With so much uncertainty and speculation, should investors still hold UK assets?
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.
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. For investors, this raises questions about what assets they should hold.
Although speculation about the possibility of a ‘hard Brexit’ has mounted over the summer, we still consider a ‘soft Brexit’ the most likely outcome.
So, if we take that as the base case, what happens next?
In the event of a ‘soft Brexit’, the pound is likely to recover. This would impact companies that generate a high proportion of revenues overseas, as these will be worth less when translated back to sterling. These companies make up close to 70% of the FTSE 100 index.
Government bond yields also have the potential to rise from current levels, which reflects the ‘Brexit pessimism’ that is priced in.
While sterling has depreciated heavily against the euro on fears of a harder Brexit, portfolios with a high exposure to sterling should benefit from a stronger pound.
At Nutmeg we are running underweights in UK and European equities (relative to the index) in our clients’ portfolios. Meanwhile, we favour US and emerging market equities. In effect, the global equity themes we are exposing clients to – expanding global growth and trade – operate at what we would describe as a ‘higher level’ than the nitty gritty of the EU-UK negotiation.
Although we are broadly positive on US equities, we have concerns about the US dollar. As we suspect a soft Brexit will result in a stronger pound, we are hedging against a fall in the value of the dollar against the pound.
What if our base case does not materialise?
Conversely, a hard Brexit is likely to lead to a 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 index 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 fare better under a hard Brexit if they favour large companies over small. Not only do small companies earn a greater share of revenue domestically, 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.
Global investors are already extremely underweight UK equities, so we think a fresh wave of selling FTSE 100 stocks by foreign investors would be unlikely in the event of a hard Brexit. Conversely, there is good reason to expect renewed interest in UK equities 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 about considering the macro and micro economic factors that impact a particular outcome, positioning asset allocation and diversification within portfolios accordingly.
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.
Brad Holland is director of investment strategy at Nutmeg
As with all investing, your capital is at risk. The value of your portfolio 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.