Investment insights from 1825 – Brexit
Colin Dyer | February 26, 2019
Time to read: 6 minutes
What does Brexit uncertainty mean for 1825 investors?
Countdown to Brexit
As Theresa May continues negotiations on her Brexit deal, less than six weeks remain before Britain’s scheduled divorce from the EU. It looks a formidable task for the PM as she seeks to rewrite an agreement that has been over two years in the making, especially as EU leaders appear inflexible regarding amendments and negotiations.
The yet to be defined “alternative arrangements” focus heavily on an agreement for an Irish border backstop, perhaps the main bone of contention going forward. The much maligned backstop is intended to prevent a need for further checks on the Irish border, keeping the UK in a customs union with the EU whilst also maintaining that Northern Ireland stays in the bloc’s single market for goods.
Even with relatively little time to go before negotiations need to be completed, there are still various permutations that can play out before 29 March. A base case scenario would be that we do leave the EU with some kind of deal, although what this would look like is still up for debate. The PM could well be forced to accept a “Norway Plus” deal that could be best for both parties. This could be the most soothing outcome for UK financial markets which notoriously abhor uncertainty. If a deal is struck that does not majorly disadvantage either side, we could expect to see sterling trace its way higher, acting as a disadvantage to those blue chip, global earners, who report foreign revenues in sterling. In this scenario, we would expect more cyclical midcaps to outperform as consumer confidence and business investment start to reignite, driving those companies that have underperformed on a relative basis higher.
To counter this, if the government fails to reach a deal, resulting in a “no deal” or hard Brexit, we could see many of the issues that have plagued domestic UK markets continue, as uncertainty prevails. Conversely, we could see sterling sink, allowing the FTSE 100 to rally, much like it did during the events shortly after the initial referendum to leave the EU, back in July 2016.
When looking at how asset prices may respond to different Brexit outcomes, it’s a helpful exercise to examine how they have reacted to various news flows in what has been a fractious period in UK politics. Remember, past performance is not a reliable guide to the future.
Sterling continues to be the main instrument through which investors have voiced their opinions on events in Westminster and Brussels. From what seemed to be a kneejerk reaction in the immediate aftermath of the referendum result in June 2016, sterling tumbled 10% from a level of around $1.50, recording its largest daily fall on record. As previously noted, markets do not cope well with uncertainty and it was no surprise to see sterling fall to its lowest point ($1.21) after the Conservative Party conference in October 2016, when Theresa May signalled that Article 50 would be triggered without shedding any light on what a prospective deal would look like. Since its nadir, the pound has slowly traced its way back up, settling at the $1.30 mark as we head into the final few months of negotiations.
The overall headline for the UK equity market has been for a broad move higher since the EU referendum. While the initial 24 hours after the referendum saw steep declines for both large and mid-cap equities, both the FTSE 100 and 250 actually traded at higher levels today than they did just prior to the event. Although the UK economy has remained surprisingly robust, domestic benchmarks have enjoyed a backdrop of synchronised global growth and strong returns across the equity universe in 2017.
However, if one digs a little deeper into the underlying constituents of the UK stock market, it is clear there is a two-speed market emerging. Companies which derive significant portions of their revenue from overseas have performed strongly; culminating in all-time highs during the summer of 2018. This has been driven, in part by a fall in the value of sterling. As these companies translate their foreign earnings back into sterling, they benefit from the now weaker currency.
More domestically focused companies have lagged on a relative basis to their blue chip peers. A powerful concoction of higher inflation, slowing business investment and weaker consumer confidence in the UK has led to nervousness around the stability of UK PLC. Indeed, outflows from mid-cap equities in general has been a trend since the referendum, with fund manager surveys regularly showing allocations to both indices at their lowest levels for years. Today the majority of the UK equity market trades on valuations below its long-term average, reflecting investor sentiment that the outlook for the economy is unclear.
There have been many scaremongering headlines surrounding residential property prices, which, to date are yet to fully materialise. National house price indices have shown growth in both 2017 and 2018, however, the rate of growth is decelerating. On a more regional level, areas of London and the South East have actually seen prices fall. These areas are viewed as more exposed to a potential exodus of jobs, while valuations were also elevated after very strong growth in 2013 and 2014. The residential market has also faced headwinds from tax changes relating to stamp duty and buy to let legislation, which has put downward pressure on prices. Demand for office space has actually remained robust, with many transactions exhibiting rental growth and office vacancy rates remaining low. This has been countered by a very difficult climate for retail commercial property. A weaker consumer and disappointing retail sales has done little to support the high street, however, with or without Brexit, it appears strong structural shifts in the way we now shop are the main drivers for increased defaults and void rates on the high street.
UK government bonds (gilts) are viewed, by some investors, as a safe haven asset in times of severe market stress, although their value, like other investments, can still go down as well as up. The asset class followed such expectations during the months that followed the Brexit referendum, with yields falling below 1% on 10-year government bonds as prices for such assets rose. Such moves have been supported by an interest rate cut in August 2016. Since then the direction of travel has been broadly upwards for UK government bond yields (and therefore a decline in prices), as the economy has continued to muddle through, hindered by the Bank of England having raised rates twice during the period.
1825 Investment Solutions
Here is some detail about recent changes in our core portfolios, based on views on long term market returns, and short term challenges and opportunities.
During the last quarter of 2018, we made a number of changes to the composition of the 1825 portfolios. These changes also applied to the MyFolio range of funds. Our investment team work to optimise our asset allocations, using a 10 year forward looking view based on current asset valuations and market conditions, whilst being mindful of potential head winds on the horizon. This is all to ensure that our clients’ risk and return experience is in line with expectations. Portfolios 1, 2 & 3 have seen an increase to ‘Growth Assets’ overall whereas Portfolios 4 & 5 are mainly unchanged at the current levels.
The biggest change recommended is a reduction in exposure to US equities. When the portfolios were being re-optimised, the valuations for US equities were getting very stretched, (20% above the cycle mean) compared to other equity markets. In addition, the US dollar is currently expensive, especially against sterling, since it was sold off following the EU Referendum. If following previous trends, we believe, over the long term, this is likely to revert to mean, which could further hurt returns for sterling based investors.
A proportion of the proceeds have been allocated to UK equities which were displaying valuations 25% cheaper than their US counterparts. Therefore, with a long term view, this gap is likely to narrow closer to the historic norm which, we believe, should benefit investors. We have also made slight adjustments to European Equities (reduced) and Japanese Equities (increased), based on their current valuations and the outlook going forward.
Moving to fixed income, there is a reduction in Global Index Linked Bonds which tend to be longer duration in nature (and therefore more sensitive to interest rate movements). Part of this has been reallocated to Short Dated Corporate Bonds with the aim of reducing the portfolios sensitivity to potential interest rate movements. The other increase witnessed within this segment is to Emerging Market Debt (EMD), which is viewed as one of the most attractive asset classes. EMD yields provide a large spread when compared with those issued in developed market bond markets. There is likely to be currency volatility at times but, over the long term, we believe the asset class is well placed to provide good returns over a 10 year period. But do remember that, as with all investments, its value can still go down as well as up.
Tactical asset allocation changes
There have also been alterations to the Tactical Asset Allocation (TAA) across the portfolios. When the investment portfolio team identifies short term mispricing or market opportunities, they are able to take underweight or overweight positions to help strengthen client returns. There is now an overweight position to Global High Yield Bonds as spreads have recently widened given the depreciation in the oil price and uncertainty on global growth. The exposure is hedged which will dampen any volatility experienced via swings in the price of sterling. There is an overweight to Global REITs (property exposures), which provides a good source of yield. The other notable moves have been the reduction in overweight position to US (to neutral), Japanese and Emerging Market equities. This therefore means that the only tactical overweight’s in equities are within the Japanese and Global Emerging Market sectors.
Management of the Portfolios
The 1825 Portfolios and the MyFolio range of funds are managed with a view to consistent client outcomes, in line with their risk profile over the long term. As opposed to making drastic, short term moves, the team rely upon their disciplined risk/return approach to multi asset investing. The portfolios are backed by 19 investment professionals who bring decades of experience to the research process. The team actively meet with all underlying fund managers held within the portfolio, they held over 450 meetings during 2018. This shows that the team are actively engaging with the underlying holdings in order to ensure they continue to offer the best opportunities to meet client objectives.
This approach is being continued as we near the deadline for the UK leaving the European Union. There is still little in the way of clarity on what the final exit will look like – deal or no deal, or if the UK will leave at all. The team’s base case view is that a deal will be agreed eventually, potentially via an extension to the existing deadline. The certainty of an ‘agreed deal’ exit, paired with the current valuations noted earlier, would, in our view, act as a strong tail wind for UK equities.
The spectre of a ‘no deal’ exit does still reside in the background, although becomes more of a reality as time passes. A ‘No deal’ exit need not be a negative to UK equities, especially the constituents of the FTSE100 which predominantly generate their revenue from overseas. Under a ‘No deal’ scenario we would likely experience a sharp selloff in sterling, forcing the price downwards. This would mean that these overseas revenues would immediately be worth more in GBP terms, resulting in higher share prices.
What we have learnt from recent market events, such as the election of President Trump or the EU Referendum result itself, is that the market does not always react as expected. There are still investors who went to cash after the Referendum, who missed the subsequent market rally, and could not buy back in. There are many studies available, online, showing the potential negative impact to investors of missing key days of growth. Timing the market is a skill very few, if any, professional investors have mastered.
It’s clearly a very interesting time for investment markets, with various challenges and headwinds on the short term. Our team are working every week to analyse the markets and position portfolios with the aim of achieving the best possible outcomes for our clients. Our overall view is that our clients should maintain a strategic, long term view, rather than try to time the markets. While it can be tempting for some clients to withdraw to cash, this invariably means swapping one risk for another – the very real risk of missing out on key growth in assets, when market confidence returns.
If you have any questions, please speak to your 1825 planner, who will be very glad to help you.
The information in this blog or any response to comments should not be regarded as financial advice. If you are unsure of any of the terminology used you should seek financial advice. Remember that the value of investments can go down as well as up, and could be worth less than what was paid in. The information is based on our understanding in February 2019.