With the final leg of the UK’s departure from the European Union (EU) reaching crunch time, it is worth considering how markets might be affected when the transition period ends at the end of the year, and what impact this could have on your portfolio.
The two sides appear to have reached an impasse on issues such as access to fishing waters and state aid rules for company subsidies, and the UK government has enraged Brussels by planning to override the Brexit withdrawal agreement. While tensions are running high, it is still very difficult to know what the final outcome of the negotiations will be.
Some people think both sides are currently sabre rattling, as was always going to happen, and that they will reach an 11th-hour deal. It is, after all, in the interests of both parties that a deal is agreed and the EU has a track record of reaching agreements under the wire, the most recent being the bloc’s rescue package in July.
Others, however, think the barriers are too high and that a deal will not be agreed. Much of the support that Boris Johnson depends on comes from hardline Brexiteers, and Mr Johnson’s government seems prepared to walk away from any deal that means sacrificing UK sovereignty.
The worst-case scenario for investors, in the short term at least, is that the UK and EU default to World Trade Organization (WTO) rules at the end of the year, something that involves an array of tariffs, quality controls and rules of origin. Given that half of all UK imports came from the EU in 2019, and over 40 per cent of all exports were sold to the EU, this could be very disruptive.
Some sectors look more vulnerable to disruption than others. The average EU tariff is pretty low (about 2.8 per cent for non-agricultural products) while cars would be taxed at 10 per cent and dairy products at 35 per cent under WTO rules. Beyond tariffs, a breakdown of goodwill could have serious implications for trade where the two sides have to agree product standards and clear paperwork at borders.
The important question for investors is how this all fits in with portfolio planning. Jason Hollands, managing director at wealth manager Tilney, says: “Don’t try to position portfolios around the unpredictable nature of political events because there are too many moving parts." He views financial decisions based on the outcome of a last-moment all night summit between the EU and the UK as “punting”.
If a trade deal is achieved, however, you might see sterling rally, with a boost for UK assets more generally. Sterling is still significantly lower than it was before the 2016 referendum, and has pulled back slightly over the past week as negotiations have soured.
Investing for a no-deal Brexit
The greatest immediate impact for investors if no trade deal is reached is likely to be on the value of sterling. The pound fell by as much as 13 per cent against the dollar on the morning of the Brexit referendum result, and it would be likely to fall again if no trade deal is agreed. A falling pound increases the costs of imports and heightens inflation expectations, which could in time lead to higher interest rates.
To inflation-proof your portfolio, you could consider using inflation-linked bonds, gold and also infrastructure. Exchange traded funds can be a good way to buy bonds, with products such as iShares £ Index-linked Gilts Ucits ETF (INXG) providing inflation protection.
Before buying a bond fund check you are happy with its duration, or sensitivity to interest rate changes. Bond funds with a high duration and long average weighted time to maturity are likely to see bigger price falls if interest rates rise. Most UK index-linked bond ETFs do have quite high durations, but the Bank of England has signalled that monetary policy will remain supportive for a while, so the risk of an imminent interest rate hike feels quite low.
Another way to position your portfolio for a no-deal scenario might be to move your money out of the UK altogether. The dollar has experienced weakness of its own in recent months and faces the uncertainty of the upcoming election, but is generally seen as a safe haven currency. Peter Sleep, senior portfolio manager at Seven Investment Management, recommends JPMorgan USD Ultra-Short Income ETF (JPST) as a near-cash product. The fund targets a duration of less than one year, which could reduce your portfolio's overall sensitivity to any rise in interest rates.
Mr Hollands suggests infrastructure as an asset class that should prove resilient. The asset class, which is discussed in this week's Big Theme, can be accessed via a number of investment trusts, including HICL Infrastructure (HICL), which is in Investors Chronicle’s Top 100 funds list. Not only has the sector been supported by funding commitments from the government’s levelling up agenda, it is not cyclical due to the long-term nature of the assets in the funds. The weighted average asset life in HICL, for example, is over 27 years.
A falling pound would also boost the value of any assets you own in foreign currencies, at least in the short term. This means increasing your global equity exposure might work in your favour under a no-deal scenario. However, as we analysed last month, the impact of currencies can be quite complicated, and for long-term investors it may be sensible to take the view that currency movements will cancel each other out over time.
A fall in the value of sterling can also be a boon for large UK-based companies that derive most of their revenues from overseas. According to FactSet data, more than three-quarters of FTSE 100 revenues are made overseas, so perhaps counterintuitively the index could do well. Companies that derive the majority of sales outside of the UK and EU could, at least, make gains.
Investing for a deal
While sterling has been fairly resilient in recent months, it is still far lower against the dollar than it was before the referendum of 2016. If a better-than-expected trade deal is agreed, we might see the pound rally. Hedging foreign currency exposure could help in this scenario, but you have to pay for currency hedging and there is no guarantee that it will work in your favour.
Matt Brennan, head of passive portfolios at AJ Bell, thinks the assets that will do well under a deal are likely to be those that were worst affected by the Brexit referendum. The FTSE 250, for example, finished the year in 2016 12.4 per cent behind the FTSE 100 index in 2016. While minimal trade barriers would benefit most companies, smaller firms tend not to be as dependent on international revenues as larger ones and shouldn't be impacted as much from a rise in the value of sterling.
Investments trusts might be a good vehicle for taking advantage of renewed confidence in the UK, as most trusts investing in the UK equities have seen their shares trade at larger than average discounts to the value of underlying assets. Broker Winterflood’s UK small-cap sector, for example, had a weighted average trust discount of 12.5 per cent on 10 September, compared with a 12-month average discount of 7.2 per cent. Henderson Smaller Companies (HSL) might be a good play if a deal is reached, as over 60 per cent of the trust is invested in FTSE 250 assets and manager Neil Hermon has a good long-term performance record. The trust was trading at a discount of 16 per cent on 11 September – much wider than its average discount of 6 per cent.
Mr Sleep points out that European equities should also benefit from a comprehensive trade deal with the UK. Any funds with a weighting towards industrial goods, automotives and clothing are likely to be those most positively affected, although the benefits could be marginal.
The bigger picture
The UK has been preparing for Brexit for the past four years, so Mr Hollands believes that whatever the outcome, it is unlikely to disrupt markets to the same extent as we saw in 2016. He believes that uncertainty is currently priced into the value of UK assets and as the UK market is very international, a pick-up in the oil market would be likely to move assets more than Brexit.
The UK has had to deal with a pandemic, lockdowns and an economic contraction of over 20 per cent. If countries are forced back into lockdown should the pandemic flare up again, that is also likely to have a more significant market impact than Brexit.
It might be sensible under any scenario to make sure your portfolio has inflation protection. While inflation is not a current problem, all the stimulus that has been pumped into the global economy drives a real chance of inflation in the medium term when demand picks up. Governments also have a vested interest in encouraging inflation, as it helps with paying off enormous debt burdens. As well as inflation-linked bonds, gold provides a more speculative inflation hedge.
As always, it’s advisable to have a diversified mix of assets in your portfolio to minimise the impact of unpredictable events.
