Most investors would prefer to not think about politics. It’s hard enough working out the link from economic growth, inflation and profits to asset prices. Trying to figure out a further link between asset prices and the whims of politicians is much harder. Instead, we think investors should prepare for a wider range of possibilities rather than try to predict specific outcomes.
The way we do this is to think through scenarios. We believe that there are three potential outcomes for the shape of Brexit over the coming months: Keep Kicking the Can; No Brexit; or No Deal.
When forming the scenarios, there are some assumptions we make. First, politicians always over-promise and under-deliver. They’ll often say things to get elected, steal headlines, connect with a certain audience, or frankly just get through the day. But it is important to remember: Can they do it? Do they have the numbers in Parliament? What are the polls saying? Have they got the backing of their party?
Second, politicians are always biased to positive economic outcomes. When push comes to shove, electorates across the world vote with their wallets and politicians of all stripes ultimately know this – even if they express “heavy hearts” in public.
Keep Kicking the Can – High probability, Sterling up in fits and starts
Despite Boris Johnson winning the leadership of the Conservative party, we do not think this significantly alters the trajectory of Brexit negotiations. This may sound surprising but what Boris, the leadership candidate, SAYS on Brexit is likely to be different to what Boris, the Prime Minister, DOES on Brexit.
Ultimately, Johnson inherits a Brexit proposal that is still fundamentally unacceptable to at least half of the population of the country – if not more. He can’t change the parliamentary arithmetic - which has rejected both the withdrawal agreement and a No Deal on multiple occasions.
That leaves Johnson with three choices: i) rebrand the withdrawal agreement, ii) seek an extension with the EU or iii) go back to the voters. It’s too early to tell which he will do, but none is likely to see a hard Brexit by the end of October.
The important point is that Parliament has the means and the will to stop a hard Brexit. It has so far signalled that it wants a softer outcome. Until we see something that suggests otherwise, we will continue to think this is the most likely scenario. However, the journey is likely to take a LONG time.
Even when No Deal is avoided, it is not unambiguously positive. The last three years don’t get undone – the aftermath of the referendum result continues to act as a drag on the economy and on Sterling. Consumers continue to spend but businesses are struggling to commit. Investment is being held back while foreign flows into the UK are drying up. UK housing, which was the main thrust to growth in the last few years, has lost its momentum. However, long-term valuations suggest Sterling is cheap. We expect it to rise in due course, possibly via a long and slow grind.
No Deal – Low probability, Sterling down sharply
For No Deal to happen, we would have to be wrong in our assumption that Parliament has the will and the means to stop a hard Brexit. This assumption rests on a majority in Parliament believing that a No Deal would be too damaging to the UK economy. The recent report from the Office for Budget Responsibility (OBR) suggesting a UK recession would be likely following a No Deal, reinforces our view that MPs will continue to believe this. MPs would struggle to explain to their constituents why they ignored the Government’s own watchdog.
However, No Deal can’t be discounted completely. If anything, Johnson will look to take negotiations to the wire. This brings the potential for some kind of procedural/timing crunch towards the end of October and with it the chance of an accidental crash-out.
In this world, we expect the Pound to be driven to new lows against most global currencies as the UK slips into recession.
No Brexit – Low probability, Sterling up sharply
Until now, Parliament has shown its resolve to avoid a hard Brexit. But it has not shown a willingness to impose how it wants a soft Brexit to look. The only way we see this changing is if the question goes back to the voters – either through another referendum or a general election.
However, this is multiple steps away – not only do we need to see an announcement, but we would also need to wait for the votes to come in before we know. This remains a low probability for now. In this world we expect Sterling to rally sharply, but it would take time to revert back to pre-referendum levels. The damage from the referendum won’t easily be reversed.
What does this mean for our portfolios?
On the basis of the scenarios, we are overweight Sterling versus the long-term neutral position.
In a Keep Kicking the Can world, there is still space for breakthroughs and setbacks, missed deadlines and last minute reprieves which pull Sterling in different directions. The overweight Sterling position looks to insulate the portfolios from large Sterling moves.
In a No Deal scenario, the foreign currency exposure in our funds would be beneficial – we have around a third of our Balanced portfolios allocated to non-Sterling assets. Should we see a rerun of June 2016, we believe our portfolio returns will see small positive returns.
In a No Brexit scenario, whilst the value of our foreign currency assets would suddenly fall in Sterling terms, we believe our overweight to Sterling will cushion the negative currency impact, whilst equities are likely to do well.