The UK left the EU on 31 January 2020 but that’s not where the story ended for investors. Negotiations over a future trading relationship are in their final stages, with the transition period set to end on 31 December 2020.
Our base case has been that some form of face-saving compromise will be reached with the UK and EU signing a basic free trade agreement, limiting a further hit to economies already suffering due to the coronavirus crisis. Political positioning could, however, lead to a “No Deal” accident and stubbornness could mean damaging tariffs remain in place.
Domestic UK assets and the pound are likely to be most impacted by these events, but sensible portfolio design can help to mitigate political risks for investors.
Diversification in strategic asset allocation
Diversification is the first line of defence against market volatility. The multi asset funds we manage are invested across a broad range of asset classes which can include UK and global equities, commodities and commercial property (Figure 1).
In the case of Brexit, a “no deal” outcome would probably lead to a sharp fall in sterling. While commercial property and domestically-focused stocks could see mark downs, the impact could be more than offset by gains in large cap UK equities and overseas investments. Companies in the FTSE100 index have significant overseas earnings and their shares would likely rise in value, as they did after the 2016 referendum when the pound dropped by 10% overnight. Overseas investments and commodities would also benefit from a positive effect when their values are translated back into sterling terms.
A positive outcome of trade negations would probably have the reverse effect, with losses on large cap stocks and overseas equities offset to some extent by an upward shift in the valuation of domestically focused assets.
Active tactical positioning
Tactical asset allocation can also mitigate political risks. We manage our multi asset funds actively, seeking to add value to the strategic mix for each portfolio by adjusting asset class weightings as the investment backdrop evolves. We have been underweighting sterling in our asset allocation on and off since the 2016 referendum and we deepened our positions in early September 2020 as tensions – and exchange rate volatility – began to rise (Figure 2).
The pound dropped sharply when the government said it was tabling legislation that broke international law to override the Withdrawal Agreement with respect to Northern Ireland. We subsequently covered some of our underweight position when news broke that PM Johnson had agreed to an amendment requiring further parliamentary consent.
Bearing in mind the relationship between large cap UK equities and the pound, as set out above, we took the opposite approach with our UK equity exposure, reducing our long held underweight when we saw a risk of sterling weakness (Figure 3) and starting to re-establish it when we judged the risk of further near-term currency weakness had reduced.
Political events merit particularly close attention over the next few weeks. The UK and EU form a large part of the world economy and a period of economic disruption would be felt far afield. In a worst case scenario, Brexit tensions might spill over into a general risk off tone in global financial markets. We have lightened up equity exposure in recent weeks due to concerns that both Brexit and the upcoming US Presidential elections could rattle sentiment. If markets do drop, however, we’d consider buying the dip on the expectation that concerns would be short-lived and Covid crisis stimulus would ultimately win the day.
Prepared for eventualities
We have lived with varying degrees of Brexit risk for more than seven years since David Cameron first promised an EU referendum in January 2013. We suspect the UK’s relationship with its European neighbours will remain a source of tension – and also positive surprises – for some years to come. We are prepared for eventualities with a broad mix of investments aimed at dampening volatility when it hits and a vigilant and active investment process designed to help us take advantage of the opportunities that such volatility may create.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For illustrative purposes – reflects Strategic Asset Allocation weightings, may vary in accordance with tactical asset allocation. Risk rating is established by Distribution Technology (DT) and is out of 10. Inflation as measured by the Consumer Price Index (CPI).
Portfolio characteristics and holdings are subject to change without notice. This does not constitute an investment recommendation. For information purposes only.
Source: RLAM as at September 2020. Chart shows the historic tactical position of GBP within the RLAM Multi Asset’s FX template. This relative score is applied to the multi asset funds at a varying scale.
Weightings may vary according to tactical asset allocation and the Fund may invest outside of indicated asset classes as the manager sees fit.
Source: RLAM. Tactical positions as at September 2020.
The views expressed are the author’s own and do not constitute investment advice.