Preparing for Brexit

29 November 2018
2018 has seen a slowdown in global growth and a rise in inflation which gives us a particularly difficult environment for markets. In the UK, we have the “known unknown” of Brexit added to the mix.

As we get closer to the critical dates, it’s really important to understand how your clients’ investments are positioned, the impact that Brexit could have on fund values and most importantly, gain reassurance that our multi asset team have the skill and expertise to navigate through the murky waters that lie ahead.

This article explains our current views on Brexit, how we’re positioned and the capabilities we have to improve returns and reduce risk within the Royal London Governed Range.

Brexit view

Brexit continues to dominate headlines with UK and EU negotiators having reached an agreement on the terms of withdrawal, covering items such as money owed to the EU by the UK (an estimated £39bn), what happens to UK citizens currently living in the EU and EU citizens residing in the UK, and how to avoid the return of a physical border between Northern Ireland and the Republic of Ireland. The UK cabinet ratified the withdrawal text in the middle of November but suffered two resignations in the process, including Brexit Secretary Dominic Raab.

While both sides signed up to the 585 page document detailing the UK’s plans to leave the EU, the more difficult task for May is likely to arise when she attempts to gain the support of parliament for her Brexit agreement in December. Conservative party rebels who view the deal as unattractive, the DUP who are concerned about potential barriers between Northern Ireland and Great Britain, in addition to Scottish politicians worried that any special status to Northern Ireland could disadvantage Scotland, all suggest navigating the finalised agreement through parliament will be a difficult task for May.

So what do we really know?  The UK will leave the EU automatically on 29 March if legislation is not changed. The Treasury’s own estimates show a No Deal exit as the most damaging outcome for the economy, shaving 5 to 10 per cent from the economy over the next fifteen years. The same Treasury study estimated the benefit of making free trade deals with the US and other countries at no more than a per cent. Brexit uncertainty has already pushed sterling volatility to its highest level since the 2016 referendum and the pound would be likely to fall sharply if a No Deal outcome becomes a realistic prospect. This is more about risk management than trying to predict the outcome in a highly fluid situation.

From an investment point of view, the greatest uncertainty is on the outlook for sterling and gilts. We are in for a fraught few weeks. With less than five months to go we still don’t know the framework that will determine UK economic policy for many years to come. For UK-based investors with a low risk appetite it makes sense to avoid or to hedge overseas currency exposure at these times. For investors with a longer time horizon and a higher appetite for risk it makes sense to balance equity exposure with commercial property. Equities are likely to do best if the pound weakens on a No Deal outcome. Property would do best in a closer relationship with the EU. Within the portfolios, we hold both equities and commercial property and this offers a degree of risk control from diversification.  

Positioning the Portfolios

The Governed Portfolios are designed for UK pension investors. As a result, the lower risk portfolios hold a bigger exposure to sterling assets because the end clients’ expenditure is in pounds and they don’t necessarily want foreign exchange risk. On the other hand, the higher risk portfolios have more exposure to global assets which will be more impacted by volatility in sterling.

With inflation continuing to rise and global growth cooling, we de-risked our portfolios into the summer, reducing exposures to equities and commodities, moving the latter to an underweight position relative to the benchmark. Given global growth is still positive and not significantly challenged by only relatively small interest rate increases expected, we moved to an overweight equity position in October market weakness when our indicators showed oversold markets. We retain an overweight position in short duration high yield bonds and stay neutral in property. Commodities have been moved to a small underweight position as they tend to do best when growth and inflation are both stronger; they also do not benefit from a stronger US dollar. We continue to be underweight fixed income given UK and US interest rates are rising gradually. We remain underweight the UK, given Brexit uncertainty, and  Europe, given renewed eurozone concerns driven by uncertainty surrounding Italian fiscal policy and weaker growth. 

Capabilities

We expect key Brexit decisions to come late in negotiations and involve last minute compromises that no one can forecast fully in advance. Volatility is likely to pick up and we could see some big intra-day moves. For this reason, it’s important that we maintain flexibility in order to adapt and react as events unfold. Typically we will use futures to gain exposure quickly to equities without having to buy physical assets (saving on transactions costs). We also have the ability to take active currency decisions as well as hedge currency to a neutral position in line with the benchmark, based on our views.

Balancing the long term and short term

Our Governed Portfolios aim to strike the right balance between the risk your clients are willing to take and the returns they can expect to receive long-term. Strategic asset allocation (SAA) is the main driver of this and our governance process ensures that the SAA remains fit for purpose on a forward looking basis. We balance this with a tactical asset allocation process which allows the portfolios to take advantage of short term market movements to either improve returns or to mitigate risk. Typically this is expected to add between 0.5-1.0% on average per annum; over the year to end September, tactical asset allocation delivered 0.4% of outperformance to customers invested in the Governed Portfolios and 1.6% over the last three years, all within the portfolio risk targets.

The chart below illustrates the range of annual returns that we expect for Governed Portfolios 4, 5 and 6 (our most popular portfolios). These returns are based on current market forecasts and historical investment scenarios. 90% of the time we would expect the annualised returns to be in the range highlighted by the white bars and the dot within each range represents the projected average annual return over that period. They also show that the longer you invest, the range of expected returns reduces; meaning that over the longer term, annualised returns are more predictable.

Source: Royal London and Moody’s Analytics, as at 31.12.17

The outlook

Whatever their risk appetite, ensuring your customers hold a diverse set of assets can help mitigate the ‘known unknown’ of Brexit. The next few years will, no doubt, bring other challenges we don’t yet know about. Life has a way of surprising us but there is no substitute for long term saving in diversified portfolios when it comes to securing a comfortable retirement.

Last updated: 31 Oct 2018

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The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL.