People expect many different outcomes in the wake of Britain’s exit from the European Union (EU).
Some foresee a period of turmoil and financial instability while others fear Britain’s relationships with other countries will damage confidence and investment.
Trade and treaties negotiations
The UK electorate voted in June to leave the EU “single market”. According to the “Article 50 – Treaty on European Union”, the UK remains part of the European Union (EU) until it submits a formal notification to the European Commission (EC) stating that it wants to revoke its EU membership.
It will then take two years to finalise the exit. However, the outcomes remain unclear as the trade contracts and treaties still have to be unpacked and renegotiated by the new UK leadership led by Theresa May.
The EU is the UK’s biggest trading partner and accounts for about 45% of the UK’s total export trade. Switzerland, Luxemburg, Liechtenstein and Norway are some of the European countries which are not part of the EU single market.
It is likely that the UK will negotiate trade contracts and policies similar to those negotiated by non-EU countries.
UK economic expectations
The UK runs the largest current account deficit in the Group of Seven (G7) and its fiscal deficit is somewhere in the middle.
Mark Carney, the Governor of the Bank of England (BoE) has put it correctly by saying that “the UK relies on the kindness of strangers to fund its twin deficits”. Attracting flows to finance the current account deficit might be more challenging outside the EU.
S&P and Fitch rating agencies have cut the credit rating of the UK to AA from AAA and AA+ respectively. Therefore the cost of doing business in the UK is also expected to increase. It seems logical to assume that most global companies headquartered in the UK are already limiting their capital expenditures as they weigh the implications of keeping their main offices in the UK.
In August, the BoE responded with a rate cut and an additional quantitative easing package. Going forward, we expect the BoE to continue being accommodative as the potential impact on the real economy and policy shift become more clear.
Global bond and currency markets initially overreacted to the Brexit vote outcome. The most recent data shows that the cost of US and SA equity protection has reduced significantly. The market is concerned about domestically focused companies in sectors such as financials, homebuilders and retailers whose earnings come from the UK. On the other hand, a significant depreciation in the Pound will largely benefit companies with large exposures to overseas earnings.
Meaningful diversification
The first thing to acknowledge for investors in constructing solutions is that markets will tend to overshoot and panic in the face of uncertainty. This often presents rare investment opportunities for long term investors.
One of the key ingredients that applies in managing multi-asset portfolios is to insure the deliberate employment of “meaningful diversification”, instead of just naively increasing underlying investments in the name of diversification.
Meaningful diversification requires one to continuously assess and manage the different “look-through” risk exposures that investors’ money is exposed to in relation to return expectations. These risk exposures include weak earnings growth/cash flow predictability, expensive assets, diminishing ability of borrowers to pay back capital, sensitivity of income assets to interest rate changes, diminishing ease of asset disposal, massive currency movements and underlying managers’ related risks.
In principle, meaningful diversified multi-asset solutions coupled with a pragmatic tactical asset allocation process and an appropriate underlying managers’ line-up will position investors to capture the long term drivers of asset returns, while at the same time reducing medium term drawdowns on their capital.
A timeless reminder to investors is that, it is time in the market and not timing the market that is of paramount importance.
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