UK fund managers discuss their plans to counter the possible outcomes of Brexit as time runs out for the divorce talks.
The Brexit countdown clock has ticked below the 150-day mark, and as things stand (at the time of going to press in mid-November) there is every chance the UK will leave the EU without a deal in place. Such a prospect will further unnerve investors who have on the whole been giving UK equities the cold shoulder since June 2016 when the referendum on EU membership took place.
A staggering £10 billion of domestic retail investors’ money has exited from UK equity funds since June 2016, with a large chunk having been redeployed into overseas businesses, global equity funds being the main beneficiaries. International investors have also been steering clear of the UK, despite the weak pound, which has depreciated by just over 10% against the euro and 12% versus the dollar since the referendum, as at 8 November.
Consensus counting on Brexit compromise
On the whole, the consensus seems to be that the most likely outcome is that some sort of compromised deal will be struck, although it should be pointed out that only a small band of fund managers have been willing to voice their opinions.
Job Curtis, the respected manager of the £1.5 billion City of London Investment Trust, is in the compromise camp. He says: “I am anticipating a bumpy ride between now and next March, but I think a deal will be struck in the end. I would put the chance of a deal at 70%, because I think most MPs favour a deal of some sort. There is a lot of noise, but ultimately it is in everyone’s interest to do a deal.”
Curtis adds that he cannot foresee enough votes being pulled together by Brexiteer MPs to force a no-deal through, as only a minority would be in favour of crashing out without a deal.
He expects a ‘soft’ Brexit to play out. This will involve the UK temporarily remaining in the customs union, giving the UK government breathing room (or in football terms extra time) to decide whether to pursue an off-the-shelf or bespoke trade deal. The customs union proposal, which is part of prime minister Theresa May’s Brexit blueprint, has been a hot topic in negotiations, as it is the key to resolving the Irish border problem. This has angered Brexiteers who are advocates of a ‘hard’ Brexit. Those in this camp argue that staying in the customs union, albeit only temporarily until 2021, will restrict the UK government’s ability to agree trade deals with other countries.
Fund manager Rathbones agrees that the most likely result of the negotiations will be politicians agreeing on the principles of the deal but not the details. The proverbial can will be kicked down the road, and the full formalities and ramifications of the UK’s departure will be settled later. Rathbones points out that until a clear solution is in sight, investors will remain nervous, but if a muddling compromise cannot be reached, a no-deal outcome or a second referendum are distinct possibilities.
Guy Stephens, technical investment director at Rowan Dartington, says the best course of action for investors is to stand back and take a deep breath.
In a nutshell, he says, the root of the problem of the UK’s divorce negotiations with the EU is that people voted the way they did in the referendum for a variety of emotional reasons. In contrast to the scenario in a typical general election, political ideology, personalities and a “selfish personal view on which administration will make you better off” were not dominating factors.
He adds: “Indeed, with the Brexit referendum, which posed a binary question, no one knew whether they would benefit or not – and nor do they know now. Hence the close referendum result, the current anxiety and now the emotion around how your employment is likely to be affected. We all want to know the outcome so that we can get on with our lives and adapt to whatever transpires, with the waiting being the most excruciating part.”
There may be a stampede back to UK stocks
As far as investors are concerned, a deal of some description would be good news, as it would remove the shadow cast over the UK stock market for the past two and a half years that has earned the country its ‘unloved’ tag. Curtis argues that there could be a “stampede” back into sterling assets as investors worldwide reappraise their underweight positions to the UK equity market.
Jamie Clarke, co-manager of the Liontrust Macro UK Growth and Liontrust Macro Equity Income funds, also hopes this scenario will play out. He says: “The most concrete point to flow from Brexit is that UK equities are cheap in aggregate. The referendum triggered downgrades to estimates about the UK’s economic prospects and a parallel de-rating of UK shares. The FTSE AllShare index’s prospective price/earnings multiple has fallen by more than five points since mid-2016 and sits at 12.2 times.”
Of course, some UK stocks are bound to enjoy a bigger bounce than others in the event of a deal being struck and the consequent expectation that investor capital will return to the UK. For Clarke, the big opportunities in this context are among the largecap names in the FTSE 100 that have more of a domestic focus.
Other fund managers, including Neil Woodford and Invesco Perpetual’s Mark Barnett, have also shuffled their portfolios in this direction, following the decline in the pound after the Brexit vote, which led investors out of domestic UK stocks. In contrast, private investors moved into internationally facing businesses, which led to their share prices rising.
Clarke says: “Brexit was harsher on UK companies with material domestic exposure. Looking at the worst-performing UK large-caps on the day after the vote, we see UK sales account for more than 80% of their total revenues on average. Housebuilders, life insurers and banks bore the brunt. The ratings of such companies remain handicapped by Brexit.”
In light of this, Clarke has been buying shares in Legal & General, St James’s Place, Lloyds Banking Group and Marshalls, the hard landscaping business. He says: “We would expect such businesses to outperform as clarity on Brexit is attained, the economic conditions improve and interest rates normalise.”
Other investors are also eyeing up large-cap names in the FTSE 100. However, according to Alex Wright, manager of the Fidelity Special Situations fund and Fidelity Special Values trust, not all internationally focused businesses benefited from a Brexit bounce.
Wright points out that there is a “misconception” that smaller domestic businesses, those that sit outside the FTSE 100 index, offer better value at this juncture. He says: “There is a strong consensus belief that UK mid and small caps are deeply out of favour and under-owned compared with their larger and more international cousins in the FTSE 100. But looking at performance and valuation data since June 2016, we see a different perspective on this one-sided narrative .”
He explains: “In reality, small and mid-caps have outperformed the FTSE 100 since June 2016, in a continuation of the trend of previous years. And although the entire market has de-rated, the FTSE 100 is 8% cheaper on forward earnings estimates than the more domestic FTSE 250.”
Wright has been focusing on UK banks and the two big oil majors, BP and Royal Dutch Shell. He has also been buying shares in what he terms “hidden defensives”, such as Pearson, Bunzl, DCC and Ultra Electronics. If the economic picture changes – for example, in the event of a no-deal – these shares are better placed than others to weather the storm clouds that will be on the horizon. “They are not classified in traditional defensive sectors, but they should show resilience in a weaker economic environment,” says Wright.
Curtis is backing bank shares to bounce in the event of some sort of deal being reached. He expects another interest rate rise in the event of a ‘soft’ Brexit, as a deal will maintain economic momentum. Higher interest rates will boost banks, as they will benefit from greater spreads on deposit accounts. Curtis owns HSBC, Lloyds Banking Group and Barclays.
Page 2: Slowdown risk and a potential Brexit bounce