Investors who think Brexit-related problems are limited to the UK need to think again, according to research by European asset manager DWS, which says the implications of any type of deal will be felt far beyond the domestic market.
Brexit has been put front and centre of the upcoming general election with the ruling Conservative Party pledging to ‘get Brexit done’ while the Liberal Democrats remain the biggest opponents to leaving. The Labour Party stands somewhere in-between.
However, while the Conservatives are ahead in the polls, DWS is predicting a hung parliament, with third parties (such as the Liberal Democrats and Scottish National Party) likely to be strengthened.
“We would caution that the British electorate has become extremely volatile in recent cycles and that polling has been highly ambiguous for much of the year,” analysts Dennis Hänsel, Niklas Heidenreich and Sebastian Kring warned.
As such, it puts the chances of a ‘no deal’ Brexit at 15 per cent, a ‘hard deal’ at 25 per cent, a ‘soft deal’ at 15 per cent, and no Brexit at all at 45 per cent.
Nevertheless, the analysts warned that they “cannot rule anything out at this stage, which makes positioning portfolios difficult, but not impossible”.
“What is clearly required for effective positioning is an appropriate mapping of ‘Brexit exposure’ to financial assets,” the analysts said.
Noting the ditching of UK equity strategies by investors since the referendum, Hänsel, Heidenreich and Kring questioned whether such a reaction was justified.
“Once you look beyond a company´s headquarters location and consider the true exposures along its supply chain, it becomes clear that a more detailed approach is necessary,” they explained.
Performance of indices since EU referendum
Source: FE Analytics
As the above chart shows, the Cboe Brexit Low 50 – an index consisting of the top 50 companies by market capitalisation deriving the smallest portion of their revenue from the UK – has risen by 48.14 per cent since the referendum, compared with a 35.07 per cent gain for the FTSE 100 index.
Conversely, the Cboe Brexit High 50 – tracking the performance of the top 50 companies with the highest exposure to domestic revenues – has risen by just 9.85 per cent over the same period.
“Consider a globally operating oil & gas company with its headquarters in London,” they said. “Even though the company is listed on the London Stock Exchange and thus a constituent of the FTSE 100 index, its link to the UK economy may still be weak.
“In fact, such a company’s share price can even correlate negatively with figures that express the health of the UK economy, such as the strength of its currency.
“Each pound depreciation increases the turnover achieved abroad when converted into pounds, which is reflected accordingly in a higher share price (in pounds).”
However, it is not just UK equities that investors should be worried about, the analysts noted.
“It’s a common misunderstanding that only UK equities and bonds exhibit UK or Brexit exposure,” they said.
A study of the blue-chip German stock market – the DAX – by the asset manager found that the cohort of companies with the greatest exposure to the UK had an average UK revenue share of 27 per cent. These stocks suffered an average share price decline of 12.5 per cent in the days following the referendum.
Performance of DAX 30 vs FTSE All Share week after EU referendum
Source: FE Analytics
As the chart above shows, the DAX 30 fell harder in the two days following the referendum, making a 9.64 per cent loss – in euro terms – while the FTSE All Share was down by just 7.01 per cent, in sterling terms.
This led the analysts to note that it is the interplay of sterling dependency and UK market exposure that is key to identifying ‘true Brexit exposure’, rather than where a company is headquartered.
In a ‘no deal’ scenario, they said, the only equity index winner would be the FTSE 100 because of its loose ties to the UK economy and the benefits of sterling weakness.
A ‘soft deal’ should be positive for those indices with a close tie to the UK economy and other indices with a high market beta that benefit from positive investor sentiment.
Indices such as the DAX, the MSCI EMU and MSCI Italy should see an uplift in the event of a deal being agreed. This is because these indices have a high concentration of export-oriented industries or high sensitivity to EU-related tensions, according to DWS.
Reasons for this include a concentration in export-oriented industries or high sensitivity to EU-related tensions.
“It is no wonder that many people, including investors, are tired of the back and forth of the seemingly never-ending Brexit story,” Hänsel, Heidenreich and Kring concluded.
“But its impact on financial markets is too big to ignore, and with the benefit of hindsight, investors will know which outcome they should have positioned for.”