Managers breathe easier over Brexit; concerns remain

Money managers and institutional investors are unwinding positions held when the U.K. voted to leave the European Union as parts of the market stabilize and investors realize nothing has changed yet.

However, some sources expect to see changes by institutional investors as they re-evaluate the impact of moves immediately following the June 23 vote — and as the clock ticks down to the actual exit. Since Pensions & Investments went to press, the U.K. government has given some clarity on the timing of Brexit. Speaking at the Conservative Party conference in Birmingham on Oct. 2, Prime Minister Theresa May said Article 50 will be invoked no later than the end of March next year, triggering negotiations on the U.K.'s exit from the European Union.

“We are in a phony war in the sense that we know the battles that are to come, but they haven't started yet,” said Simon Hill, London-based chief investment officer and senior investment consultant at Xerox HR Services. “Having settled down after the initial turmoil in the summer, partly due to the EU referendum, markets are in a false period at the moment where ... (they) aren't trading on news.”

Equity and currency markets did react in the immediate aftermath of the vote. The S&P 500 lost 4.07% between June 22-27, while the FTSE 350 lost 5.8% in the same period. However, year-to-date as of Sept. 27, the S&P 500 gained 6.7% while the FTSE 350 has returned 10.96%. The pound dropped more than 10% after the vote, falling at one point below $1.28.

Sources said the sterling move against the dollar and other currencies is preoccupying institutional investors right now. “One frequent comment is, "we just made shedloads of money in overseas portfolios with the collapse of sterling — what should we do about it?'” said Neil Dwane, global strategist at Allianz Global Investors in London. “If they have significant overseas positions they could potentially have taken some profits,” since the currency seems to have stabilized around $1.30. “Then (clients) can form a view of where they think sterling will go in the next two to three years” once the U.K. starts its exit.

Mark Astley, CEO at Millennium Global Investors in London, said executives have been talking to clients and consultants about the impact of Brexit on portfolios, given some U.K. pension funds had unhedged currency exposures and others had substantial hedges back into sterling. “Those who were unhedged have had a wonderful windfall gain and are asking what to do next. Those who had a 50% or 75% hedged position back into the pound have suffered a massive realized loss, and those clients are also asking what to do now.”

For some funds, currency is not an issue. “As a rule — and it's simply our guidelines — we don't have any currency risk,” said Inger Huus Pedersen, Copenhagen-based head of fixed income at the 250 billion Danish kroner ($37.4 billion) PKA, Hellerup, Denmark. “On June 24 we had that risk hedged away, so it wasn't a concern for us that the pound depreciated pretty heavily that day.”

Investments in the U.K. account for around 7 billion Danish kroner. Where the funds do have exposure to the U.K. it is largely infrastructure, “and of course it was something that we had looked at.” However, executives found there was no impact.

“Immediately after Brexit we asked our external managers to hold their horses, but we have now told them to go on with business as usual but taking Brexit into consideration.” She also said it may take a while for the U.K. to fully exit the EU. “I don't see anything preventing us from allocating (to the U.K.) but of course we have to look at potential effects from Brexit. However, at the moment we don't see any major impact.”

In the aftermath of the Brexit vote, some investors are reconsidering the way they invest in the region. “In our conversations with North American investors, we understand that some are separating out their U.K. allocations from their continental European allocations,” said Paul Shea, London-based co-founder and managing partner at alternative finance firm Beechbrook Capital LLP. He said these comments have only been made post-Brexit. Any such move could be advantageous for U.K.-only strategies. The manager, which has almost e500 million ($558.1 million) of assets, has continued to see interest from borrowers for its U.K. SME Credit fund, and is “cautiously optimistic about the opportunities for direct lenders in the U.K.”

Prior to the vote, some managers upped due diligence, particularly those investing in credit. “We took every deal we owned and went through the underwriting process again,” said Martin Horne, head of Barings LLC's European high-yield investments group and the European high-yield investment committee, based in London. The firm was looking for impact from a drop in consumer sentiment and an immediate mild recession on its holdings, and also the impact of a “rapid depreciation of sterling.” Executives were looking to take out names that did not look robust enough, and the result was that only one was put on its sell list. “Most of the companies we have been investing in in recent years have already been survivors of mild recessions,” such as the eurozone sovereign crisis.

While volatility did hit the markets, as predicted, Mr. Horne said it was “disappointing” that it only lasted a couple of weeks. “There was some selling but it was largely technical — most investors were rational, with no run for the hills. We picked up what we could, but really the market got itself back to a rational place quite quickly. There was an opportunity ... it was all too brief,” said Mr. Horne.

Due to opportunities thrown up by Brexit, managers also re-evaluated their positions. A popular trade in the runup to the vote was to short U.K. sterling. Executives at BNP Paribas Investment Partners, Insight Investment and Robeco said they took short positions on the sterling but have since altered their exposures.

“We are not as bearish on sterling as we were before,” said Daniel Morris, senior investment strategist at BNP Paribas Investment Partners in London. He said that as Brexit plays out, the effect on the currency will not be so hard. “There has already been a fairly significant decline, and so (we have moved) from bearish to neutral.”

Taking a short position on sterling was a “crowded trade,” said Matthew Merritt, head of the multiasset strategy group at Insight, based in London. The manager started to build a short position on sterling in February, but viewed Brexit as an event that “would have been a catalyst for further weakness in the pound.”

The firm also had a preference for gilts, in part reflecting a “dislike of negative yielding bonds elsewhere,” and had a number of trades such as long FTSE 100 — where the majority of revenues are earned overseas — and short FTSE 250, “which would work on the basis that if sterling goes down, that's good for U.K. stocks with an international bias.”

On Aug. 4, the Bank of England cut interest rates by 25 basis points to 0.25% and restarted its quantitative easing program. That further depreciated the pound, but flooded the market with stimulus — yet Article 50, which will kickstart negotiations on the U.K.'s exit from the EU — has yet to be triggered. “We have had a lot of stimulus pushed into the market, but the debate of when (the U.K. triggers) Article 50 is ongoing, and there is virtually no probability it will happen this year. So against that background, we faded some of those positions; some of our long gilts over other markets, most obviously (German) bunds, we have taken off. We have stepped away from our large-cap/small-cap trade, and we faded certainly the size of our position on sterling,” said Mr. Merritt.

He said Brexit was a difficult situation from a portfolio management perspective, particularly given that the consensus view was that the vote would not result in leaving the EU. “On that basis, to some degree, we didn't have the whole portfolio skewed toward a view of Brexit. We had a strategy that recognized that the greatest challenge, particularly to risk assets, was lack of growth,” and that a vote to leave would exacerbate growth fears.

The multiasset team will “re-engage with those (positions) at some point in the future, but we've had the policy response and we're still some way off from seeing the real uncertainty that is going to come through in discussions” and negotiations regarding the actual exit.

Barings multiasset team had a significant underweight on sterling around Brexit. Prior to the vote it was 30% underweight, and at one stage moved to 40% underweight, said Marino Valensise, head of multiasset at Barings. However, at the multiasset investment committee meeting in August, “we upgraded sterling from underweight to neutral. Members of the strategic policy group "'have now decided to close those positions in their portfolios and we are buying back some sterling.” n