As the 31 October deadline approaches and the increasing likelihood a ‘no deal’ Brexit looms under new prime minister Boris Johnson, asset manager Invesco claims there are some assets that might help protect investors from ongoing uncertainty.
With Johnson taking over negotiations since his appointment as prime minister over the summer, the UK language has shifted in favour of a ‘hard Brexit’.
Johnson has unveiled three key aims, which Invesco claims are likely to impact UK growth and financial risk premia for at least several quarters.
The first is to deliver Brexit by 31 October, pressure the EU to renegotiate the so-called Northern Irish ‘backstop’, and prepare for a ‘no deal’.
The increasing likelihood of a ‘no deal’ Brexit has seen sterling and gilt yields falling to multi-decade lows, according to Invesco’s global market strategist Arnab Das, head of UK government relations & public policy Graham Hook and global head of asset allocation research Paul Jackson.
Source: Invesco
However, that has been complicated by events that have led the governing Conservative party’s majority to shrink to just one seat and the prospect of confidence votes in the autumn.
“Not only is Johnson setting up for a showdown with the EU, he is also quietly preparing the stage for a general election in the event he loses a parliamentary lack-of-confidence vote in September,” they said.
The best the prime minister can hope for, they said, is “kicking the can down the road” although any extension beyond Halloween is likely to be complicated with changes of EU and eurozone leaderships.
Should Johnson’s ‘do or die’ approach fail and his strategy be blocked by parliament then it would be likely that a new election would be called for Johnson to seek a personal and party mandate to renegotiate Brexit or realise a ‘no deal’.
“Former prime minister Theresa May tried the impossible: to reconcile the views of ‘remainers’ and ‘Brexiteers’ by trying to minimise damage to the traded goods and services sectors, while protecting the integrity of the UK via the aback stop and securing sovereignty over trade in goods and over immigration,” they said.
“Compromise may have been a rational and honourable approach, but it repeatedly proved untenable.”
The Invesco team believe any such election would emerge as a three-way battle between Johnson, Jeremy Corbyn-led Labour party and Jo Swinson’s Liberal Democrats, albeit with a Conservative win.
Such an election might result in a further minority government given the strength of the Scottish National Party. And were it to occur before Brexit is achieved, Nigel Farage’s Brexit party may have a say in the process.
“The silver lining could be a shift towards a more liberal Britain in the event of a strong Tory performance that would help offset – or possibly outweigh – the rise in trade barriers with the EU,” they said. “The downside risk is the possibility of a shift to a hard-left government should Labour win big either in an early election or in a later, post-no-deal Brexit, election.”
In terms of likelihood, the Invesco strategists believe that a ‘no deal’ Brexit with no general election has just a 10 per cent probability of occurring, the same chance of a renegotiated deal and Brexit in 2019/2020.
The most likely scenario is that the government loses a no-confidence vote and a general election is called, with an 80 per cent chance of occurring.
Of all the election scenarios, a general election after a ‘no deal’ Brexit on 31 October is most likely, with a 40 per cent chance of happening.
As such, investors should look to prepare themselves for an increasingly uncertain outlook.
The global strategists prefer stocks outside of the UK, particularly in the US and emerging markets.
“Managing portfolios for a ‘no deal’ Brexit UK/GBP-based investors seem to believe that domestic assets and currency are cheap,” said Das, Hook and Jackson. “Nevertheless, the UK current account deficit remains close to record levels and is increasingly financed by the repatriation of resident holdings of foreign assets.
Source: Invesco
“UK investors seem to be buying from foreign investors, who appear to be divesting or at least ploughing less into the UK – very likely flip sides of the same Brexit coin. We would not be surprised to see this asset swap continue.”
On the fixed income side, the trio recommends US government debt or US high-yield and emerging market debt for higher yields.
For yield-hungry investors switching out of gilts, an alternative would be the FTSE 100, which is currently yielding almost 5 per cent and is made up of companies with most of their revenues and profits coming from overseas.
Once translated into sterling those overseas revenues can help UK equities outperform other markets when sterling weakens, the Invesco strategists said.
Performance of sterling vs US dollar over 10yrs
Source: FE Analytics
“Of course, if we are buying UK equities because we believe sterling will decline, we are likely to lose more on the currency than we gain on the equities,” they said. “Hence the hedging of currency exposure becomes a valid option, in our opinion.”
“The risk of such a strategy is that sterling recovers, win which case UK equities may underperform other markets and we will enjoy no currency gain.”
With MPs due to return from the summer recess, it remains to be seen which of the possible scenarios will unfold in the coming weeks.
It is, however, likely that levels of uncertainty will remain elevated for the time being.
“Over the coming weeks, we suspect that Brexit uncertainty will maintain the downward pressure on sterling and gilt yields, while at the same time raising concerns about the domestic economy,” said Das, Hooker and Jackson.
“The only certainty is uncertainty – we fear,” they concluded. “Accordingly, the UK economy appears to suffer further declines in business and consumer confidence, with the risk of corresponding weakness in investment and consumer spending.”