As we enter another period of accelerated Brexit negotiations, how can
investors best navigate the next few weeks and months? Our assessment is
that a number of U.K. assets have already priced in a significant chance of
a disruptive Brexit, but there is scope for further moves in either
direction, depending on the path the negotiations take.
Base case: Cooperative outcome to Brexit talks
Our base assumption is for a cooperative outcome to the current
negotiations, such that both the U.K. and European Union (EU) can sign the
transition deal extending the negotiations out to December 2020. We see
incentives for both sides to agree to the transition: For the EU, it would
ensure that the U.K. contributes to the EU budget until the end of the
current fiscal period in December 2020; for the U.K., it would assuage the
risk of a disruptive separation in just five months’ time, an event for
which the economy would unlikely be fully prepared. Indeed, we see a
greater risk for a disruptive Brexit at the December 2020 deadline than the
current March 2019 deadline. That said, we consider it prudent risk
management to think through all eventualities.
Near-term Brexit risks
We see a number of U.K. assets pricing in a relatively high chance of a
disruptive Brexit, given current levels.
When we look at the bond market, U.K. yields have tracked euro yields very
closely, despite the U.K. having already started its interest rate hiking
cycle. We believe this is because some market participants expect the U.K.
monetary cycle to pause (or even reverse) in the event of a disruptive
Brexit. So rather than tracking moves across both the U.S. and European
markets, U.K. yields have tracked those in areas where the tightening cycle
has yet to begin.
Meanwhile, we view the British pound as between 5% and 10% below its
long-term fair value, which we attribute predominantly to Brexit risk. And
when we look at the sterling corporate bond market, while most U.K.
industrials trade in line with their peers, U.K. banks still trade at a
yield premium, which again we would assign to Brexit risk. U.K. banks
operate in one of the world’s most regulated financial systems and have
some of the highest capital ratios in the industry.
For this reason, we think there is good reason to appropriately scale
exposures to assets that could benefit from a cooperative Brexit. In a
cooperative Brexit, we would expect U.K. government yields to underperform
German bunds and U.S. Treasuries, and see scope for a steady appreciation
of the British pound and for U.K. bank debt to outperform broad financial
debt. For global portfolios, we reflect this view through a modest
underweight to U.K. duration and a modest overweight to U.K. commercial
bank debt. However, given the binary nature of the potential outcomes, we
continue to emphasise appropriate sizing of these exposures.
Hedging Brexit risk
Irrespective of one’s view on Brexit, we think it is prudent to consider
appropriate portfolio hedges against a disruptive Brexit. In such an
outcome, we think U.K. bond yields could fall by 25–40 basis points, the
British pound would likely fall a further 5%–10% and U.K. commercial bank
debt would come under further pressure. Asset classes such as commercial
real estate would also likely see a drop in liquidity due to the economic
uncertainty. For portfolios with less -liquid U.K. assets, we still see the
British pound as a strong tool to hedge overall portfolio risk; not only is
it sensitive to Brexit risk, but it is also highly liquid. In this way,
portfolio managers can seek to mitigate short-term portfolio volatility
without being forced to transact in less-liquid securities in the
The good news? We believe markets still provide participants with both the
scope to benefit if their view on Brexit proves correct and sufficient
opportunity to hedge unwanted risks if their assessment of the outlook