So, the fateful day has finally come that even a year ago few believed they would ever see – the triggering of Article 50.
Such a momentous event will undoubtedly have consequences for the UK economy and the markets generally, but the fact is that w e have been considering the possible implications of a Brexit for some time.
Ahead of the referendum last year, for example, we were underweight UK equities in favour of overseas markets and had taken a meaningful position in the US dollar.
Of concern to us now is the prospect of long-drawn out UK-EU negotiations, with no certainty even of a concrete result.
Negotiations will take at least two years, and the range of possible outcomes is wide – from an amicable divorce through to a real risk that no deal is reached at all. Concurrent with these negotiations, we will also see a run of general elections across the continent (including the France, Germany and possibly Italy), which has the potential to radically change the political landscape and the outlook for the EU project.
Regardless of the results of these elections, the need for change in Europe is palpable.
The recent Dutch election result was a vote for the establishment – or at any rate against radicalism - and the likelihood is that Marine Le Pen is also unlikely to win for the same reason. But the general sense of dissatisfaction at the current political order in Europe means that change is inevitable. The status quo is no longer good enough.
Whether the EU will assuage that dissatisfaction by ‘punishing’ the UK in the Brexit negotiations is uncertain.
From the UK’s perspective, an additional level of uncertainty is the possibility of another referendum on Scottish independence.
Political risk is therefore a crucial consideration for our asset allocation. We have a sizeable position in gold, in part due to uncertainty over the future of the EU.
While we do not expect a break-up, the possibility of fundamental reforms to the EU has grown significantly over the past year. We are also positioned for other important global themes: the trajectory of the US economy under president Donald Trump, rising inflation and the potential for higher interest rates.
Our client portfolios generally benefited from sterling’s fall after the referendum, and one of the key questions is whether there is further weakness to come.
Looking ahead, we do have concerns that the current strength of the UK economy may not last if Article 50 negotiations run into trouble or if unemployment picks up. There have certainly been signs recently of retail spending starting to roll over, although on balance we think the majority of sterling’s fall is behind us.
In terms of stock markets, FTSE 100 companies have continued to perform strongly, in part because the bulk of their earnings come from outside the UK, with many of them reporting their financial results in US dollars.
For example, valuations of energy and mining companies are more influenced by the global price of oil and commodities than by fears over a ‘hard’ Brexit.
We have also seen the banking sector perform well of late, thanks to the prospect of higher interest rates, particularly in the US, and this is something we think has further to run.
FTSE 250 companies, which are much more domestically oriented, would clearly struggle if the UK economy enters a more challenging phase and so we are being quite selective in this area. UK domestic commercial property could also suffer from a ‘hard’ Brexit, as companies may decide to relocate overseas, thereby depressing rental revenues, and we have maintained a cautious stance on the sector.
Bond markets and gilts, in particular, have been on a bit of a rollercoaster ride since the referendum, initially rallying as the Bank of England re-started QE and then selling off as the economy carried on regardless.
We are currently underweight bonds on valuation grounds but within the sector are generally biased towards the higher quality and more liquid end, namely government and investment grade debt. Index-linked gilts did phenomenally well following the referendum, thanks to the prospect of higher inflation, but we have recently been locking in gains in this area.
We expect to see some volatility in financial as events unfold, creating opportunities to buy and build long-term positions in what we see as attractive investments, as and when they arise.
Richard Carter is fixed interest specialist at Quilter Cheviot. The views expressed above are his own and should not be taken as investment advice.