Brexit Minister, Dominic Raab, told BBC Radio 4’s Today programme last week that the Government would be releasing a series of papers outlining preparations for a ‘no deal’ Brexit. So, with so much uncertainty and speculation, should investors still hold UK assets?
There’s no doubt that Raab faced a difficult task: to show the Government was preparing for all possible eventualities without adding fuel to either side of the Brexit debate. How well he navigated the challenge will be determined in the coming weeks and months. But what we do know, is that with ongoing uncertainty comes market speculation and, for investors, questions about what assets they should hold.
Over the summer we have felt the possibility of a ‘hard Brexit’ has increased, albeit from a low starting point, and we still consider a ‘soft Brexit’ the most likely outcome. So, if we take that as the ‘base case’, what happens next?
The UK currency is likely to recover, which would cause UK equities to underperform other global indices. Government bond yields are likely to rise since, as along with the currency, Brexit uncertainty will have an impact.
Portfolios with additional exposure to the UK currency, which had depreciated heavily against the Euro on fears of a harder Brexit, should benefit from a stronger pound. At Nutmeg, while we’re underweight in UK equities, we have also chosen to underweight European equities in our client portfolios, favouring the US and emerging equity markets. In effect, the global equity themes we are exposing clients to – expanding global growth and trade – operate at a ‘higher level’ than the nitty-gritty of the EU-UK negotiation. We have also hedged large amounts of the US equity exposure back into the pound, reducing our ultimate exposure to the US dollar.
But what if our base case does not materialise?
Conversely, a harder Brexit is likely to lead to further weakening of the pound. In this case, large (global) companies based in the UK will be able to repatriate overseas earnings at the cheaper exchange rate. So, owning a diversified FTSE 100 basket of stocks should provide some level of protection within diversified portfolios.
Portfolios that are underweight in UK equities overall, like the ones at Nutmeg, are likely to fair better under a hard Brexit if they favour larger companies over smaller ones. Not only do small companies earn a greater share of revenue in the domestic economy, but they are likely to have less managerial experience across different legal jurisdictions and less resource to cope with the business environment shock of losing access to the EU market.
Meanwhile, global investors are already extremely underweight in the UK equity market, so we think extensive new selling of FTSE 100 by foreigners would be unlikely even on a hard Brexit. Conversely, there is good reason to expect renewed interest in UK equity assets after a soft Brexit, given the underweight position of global investors and the cheap pound.
So, should we discard all UK assets?
Structuring client portfolios is not a matter of putting all your eggs – or assets – in one proverbial basket – or in this case, backing only one outcome. Rather, it’s implementing base views within diversified risk-rated portfolios and to use risk/reward considerations to add asset allocation nuance around the base case. UK large-cap equities are a good example of this nuance.
At the moment, the balance of risks favours a soft Brexit. If developments over the coming months result in a change in the base case, investors should take this into consideration when they review their asset allocation.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.