At 29th of March 2019, the United Kingdom is meant to exit the European Union. Whether the “Brexit” will be a soft one or a hard one has been on everyone’s minds ever since the 2016 referendum was narrowly won by those who wanted to leave the EU.
Since the day of the referendum, British asset prices have gyrated. The British Pound Sterling dropped from 1.50 right ahead of the referendum to close to 1.20 at the start of 2017, since recovering back to around 1.40. Similar numbers were seen for UK government bond yields, while UK stocks have been on a generally upwards trajectory.
In case of a soft Brexit, expect more of the same and no further big shocks, though with some sectors faring better than others and some outright profiting from the new dynamics. In case of a hard Brexit however, brace for volatility in any UK related assets.
First things first: what dates matter for Brexit?
The key dates in the Brexit process to keep in mind are the following ones:
- March 2018. Target date for agreeing on a transition dea
- April 2018. Target date for trade negotiations to start
- October 2018. Target date for agreeing on a withdrawal treaty
- 29 March 2019. Britain exits the EU and the transition period starts, possibly lasting all the way to the end of 2020
What are the risks and opportunities of a hard Brexit?
Whether in the longer term Brexit is a good or bad thing for both the European and British economy is still very much open for debate. Clearly the markets were not happy on the day of the referendum itself, but given that assets like GBP, UK GILTS and equities have either strengthened or at least undone much of the damage since then, it’s not unfair to say that an ambitious free trade deal – which is currently being aimed for on, as one presumes, both sides – would soothe many longer term concerns for the British economy. Currently a soft Brexit is being priced in.
What is also sure however, is that markets do not like surprises, and currently a hard Brexit would firmly fall into that corner, despite it being frequently talked about. On a macro level, a nasty Brexit surprise or an outright hard Brexit announcement anywhere between now and March 2019 would mean an instant weakening of GBP against all of the majors but predominantly USD, JPY and EUR. It would also lead to gains in UK GILTS and US Treasuries, while emerging market currencies may suffer as part of the stereotypical flight to quality. But any moves not directly related to the UK are likely to be short-lived, if June 2016 and other similar stress events are any guide for the future.
Assets to avoid in case of a hard Brexit
UK stocks with mostly domestic exposure. UK stocks with mostly domestic exposure will not do well if economic conditions deteriorate, while UK stocks with large EU exposure would be hard hit. Agriculture, services and manufacturing are simply best avoided
UK Property. If demand for commercial real estate falls as global business vacate the UK for continental Europe, property prices and REITs will naturally drop.
GBP vs majors. Pound Sterling is likely to weaken against USD, EUR and JPY in case of a hard Brexit
So what should you invest in?
UK stocks with non-EU international exposure. Stocks with significant international but non-EU exposure will be expected to do well in case of a hard Brexit and weakening GBP. Examples are the mining and telecom sector.
UK GILTS. GILTS are seen as a safe haven asset, and post the Brexit referendum went up in value as rates declined. If that trend persists you will see the same thing, with subsequently things moving back to the way they were. Of course, if the Brexit news is sufficiently bad you could see the UK’s safe haven status being put to question, but no one really foresees that.
European financials. with banks, asset managers and insurance companies potentially moving jobs and activities out of the UK into continental Europe, and some competitors potentially not being able to serve the mainland anymore from London, European financials may gain new business.
How likely is this theme to play out?
I’d say the chance of a hard Brexit at the moment is somewhere between 25% and 50%. I actually reckon that most people underestimate the probability of this happening. If you are a British investor I’d say the key thing you need to do is diversify internationally as much as possible.
If you’re a non-British investor the safest thing may be to stay away from British assets as a whole. Why run the risk? If however as an international investor you want to position for UK assets that should be able to weather the hard Brexit storm, below portfolio will meet your requirements. I’d allocate anywhere between 0% to 5% to this theme and hold on to it until mid-2019.
Portfolio construction: long mining/telecom, Europe financials, GILT, short GBP
- The hard Brexit portfolio contains British mining and telecom stocks, as these have relatively little UK exposure and thus would benefit most from a weakening GBP
- European financials should benefit in case the position of the City of London weakens, while GILTS will strengthen as a safe haven. While other safe havens will likely mean revert, GILTS could be expected to stay at the stronger levels for a while longer
- As all of these assets except for European financials are GBP denominated, you’d have to hedge out some of the currency risk. The short GBP ETF serves this purpose (ideally you would use a derivative such as an FX forward here instead so that it doesn’t eat up cash allocation, but this does the job too)
|Short GBP||ETFS Short GBP Long USD ETF||SGBP||0.39%||30.0%|
|UK mining stock||BHP Billiton Plc||BLT||-||20.0%|
|UK mining stock||Glencore Plc||GLEN||-||12.5%|
|UK Telecom stock||Vodafone Plc||VOD||-||12.5%|
|UK GILTS||iShares Core UK Gilts UCITS ETF||IGLT||0.20%||10.0%|
|European financials||iShares MSCI Europe Financials ETF||EUFN||0.48%||10.0%|
|UK telecom stock||Sky Plc||SKY||-||5.0%|
Risk, diversification and allocation
- Risk level: medium to high
- Diversification: medium
- For risk and total return since initiation see Portfolios
- Probability of this theme playing out in the next 3-10 years: 25%-25%
Portfolio characteristics (full look-through, from USD perspective)
- Dividend yield: 2.45%
- Ex-ante predicted volatility: 10.0%
- 1 year 95% Value-at-Risk: –15.1%
- Scenario: 2008 Lehman Brothers default period: -15.3%
- Scenario Interest rates +100bps: +4.4%
- Scenario 2008-2009: -7.7%
- Scenario 2010 onwards: +49%
- Scenario Equity up +10%: +9.6%
- Brexit replay (23 June 2016): -3.7%*
- Brexit replay (23 June-23 July 2016): +0.9%*
- Brexit replay (23 June-23 Sep 2016): +5.4%*
* European financials were hard-hit, as were Sky and PLC (all returning worse than -11% on the day). My premise behind all of the above is that in case of a hard Brexit, over the longer term the benefits to these holdings would become apparent. In the second longer Brexit scenario this becomes apparent.