Despite a relative calm reaction to the triggering of Article 50, schemes should be braced for a bumpy ride during the coming two years of tough Brexit negotiations. Stephanie Baxter looks at what to watch out for
Last week the prime minister triggered Article 50, formally notifying the European Council of the United Kingdom's intention to leave the EU, almost nine months after the historic vote.
The markets reacted somewhat calmly to the expected event on 29 March, and the UK economy has been surprisingly resilient since last June's referendum with positive growth figures.
However, things are about to heat up as we embark on two years of tough negotiations with the EU - with no clarity yet as to the terms of the UK's exit and what trading deal it could get.
Volatility is expected as the markets react to details that emerge throughout the talks and give an idea as to what the final deal could look like.
Punter Southall principal Danny Vassiliades explains: "There's a greater expectation of volatility in the markets because there will be jitters regarding the terms under which the UK leaves EU, and whether any trade deal struck at the end of that period is going to be good for the UK, or not so good."
Trade uncertainty could put pressure on the pound, which has, so far, taken the brunt of the negative reaction to Brexit. Sterling is still around 18% below mid-2015 levels and 7% lower than before the referendum. In the long term, some currency experts predict it will stay at least 10% below where it was before the Brexit vote, even if it regains some of its value.
Kames Capital senior fixed income investment specialist Adrian Hull says: "If there's a perception that this will be a fair Brexit negotiation, then sterling will rally, but if phrases come out saying the EU is being unreasonable and it will be hard for the UK, sterling will weaken on that and the gilt market will also take its cue."
Pressure on the currency also means potential for wide variations in inflation, especially if import goods become more costly. Conversely, if sterling deteriorates then the UK's exports become cheaper.
There's a balancing act here, says Vassiliades: "Sterling cannot fall too far because if it falls a long way we can sell more things to the world, we attract tourists as a cheap destination, and that reduces pressure on the currency. But it's hard to see it rising a lot in value until people have gotten used to what Britain looks like outside the EU, which we won't know for many years."
A lower sterling and higher inflation could have a big impact on the gilt market.
"Upcoming trade uncertainty will put significant pressure on the pound, and in turn this may see investor sentiment towards UK gilts start to go sour because they buy them due to the safe haven status of sterling," according to WisdomTree research analyst Nick Leung.
The threat of a second referendum on Scottish independence could present an additional source of concern for gilt investors, and undermine sterling even further, he adds.
Hull does not think there will be a material change in the dynamic of the gilt market, and says the concern is really about how far growth slows and whether the Bank of England (BoE) becomes interventionist again.
"Given the BoE has done its QE programme, to bring that out again is less rather than more likely as it's had criticism of promoting 'project fear'. It would take a materially worse economy to want to wheel out QE, and it's not obvious the market is going to take a materially weaker outlook for the UK. It takes a brave person who breaks from 1% to 1.5% gilt trading range that we've established post-Brexit. Despite headline inflation being materially higher, you won't get gilts to catch up to that level."
He says there will probably be a "slightly dampened" UK economy, which justifies the BoE leaving the base rate at 0.25% on top of events around the EU discussions.
But the central bank could become more proactive in a worst-case scenario where the UK comes out of the EU at the end of the two years with no deal, and falls on World Trade Organisation rules.
Despite the uncertainty, Hull says he wouldn't take the signing of Article 50 as a trigger to materially change gilt allocation versus overseas government bond allocation.
The big problem is that while we expect to see more risk during the next two years, it is impossible to know where it will manifest itself.
Given that last year a lot of risks in portfolios were only discovered after the event, schemes now need to ensure there aren't any unintended risks.
WisdomTree Europe director of research Victor Nossek says UK domestic equities remain most at risk from the macroeconomic uncertainty. However, he argues that baskets of UK dividend payers with high exposures to UK multinationals could provide better opportunities, with the fall in sterling boosting overseas earnings. "Equities could become more attractive to long-term investors as dividends compensate for inflation," he says.
As the two years progress, there will likely be heightened volatility in growth assets that rely on future economic or corporate earnings growth.
Hymans Robertson Calum Cooper says: "Growth assets have priced in a lot of upside from Trump and his expansionary policies including the potential for corporate tax cuts, but they're possibly not pricing much downside potential from Brexit, as it's really intangible right now.
"As the details become clearer as to what Brexit means, there will be heightened volatility and that's when uncertainty will start to manifest in prices. There would be winners or losers within various industries in those growth assets. If a trade agreement was done bilaterally with a particular industry, then that industry might do quite well."
As such, it is important to have good diversification within growth portfolios to handle heightened uncertainty. Another option is to put floors on equity falls by using derivatives to protect against Brexit-related shocks.
"Schemes may also consider whether they want to rely less on traditional growth assets like equities to heal deficits, and go for ones with more certain contractual flows through this uncertain period," says Cooper.
These include assets that are economic growth or corporate growth agnostic such as asset-backed securities, emerging market debt, or secure income property, which give relatively predictable cash flows and much higher than traditional assets like government bonds.
Vassiliades says schemes still need to be well-hedged against inflation and interest rates, and adds: "They should also look at their currency exposure, and think about hedging around 50% of overseas currency."
While investment advice to schemes has not changed much, Brexit adds yet another layer of difficulty to investment decisions and risk management.
But on a positive note, getting more granularity on the final Brexit deal can only be a good thing by allowing changes to be assessed with some meat, rather than pure speculation.
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