Brexit - an update on our thoughts

The UK’s future relationship with the EU remains very uncertain, and we are positioned cautiously with regard to the UK. We continue to monitor the risks and advocate a global multi-asset approach. In this Investment Insight we examine the key issues and investment implications.

Since the 2016 referendum, when the UK voted to leave the EU, the UK equity market has under-performed and Sterling has weakened. While the UK economy has been more resilient than many forecasters expected, growth has slowed significantly and business investment has been weak.

As per the June 2018 Withdrawal Act, the UK will exit the EU on the 29th March 2019 and, if a withdrawal agreement is reached with the EU, the transition period will begin. The transition period is expected to last until December 2020, by which date the UK and EU need to agree on a future trade relationship. If a future relationship cannot be put in place in December 2020, a temporary customs arrangement, lasting until December 2021, may be implemented or the transition period may be extended.

What could happen from here?

There are two main stages that will dictate the outcome of Brexit negotiations in the run-up to March 2019:

1. Can the UK and the EU agree on a withdrawal deal? At the time of writing 95% of the agreement is reportedly established, but so far the issue of the Irish backstop remains unresolved. The 13th December European Council is likely to be the last opportunity for the UK and the EU to reach an agreement. The deadline for negotiations, according to the June 2018 Withdrawal Act is the 21st January 2019. A withdrawal agreement makes a future trade deal with the EU more likely. The UK may or may not be able to negotiate trade deals with
   other nations.
2. If a withdrawal deal is agreed, will the UK Parliament vote it through? Given that the Conservative party is divided and has a weak majority, MPs breaking ranks could derail the deal. Many MPs in favour of leaving the EU object to an open-ended (without an expiry date) Irish backstop solution arbitrated by the EU, which could see the UK unable to leave the EU. However, the EU believes that by definition the backstop needs to be open-ended in order to work. Such a deal risks being defeated in the Parliamentary vote without Labour party support.

Potential scenarios

While there are many potential permutations, we outline below four core scenarios. Our base case is that the UK and the EU will reach a withdrawal agreement. The permutations of each of these scenarios could bring new positive surprises but also negative unintended
consequences, potentially significantly altering market implications. For example, the breakdown of negotiations may increase the likelihood of both a “no deal” scenario and a second  referendum, outcomes that would favour different groups of assets. For this reason, we are not positioning strongly in either direction ahead of the outcome.

Four core scenarios

1. A withdrawal deal is reached and passes through Parliament
2. Less likely, a second referendum is called which results in reverting to the pre-Brexit status quo
3. A withdrawal deal is reached but does not secure Parliamentary approval, or no withdrawal agreement is reached with the EU, resulting in the UK leaving the EU with no transition period on WTO trade terms
4. A general election, with the possibility of a Corbyn government

Investment implications

Scenarios 1 and 2 would likely be positive for UK GDP growth expectations and for Sterling. As a result, we would expect these outcomes to benefit companies exposed to the UK economy, with a higher proportion of UK earnings, “domestic earners”. Conversely, we expect scenarios 3 and 4 to be negative for the currency and growth expectations – we would expect companies with a higher proportion of earnings overseas, “overseas earners”, to outperform.

How are we positioned for Brexit?

• Brexit is a significant source of uncertainty for the UK economy and UK assets, with different outcomes favouring different investments. The ideal portfolio in a “no deal” scenario would differ to the ideal portfolio if a second referendum were to lead to a return to the status quo.
• On a tactical basis, our portfolios have been underweight UK assets versus our long term asset allocation since before the referendum, with a bias towards overseas earners versus domestically exposed shares. This has benefited clients because Sterling has weakened and overseas earners have outperformed.
• As the March 2019 deadline approaches, we remain underweight UK assets, as there remains a risk that no deal is agreed between the UK and the EU, or that a deal is agreed but is then voted down by Parliament. However, we think that UK assets become more attractive if the balance of risks changes, as valuations remain attractive. The UK currently trades on 12x 2018
  earnings and offers a 4.7% dividend yield, versus the global market on 15x, offering a dividend
  yield of 2.5%.
• In the meantime, we are focused on UK names with stock specific investment cases not solely connected to Brexit, as well as those companies benefiting from strong economic growth elsewhere in the world.
• As global, multi-asset investors, we also have greater flexibility in positioning our portfolios so as to diversify our sources of risk, reducing the exposure we have to any one investment theme and holding shares in international markets. We also hold assets, such as alternatives, that can help limit volatility in times of market stress.
• In summary, while Brexit is a significant source of uncertainty, we are closely monitoring the balance of risks. Each of the many permutations the course of negotiations may take will offer investment opportunities.

Important information
The value of investments will go up and down and clients may get back less money than they invested. Past performance is not a reliable indicator of future returns. The information contained in this document is believed to be correct but cannot be guaranteed. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation.