With less than six months to go until the UK leaves the European Union, charity trustees are looking for answers on how Brexit will play out. The eventual deal will affect their organisations in different ways in the years ahead, including potential access to funding streams, workers and volunteers. Yet over the long term, it’s unlikely to have a substantial impact on their investments, particularly for those with globally diversified portfolios.
Investing is a process that requires patience and commitment as well as the ability to remain calm when market conditions fluctuate. However, over the short term, many charities are concerned about the potential impact on investment performance. To help inform our decisions and give trustees the confidence to remain invested through this period of uncertainty, we’ve looked at a range of possible outcomes and how they relate to markets, economics and currencies.
We’ve filtered out the day-to-day noise in the news to make sense of how Brexit could develop over the coming year by calculating the odds of different scenarios. We start with what is perhaps the most important question. Can the UK government strike a plausible deal with the EU? We believe there is a strong probability that it can — there’s just too much at stake on both sides of the Channel.
We’ve assessed the impact of each outcome on five key asset classes – sterling, UK-listed multinational companies, more domestically focused UK companies, and both conventional and inflation-linked UK government bonds.
Brexit is not a globally significant event from an investment perspective and non-UK markets are unlikely to move in response (excluding the impact of any foreign exchange movements relative to sterling). For example, only 3 per cent of the revenues earned by US companies originate in the UK, and just 6 per cent for non-UK European companies.
When we calculate the probabilities, we find that by far the most likely result is a ‘never-ending story’. Politicians agree on the principles of Brexit but not the details. In short, they keep kicking the issue down the road. Sterling would probably rise in this case, potentially benefiting investors who own domestically focused UK shares and hurting those with foreign investments and the FTSE 100 (which predominantly comprises large global businesses with internationally derived revenues), which tend to do poorly when the pound strengthens.
According to our estimates, a hard Brexit has the second-highest probability, where the UK crashes out of the EU without agreeing the terms of the divorce. We believe a no-deal break could send sterling tumbling as low as $1.20 or more. Holders of overseas assets and large multinational companies in the FTSE 100 would probably do well in this scenario. Gilt prices could also rise in anticipation of lower economic growth.
A sterling opportunity
In the period immediately following the vote for Brexit in June 2016, sterling plunged in value. After an initial wobble, the FTSE 100 surged. That’s largely because around two-thirds of the profits made by companies in the index are generated overseas. When converted back into sterling, they are worth more when the pound is weaker.
However, the UK stock market then underperformed dramatically for the next 12 months or so as foreign investors sold UK companies indiscriminately (regardless of their exposure to UK revenues). As a result, there’s a good case to be made for a softer Brexit (or even no Brexit) resulting, somewhat counter-intuitively given what was written above, in both a stronger pound and a stronger FTSE.
That’s because the FTSE is so underowned by global investors. A recent BoA Merrill Lynch Fund Manager survey tells us that investors around the world have the most underweight allocations to UK-listed equities in the poll’s history. Meanwhile, the national accounts tell us that net outflows from UK equities were larger after the referendum than at any time since 2007.
If a hard Brexit starts to appear more likely, UK multinationals may be so under-owned that further selling could be limited and the exchange-rate effect (which would be positive) should dominate.
Weighing together the political probabilities suggests to us that sterling is likely to appreciate and UK multinational companies should also do well. Performance is likely to be unusually volatile in the meantime until one of our scenarios is realised.
There remains a risk that sterling gains could erode returns from overseas assets (if the currency risk is not hedged out). Yet we believe today’s uncertainty should not encourage investors to sell UK equities, which could mean missing out if the market rallies.