Deal or no deal: Brexit hopes, fears and money-making strategies

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.

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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.”

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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

Sharp slowdown likely in event of a no-deal Brexit

On the whole, since the referendum, the UK economy has performed better than expected: the annualised growth rate is 1.5% and unemployment has reached a 40-year low.

According to wealth manager Coutts, the relatively modest impact of Brexit on the economy to date can be explained by two factors. First, while notice to leave the EU – which has caused uncertainty and weighed on investor confidence – has been given, the UK has not yet exited the EU or felt the force of disruptions that may accompany leaving the EU. Secondly, Coutts notes, the UK economy has benefited from a period of strong and synchronised growth across other major economies. Coutts makes the point that without this global backdrop, it’s likely that growth would have been significantly weaker.

However, in the event of no-deal, Coutts warns of a “sharp slowdown, possibly even a recession”. It adds that a no-deal scenario would result in “meaningful disruption of economic life in areas such as trade, transport, food supply and travel”.

It adds: “Despite Bank of England governor Mark Carney warning that this could lead to both higher inflation and an increase in interest rates, the bank would be likely to prioritise growth over inflation, cutting rates back to zero and relaunching asset purchases. Gilt yields and sterling would fall, reflecting greater economic risk.

“It is important to note that this doesn’t account for negotiations between the EU and the UK starting again or temporary measures being put in place to prevent too much disruption for either economy.”

Coutts is not the only firm to publicly express its concerns. In late October global ratings agency Standard & Poor’s warned that a no-deal scenario could trigger a recession.

A report by Standard & Poor’s projected that unemployment would rise from its current record low of 4% to 7.4% by 2020, house prices would depreciate by 10% over two years and inflation would rise and hit a peak of 4.7% in mid-2019.

Paul Watters, an S&P Global Ratings credit analyst, says: “Our base-case scenario is that the UK and the EU will agree and ratify a Brexit deal, leading to a transition phase lasting through 2020 followed by a free-trade agreement.

“But we believe the risk of a no-deal outcome has increased sufficiently to become a relevant rating consideration. This reflects the inability, thus far, of the UK and EU to reach agreement on the Irish border issue, the critical outstanding component of the proposed withdrawal treaty.”

The rating agency’s forecasts starkly contrast with the government’s expectations of 1.6% growth next year (raised from 1.3% in the autumn Budget) and 1.4% in 2020, although the government figures (from the Office for Budget Responsibility) are based on a smooth Brexit. In the event of a no-deal these figures would have to be adjusted. Moreover, there would be another Budget, something chancellor Philip Hammond has already conceded.

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It may be that it’s better to arrive than to travel

Curtis agrees that the UK economy would be negatively hit in the event of a no-deal outcome, which would slam the breaks on further interest rate rises. As far as individual equities are concerned, it would probably lead to a strong feeling of déjà vu. He says: “A no-deal scenario would cause the pound to fall and, once again, hurt the more domestically focused UK stocks, whereas the more internationally facing UK stocks will be better placed.”

That said, given that the UK is already loathed by domestic and international investors alike, perhaps the sell-off will prove to be tame rather than tempestuous. Clarke notes that by now investors should be well-versed on the spread of probable outcomes.  

He says: “The defining insight of behavioural finance is that we feel losses more keenly than gains. Given the weakness of UK-centric shares and two years of Brexit  navel gazing, our sensitivity to loss means the worst could well be in the price. To invert the well-known expression, it may be that  it’s better to arrive than to travel.”

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A smarter way to play a Brexit bounce

As outlined in the main article, UK fund managers have been putting action plans in place to try to benefit from a Brexit bounce, providing some sort of deal is reached.

For investors who prefer to buy equities themselves, their ideas will hopefully have provided some food for thought.

On the other hand, for those who prefer to outsource the decision-making to a fund manager, there is a smarter way to play a potential Brexit bounce: by selecting an investment trust in preference to a fund.

That’s because UK-focused investment trusts are on the whole trading on sizeable discounts, due to the sector being off form and out of favour.

In the event of a Brexit deal occurring, there could be a pleasant surprise for investors, and this would improve the fortunes of UK funds and trusts.

With investment trusts, investors could bene­fit from a ‘double whammy’, as the discount will in theory narrow, magnifying total returns.

Stockbroker Stifel agrees there “could be a positive surprise ahead for investors”, which may lead to increased capital flows and a “signi­ficant rise in equity markets to the bene­fit of investment trusts investing in UK equities”.

The broker notes that three trusts are trading on relatively wide discounts to net asset value: Perpetual Income & Growth on 9.7%, Murray Income on 7.7% and Temple Bar on 5.9%.