Investors should expect the heightened chance of a ‘Brexit’ from the European Union to be an snowballing market risk for the next several months, according to Mike Amey, portfolio manager at PIMCO.
Whatever your view - even if you are still on the fence - the first British referendum on membership of the European Union in 40 years is set to take place, and it is something that most in the City increasingly expect to weigh on market sentiment.
Indeed, the possibility of Britain exiting the EU – “Brexit” – has received considerable market focus over the last six weeks at the same time global investors have been pre-occupied about a global economic slowdown.
However, even if concerns over the global business cycle declines, the likelihood is that the Brexit referendum will continue to dominate sentiment, Amey says.
“UK polls suggest a tight vote with a very high degree of uncertainty. We assume the UK will vote to remain in the EU. However, we assign a probability of up to 40 per cent to a Brexit,” he said.
“[David] Cameron appears to intend to hold the referendum in June, or failing that, September. So irrespective of the twists and turns of the debate, uncertainty over the outcome is likely to weigh on UK markets for a good few months yet.”
If the UK does indeed vote to leave, the market response will likely be guided by two alternative responses, he adds, the first a smooth “good tempered” negotiation and the second “a confrontational separation where the two sides act as if in an unpleasant divorce.”
“In such a situation, the market response could be more long-lasting, with obvious pressure on the British pound and large UK listed companies with significant European activities.”
Buy gilts
After being broadly flat in 2015, gilts and funds in the IA Gilts sector have rallied in 2016 so far due to the worries over global growth, plunging equity markets and the Brexit debate.
Performance of sector and index in 2015
Source: FE Analytics
Amey, thinks some gilt exposure in investors portfolios could have a beneficial effect as we move closer to the vote as it did in the few months prior to the Scottish referendum date – when the gilt market rallied and the equity market stalled.
“Contrary to some commentators, our sense is that this would be bullish for gilts as any hope of an interest rate rise is pushed yet further back. If there is any gilt market weakness, this should come through in longer-dated yields, where a higher risk premium may come into the real yield,” he said.
Avoid London property, UK banks and buy bonds
Samy Chaar, chief economist at Lombard Odier says two areas to avoid would London prime property which has a well-publicised link with foreign investment, particularly from Europe.
“Those concerned about the impact of Brexit should avoid anything that relies heavily on foreign investor demand – like prime London property. Avoid UK banks and keep a low exposure to sterling.”
“Instead choose high quality corporate bonds issued in dollars. For those with more stomach for short term volatility emerging market government bonds have been hit hard in recent years, they offer good value and will be barely affected by Brexit if it comes.”
Performance of sector and index over 3yrs
Source: FE Analytics
Hedge sterling exposure
Sterling is currently at a seven-year low against the US dollar, meaning earnings in FTSE 100 firms from abroad are being diluted by the exchange rate and Jean Medecin, member of the investment committee at Paris-based Carmignac says it is the key concern for investors
Performance of sector and index over 7yrs
Source: FE Analytics
"Sterling is the weakest link where Brexit is concerned. It's likely to be thumped by uncertainty as the Brexit poll approaches and if Brexit actually happens it will get a right hook,” he said.
He said concerned investors need to look to greater diversification for their portfolios.
“US Treasuries offer a safe haven from Brexit and offer a decent return yield of 1.7 per cent, above UK gilts at 1.4 per cent and French government bonds offering just 0.6 per cent.”
However he thinks equity investor should favour large UK companies as they are more diversified in their earnings while UK small companies are more domestically-focused but should stay away from the big UK banks.
“Avoid financials, London is the European financial centre and may suffer upheaval on Brexit. Some companies will benefit, notably UK manufacturers exporting around the world like Smiths Group, or multinationals like SAB Miller (merging with AB Inbev)."