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Brexit: The week that was

DIn the largest government defeat since 1924, Prime Minister Theresa May’s Brexit deal was overwhelmingly rejected by MPs by 432 to 202 earlier this week. Almost immediately the opposition Labour Party called for a motion of no confidence in the government, which was narrowly defeated (325 to 306) thanks to the support of the prime minister’s “confidence and supply” partners the Democratic Unionist Party (DUP).

But with the government now engaged in “cross party talks” and with plans to unveil the next steps on Monday 21 January 2019, the team at Quilter Investors highlights their thoughts on the effects Brexit week has had on markets and investors.

How have markets reacted?

Market reaction was initially positive after the deal vote with sterling rallying, despite warnings that a huge defeat could be negative for the currency. Of the 400 or so MPs that voted against May on Tuesday, around 300 of them appear to want a softer Brexit, which lays the foundation for a cross-party solution, perhaps including extra assurances around worker rights to secure opposition support.

This is possibly why markets have taken the vote in their stride. UK equity markets also remained steady on Wednesday morning, with a small move upwards at the open slightly retracing to remain flat, despite the possibility of a no deal also increasing. Equally, with the government having been expected to win the no confidence vote, markets have remained relatively sanguine. As a result UK small and mid-cap domestic stocks have continued to appreciate – retracing losses from December – as the likelihood is more of a no Brexit at all than a no-deal scenario and markets are taking comfort from that. This shows just how quickly the political landscape can shift and how dangerous betting on binary political outcomes can be.

That said, while international investors might be watching Brexit unfold with interest the resulting outcome of a soft or hard Brexit or no Brexit at all is unlikely to have a material impact on the global economy given that the UK accounts for just 3% of global GDP. Equally, the UK is a small part of the much wider global equity markets that are likely to be influenced more by a variety of other events, such as a slowdown in the US and China and the ongoing trade war situation.  

Will Brexit be delayed and is this being priced into markets?

While a cross-party consensus on a softer Brexit that would be positive for both sterling and UK mid-caps might still prove too hard to reach, and we could slip back to a no deal outcome, any solution is likely to take more time than we currently have. This could particularly be the case if the House of Commons has to resort to new methods such as indicative votes on the preferred way forward, or a second referendum is called. Therefore markets appear to already be pricing in a delay to the implementation of article 50 to prevent us crashing out of the EU without a deal at the end of March, which can also go some way to explain the relatively neutral reaction to Brexit events.

How will sterling be affected in the different scenarios?

The Bank of England has stress-tested the currency for a no-deal scenario and in the worst case sterling could fall 25%, mainly due to the costs associated with the disruption around customs and tariffs. Analysts suggest sterling may not fall that much, but probably still in double digits, in a no-deal situation, which would still pose an issue. Weaker sterling is likely to lead to higher inflation, which in turn could see interest rates increase. But this would then affect consumers, particularly homeowners with mortgages, and so it becomes a difficult balancing act.

In anything other than a no-deal scenario sterling is likely to appreciate. However, given that markets have already started to price in a softer Brexit, the likelihood is sterling will appreciate less than it would fall in the event of a no-deal.  Sterling would also be expected to suffer worse than the euro in a no-deal situation, on the basis that it is one country versus 27 and our economy would be expected to take a 10% hit to GDP over time. However, that’s not to say the euro won’t suffer, as it would probably depreciate against the dollar.

What should investors be doing?

While it is understandable to want to take action in periods of uncertainty, often the best action is to do nothing at all. The biggest concern in the short term is political uncertainty, not just in the UK but also around the world. This could lead many investors to consider panic selling and moving to cash but with such low interest rates and inflation of more than 2% the real return is negligible.

No-one has a crystal ball, so it is less about timing the market and more about stacking the probability in your favour, and positioning for multiple scenarios to mitigate against unexpected market events. However, we’re in the late stage of the cycle so the potential for growth and profits is lower, while the potential volatility is higher.

Many investment opportunities only appear after a period of fear, however, which what we saw in the final three months of last year. People desire security, but not being invested can count against you, and in these periods of uncertainty and volatility is where you find there are more opportunities if you are willing to diversify and look globally.

What will happen in a no-deal?

Markets haven’t yet priced in a no-deal situation, so if that happens markets will fall further. They do however, appear to have priced in a difficult time ahead, particularly for UK domestic companies, so anything other than a no-deal will be positive and investors should see potential upside for these companies. However, in a no-deal sterling would almost certainly depreciate and UK domestic stocks, particularly in the small and mid-cap space would suffer further. There would also be an impact on capital expenditure and investment by companies. They have already been hesitant to spend their money in this uncertainty and a no deal scenario is likely to make them only more hesitant.

What are the biggest risks?

Political uncertainty is the biggest risk, and while at this stage a Corbyn government looks unlikely, it remains one of the possible tail-risks as his policies are decidedly un-market friendly and would likely result in weaker UK asset prices, including the currency.

Where are the opportunities?

While the UK is part of the world, it isn’t the whole world, and so there are lots of things to take into consideration and lots of opportunities on offer. We look for good quality businesses and assets diversified across the globe, which includes both UK domestic stocks and certain European companies. Equally there is the ability to invest in absolute return strategies and globally diversified bonds to spread the risk. We also have a high weighting in assets overseas, so if we do get a no-deal scenario and sterling depreciates then this positioning would be beneficial.

In 2018 the global economy and corporate profitability grew, yet 90% of asset classes fell highlighting the irrational nature of markets last year. The impact on share prices of an earnings miss was estimated to be an average 20% fall, which was a figure last seen in the midst of the financial crisis.

Many investors will have started last year, after a strong 2017, optimistic about growth and returns, before being disappointed and having to rebalance their thinking. However, a lot of the bad news has now been priced in and the increased volatility has actually made valuations in certain asset classes more compelling.

For example UK small and mid-cap stocks have suffered, not just from Brexit but from changing consumer trends, yet they are now lowly valued and underowned, which makes them an attractive opportunity, particularly as anything other than no deal is likely to be supportive and push them higher.

What happens next?

Uncertainty remains the watchword of UK politics, as we have a government that can’t get its flagship deal through parliament, while cross-party negotiations to find a deal are being hampered by the fact that the prime minister won’t currently bend on any of her “red lines”, while the leader of the opposition Labour Party has warned “positive discussions” can’t begin unless the government rules out a no-deal Brexit.

With no clear reassurance that a stable resolution can be reached, it is likely that asset prices will continue to reflect the extreme uncertainty that prevails in UK politics. Sterling will remain sensitive to changing rhetoric and, should the likelihood of a no deal increase significantly, the coming weeks could prompt significant shifts in UK asset prices and potentially move markets.

That said, for long-term investors it is crucial to take stock of the big picture. While uncertainty is clearly a concern for business leaders, the fate of UK listed firms is not totally reliant on the domestic economy. UK large cap companies derive a huge share of their revenues from overseas operations, and many have in fact benefited from sterling weakness, which may boost their competitiveness.

Risk events with an unknown outcome such as this are a perfect example of the importance of diversification and a global outlook for investors. When one region or asset class faces a period of uncertainty, diversification is an investor’s built-in defence.

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