Heartwood Investment Team
What are our expectations for UK financial markets?
A higher risk premium across UK financial markets is likely to persist in the interim to June 23rd, with sterling most likely to be the lightning rod. We have already observed the UK currency’s meaningful depreciation since David Cameron announced the new settlement with the EU, having fallen 6% on a trade-weighted basis since the start of the year. UK equities and gilts have remained fairly resilient so far, swayed more by global considerations: the US interest rate cycle, China and commodity prices. Nonetheless, Brexit headlines between now and June have the potential to create toxic vapour that are unlikely to be helpful to UK financial markets.
And what happens after 23rd June?
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It is obviously difficult to predict the electoral outcome, but also since there is no precedent we should be wary of making sweeping statements about the potential financial market implications. The referendum in 1975 perhaps draws more political rather than investment or economic comparisons, in light of developments in the global economy over the past two decades.
We assume that a vote to stay in the EU would be seen by investors as largely business as usual and greeted with relief, much in the same way as the post-relief rally following the Scottish referendum result in 2014. There could, however, be questions about a second referendum if the result is far from decisive, which could add to market uncertainty in the longer term.
Broadly, though, the proposed agreement with the EU does not appear to change the economic framework to any great extent, nor does it appear likely to significantly impact the inward flow of European labour, which has helped to keep UK wage growth relatively modest, to the benefit of the corporate sector. Overall, therefore, a vote to remain within the EU on renegotiated terms would be taken as a net positive by the markets, especially in light of the UK’s current account deficit of 4.2% of GDP and the UK’s high dependence on foreign capital flows to fund it.
We expect some of the risk premium being built into UK assets, particularly sterling, to unwind. The UK gilt market may sell off moderately, particularly if there has been a risk off trade in advance of the decision, but longer-term economic fundamental dynamics will continue to drive bond yields, which should be ultimately positive for gilts, and in particular there would be no clouds overhanging the UK’s sovereign credit rating. The UK economy is performing adequately, and the recent weakness in sterling will go some way to improving the terms of trade, which clearly deteriorated in recent months as sterling, on a trade weighted basis, appreciated. Investors will also, as ever, prefer the certainty of the new regime over the current uncertainty, which, all other things being equal, should help the bid for sterling assets, including gilts and equities. Finally, UK property assets should also enjoy continued support from overseas investment flows.
What if the UK votes to leave the EU?
The consequences of leaving are of course more uncertain, both in terms of the mechanism of leaving (which has not been tested) and the length of time to achieve it; although two years is timetabled, it is open to question as to whether this is achievable. The negotiations could be messy and protracted, and the EU will want to maintain a firm hand to avoid encouraging other potential exit candidates. Furthermore, we would expect UK economic growth to contract if external demand for services weakens and confidence is undermined, resulting in slower consumption that might hurt growth, employment and wages.
The price action of sterling is largely driven by monetary policy and capital flows and on this basis we would expect the UK currency to stay weak on concerns about Bank of England deferring interest rate hikes, concerns of capital flight and uncertainty on the credit rating outlook. As these concerns are assuaged and depending on the level of sterling reached, we would have a more optimistic cyclical view of the currency over the longer term, as ultimately we see no significant lasting damage to the UK economy.
UK Fixed Income
In theory, an ‘Out’ result would be negative for the UK gilt market since there will be questions around the UK’s ability to maintain its AAA sovereign credit rating (although ultimately we do not believe this to be a significant factor) and the threat of capital flight, given the UK’s rather sizeable current account deficit which needs to attract foreign buyers.
However, in reality, there will probably be few places to hide among UK assets, and gilts may offer the safe haven, risk-off trade, particularly if Bank of England interest rate hike expectations are pushed back as a result. The gilt market is a predominantly domestic-owned market, notwithstanding that foreign ownership currently stands at an all-time high. We expect the Bank of England to counter the negative effects of any potential international selling of gilts as it has the capacity to absorb non-domestic-owned bond sales through a new round of quantitative easing. Such action could be justified on the basis of the need for central bank support to lower funding costs through the transitional period of the UK leaving the EU.
From a yield curve perspective, shorter-dated bond yields could outperform as the risk premium at the long end increases on the overall business and economic uncertainty, a weaker sterling and the potential for the UK to return to its more inflationary past.
More than half of the UK equity market is owned by overseas investors and it could be vulnerable to weaker sentiment in the short term, particularly among financials and exporters to Europe. That said, large-cap UK indices are driven more by global factors and heavily skewed toward cyclical sectors, such as mining and energy, which are in aggregate beneficiaries of a weaker sterling. Over the longer-term, uncertainty is likely to weigh on the financial sectors, as investors struggle to understand any new regulatory regime.
Further down the market-cap spectrum, domestically-exposed small and mid-cap stocks could see more pressure on the basis of the economic uncertainty presented by a Brexit scenario. In addition, import costs for these companies could rise, due to the deteriorating terms of trade, which would squeeze profit margins.
In the coming months, we would expect a period of subdued activity as overseas investors wait to see how the referendum campaign evolves. However, post June we would expect flows to pick up as international investors take advantage of the fall in sterling, and on the view that any exit will take time and is unlikely to prove damaging to UK asset values in the long term.
What is the likely impact of Brexit from a European perspective?
Clearly if the UK were to leave the EU, we would expect headline noise questioning the validity of the overall EU project. German assets would most likely see a safe-haven bid for euro-based investors in the short term, as equities and bond markets in periphery countries (for example, Spain, Italy and Portugal) could be vulnerable, although a weaker euro could prove beneficial over the longer term to the euro-area’s external economy.
There must be some possibility that discussion over Brexit creates the domino effect of other countries seeking to leave the EU, though this is not our central case. However, we do think that a Brexit outcome might create an opportunity for countries to advance their own individual agendas and renegotiate their own terms of membership with the EU. Overall, we are not expecting the EU to fracture as a result of Brexit, but it could well raise tensions within Europe. At the same time, however, the UK’s exit could strengthen the European Parliament’s hand in leaning towards further progress in areas such as fiscal integration, regulation, taxation, subsidies or investment programmes.
The UK’s potential departure would create a funding gap that would have to be filled by other countries. In 2014, the UK’s net contribution to the EU’s budget was €4.93bn, or 19% of total net contributions. Current net-contributing nations may push for expenditure cuts, while net receivers may ask other countries for greater contributions. Future budget negotiations would therefore have a further layer of complexity. These issues could raise questions around the impact on funding costs of EU supra-national borrowers. For example, could a potential UK departure and the associated loss of UK guarantees lead to ratings downgrades for the EU and the European Investment Bank and thus increase their borrowing costs? It is possible, but in the current climate we expect the impact may be marginal.
Brexit would likely have far smaller financial repercussions compared with the exit of a eurozone country, since the UK has its own currency and fast outflows of bank deposits would be far less likely. With much of the UK exposures most likely funded in sterling and therefore hedged against the currency risk, it would take a very large and persistent swing in the exchange rate, and potentially large-scale defaults in the UK, to actually create a significant impact negative on the rest of Europe.
Finally, how are we positioning portfolios?
While we are cognisant of the risks of the UK leaving the EU, we are not specifically re-positioning our portfolios in anticipation of such an outcome. Other global factors remain more significant drivers of financial market performance – China rebalancing, Federal Reserve tightening and commodity prices.
In any case, we have for some time maintained an underweight exposure to UK equities and to sterling. Our view on sterling was based on expectations of UK interest rates staying low, the higher valuation of sterling after a period of significant strength, and the relative interest rate differential with the US that was likely to favour the US dollar. In the gilt market, we are maintaining a short duration position based on our longer-term expectations for inflation and the Bank of England interest rate cycle.
We have also held a long-term positive view on the UK commercial property market, which has benefitted from supportive supply/demand dynamics and low interest rates. The property cycle is maturing and we would, in any case, expect to be reducing our exposure to this sector through the year, and headline noise surrounding Brexit is also likely to prove a headwind.
In summary, our positioning in assets most exposed to Brexit risks is:
- Underweight sterling, not solely on Brexit but in response to global factors including Federal Reserve tightening and the significant appreciation that sterling has experienced over the past year or more.
- Maintain short duration position in UK gilts, with a bias towards shorter-dated bond maturities.
- Underweight UK equities from an asset allocation perspective, but within UK equities we are holding higher exposure to large-caps versus small- and mid-caps.
- Maintain exposure to UK commercial property, but with a view to reducing this allocation to reflect the maturing cycle, rather than as a reaction to Brexit.