Caution is watchword; how negotiations play out is key
With the clock now ticking on negotiations that will see the U.K. leave the European Union, executives at money management firms, consultants and pension funds are split as to whether the true impact has yet to be priced in.
The consensus is not to make any sharp moves as a direct result of the March 29 triggering of the so-called Brexit, under Article 50 of the Lisbon Treaty. With all eyes now on the way negotiations will play out, some observers warn there might be more downward pressure on U.K. markets.
“Triggering Brexit ... has been known about for a long time and should not have a particularly meaningful immediate impact onto markets,” said Colin Pratt, investments manager at the £3.2 billion ($4 billion) Leicestershire County Council Pension Fund, Leicester, England. “The unknown is the ability to agree (on) the terms of Brexit in a speedy and harmonious way, and markets seem to be relatively relaxed that this will not throw up any major issues.”
But there is some fear the markets are too complacent about the negotiations. “Given the EU's position almost necessitates a hard stance — to discourage anyone else leaving — harmony seems an unlikely outcome,” Mr. Pratt added. “Markets hate uncertainty, and the more issues that the negotiations throw up, the more likely it is that markets will be nervous and volatile. There just seems to be more downside risks to equity markets at present than there are upside risks.”
The U.K.'s FTSE 100 fell more than 7% within minutes of opening on June 24, the day the outcome was revealed. The index has more than recovered since. Sterling, however, has borne the brunt of Brexit. The currency dropped more than 10% against the dollar June 24 to $1.35, and has continued to plummet. As of March 31, sterling was hovering around $1.24, after falling slightly after Article 50 was triggered.
But executives warned there might be more to come. “Right now we are underweight U.K.,” said Mike O'Brien, CEO of investment management, Europe, Middle East and Africa, and co-head global investment management solutions at J.P. Morgan Asset Management (JPM) in London. “We think the risks that Brexit poses to the U.K. are not fully appreciated and are not fully incorporated into the pricing of the U.K. stock market.”
While J.P. Morgan executives think the world is moving into a global growth phase and the firm is generally overweight risk assets, it is underweight U.K. equities across asset allocation strategies and sees sterling as the only currency that might not strengthen against the dollar.
“We won't know how bad this will be until we start to get some degree of momentum in negotiations,” Mr. O'Brien added.
“I don't think everything is priced in,” said Paul Hatfield, London-based president and global chief investment officer at Alcentra. He said once investors focus on the potential that all risks are not yet priced in, combined with warnings from other markets on their expected relationship with the U.K. after Brexit, “news flow is going to be very important.” Although the euro continues to look resilient, and Alcentra executives remain bullish on the dollar, “I think sterling (will) come under fairly downward pressure just on the basis of news flow, and realizing how difficult the process of extricating (the U.K.) from Europe is going to be,” Mr. Hatfield said.
“The Brexit event has a strong political and institutional value in the short term, but the economic spillovers will materialize in the long run,” said Monica Defend, Milan-based head of global asset allocation research at Pioneer Investments.
While the U.K. economy has been a bit stronger than expected because of the fall in sterling, Azad Zangana, senior European economist and strategist at Schroders PLC in London, said: “We are still expecting a slowdown to come through over the next few months.”
Ms. Defend agreed. Exiting the EU single market will cause “a massive need of reorienting U.K. trade, and this will be particularly relevant for some sectors heavily exposed abroad. The potential loss of its financial services business due to the loss of “passporting” rights and the need to move parts of the business to continental Europe will eventually impact (the) U.K. trade balance” because of diminishing capital inflows and the likely contraction of the current trade surplus, she said.
Executives maintain an “agnostic positioning on the U.K. markets,” deeming it too risky to invest based on political triggers for the time being.
Colin Harte, portfolio manager and strategist on the multiasset solutions team in London at BNP Paribas Investment Partners, said the U.K. real estate market looks very cheap. “The only issue is we have a structural break coming (in the form of Brexit). Sterling is close to reflecting a hard exit, but I don't think the equity market is yet.” And while sterling does look cheap, it is not yet a buying opportunity, Mr. Harte said.
Whether Brexit risks are priced in, executives will keep a close eye on negotiations.
Chris Teschmacher, multiasset fund manager at Legal & General Investment Management in London, does not expect momentum to change, but he said the nature of the discussions with the EU could prove otherwise. “Friendly” negotiations could see a strengthening of sterling, but a more aggressive tone could see sterling selling off further. The team is overweight sterling, a view held for some time because the “sell-off in sterling was way too sharp.” Executives hold a “decent basket of overseas currency,” with portfolios aiming for a high level of diversification.
Bill Street, a senior managing director and head of investments for Europe, Middle East and Africa at State Street Global Advisors in London, believes the triggering of Article 50 is broadly priced in. “I think it will be taken in its stride because there is a lot of risk priced in already post-referendum. A lot has been priced in through the currency rather than some of the more risky assets, because in some respects the weak currency is helping support other assets,” he said.
The negotiation period will be an “unraveling story. My concern is the market moves on the punctuation points rather than the conclusion. A lot will be played out in the headlines rather than on fundamental analysis, which is not great for the market. And I expect short-term inflection points of volatility over the next couple of years,” said Mr. Street.
The post-Brexit pain is a “slow burn, and exposures to U.K. domestic risk are limited in equities and credit,” said Tapan Datta, London-based head of asset allocation at Aon Hewitt. Any exposure is probably at the security level rather than broader markets. “Given the limited, or non-existent, damage to U.K. assets — excluding sterling — you could argue there may be some impact over time if Brexit plays out badly. This could happen, but the imponderables are too big to use Brexit as an excuse to sell.” Aon Hewitt expects U.K. equities to lag and doesn't like U.K. credit that much either, “but Brexit itself is marginal to this view,” Mr. Datta said.
However, there might be opportunities for active managers, said Ronnie Sabel, senior portfolio manager, Europe and U.K. equities at Russell Investments in London. “Most people are expecting the trigger won't have a big impact on markets, but as negotiations start unfolding, markets will probably be volatile, and that creates an active management opportunity. It hurts at first, but (for those) skilled investors who can identify (stocks that have been) oversold or overbought, that creates fantastic active management opportunities.” Mr. Sabel said he hasn't seen managers “trying to position themselves too cleverly around the Article 50 trigger date.”
However, “Investors have been fairly cautious about investing in U.K. equities because of the uncertainty,” Mr. Sabel said. He is starting to have conversations with continental Europe-based investors about allocations to Europe ex-U.K. strategies.
This article originally appeared in the April 3, 2017 print issue as, "Brexit market fears still haunt investors".