18 January 2019

Financial Times: It will be hard to wipe Brexit blot from asset landscape

[...]The dysfunction on show has tarnished one the UK’s most compelling selling points: its political stability.

As investors crunch the numbers on the merits of buying or selling other asset classes, the UK remains a deeply underweight holding in portfolios as BofA data has consistently shown. FTSE 100 blue-chips are lagging the new year bounce in global equities, with the index up 3.6 per cent in 2019 next to a 6.1 per cent gain for the FTSE All World index, excluding the UK. The resilience of the pound has duly weighed on the shares of blue chips that generate hefty revenues in foreign currencies.

In contrast, the FTSE 250 index, whose mid-tier members are more representative of the UK economy, has risen 7.2 per cent on hopes that a softer divorce will be achieved. Thanks to a modest rise in the pound this year, a dollar-based investor in the FTSE 250 will be enjoying a gain of 8.4 per cent, while a euro-denominated return stands at 9.4 per cent for the benchmark.

Richard Colwell, head of UK equities at Columbia Threadneedle Investments, made the point that “international investors are almost as underweight UK equities as they were during the financial crisis of 2008/2009 when the banks were technically insolvent”.

So does the negativity mean global investors are running the risk of missing out on the early days of a real recovery in beaten-down UK shares? It happened before France’s presidential election in 2017 when political risk worried investors, but some hedge funds bought domestic equities and were rewarded for their pluck.

Since the 2016 referendum, the fortunes of the currency have been the tip of the Brexit trade, with the risk of a sharp slide in the pound, even from historically cheap levels, keeping large investors nervous.

During the post-Bretton Woods era of floating exchange rates, the pound has never languished for so long. Only during the mid-1980s was sterling stuck below $1.40, which reflected the US dollar’s surge during the Reagan boom.

Given that the inflation and unemployment levels in the UK and US are fairly similar, the pound’s prolonged weakness underscores the extent of the risk premium that Brexit has introduced. UK two-year gilt yields remain much lower than those of short-dated US Treasuries as the Bank of England’s hands remain tied on interest rates.

For those assessing exposure to the UK currency, the Brexit outcome remains a binary one for the pound and even for traders anticipating a rally in the event of an extension to Article 50, there’s good reason for caution. For all the pound’s resilience, it has been unable to close above $1.30 in two months.

A hard Brexit leaves the pound heading towards $1.20 and hitting parity against the euro. By contrast, an extension to Article 50, accompanied by a push in parliament towards a softer exit or even a second referendum, has the currency market primed for a rally, possibly back towards $1.40.

“The investment strategy is to buy the pound as soon as the UK parliament coalesces a majority around an action plan to counter a no-deal Brexit,” notes Dhaval Joshi at BCA Research.

Whether that is enough to entice a wall of global money back into the UK is the big question. Certainly there are good UK companies, whose share prices have been tarnished by the Brexit drama. Yet the harsh reality is that the prolonged process has delivered a reputational hit to the UK.

The messy drama comes just as a slowing eurozone weighs on the global economy. While the UK and the rest of the EU are divided over Brexit, what they do share is cheap equity markets. But unless economic and political uncertainty abates, investors will rightly question the merits of upping their exposure to both Europe and the UK. 

Full article on Financial Times (subscription required)

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