22 June 2016 /
A potential Brexit has been a part of our thinking on the UK economy since before the referendum was formally announced in late February. With the results of the referendum imminent, we don’t intend to wade into public debate today. Rather, we wanted to share our thinking on portfolio positioning to address the risks and opportunities the event poses. We initially moved to an underweight position in UK equities in January, with uncertainty regarding Britain’s future in the EU an unwelcome additional concern that compounded the already undesirable profile of the UK equity market, with its high concentration of commodity producing companies and overall sluggish earnings growth. Since the announcement of the referendum we have seen fears over the UK’s current account and fiscal deficits amplified and this has led to increased volatility, particularly in sterling’s exchange rate.
This volatility has been particularly pronounced over recent days, as polls have suggested that ‘Leave’ may be edging into the lead as the race nears its conclusion. Like most, we have followed the polls closely, as well as betting markets, with the latter reflecting a much stronger likelihood of ‘Remain’ winning, although these markets have also tightened considerably over the last few days. Overall though, despite much internal debate regarding the issue, we do not purport to have any special insight that will help us to predict the outcome. As such, we have prioritised ensuring our portfolios are robust and positioned properly for either outcome.
In common with most risk events, and in particular with a binary event such as the EU referendum, the first line of defence is to ensure portfolios are properly diversified. This means holding a range of assets, well-diversified by sector and geographic exposure. Stylistically, we have blended higher risk equity that is expected to deliver growth over the longer term, with holdings in companies with more robust earnings and less volatile share prices, which have tended to behave relatively defensively during periods of market stress. Apart from this general diversification, we did take specific steps, as outlined above, to reduce portfolio equity exposure to the UK economy.
The currency exposure of our portfolios has also been widely discussed, especially with the performance of sterling being subject to the vagaries of the latest trend in opinion polls. With little clear evidence that one side or another will prevail we have had to consider where the greatest risks to portfolios lie, as well as trying not to introduce new ones with any pre-emptive measures. As we write sterling is revisiting some of its low levels from earlier in the year, but these are not dramatically low by historical standards. A ‘Leave’ vote would certainly weaken sterling further, while a ‘Remain’ vote would see some of this lost ground recovered. For sterling denominated portfolios we are not intending to gamble on a particular outcome and have ensured sterling is towards the lower end of its guideline limits. We also take comfort from our high cash levels and reduced exposure to global equity markets. For portfolios denominated in US Dollars and Euros, our underweight view on the UK equity market results in relatively low overall sterling exposure.
While not being able to position portfolios to benefit from every scenario, we have sought to introduce sufficient defensiveness in case of a short term negative impact of a Brexit result, while retaining exposure to assets that could benefit substantially in the event of a relief rally.
Our broader view of the macroeconomic picture beyond the UK is that public equity markets are likely to produce returns at the lower end of their historical range over the medium term. With equity valuations above average levels and a range of geopolitical risks aside from the Brexit question, we believe it has been appropriate to be positioned underweight equities generally. We used the equity rally from oversold levels earlier in the year to reduce equity risk and increase cash levels, while also improving the defensiveness of our equity positons with allocations to companies with more robust earnings and less volatile share prices. This year we have also added inflation-linked government bonds, which offered an attractive entry point for inflation protected securities, combined with the generally defensive characteristics of government bonds. The elevated cash levels will help us withstand any drawdowns in equity markets, while giving us the opportunity to add to positions at lower levels in the event of a Brexit-related sell-off. If ‘Remain’ wins we would expect to see a relief rally in sterling and our higher risk equity positions, and perhaps also in the European equity market more broadly, which is one of our favoured equity regions.
With these thoughts in mind, we feel we are surely able to adjust to the result being one way or the other. In conclusion, we approach the referendum as highly interested observers; with a balanced view and a robust approach to the positioning of our portfolios.
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