Continued uncertainty on Brexit putting a chill on U.K. markets

The possibility of another delay to the U.K.'s withdrawal from the European Union prolongs uncertainty about the U.K. economy and assets, leaving investors at risk that a no-deal exit could still occur in 2020.

Brexit was originally slated to happen in March 2019. But the U.K. Parliament's failure to come to agreement with its members as well as with the government on an exit plan has twice pushed back the date, which now stands at Oct. 31.

But even as Prime Minister Boris Johnson and his government have guaranteed he will request another extension from EU leaders if no deal is struck with the EU by Oct. 19 that is acceptable to Parliament, little progress appears to be made toward support from MPs for a viable Brexit policy.

Mr. Johnson is set to appear before Queen Elizabeth II on Oct. 14 to outline his key policies for the country, including his Brexit strategy for the final EU summit on Oct. 17. In the days that will follow the speech, the prime minister's priorities will be subject to a vote by MPs.

Extending the Brexit deadline further could be Mr. Johnson's defeat at the hand of MPs if he loses this vote, triggering a no-confidence motion from the opposition. A condition for the U.K. to remain in the trading bloc for a longer period of time could also be made by the EU leaders if no withdrawal agreement is accepted by the Parliament before the October deadline.

Meanwhile, the political deadlock is adding pressure to an already underperforming U.K. economy, a devalued currency and overall investment sentiment, which makes the U.K. a "frozen" market, sources said. Comparing the U.K. to Europe during its 2014 political turmoil, sources said the risk premium on U.K. assets along with an unpredictable currency are still not enough to attract investors.

Global fund transaction network Calastone Ltd.'s fund flow index found that active equity funds with exposure to U.K. equities experienced £3.5 billion ($4.2 billion) net outflows from institutional investors in July through September, more than in the previous three quarters combined. Active U.K. equity-only funds shed a net £1.2 billion, Calastone data showed.

"Clearly, the U.K. is pretty hated at the moment," said Richard J. Tomlinson, deputy CIO at the £17 billion Local Pensions Partnership, London, warning that in the long run, investors may struggle to have confidence in the market because they are not able to see how Brexit will play out during the life of their investments as the next stages of Brexit negotiation are unfolding, even if an initial withdrawal deal is struck.

Paul Flood, multiasset portfolio manager at Newton Investment Management in London, added that the uncertainty in the short term associated with delaying Brexit continues to make businesses more cautious, particularly stopping U.K. companies from investing since the last extension was granted in April.

"We hear a lot of businesses are looking to cut costs because Brexit uncertainty is delaying their investment decisions. Numerous U.K. businesses are now talking about job cuts," he said.

Mr. Flood also said that in the last two years U.K. indexes have underperformed global peers. As of Oct. 11, FTSE All-Share Index has fallen 3.62% since July 31, after Mr. Johnson took office on July 24, and has lagged the S&P 500 index by an annualized 6.9 percentage points since the Brexit referendum on June 23, 2016.

Mr. Flood noted U.K. cyclical companies — oil and gas, banks and financials — are "unloved" by markets.

For investors with global exposures, Brexit has continued to obstruct investing due to the impact of the weakness of the pound sterling on U.K. businesses. Pound sterling fell 3.1% against the dollar to $1.27 since April 12, when the last Brexit deadline was effective.

"Naturally, the Brexit unrest is creating some prolonged uncertainty for the financial markets that we would be happy to go without," said Jan Ritter, head of hedging and treasury at the 880.8 billion Danish kroner ($129 billion), ATP, Hilleroed, Denmark.

Charles Kalshoven, Amsterdam-based senior strategist for economics and strategic asset allocation at APG Asset Management, the manager of €456 billion (€498.7 billion) Stichting Pensioenfonds ABP, Heerlen, Netherlands, said in a telephone interview that an uncertainty about the U.K.'s economic relationship to the other 27 countries of the EU and future market access harms investment in new plants, factories and machines.

"Any delay prolongs the period of uncertainty," he said.

Mr. Kalshoven noted the environment means U.K. companies with domestic revenues suffer, forcing investors to consider how weakening of pound sterling affects these businesses.

According to the Cboe Brexit index of relative performance of high- and low-exposed companies compared with sterling, we see "weaker sterling results in a decline in the relative performance of the highly exposed companies," Mr. Kalshoven said.

On the credit front, U.K. companies are also facing damaging consequences of Brexit. Since October 2018, almost 40 U.K. companies, including housing associations, have suffered a negative outlook change or rating downgrade when Brexit is a factor in their operations, said Paul Watters, senior director and head of Europe, the Middle East and Africa credit research at S&P Global Ratings.

The prolonging of the Brexit process is inflicting further damage to the U.K. economy as money managers are reluctant to make portfolio recommendations.

Didier Borowski, head of macroeconomic research at Amundi in Paris, said in an emailed comment: "In the event that the outcome is unfavorable for the U.K., we would see a weaker pound sterling and below-trend GDP growth. But should a deal be approved or Article 50 (which, triggered Brexit) be revoked, we would see the opposite. The situation remains very binary and thus not very conducive to strong portfolio recommendations."

Going forward, Wouter Sturkenboom, chief investment strategist, Europe, the Middle East and Africa and Asia-Pacific at Northern Trust Asset Management in Amsterdam, said he thinks the Brexit impact still depends on the circumstances of the delay — such as whether a general election is scheduled to re-decide Brexit or if a vote of no confidence occurred against Mr. Johnson's government.

Sources said the delay guaranteed under the recently approved Benn Act, which forces Mr. Johnson to request an extension, does not resolve all of the issues, such as the threat should Mr. Johnson's government fall.

Should that happen, the new leadership could derail trading arrangement talks for longer.

"In and of itself, we think a delay is largely priced in but the circumstances will drive markets to either price in a lower or higher probability of no-deal," Mr. Sturkenboom said, adding there is a potential for more volatility particularly in the pound sterling exchange rate.

To prepare against the negative effects of higher volatility, continued economic slowdown into recession territory and the potential for interest rate cuts, global investors do not have much room to maneuver.

"We might expect to see more equity protection or rolling (of hedges) if uncertainty persists. A number of plans have already been doing this in both the public and private sector," said Mark Johnson, head of institutional clients at Legal & General Investment Management in London.

But the outlook for U.K. assets remains weak. Global money managers have been underweight the U.K. equity for three years, according to Bank of America Merrill Lynch's global fund manager survey. U.K. equity allocations declined 7 percentage points between the survey's July and September reports, to a 30% underweight.

The Investment Association, the U.K. association that represents managers running £7.7 trillion in assets on behalf of U.K. investors, said net institutional sales in U.K. equity sectors to pension funds have been falling since January through July 2019. As of July 31, net institutional sales to pension funds were -£220 million.

However, John Roe, head of multiasset funds at Legal& General Investment Management in London, said: "While the U.K. is deeply unpopular with active managers, this is only partly related to Brexit. Similarly, some strategic asset allocations will have reduced U.K. weightings based on a longer-term view of increased risk and uncertainty rather than for short-term tactical reasons."