So Theresa has finally spoken, and we are… not that much the wiser. There were a few new bits of information though – highlighted below with some comment.
- House of Lords and House of Commons will vote on final deal before enacted: This will be interpreted as good by those wanting a soft Brexit, as it allows the possibility of challenge due to lobbying of MPs etc.
- Not going to seek single market membership: This is an interpretation of the referendum result to mean out of the EU and all similar institutions. Even if Britain ends up with a trade deal similar to the single market, it will not be labelled as such.
- Phased process of implementation: This allows transitional arrangements to be negotiated, perhaps even on an individual industry basis. And it is a clear nod to managing the Brexit procedure in order not to damage businesses. As a business owner though, you’d want a lot more detail before you got comfortable with the situation.
- If no deal agreed, the UK leaves anyway – our way or the highway. It keeps the hardest of hard Brexits on the table – particularly worrying if Parliament votes ‘no’ on any proposed deal. Does that mean no renegotiation possible?
- Security arrangements with the EU are a priority: Perhaps a negotiating tactic, but it reminds the EU how important UK Intelligence agencies are to security in their own nations.
The rapid bounce in Sterling will make headlines, and it suggests the currency market was pricing in a more aggressive speech than the Prime Minister delivered. However, even with today’s 2.5% rally, the Pound is still below where it started the year. This highlights to us that currency positioning is still likely to be an important factor for our clients, and we discuss this more below.
Going into the Referendum on 23 June, we had identified Sterling as the key lever to be pulling, in order to manage portfolio risk. This proved to be the right call and it remains important today. At present, the market is responding to the hard Brexit rhetoric by punishing the Pound.
The chart below shows the performance of Sterling vs US Dollars from May 2016, with our portfolio Sterling weights below. In June following the referendum, we moved from 48% in Sterling to 59%, locking in our profits. We continued this movement through July, eventually reaching the +70% Sterling allocation we have today.
The investment rationale for our current Sterling weighting (overweight versus our Strategic Asset Allocation (SAA) bears repeating. From a fundamental point of view, the Pound is at a multi decade low versus. almost all major global currencies. This makes it very cheap from a long term perspective. Absent of politics (ha!), we would be looking at this as a level at which to be overweight Sterling for our clients.
Having benefitted enormously from the post-Brexit fall in Sterling, we are very wary of giving back gains from even a partial recovery in Sterling.
Once we take Brexit into account, we still think an overweight to Sterling is reasonable. Despite the current headlines, there are all sorts of catalysts that could see a swing towards a soft Brexit, whether through legal constraints, political backsliding, or economic reality checks. Having benefitted enormously from the post-Brexit fall in Sterling, we are very wary of giving back gains from even a partial recovery in Sterling. At our SAA Neutral level of 56% in Sterling, a 10% bounce in the Pound would cost the portfolios over 4% in absolute terms. Our 15% overweight to Sterling reduces that potential loss to 2.5%.
So why do we still have 30% of the Balanced fund in foreign currency? Why aren’t we entirely in Sterling? The answer is because we may not have seen the worst of the hard Brexit speculation yet. So if we see more tension between Theresa May and her European counterparts, the Pound could fall further. If there were a further leg down in Sterling, this 30% in overseas currencies would add positive performance, in an absolute sense. For example, if Sterling falls by 5% our portfolios would see a gain of 1.5% of the underlying value of our portfolios (30%*5%).
There are a number of potential catalysts in the next few months that could swing us from Hard to Soft, and possibly back again. The Supreme Court ruling on Article 50, byelections across the UK, the actual triggering of Article 50, the possibility that Parliament may fight for a vote on the final terms of Brexit… All of these create the probability of Sterling volatility. We are in a situation where the likely path is a grind-down, but the really big surprises would result in a dramatic melt-up. We will try to ensure that our clients are not unduly hurt by a Sterling bounceback, but continue to benefit from the protection offered by foreign currency in the event of Sterling weakness.
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