Given the recent rally in UK equity markets, one may be forgiven for believing the economic implications of leaving the EU can be overlooked. But the main battleground since the Brexit vote has not been in the stock market – rather, it has been in the foreign exchange market. The pound is now in the unenviable position of being the worst-performing G10 currency year to date. Down by 30 percent since its peak in 2014, sterling has barely outperformed the Sierra Leonean leone (-31 percent) through mid-October 2016.
The pound’s nosedive in the wake of the June 2016 Brexit vote was intensified during the Conservative Party conference on October 2 when Prime Minister Theresa May said the UK will invoke Article 50, the mechanism to leave the EU, by the end of March 2017. She also suggested the country could go down the route of a ‘hard’ Brexit if EU negotiators do not budge on their requirement to uphold all four pillars of the EU framework – the free movement of labour, goods, services, and capital – to allow single market access.
Leaving the EU’s single market will mean a large economic adjustment for the UK given that trade relationships will need to be renegotiated. Meanwhile, a weaker pound, despite boosting exports in the short term, will likely fuel inflation by making the price of imported goods more expensive. While this spike in inflation is likely to be short-term in nature, it could rise more than initially thought due to recovering oil prices, a resilient economy and a weaker pound. Indeed, market expectations for inflation in the medium term, as measured by 5y5y (5-year/5-year) inflation swap rate, have risen above 3.5 percent.
Given recent economic strength and a moderate outlook for inflation, the probability of the Bank of England (BoE) cutting rates in November has decreased. This also means Philip Hammond, the chancellor of the exchequer, will find it difficult to propose large stimulus measures in the November 23 Autumn Statement, although he does appear set to show a loosening of austerity. In the medium term, however, Brexit poses structural challenges to the economy through an initial fall in investment, monetary policy is likely to remain accommodative, and the chancellor could use future budgets to stimulate the economy.
Against this backdrop of uncertainty and upheaval, financial markets are likely to be turbulent for UK investors. We believe that this requires a degree of caution and continued focus on diversification and high-quality assets.
A not so sterling pound
Despite recent positive economic data in the UK, our preference for being underweight in sterling remains in place. A weak pound might fuel inflation, but it also offers some support for the UK economy during the difficult and uncertain process of exiting the EU. However, the short-term benefits of this will likely be offset somewhat by a market preparing for the economic damage of leaving the single market. We believe UK economic activity will start to weaken towards the end of 2016.
RBC Capital Markets expects the pound to go as low as US$1.15 by the end of March 2017, which seems plausible given May’s recent comments. This outlook is further supported by what is likely to be a stronger US dollar as markets position for a rate hike by the US Federal Reserve at the end of this year—assuming a robust US economic outlook and relative calm in global markets.
Falling bond prices
Immediately following the Brexit vote, UK government bond prices initially went up, causing yields to fall, as the BoE delivered a raft of measures designed to combat the negative ramifications of the vote. More recently, however, government bond prices have been driven down as investors have started to demand a higher return for holding UK instruments, with the result being that the yield on benchmark 10-year gilts has doubled to more than 1 percent.
We believe that a cautious stance is necessary in fixed income right now, especially for bonds with longer maturity dates. We would focus on corporate bond issuers that have global earnings, with our preference being conservative sectors of the UK domestic market, such as utilities, which attract the BoE as a natural buyer as part of its asset purchasing programme and also offer a more attractive income yield than can be achieved through gilts.
We are cautious when it comes to UK retailers and banks. For banks, the potential risks of an acceleration in non-performing loans, extended regulatory fines (PPI), and squeezed net interest margins as a result of low interest rates are all causes for concern. For investors seeking exposure to financial companies, we would select global banks that issue debt denominated in the pound sterling.
Too early for domestic equities
In equity markets, we continue to prefer UK large-cap companies that generate most of their revenue abroad to mid-cap companies that tend to be more domestically focused. We also have a preference for defensive companies that generate a large percentage of their revenues abroad, such as those in the consumer staples and pharmaceuticals industries. Companies in the commodities and energy sectors will also benefit from a weak currency.
Conversely, we are more cautious on domestically focused sectors, even defensive companies such as utilities. These companies not only face an increasing risk of government interference, but their share prices appear historically high. Meanwhile, financial companies and retailers have historically suffered during periods of currency weakness. We are also cautious of companies with overly large pension deficits given that they will need to be recapitalised in this low-yield environment. Domestic stocks will eventually become attractive again, but we will wait for the economy and the pound to start stabilising and for valuations to become more attractive before making such a move.
Looking ahead, we believe the pound could fall further and therefore we continue to shy away from most domestic exposure in fixed income and equities. However, we acknowledge that UK financial markets will continue to be driven by political forces. With markets increasingly expecting the possibility of a ‘hard’ Brexit, the emergence of a ‘soft’ Brexit scenario where the UK retains some access to the single market could lead the pound to bounce back.