As investors, there are two ways of handling the risks and opportunities that Brexit will create. The first is to pay no attention at all and to focus on the long-term factors that affect returns. The second is to trade the market vigorously, attempting to pre-empt the effects of every development.
Brexit has mattered and will matter for the UK economy, the currency and the stock market.
However it is important to recognise that the UK’s relationship with the EU is not the be all-and end all which some newspaper columnists and politicians suggest. There are much more significant threats to investors - a US recession, an EMU crash, a Chinese debt crisis - which could seriously affect the world economy and therefore UK-based companies. Conversely, the opportunities from technological developments such as artificial intelligence, machine learnings, robotics and autonomous vehicles have the capacity to be game changers. Furthermore, the UK stock market contains many companies whose business model will not particularly be affected by the outcome of Brexit. Some of the biggest FTSE 100 constituents are global mining or energy companies with very few operations at all in the UK.
Taking a view on sterling
If an investor is worried by the potential impact of Brexit on their portfolio, then it is necessary to become a currency analyst. The FTSE 100 group of companies derives about two thirds of its revenue from operations outside the UK, compared with about half for the FTSE250 companies. Hence a weaker pound versus the dollar and euro is, generally speaking, a positive for larger company earnings, as these revenues are worth more when converted back to sterling This is particularly the case for such sectors as health care (where foreign revenue exposure is over 85%), industrials (about 80%), energy and commodities (about 70%). The exposure is much lower for other sectors such as utilities and financials (about 30%).
Forecasting currency moves is never easy as a ream of factors - economic, political, monetary, behavioural - need to be taken into account. Nevertheless, there is a consensus view at present amongst investors. If the outcome from Brexit is seen as very ‘bad’, then sterling is expected to slide versus the dollar and the euro. However, a weaker pound will boost corporate earnings estimates for many firms, and paradoxically therefore parts of the UK stock market would be expected to rise. Buy FTSE100 versus FTSE250, and buy energy versus utilities would be examples of trades to examine.
The reverse is the case, of course, if the outcome of the Brexit negotiations is seen as a ‘good deal’ compared with market expectations. On that basis, the pound would be expected to rally, as political uncertainty declines and overseas investors are more interested in buying, for example, UK property. Hence smaller and more domestically focused UK companies would benefit in relation to their larger more global brethren.
Such currency analysis does need to be put into context. Despite Brexit coverage dominating the newspapers, the pound is actually broadly flat year to date against a basket of its major trading partners. Sterling started the year at 1.35 to the dollar, and is currently 1.30 – with a range as wide as 1.27-1.43 over this time. The effects of such wide moves on import prices and therefore headline inflation and consumer spending have already been seen. The fall in sterling in the wake of the Brexit vote made imports more expensive, which resulted in inflation rising to a six-year year high of 3.1% towards the end of 2017. How are investors positioned on the pound? It appears that the majority of investors are negatively positioned, but not aggressively so. As one broker recently said: “markets remain reluctant to chase the constant flow of Brexit headlines”.
Brexit isn’t everything
The pound is by no means the only factor likely to affect the UK stock market in coming months. Traditional factors that investors take into considerations mustn’t be ignored. One example is the relative dividend yield of the UK versus many of its global counterparts. UK companies currently provide the highest dividend yield of all the major national or regional markets. Hence the ability of UK firms to cover those dividends will matter, so company taxation and regulation are important issues. Meanwhile, movements in the US dollar, Chinese policy making or Middle Eastern politics have strong implications for oil and other commodity prices, an important sector within the UK market. Thirdly, the UK equity market has a lower weighting towards technology than say the US or Asia, so it will rise and fall as sentiment alters towards that sector.
As ever, market movements are likely to be dictated by expectations. Markets will go up or down depending on the extent to which any deal is judged as ‘good’ or ‘bad’ against these expectations. Financial markets are forward looking, they are constantly assessing the likely outcome against a range of scenarios. For example, how the pound, the stock market or government bonds perform between today and end March 2019 will partly depend on whether any news slowly edges into the market over a period of weeks, or whether there is a cliff edge shock, say in March 2019. We are examining a range as broad as 1.10-1.50 for sterling versus the dollar in coming months, but just as important as the edges of the range would be the speed of movement and how quickly this feeds into second round effects such as confidence.
All in all, we expect investor sentiment to wax and wane in the coming seven months, as a stream of news, views and announcements about negotiating positions appear. It is important to recognise that even if there is an agreement by March 2019 that will not be the end of the trail. Whether there is a transitional period or a return to World Trade Organisation rules, uncertainty about the details of the future relationship, and what is happening in domestic politics, is likely to persist.