You’d be forgiven for thinking the investment industry is united against Brexit. Accompanied by alarming forecasts about the impact of a Leave vote on sterling or the risk to various sectors of the UK economy, repeated reports have painted the referendum as a choice between emotion and reason, with Remain the only sensible option for anyone concerned about their wealth and that of their family.
In February, for example, BlackRock argued that Brexit would have “a large and negative economic impact in the near term – and meaningful implications in the long run,” and that it could prove particularly harmful for trade and investment inflows. Sterling could fall sharply (pushing up inflation), UK equities could take a hit, and the financial sector would suffer dearly.
Other analysts have warned of plunging business and consumer confidence and spiking government bond yields, and Jupiter fund manager Ariel Bezalel has even argued that a vote to leave has “the potential to generate a global shock that would spark significant volatility across risk assets”. Nutmeg said earlier this year that it was offloading its investments in small and mid-sized UK firms, citing Brexit risk to domestically-focused companies.
Divided we stand
Yet the industry is more divided on the EU than appearances suggest. “There are prominent figures on both sides,” says Tilney Bestinvest’s Jason Hollands. Newton chief executive Helena Morrissey, Fundsmith’s Terry Smith, and Hargreaves Lansdown co-founder Peter Hargreaves have all made personal statements in support of Brexit. The Share Centre chief executive Richard Stone backs Leave on a personal basis too. “It’s something I’ve thought for a while, and it’s intensified since working in this industry,” he says.
A series of industry reports have also taken on some of the more alarmist claims and even suggested that Brexit could be a net positive.
Although raising concern about the impact on the City, investment management group Rathbones, for example, has argued that trade and foreign investment would not collapse. A report for Woodford Investment Management found that “it is slightly more plausible that the net impacts [on jobs and growth] will be modestly positive”.
While accepting that there could be sectoral problems – a shift away from openness to low-skilled labour would hit agriculture, for example – the Woodford report concluded that less regulation could be a marginal boon to businesses, there would be savings to the public purse from lower EU Budget contributions, and any negative impact on sectors like financial services would likely be short term.
Who to believe?
With the polls close, what Axa strategist David Page calls the “majority of debatable size for remaining in the EU” may be smaller than once thought, or non-existent. Yes, the EU referendum could mimic Scotland’s independence vote, when polling failed to capture the attractions of the status quo. But with research finding that Remain leads evaporate when adjusted for probable turnout, and that voters tend to swing towards Brexit when exposed to the arguments, this can’t be taken for granted.
Fundamentally, nobody knows what the impact will be. You can make a compelling case on both sides
If you’re looking for certainty on virtually any aspect of the EU vote, prepare to be disappointed. “Fundamentally, nobody knows what the impact will be. You can make a compelling case on both sides,” says Stone. This doesn’t reflect an absence of facts, but different assumptions about what would happen the morning after Brexit. No one serious can claim to know for certain whether the EU will shoot itself in the foot and refuse to negotiate a free trade deal with Britain if it votes to leave, for example. And all the published projections rest on judgements about what would happen the morning after.
But with this proviso in mind, there are good reasons to think that Brexit is not an issue investors – particularly long-term ones – should be worrying about. Here is that case.
What will the short-term impact be?
The referendum is contributing to market volatility, and an actual vote for Brexit will likely see this heighten further. “As the vote approaches, the market environment will become very tense, not dissimilar to the Scottish referendum,” Guy Stephens of Rowan Dartington Signature said in a note earlier this year. According to UBS Wealth Management economist Dean Turner, there are already “tentative signs that there is some impact of the referendum showing up in business activity”.
Currently, analysts say markets are pricing in a 20-30 per cent chance of Brexit. So if Britain votes to leave, expect a reaction, probably a sharp one. Politics will complicate matters. David Cameron would likely have to step down as Prime Minister, and another independence referendum for Scotland could be on the cards. Even though none of this would impact the day-to-day operations of businesses, Stephens argues that it “will not stop the inevitable hysteria that would follow” and it would therefore be wise “not to commit too much cash right now”.
Immediately after a Brexit vote, currency exposure should be front of mind. “The uncertainty around Brexit is primarily being played out in the currency markets and will continue to do so,” says Hollands. Aviva Investors has warned that, given the UK’s large current account deficit, Brexit could cause international investors to “re-appraise their appetite for sterling assets”. The Bank of England’s latest Inflation Report said that sterling is 9 per cent below its November peak, “a material proportion of which appears to reflect the referendum on UK membership of the European Union”.
But there are two sides to every coin. “From an investor’s perspective, companies translating earnings from overseas back to sterling will benefit [from a further decline in the pound]. It would be a good thing for exporters too, as their goods and services would be cheaper,” says Stone. And in another area of short-term Brexit risk, the bond markets, even if yields rise on gilts and potentially investment grade bonds, says Hollands, “is that such a bad thing after years of bombed out yields?”
So far, the Bank of England has not found any “clear referendum impact” on equity prices. So-called UK indices like the FTSE 100 are composed of global firms that make 70 per cent of their earnings abroad, and would therefore not be unduly affected by a potential knock to the economy from Brexit uncertainty.
As EQ Investors chief executive John Spiers told me earlier this year, “bearing in mind that any sensible person will have a very well diversified portfolio, and most UK equities are not UK equities but just happen to be listed here, most people’s exposure to domestic UK companies is pretty small,” with UK stocks a relatively minor component of total global equity markets. Also remember that fund managers have known about the referendum for months, so have had time to adjust their portfolios. Bank of America Merrill Lynch’s May fund manager survey saw Brexit rise to become the biggest tail risk, with global fund managers cutting their allocations to UK equities to their lowest weightings in seven and a half years.
Nevertheless, says Hollands, any “short-term market sell-off driven by Brexit paranoia might provide a buying opportunity.” Why?
What about the long-term?
Hollands alludes to the fact that, even if UK-focused stocks fall in the event of a vote to leave, nothing fundamental will have changed in Britain’s relationship with the EU.
Instead, at a date of its choice, the UK would begin a two-year period during which it would negotiate an exit deal with the rest of the EU.
Some suggest this is where the damage will be done – that the EU will not want to make exit look easy, and will therefore accept pain from trade restrictions or limits to European access to London’s financial markets. In the meantime, uncertainty over the outcome could push the UK economy into recession, with businesses putting off investment and hiring decisions, and domestic UK equity prices plunging.
Trade, investment and financial services are the key variables on the negative side – will British firms find it harder to export because of EU tariffs, will Britain lose the halo of being the investment location of choice for global companies seeking access to EU markets, and will EU countries seek to undermine the City in favour of their own financial centres?
There is no straight answer, but aside from the risk of EU vindictiveness, the incentives would be for a deal to be reached that caused as little disruption as possible, especially given the weak state of the Eurozone. “We import more from the EU than they import from us,” says Stone. “The idea that BMW will suddenly close all its factories and stop making cars here is nonsense. They need to trade with us as we need to trade with them.”
This was also the conclusion Rathbones came to. Even under a “hard Brexit” – where the UK would lose all special terms in its access to EU markets – the trade relationship between Britain and the EU would revert to World Trade Organization tariffs, and this “is not likely to render the majority of UK goods uncompetitive”.
UBS’s Turner thinks the most likely outcome is that we end up with something between a soft and a hard Brexit – and not a simple copy of one of the existing arrangements (the Norwegian, Swiss, Canadian, and Turkish models). “A free goods trade agreement is probably quite easy to strike – the fact is that the UK runs a deficit in its goods trade, so it’s in both sides’ interests.”
Services may be harder – and Britain would probably have to concede on areas such as free movement of people or contributions to the EU Budget if it wanted to maintain favourable access. But few believe a deal wouldn’t be done. And given that the UK is already compliant with all EU regulations, Brexit probably won’t be the wildly uncertain clean break that many fear (and others desire), but rather a slow withdrawal in which major changes that could affect the structure of the economy are well-signposted.
What about financial services?
Financial services deserve special attention, since they are the focus of much Brexit angst. The UK has a competitive advantage in this sector, and one of the potential problems is that leaving the EU could result in the erection of non-tariff barriers that prevent London-based institutions from easily selling into Europe.
In the doomsday scenario, leaving the EU could mean UK financial services losing their “passporting rights” – their ability to sell services freely across the EU – thereby hitting London-based institutions hard. Other scenarios would see these rights retained, but Britain required to adopt EU financial regulations, or UK institutions simply operating in Europe through brass plate subsidiaries. All this means that sentiment towards UK financial stocks would probably darken in the period between a vote for Leave and a deal being reached.
But from an investor’s perspective, there are a few reasons not to expect the worst. First, any fallout from Brexit would have a different impact on different companies. “While there would be an effort to see some business move back into Eurozone countries” at the margins, says Turner, “it’s harder to determine how that affects listed companies in the UK.” For the domestically-focused banks, for example, the more important variable would be the health of the domestic economy rather than Britain’s terms of access to Europe.
Second, as the Woodford report notes, “even if exports to Europe did suffer, those losses could be offset over the long term by greater opportunities to boost trade with non-European Union countries.” One of the conditions of the UK’s EU membership is that it cannot negotiate trade deals with other countries – everything must go through the EU.
The report argues that the potential for greater UK financial services exports outside the EU could be particularly high – especially to places like Hong Kong and China, which account for just 2 per cent of the UK’s total financial services exports today, and with which the EU does not currently have a trade deal. Switzerland has brokered a deal with China, it says, that has reduced non-tariff barriers to its financial firms, pointing to the potential long-term benefits.
Furthermore, says Stone, the City of London has “massive advantages around time zone, language and expertise that are not going to disappear, and they certainly won’t disappear overnight as some of the press have been suggesting.” In addition, regulatory standards are unlikely to diverge. As the Investment Association told MPs in January, most rules affecting the City are set at a global level.
Risks of remaining
All this is to say that Brexit is not a risk-free decision – but then again, neither is voting to Remain. On the one hand, Stone notes the continual problem of inappropriate regulation and how this impacts investment. “I am not sure many people are aware that we’ve ceded so much control. The mindset on the continent at a political level is far more about the state protecting the individual and limiting the amount of risk that an individual can take.”
He cites the EU’s MIFID II, which will harmonise the regulations around how investments can be sold and traded. “The initial draft would have outlawed our business, as it would have prevented people from investing in equities without first taking advice. That’s crazy.” That particular requirement has been dropped, but for Stone it highlights the risk of EU lawmakers imposing rules on Britain that would hamper investors and the firms they invest in.
UBS has highlighted another risk to remaining – the Neverendum. “There’s clearly going to be a drive for further integration in the Eurozone,” says Turner, both as more countries join the euro and as the single currency reforms itself in the wake of the sovereign debt crisis. “If we take that to the extreme, where there’s 28 member states and all but two (the UK and Denmark) have an opt-out from the single currency, the centre of gravity is going to be moving towards the interests of the Eurozone relative to the outs.” This scenario could see EU institutions – the Commission, Parliament and Council – increasingly become Eurozone institutions, with the UK’s already diverging interests being accommodated less and less in Brussels.
You’re in limbo land where you’re part of it but not integrating. That seems to me to be the worst of both worlds
And if the UK vote is close, these institutional tensions could interact with political tensions in Britain to create a perfect storm of uncertainty – much like what has happened in Scotland following its vote against independence. “You’re in limbo land,” says Stone, “where you’re part of it but you’re not integrating. That seems to me to be the worst of both worlds.” At some point in the next 10-15 years, Britain could be faced with a choice between voting to leave the EU once again or joining the euro, so uncomfortable has its position as a non-euro member become.
What we can’t change
All investors have to grapple with risk, even with investments as safe as cash. And there are many to be aware of. But perhaps the reason this referendum has led to such heightened anxiety is that it concerns a risk that the UK is not used to – that of major political and constitutional change.
All outcomes are possible, even a messy break that sends Britain into a major recession. Brexit would also not insulate the UK from the major problems plaguing the Eurozone. “The one thing we can’t change is geography,” says Turner. “My sense is that, in or out, if there’s an economic event on the continent, there will be spillover effects.”
But there is a good case for thinking that Brexit would not be the disaster for the UK economy some argue, and that Britain’s strong global and domestic companies would prove resilient even in the face of uncertainty. And for well-diversified investors fully mindful of the implications, Brexit is probably not to be feared.
Referendum fund: Standard Life Global Absolute Return Strategies
If you’re concerned about volatile markets in the lead up to the referendum vote on 23 June, Adrian Lowcock, head of investing at Axa Wealth, suggests the Standard Life Global Absolute Return Strategies fund.
“The fund aims to provide a positive return in all markets over the medium and longer term. It is managed on a team basis and uses many different investment strategies, investing across a wide range of assets including equities, bonds, commodities and currencies,” says Lowcock. “The result is a highly diversified portfolio.”
Lowcock says the fund should protect investors from volatility in global markets as well as from the UK. However, he warns, “because the vote is a binary decision, an outcome for the status quo could see sterling rebound and markets rally, so don’t put all your eggs in one basket, be diversified and have some protection.”
Referendum fund: Fidelity Global Dividend
The problem with selecting a fund that could protect you if the UK votes for Brexit is that “no one really knows how it will affect the rest of the world,” says Axa’s Lowcock. He therefore suggests the more defensive global equity fund, the Fidelity Global Dividend fund.
“It invests in companies across the world so gives a well-diversified portfolio. Manager Daniel Roberts targets income and long-term capital growth from the fund by seeking simple companies with good cash flow generation,” says Lowcock. “Income is targeted to grow ahead of inflation and 25 per cent greater than the MSCI All Country World index.”
The fund is fairly concentrated on large global equities, he says, and the dividend element means it is looking for firms that have a focus on shareholder value. Investing income might be beneficial in volatile markets too, providing some protection, and because it is global, “the manager can move into the UK and Europe when opportunities arise”.
This article appears in the May edition of City A.M.'s Money magazine, which will be distributed with the paper on Thursday 26 May.