As the UK’s referendum about continued EU membership on Thursday June 23rd draws ever closer, we are increasingly receiving client enquiries on how we may be addressing potential investment risks should the UK electorate vote to leave the European Union.
As you would expect, we have discussed every aspect of the Brexit risk and what it may mean for the short term in capital markets and the longer term for the UK economy. Below you can find a summary of our thoughts in 9 key points. Crucially, there are no easy answers, but there are options for decision making.
We firmly believe that as part of our responsibilities, we have the obligation to position portfolios in what we believe will be in the best interest of our investors. However, we also feel obliged to point out the limitations of our investment mandate and reflect on the options available to clients themselves.
9 key points to consider:
1. We expect a ‘Remain’ outcome
Our portfolios are currently set for the scenario that the UK will remain in the EU.
2. The odds are that the UK will remain a EU member
Market valuations, reputable political analysts, recognised opinion polls and the odds at the bookies all currently indicate a strong likelihood that the UK will remain a EU member.
3. Stock markets have priced in a ‘Remain’ outcome – a ‘Leave’ would result in negative surprise shock
Markets have currently priced in a first half of 2016 UK economic slowdown due to the Brexit induced uncertainty amongst businesses – this is one reason why the past 12 months have not yielded much in terms of investment returns or a bigger fall in £-Sterling.
Last week we noted that the comments made by Bank of England Governor Mark Carney that a Brexit could lead to a temporary recession did negatively affect markets. Uncertainty is playing on markets, but a UK exit from the EU is not priced in by markets. Therefore, if it was to happen against the current odds, then this would be a negative shock for capital markets in the UK and would most likely cause a sharp fall in values in the immediate aftermath.
Given today’s interconnectedness of capital markets, we would expect stock markets in other regions to suffer – at least that was the experience of the January/February 2016 stock market correction. Portfolio holdings in UK fixed interest gilts could prove a counter balance if stock markets were to fall, but this is by no means guaranteed given the UK government would also likely deemed to have been weakened. Only gold and US government bonds have in the past proven to be reliable safe heavens in such scenarios.
4. Stocks are likely to recover from a ‘Leave’ shock, but future growth is less certain
Stock markets would probably recover over the following 12 months, but the UK’s growth prospects would be seen as impaired for a substantial number of years and lower UK investment returns would ensue – at least until there is good evidence of benefits.
5. A ‘Remain’ outcome stock rally could happen before referendum
Unlike the 2014 Scottish referendum, we think it is a reasonable scenario that markets gain confidence in a ‘Remain’ outcome ahead of the vote, making a pre-vote rally in UK stock markets and £-Sterling at least a possibility.
6. Diversification reduces risks, but our advisory mandate limits our response options
The nature of risk related asset allocations is that they provide diversification in uncertain times, such as this. In case of a ‘Leave’ vote, the diversification of portfolios across asset classes and regions should soften falls relative to a pure UK stock market investment. How much depends on the respective risk profile and how extended the regional contagion effect will be.
Please note in this context that the advisory management mandate that we hold does not permit us to invest beyond the parameters of the profile. Thus portfolios cannot be completely immunised should Brexit actually happen other than by investors giving us instructions to move their portfolios to cash. This is why we have sent out letters to offer clients this option.
7. What would change our view about Brexit?
Only a major geo-/euro-political event would have the capacity to change our general feeling that Britain will vote to ‘Remain’ on 23 June.
8. Why we believes in ‘Remain’ outcome
We feel reasonably confident that a Brexit will not happen – for the same reasons the Scottish referendum failed: Personal economic risk considerations in the end overwhelm heartfelt passion and patriotism. As a result, we expect investment returns by the end of 2016 will be positive and to reflect the steady progress and growth of the UK and Global economy.
We therefore are not formally advising clients to move to cash unless there is a move in the voting intension poles towards the ‘Leave’ campaign or that ‘Leave’ take a lead. On current polling evidence we feel that a move to cash would in all likelihood result in foregoing not insubstantial investment returns for 2016. We estimate that missing those investment returns as a consequence of a temporary 100% cash allocation could amount to a return opportunity loss in 2016 of around 5%, depending on portfolio type.
9. Options for investors
We acknowledge that this is a special time and potentially unnerving position for investors. Clients may disagree with our conclusions and investment direction around the Brexit risk potential. They may also feel that the potential 5% loss of return, that we approximate as the potential cost of a client instructed temporary move to 100% cash, as an acceptable price to pay for not having to worry about the value of their lifetime savings for the coming 6 weeks. It is for this reason we wish to offer clients the option to move their holdings to cash on a temporary basis.