The UK is set to leave the EU on 31 October. Under new Prime Minister Boris Johnson the prospect of a ‘no-deal’ Brexit – once viewed by many as unthinkable – is now a real possibility. The questions are: what might be the fallout if the UK crashed out of the EU? And what would it mean for investors?
To answer the first question, it is instructive to look back. Indeed, a key output from our suite of risk management tools is the ability to stress-test our portfolios under both historical and simulated events. In recent months, this has included analysis for ‘no-deal’ Brexit scenarios.
How does this look in practice?
Following the surprise 52-48% Leave victory in June 2016, sentiment towards the UK abruptly turned negative. UK stock markets and sterling tumbled. Companies with a domestic focus sold-off heavily, notably housebuilders. Airline, banking and auto shares also came under pressure. In the intervening years, the retail sector has been buffeted by waning consumer confidence – a situation that has been compounded by the inexorable rise of e-commerce.
But there were also relative winners within the market rout. Mega-caps and defensive stocks (e.g. consumer staples) did well as investors sought safe havens. Companies able to deliver diversified, low-volatility sources of earnings have been particularly prized over the last three years. Additionally, those businesses with a high proportion of overseas earnings, such as oil & gas and miners, found favour among investors. The reasons for this were twofold. First, the success of their operations is not generally reliant on the UK domestic environment. Second, a weak pound makes their overseas earnings worth more when converted back into sterling.
And what if there’s a ‘hard’ Brexit?
While we can’t predict the outcome of a ‘hard’ Brexit, it seems reasonable to assume a similar scenario as described above. The upheaval would no doubt be great. Again, domestic stocks would probably bear the brunt of any selling, while overseas earners and defensives would likely fare better.
As investors, it’s our job to look through the short-term noise and consider the longer-term picture.
But as investors, it’s our job to look through the short-term noise and consider the longer-term picture. It also means being comfortable with the stock-specific risks taken within a portfolio.
Take housebuilders, for example. It is probable that their share prices would fall sharply were the UK to careen out of the EU. This, though, would create long-term opportunities. After all, the fundamentals for housebuilders remain intact. Many companies have strong balance sheets, and are run by talented and highly experienced management teams. The UK has a benign land market, while there is a pressing need to build more homes. These factors would remain in place, irrespective of Brexit.
That is not to say there wouldn’t be casualties. As we have already seen, the retail sector is suffering from Brexit uncertainty. A no-deal situation, with the related weakening impact on sterling, would add cost pressures to retailers and others who source goods internationally. Meanwhile, supply concerns could adversely affect pharmaceutical firms. Many farmers have expressed concerns about the possibility of WTO tariffs.
Of course, all this assumes that Brexit and, indeed, ‘no-deal’ are inevitable. Mr Johnson has indicated that the UK is leaving on 31 October – “do or die”. Nonetheless, there are still many eventualities that could see the Brexit date once again postponed. A host of politicians in Parliament have vowed to block a ‘no-deal’ at all costs. While seen as unlikely, Brexit itself may be called off through the revocation of Article 50. In other words, as with the referendum itself, nothing is guaranteed.
Interestingly, any one of these outcomes could see a surge in UK share prices. In fact, valuations on many domestic stocks are at such extreme levels that, for a sizeable reversal to occur, the news flow need not become outright positive – just less negative. Investors that held domestic stocks through the current uncertainty would therefore be rewarded.
Whatever happens, we will watch the market closely over the coming months. As active investors, this means remaining particularly attuned to the evolution of risks and opportunities as and when they arise.
The above article was previously published by Aberdeen Standard Investments’ ‘Thinking Aloud’ blog on 20th August 2019