supported and banks treated more positively, I would be quite positive on the market come 24 June if we get a remain vote.”
For Lowcock, the volatility surrounding Brexit serves to highlight the relative lack of protection many people have in their portfolios. He said: “Recent Investment Association data shows that a lot of investors in February moved into defensive funds. This highlights generally that investors are underweight defensive assets and don’t have a lot of protection in their portfolio. While I don’t believe investors should weight a portfolio one way or another in anticipation of Brexit, it is important that investors should have some protection.”
At the very least, he said, this should help them take advantage of opportunities as they arise in a post-Brexit environment. He said: “There will be opportunities, so the UK will look quite good for active managers. Investors can’t position for what they don’t know, but they do need to make sure they have got a bit of cash to allocate.”
Broomer has been moving up the market capitalisation scales on the group’s portfolios since last year. He has also reduced sterling exposure. This is not based on Brexit, but it has certainly been a contributing factor, he says.
However, the problem is that markets are still, for the most part, expecting a “remain” vote, and to date, sterling has borne much of the brunt of the speculation. Hollingsworth points out that if we start to see a shift in the polls towards a big “leave” vote, there may be real weakness in sterling or in UK equities. Equally, if the polls remain as they are, and then we have a “surprise” vote to leave, the movements could be quite significant. In this situation, investors may also want to question their European allocation, suggests Lowcock, as it poses a threat to the long-term stability of the European Union.
Even if we stay, investors would be wise not to expect a return to the races; Flanders points out that there are a lot of other problems in the world with which markets have to contend. A Brexit vote would be a lot easier to manage if there was a stabilisation in wide economic conditions, in emerging markets and commodities, for example. She said: “The bigger question is whether we can get to a world where the US is back on track to raise rates. Is a falling dollar and rising commodity markets structural? Or was all of that because the Federal Reserve said it was deferring rates?”
Equally, the Scottish referendum and the General Election suggested that relief rallies don’t tend to last very long. Lowcock said the markets may swiftly turn their attention to other problems – the US election, the refugee crisis, to name a couple.
Custis said: “The experience of the Scottish referendum and the General Election suggests that a short-term bounce and then back to business as usual is more likely. So do you want to back the truck up in terms of all these domestic names for a two-day bounce?”
However, Flanders said the environment of the past few months, with a stabilisation in commodity markets and emerging economies, should favour the UK: “Would the UK have looked more attractive had it not had the shadow of the referendum? It has done poorly and is now relatively more attractively valued. I wonder whether we would have seen the UK mega-cap companies doing better. Equally, when we look around, most investors are not looking for capital growth, but for income. On this basis the UK market looks very attractive.”
In the end, said Lowcock, it may come down to the data that emerges after the vote, whether business investment and consumption recovers. He said: “We will need to see what economic data shows. Economic data has been a bit softer and it is clear from consumption data that the oil price fall has gone into household pockets, rather than the shops. We need to see a more confident UK to see a step-up in UK assets.”