How Brexit will hit investment portfolios: What (little) we know so far
The Bank of England and the International Monetary Fund both issued stark warnings last week about the EU referendum and the potential impact of Brexit.
In a report, the IMF said that a Leave vote could have a “negative and substantial” long-run effect on UK output and incomes. Later, IMF managing director Christine Lagarde added that a Leave vote could have “pretty bad to very, very bad” consequences for the UK and its economy.
Read more: Why Christine Legarde has got the Brexit impact very wrong
Economic forecasting is notoriously difficult. Iain Duncan Smith was right to say last week that Mark Carney’s “technical recession” prediction should be taken with a pinch of salt because, in his words, “forecasts are almost always wrong”.
Nonetheless there are some consequences of a Brexit vote that would, in Lagarde’s phrase, be “pretty likely to very, very likely”. This is as far as I think we can go.
Unanswered questions
First, it is broadly accepted that, following a vote to leave the European Union, UK economic growth would be hit at least in the short term – and possibly also in the long term. This short-term growth hit comes partly from the uncertainty that UK companies would face. Should we stop hiring EU workers? What markets will we have open access to? What tariff regime would UK companies face in 2018?
Because we won’t have answers to many big questions straight after the vote, we can expect that business confidence would be hit and investment decisions would be delayed, at least until some certainty could be offered over what a UK outside the EU would look like.
What the markets are saying
UK financial markets already reflect some of these concerns, albeit based on a relatively low probability of Brexit actually happening – odds of about one in three.
Much has been made of the sharp fall in the pound this year, in part due to Brexit risk, but also due to the disappearing chance of an interest rate hike any time this year (or next). The futures markets show that bets against the pound are at a very high level, while the cost of protecting against a sharp fall in sterling is at the most extreme level seen in the past 10 years.
Bond and equity markets, however, show little evidence of widespread foreign selling ahead of the vote. It is somewhat surprising that selling of UK stocks was more pronounced in the lead-up to the Scottish independence vote in 2014 than it is now.
Read more: Why the British economy would benefit from Brexit
Perhaps, with UK equity markets’ high exposure to commodities, emerging markets and financials, foreign investors lost interest some time ago. In fact, the latest Bank of America Merrill Lynch survey of global fund managers shows holdings in UK equities to be the most low weighted since November 2008.
What we’re doing to prepare
For Nutmeg’s portfolios, the lead up to the referendum has meant some changes. We do not expect a vote to Leave, but we are watching the situation very closely, and taking action where we can to protect portfolios as much as possible.
We hold long-dated government bonds, as the Bank of England base rate would likely be cut if we voted to leave. We are also underweight UK equities with no exposure to small or mid-sized companies, and own a healthy dose of US stocks and dollars.
Ironically, the vote could provide an opportunity for contrarian investors, given the UK market is so despised. A very weak pound will raise profits on overseas earnings, the oil price has staged an impressive recovery, and UK stocks yield a high dividend, with reasonable valuation levels.
All investors in financial markets across the globe will be paying close attention to the result.