UK investors can't ignore Brexit. Brexit will be one of the most important drivers of return in your portfolio over the next few years, so it is worth getting your portfolio prepared. Unfortunately nobody knows how Brexit will unfold and so you have to manage this uncertainty by considering the alternatives and their likelihood. Here we provide a structured approach (and a spreadsheet!) that helps you decide which outcomes are most likely and position your portfolio in line with your beliefs.
The further ahead we look the more conditionals we have to assume, so this is a very crude map of the future path of Brexit. A key date was November 2018 by which time the EU said a deal must be agreed.
- December 10: Parliamentary vote on the Brexit deal (expected to be held before the next meeting of the European Council on 13 December).
- December 13-14: Last EU Council meeting of 2018. If a deal is on the table it has to be agreed by more than half the leaders of member states representing at least 20 of the other 27 EU countries.
- March 29 2019: Brexit Day when the UK officially leaves the EU. If there is a deal then a 21 month transition period would begin. If not then the UK will "crash out" of the EU.
- December 31 2020: End of transition period (if no-deal was avoided).
If a deal is agreed it has to be ratified by Parliament. If a deal is ratified then it will be implemented, and there will probably be a smoother Brexit with the transition period lasting until the end of 2020. However, the outcome is much more uncertain if the government's deal, or lack of a deal, is not ratified.
- Parliament Says "No" To Deal: If it fails to get Parliamentary approval the future becomes much more uncertain. One possibility is that we will go back to the negotiating table with the EU if there is still time and the EU agrees to this. If the EU doesn't agree then we will go into the "no-deal" scenario. Other possibilities are that we would have a General Election or a second referendum.
- Parliament Says "No" to No Deal: Again, if there is time and the EU agrees the government could go back to the negotiating table to try and thrash out a deal. If it is too late or the EU disagrees then a "no deal" is the most likely outcome.
If you are having problems assigning probabilities to these outcomes you are not alone. The ratings agencies are also scratching their heads. For example, Fitch Ratings said:
"An intensification of political divisions within the UK and slow progress in negotiations with the EU means there is such a wide range of potential Brexit outcomes that no individual scenario has a high probability, Fitch Ratings says. We no longer believe it is appropriate to identify a specific base case. An acrimonious and disruptive "no deal" Brexit is a material and growing possibility."
Fitch points out that Prime Minister May's July 6th "Chequers Plan" is facing opposition from both remainers and brexiteers and that this has led to close parliamentary votes on Brexit legislation and underlines the depth of division within the Conservative Party and parliament on Brexit. They think that any deal is "likely to provoke brinkmanship and may not gain parliamentary approval. This could trigger a general election and greater talk of a second referendum." They say their base case of a Free Trade Agreement and a transition period is now just as likely as other outcomes.
Following the "Meaningful Vote" in Parliament the number of outcomes rapidly multiplies. In the diagram above, adapted from an infographic by the Institute For Government, the number of paths leading to Orderly Brexit are rather sparse which seems to tilt the odds towards "No Deal".
Why the EU trade deal matters
The amount of trade between countries is driven primarily by physical distance and size. Countries trade with their neighbours more than distant countries. The size of the economy matters too, which is why we trade more with the US and China than smaller economies even though they are distant.
Proximity and size are two reasons why both imports and exports to the EU are such a large part of our total trade. The EU made up 54% of our imports and 43% of the UK's goods exports according to the interactive graphs below from the ONS from 2017.
You can click on the boxes below to drill down into the per-country import and export data.
The nature of the deal will affect various aspects of our economy beyond trade:
- Foreign Direct Investment: while foreign companies have seen the UK as a gateway to Europe as part of the EU, this will no longer be the case after Brexit. For example, see Japan’s Message to the United Kingdom and the European Union. Foreign investment increases UK productivity e.g. Fujitsu employs 14,000 people in the UK and Ireland in highly skilled and relatively highly paid (productive) roles. The Japanese ambassador told reporters when asked how real the threat was to Japanese companies of Britain not securing frictionless EU trade: "If there is no profitability of continuing operations in the UK - not Japanese only - then no private company can continue operations".
- Migration: Restricting the pool of labour will be inflationary as the size of the pool of workers shrinks. This is because labour shortages will push up the salaries of workers who are in the highest demand. To some extent this can be mitigated by allowing a limited number of visas for more qualified workers. Restricting EU migration will also worsen the aging demographic trend in the UK. The proportion of the population aged 65 years and over has increased by at least 0.1% every year since mid-2008 and was about a fifth of the population (18.2%) in mid-2017 according to the ONS.
Here are four scenarios ranked from "hardest" to "softest" where "hard" means the greatest negative impact on the UK economy. While economists argue about the size of the effect, almost all agree that going from no tariffs to WTO tariffs on 50% of UK trade with the EU will be a drag on corporate earnings.
No Deal & WTO Tariffs
In this scenario a deal is not agreed with the EU before the November 2018 deadline:
- EU Tariffs: UK would have to pay the EU's Most Favoured Nation WTO tariffs
- UK Trade Deals: The UK could strike trade deals with countries outside the EU
- Political Support: This will be liked by hardline Brexit-supporting MPs but disliked by more moderate and business-friendly MPs.
Free Trade Agreement
In this scenario a deal is agreed with the EU before the November 2018 deadline:
- Transition Period: There may be a period of WTO tariffs leading to a Free Trade Agreement
- Lower than No-Deal EU Tariffs: Involves tariffs and other barriers being lower than the Most Favoured Nation level
- UK Trade Deals: The UK could strike trade deals with countries outside the EU
- Trade Friction: UK exports to the EU would face customs checks and may need new licenses to trade
- Political Support: This scenario will be the one favoured by moderate MPs
This scenario is closest to membership of the European Union:
- Access: The UK would have substantial access to the single market
- Cost: The UK would have to make contributions to the EU budget and continue to meet almost all EU regulations and accept free movement of people
- No EU Voice: The UK would have no say in how EU regulations are set
- No EU Tariffs: EU trade would be largely tariff-free but still require border checks
- Political Support: This scenario will be strongly disliked by hardline Brexit MPs because it is seen as EU-lite, but would be supported by MPs who favour maintaining close ties with the EU.
This scenario would maintain the status quo:
- Cost: The UK would maintain the free movement of goods, services, capital and people
- Access: The UK would keep free access to the EU single market
- No Tariffs: Trade with the EU would remain tariff free
- Political Support: The only way that this outcome would be ratified by Parliament is if there is a second Referendum that shows a shift in the popular vote towards closer ties with the EU and/or a general election that puts a pro-EU party into power.
Post Referendum Returns
The biggest impact of the Brexit Referendum was on currency for UK investors. Sterling rapidly lost its value versus all its major trading partners, such as the US, Europe and Japan, as shown below. The currency devaluation was also a primary driver of other asset returns because these too are affected by currency, but in very different ways.
The general pattern for Sterling investors in the UK was:
Sterling weakening meant foreign assets rose in value
To illustrate that here are the returns of a wide range of exchange traded funds spanning the referendum from the day before, June 22, to two weeks later. Notice that any asset denominated in foreign currency, such as commodities which are priced in dollars (the physical gold fund SGLN and diversified commodity fund CRBL), Emerging Market government bonds which are priced in dollars (SEMB), Japanese shares priced in yen (SJPA) and global shares which are dominated by dollar denominated stocks (SWDA).
However some of these funds are traded in US dollars or in euros. Others contain assets priced in foreign currency but converted to Sterling for the version of their fund traded on the London Stock Exchange. For example gold rose just 8.1% from $1265.30 to $1368.30 over this period priced in dollars, but it got a sterling devaluation boost of 12.7% which took the return of SGLN up to 23%.
If we convert the remaining foreign currency funds to sterling the picture looks quite different.
The US dollar denominated funds and euro denominated funds are boosted by the 12.7% weakening of sterling versus the dollar:
- CSPX US S&P 500 boosted from -0.5% to +13.9%
- EIMI MSCI Emerging Markets boosted from -1.2% to +13.1%
- CPXJ MSCI Pacific ex Japan boosted from -1.3% to +13.0%
And the euro funds are boosted by the 10.8% weakening of sterling versus the euro:
- IEGA Barclays Euro Treasury Bond boosted from +2.0% to +14.4%
- CSX5 Euro STOXX 50 boosted from -7.9% to +3.3%
- IEAC Barclays Euro Corporate Bond from +1.1% to +13.3%
Since the Referendum currency has been the barometer for hard Brexit. As news of a harder Brexit emerged sterling weakened. While some politicians have suggested that no-deal would be "okay" currency markets disagree completely. The view of markets is what drives your portfolio return, not the view of politicians so it is useful to know how markets reacted to the news of Brexit.
Consequently a primary factor of your portfolio allocation as Brexit unfolds is how much of your investments are in foreign currency versus sterling. You should set your sterling versus foreign currency holdings according to your view of the "hardness" of Brexit i.e. which scenario you think is most likely above.
- Hard Brexit => put more in foreign currency assets
- Soft Brexit / No Brexit => put more money in sterling assets
The laggards in the sterling graph above are the UK assets (IGLT UK government bonds, SLXX UK corporate bonds, ISF the FTSE 100 tracker) and European stocks despite the currency boost (CSX5 the Euro STOXX 50 tracker). This suggests European equity will also suffer a price fall because it will be negatively impacted by a hard Brexit. Stocks in the US and Japan, on the other hand, were not affected so these may be a better choice than European stocks in the event of hard Brexit.
Sterling Downside Smaller Than Upside
Sterling has already priced in a lot of the downside of a hard Brexit. If it turns out that the UK gets a good trade deal which will be less harmful to the UK economy than expected there is a large scope for Sterling to rally. If we get a hard Brexit sterling will weaken further but the downside will be smaller than the upside because sterling has already weakened a great deal versus the euro.
What this means is that if you position your portfolio expecting a hard Brexit, with lots of your portfolio in foreign currency assets, you would suffer large losses if Sterling rallies strongly. If you position expecting soft Brexit, with lots of your portfolio in domestic currency or sterling hedged foreign assets then the downside will be smaller if we get a hard Brexit.
FTSE 100 versus FTSE 250
In the post-Referendum graphs above notice that the FTSE 100 rose in value by 3.3% in the two weeks following the Referendum whereas the FTSE 250 fell by -8.3%. It is worth knowing the characteristics of the UK equity market to help understand why this is the case.
The diagram below shows the structure of the FTSE indices. The FTSE 100 contains the hundred largest stocks that trade on the London Stock Exchange where size is the market capitalisation ("market cap") of each stock. Market capitalisation is the number of shares issued times the price of each share.
The next 250 stocks by size are in the FTSE 250. This is often called the FTSE mid-cap index. The smallest stocks are in the FTSE SmallCap index. The FTSE AllShare contains all the stocks in the FTSE 100, 250 and SmallCap indices. In each box on the left we have listed the Exchange Traded Funds that track that index. Unfortunately, there are no FTSE SmallCap trackers at all.
Notice how the FTSE 250 fell more than the FTSE 100 in the days following the Referendum. This is illustrated with the iShares FTSE 100 ETF (ISF) and iShares FTSE 250 ETF (MIDD) scaled to a value of 100 on the day before the Referendum. The FTSE 250 also took longer to return to its original value.
The reason why the FTSE 100 weathered the post-Referendum selloff well was because many of its companies are not UK domestic businesses. Large caps in the FTSE 100 are mostly multinational companies such as the oil company Royal Dutch Shell which generate most of their revenue outside the UK. Only about a third of Shell's revenue comes from Europe so Brexit is less of a concern and may in fact be a benefit. This is because Shell reports profits in Sterling so when its foreign revenue is converted into a weaker pound it is boosted by devaluation.
In contrast here is Moneysupermarket's geographic revenue breakdown. You can see that its turnover depended 100% on the UK. If there are growth worries about the UK domestic stocks such as Moneysupermarket will suffer more than multinational stocks. As we delve down into the FTSE SmallCap this will be even more domestic.
The consequence for investors of this geographic revenue distribution across the FTSE indices is:
- Hard Brexit => benefits multinational UK stocks & indices (e.g. FTSE 100)
- Soft Brexit / No Brexit => benefits domestic focussed stocks & indices (e.g. FTSE 250)
Long-Term and Short-Term Effects
We should always try to think about investing over the long-term. So with a long-term view and a diversified portfolio is it possible to ignore Brexit as a temporary hiccup? Economic forecasts suggest that the possibility of long-term effects on the UK economy and UK corporate earnings cannot be ignored.
The most important driver of share prices is how much profit a company generates, and it sometimes takes several months or even years for a macroeconomic shock like Brexit to feed through into reported company profits. Currency markets tend to react quickly to news and slowly to interest rates with currencies that have higher interest rates strengthening versus those with lower rates. This means we have two time-scales to consider, a short-term time scale of weeks and months and a longer time scale of years.
While we can slowly adjust our portfolio for the long-term effects of Brexit we can't do that for the short-term effects such as currency.
- Short Term: Scenarios have a predictable effect on currency but there's uncertainty over which scenario will materialise
- Long Term: Scenarios have a less predictable effect on share prices because growth forecasts vary widely, and these will affect corporate earnings.
There is a significant disagreement between economic forecasters on the long-term impact of various Brexit scenarios, as you can see in this table summarising the forecasts taken from an Institute for Fiscal Studies paper published in 2016.
Only one of the eight forecasters ("Economists for Brexit") predicted that Brexit would boost UK growth over the long-term. Furthermore, excluding Economists for Brexit, the other forecasters predicted that all scenarios would have a negative impact on growth, it is simply the severity of the slowdown that varies. The general pattern is that harder Brexit (WTO) hurts growth more than softer Brexit (FTA and EEA).
If these forecasts are correct the long-term Brexit growth drag would hurt the shares of UK domiciled companies that rely on the UK for their earnings. As discussed above, this would be more of a problem for the FTSE 250 and FTSE SmallCap index than it would for the FTSE 100 which is made up of large multinational companies which generate most of their earnings outside the UK.
A recent study by the National Institute for Social and Economic Research (NIESR) looks at variations of Theresa May's deal either with a free trade agreement, or a backstop agreement for the Irish border or an orderly no deal ("The Economic Effects of the Prime Minister's Brexit Deal", November 26th 2018). The NIESR model predicts that the smallest damage to economic growth will come from the backstop scenario.
Rather than being a one-off hit to growth tariffs and trade effects will be long-lasting according to the NIESR model, particularly in the no-deal and deal + FTA scenarios.
Probabilities and Portfolios
The portfolio you create to position for Brexit will be based on your beliefs. If you want to approach it in a structured manner you need to come up with some numbers: i) a list of scenarios ii) the asset price change in each scenario iii) your preferred allocation in each scenario and iv) the probability of each scenario.
We will work through a simplified example here to show the approach, then you can extend it to incorporate your choice of assets.
- Firstly we will assume that there are just two outcomes: hard Brexit and soft Brexit.
- Secondly we will include just a few assets: trackers for the FTSE 100, FTSE 250, UK Gilts, the US S&P 500, and Emerging Market Government bonds.
- Thirdly we will assume the asset price impact for hard Brexit will equal plus (hard Brexit) or minus (soft Brexit) the return in the two weeks after the Referendum.
These returns and probabilities do not reflect my views, they are for illustrative purposes only. Returns and probabilities for the hard and soft Brexit scenarios are shown side-by-side. The soft Brexit returns are just minus the hard Brexit returns except for Gilts where we assumed a small positive return as there is no foreign exchange effect and Gilts are unlikely to react as violently as equity in a positive scenario. We also want some diversification in the soft Brexit portfolio.
FTSE 100 (ISF)
FTSE 250 (MIDD)
UK Gilts (IGLT)
US S&P 500 (CSPX)
EM Govt Bonds (SEMB)
We have chosen portfolio allocations that ignore assets with negative return (allocation = 0%) and which have an allocation proportional to the risk-adjusted return in that scenario. We have risk-adjusted using the long-term volatility of the fund. It would be more sensible to use your estimate of the volatility in each scenario.
The combined weight is the weighted average of the hard and soft scenario where the weight is the probability of that outcome. So for example, the FTSE 250 weight is 40% * 0 + 60% * 80.5% = 48.3%. If the probability of hard Brexit were 100% then the combined weights would be equal to the hard Brexit weights and as this probability falls to 0% the combined portfolio transitions smoothly to the soft Brexit portfolio.
FTSE 100 (ISF)
FTSE 250 (MIDD)
UK Gilts (IGLT)
US S&P 500 (CSPX)
EM Govt Bonds (SEMB)
If you want to play around with the numbers or expand on this toy example you can download it as a Google Sheet by clicking on the image of the spreadsheet below. The spreadsheet is view only, so you will need to go to "File > Make a copy" to edit your version.
The ways in which you could expand on this template are to include your own return expectations, add more assets, add more scenarios (for example "No-Deal & WTO", "Free Trade Agreement", "EEA" and "Single Market" above), and perhaps consider different investment horizons that incorporate the short-term and long-term effects of Brexit.
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