Brexit one year on

James Horniman, Portfolio Manager

A year on from the decision to leave the EU and we are still only beginning to work out what that actually means. It is unlikely to be pleasant, so why do markets keep rising?

Let’s first deal with what we know about the Brexit negotiations and how they will affect portfolios.

There, that didn’t take long.

The truth is we can only guess. A number of scenarios are possible – from talks breaking down and no deal being agreed (which would be pretty calamitous for Britain and not pleasant for Europe either) to something close to what we have now.

May and her successor – for we have to assume she cannot continue to the end of the talks – have a tricky balancing act to play. The election result is being interpreted by many as a vote for soft Brexit that will hearten the old Remainers. But with margins so tight it arguably also gives enhanced power to the UKIP-leaning camp within the Tory party. They will not want to soften on issues like immigration.

The best compromise deal is probably one that leaves everyone equally dissatisfied.

The key for us is that it supports free trade and respects free movement of people – in other words, that it is good for the economy.

Our key concerns as investment managers are currency and sentiment.

Brexit one year on – currency

Sterling currently sits mid-way between forecasts of where it could end depending on the outcome of negotiations. That seems about right. It can go either way. A good divorce might strengthen sterling. A bad deal or no deal is likely to lead to sterling weakening.

The weakening of sterling in the wake of the Brexit decision last year was good for a lot of investors in the FTSE 100 as many of these constituent businesses are multi-nationals that generate income in overseas currencies.

This was a one-off bonanza. Since then sterling has recovered a little but we have seen the impact of currency on inflation. If it drops again and further it might be good for exporters and multi-nationals but it will continue to make imports more expensive and that is likely to fuel inflation further. It may lead to an increase in interest rates as attempts are taken to shore up the currency and that could take some of the heat out of a recovery that is only just warming up.

A good deal and a stronger sterling may dampen returns on the FTSE but will be better for the economy generally and could help keep inflation in check. That might be seen to be better for mid and small cap companies.

Brexit one year on – sentiment

Markets generally hate uncertainty but there has been so much of it in the past year that they seem to have become immune to the trauma and have stopped reacting. The UK stock markets barely flickered as Mrs May looked upon the wreckage of her election campaign on June 9th. They feel like a one-way street at the moment.

On the one hand this supports our view that in the long term politics matters little to markets and that we should not be over-stressed by what happens politically. On the other, when markets become desensitised it is usually a sign that they are entering “irrational exuberance” territory and that a major correction or bear market is imminent.

Our view on the UK

It is not all doom and gloom. A softening of the austerity agenda in the light of the election might be healthy for markets and the economy generally. But we can’t help feeling that Britain is taking its turn as the sick man of Europe – a perception not helped by the rise of Macron Economics in France.

Within our portfolios we have reduced our exposure to the UK. So, for example, our Steady Growth Mandate 3 portfolio would typically have 35% exposure to the UK, and 35% to International stocks. Today it stands at 31% UK, 39% International.

Even within the UK element of portfolios, the emphasis is on firms with greater exposure to international earnings. Within the International element, we are reducing exposure to the US, where the likelihood of Trump’s impeachment grows each week and where valuations are looking saucy in places.

As an aside, we are generally reducing exposure to equity income funds. We believe the hunt for yield is encouraging managers into non-traditional areas of the market. This is not necessarily a bad thing but it increases risk and we cannot forget our first priority – to protect wealth.

We see evidence of economic recovery everywhere we look and that is what is fuelling the continued rise of markets. Valuations may seem high but earnings are improving too and that means we are confident that they are not, in general, overstretched.

Of course we recognise the threats around us. We expect volatility and we do not anticipate another year of double digit returns but this is classic for this stage of an ageing bull market where you “climb a wall of worry”.

Our message to clients is to leave the worrying to us. We are neutrally positioned to capture returns from rising markets, but also working constantly to build portfolio defences.

James Horniman

Posted on June 26 2017

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