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Picture remains fuzzy a year after Brexit

Kasper Ahrndt Lorenzen believes the impact of the U.K.’s exit will be limited — as long other major EU countries don’t follow suit.

Institutional investors still not sure of risks; regulation also unclear

A year after U.K. citizens voted to leave the European Union, more questions than answers remain for European pension funds and other institutional asset owners working to assess the risks associated with the U.K.'s surprise decision to exit the bloc.

And currency risk is far from the only peril on their radars.

For some pension funds, Brexit is expected to prompt allocation adjustments to U.K. alternatives and equities due to concerns about the country's economic growth and London's declining status as Europe's premier financial hub.

Market implications for the investment community also are yet to be seen, with the U.K. government attempting to strike the least disruptive deal to managers' business interests. Despite reassurances from both U.K. and EU regulators, key matters such as the regulatory status of money management firms remain unclear.

Britain's June 8 election also raised questions regarding the Brexit negotiations, at least in the short term.

While Prime Minister Theresa May's plan to capture additional seats in Parliament backfired — her Conservative Party lost a majority — Ms. May said at a news conference on June 9 that she would be forming a coalition government with the Democratic Unionist Party. The DUP platform is pro-Brexit, but advocates a softer approach than the Conservatives.

Should the Brexit negotiation process be prolonged beyond March 2019, it likely will further affect equity and real estate valuations, sources fear. Further contagion could still be in the cards if other European countries decide to follow Britain or if the U.K.'s swift exit deal is derailed, industry sources said.

Not convinced

In the U.K., pension funds are not convinced the risk has subsided. But many are avoiding making predictions or changing investment strategies, sources said.

Sean Pearce, chief financial officer at the £1.9 billion ($2.4 billion) Worcestershire County Council Pension Fund in Worcester, England, said: “We have a strategic asset allocation in place for the next three years and keep the opportunities and risks of a number of macroeconomic activities under review, including Brexit, as part of that strategy.”

Tom Joy, director of investments of the Church Commissioners for England, a £7.9 billion endowment and pension fund, said: “We will see an impact of Brexit both in the long and in the short term. Making predictions about negotiations is not sensible. We haven't made any changes to our strategy as a direct result of Brexit for the next two years — but having said that we tend to prefer global equities and therefore maintain a low exposure to the U.K.”

Equity assets constitute approximately 37% of the fund's assets.

Meanwhile, global investors have been shunning U.K.-focused mutual and exchange-traded funds since the beginning of the year. According to June data from EPFR Global, a provider of fund flow and asset allocation data based in Cambridge, Mass., funds dedicated to the U.K. recorded their sixth straight week of outflows — pushing the total year-to-date outflows to $1.6 billion as of June 1. 

Invesco (IVZ) Ltd.'s annual Global Sovereign Asset Management Study, released June 5, revealed sovereign wealth funds are increasingly skeptical about London's position, too, due to the U.K.'s impending exit from the European Union. Some 41% of investors said they expect to introduce new underweight positions in 2017, the study found.

The European market has shown much stronger signs of recovery than the U.K. since the June 23, 2016, Brexit referendum, when the FTSE100 and MSCI Europe closed on the day of the vote at -3.15% and -2.29%, respectively. Since the vote through June 6, the FTSE 100 is up 7.1% while MSCI Europe is up 14.8%.

Currency risk

Stephanie Flanders, chief market strategist for Europe at J.P. Morgan Asset & Wealth Management in London, said the U.K. economy appeared to have weakened significantly in the first few months of 2017, as higher inflation tied to last year's fall in the pound started to reduce the purchasing power of U.K. households.

“We do expect a fair bit of currency volatility in response to news about the negotiations. So, the relative performance of large-cap international companies, relative to mid- and small-cap domestic focused companies is likely to remain highly uncertain for several years. In this environment, U.K. equities could still perform well, but it probably makes sense to avoid taking large sector or size bets,” she said.

The U.K.'s decision to leave the bloc last June 23 instantly shocked global markets, sending pound sterling on a downward spiral: It plunged a record 17.5% against the dollar from June 23, 2016, to March 13, 2017. The currency is finally recovering. Sterling traded 5% higher on June 7 compared to mid-March.

Despite this visible recovery, asset owners across Europe continue to hedge the currency risk.

Kasper Ahrndt Lorenzen, chief investment officer at the 753.2 billion kroner ($113 billion) ATP based in Hilleroed, Denmark, said: “We are still hedging our foreign currency risk outside of Danish kroner and the euro and we keep a balanced investment approach which enable us to navigate accordingly as political landscapes may change.”

Sources said, too, that the European political risk has not completely disappeared, following Emmanuel Macron's triumph in French presidential elections in May, although many believed it to be the key to stopping a populist domino effect in Europe.

“Our overall investment strategy is based on a long-term perspective and the British decision to leave the EU has a limited impact on our strategy as long as core EU countries don't follow the U.K.,” Mr. Lorenzen warned.

While the upcoming September ballot in Germany is not expected to take an unpredictable turn, there is a likelihood of populists coming to power in Italy, reigniting that country's ambitions to also exit the bloc.

Ms. Flanders said, “The biggest risk on a 12-month time frame is that (Italy's populist) Five Star Movement will either win the election outright or manage to form an unlikely coalition” with other anti-European Union forces.

Not just a domestic issue

The U.K. decision to leave the European Union doesn't just affect domestic pension funds. European asset owners investing in U.K. alternatives point out they also are preparing to shield their portfolios against the adverse effects of Brexit.

Stefan Beiner, head of asset management and deputy CEO of the Swiss Federal Pension Fund Publica, Bern, said that while he could not give specific details, Brexit had made the 36.5 billion Swiss franc ($37 billion) pension fund take into consideration Brexit scenarios in its tactical allocation to infrastructure debt. He declined to provide more details.

For the Paris-based Etablissement de Retraite Additionnelle de la Fonction Publique, Brexit has consequences, too. The €26 billion ($29 billion) French pension fund allocated to U.K. real estate some two years ago.

“Our real estate allocation is rather small and as a long-term investor, we are not that worried about Brexit and a virtual capital loss is not really an issue. We can hold the assets we invest in for a long period. Nevertheless, it is always an uncomfortable situation for a board to have to reserve in the balance sheet a virtual capital loss,” said Philippe Desfosses, CEO at the pension fund, in a telephone interview. ERAFP's total real estate allocation is €2 billion, with exposure to the U.K. at €200 million.

Mr. Desfosses said Brexit could prompt asset owners to question if there is a long-term prospect in the U.K. For example, he said, Brexit could halt the real estate sector's growth.

“There are some questions about the future attractiveness of the U.K. market for EU students and workers — which put a question mark over investment in student housing or offices.”

This article originally appeared in the June 12, 2017 print issue as, "Picture remains fuzzy a year after Brexit".