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Investing through a constitutional crisis

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In the past three years, many articles have been devoted to the outcome of the UK’s withdrawal from the EU, and the underlying risk that 500 million consumers may be thrown under the wheels of the Brexit juggernaut.

The facts are that whatever deal materialises from the fog, it may not be as painful for investors as the commentariat feared. In actual fact, as political adversaries on both sides of the English Channel prepare to play their final cards, the fallout of each possible outcome is becoming easier to predict. That said, some investors’ fears are bound to be heightened at just the time when a steady hand and a bit of know-how could deliver superior performance in the post-Brexit world.

The background

Since the referendum on 23rd June 2016, the FTSE 100 has been one of the worst performing equity markets, globally. In US dollar terms, it’s down 8% (up 13% in local currency) versus the S&P 500, which has been up over 38% during the same period. Simply put, UK corporate assets are becoming very undervalued relative to their global peers. At the same time, the pound has been one of the worst performing currencies globally. Experienced market watchers may be entitled to ask how weak the FTSE 100 would have been if 70% of its earnings weren’t made outside the UK.

It is also important to note that the 10-year Gilt is yielding 0.5% – its lowest level ever – albeit as part of a world-wide slide to negative long-term rates as global GDP growth is forecast to slow in 2020. This suggests that should the next two months see some kind of exit deal hammered out between Britain and the EU, then equity assets will be left significantly undervalued over the medium term, which in turn begs three important questions:

  • What can be legitimately be construed as a successful exit?
  • What might it look like?
  • What could the investment implications be?

The three outcomes

To begin answering these questions, let’s consider the likely outcomes of Brexit being delivered by 31st October 2019. Experts are predicting that the advent of Boris Johnson as Prime minister and the rhetoric surrounding his arrival to high office means there’s a higher probability of a no-deal scenario. Arguably, a no-deal is broadly priced into the move in the pound and any slide below 1.20 against the US dollar could provide a good long-term entry point even if the UK is plunged into an early election. The questions around other UK assets – equities, bonds and even property – are more difficult to answer. Given the expected underperformance (see above), we should be challenging ourselves to look for buying levels. In the event of no deal, the government will pursue a more expansive fiscal policy, coupled with the Bank of England sanctioning a likely short term cut to interest rates. Corporate tax levels will also be reviewed as there will be a deliberate attempt to attract business investment (that has been slowing), to the UK. Under these scenarios, domestic sectors that require inward investment (and in some cases government support) are likely to perform better against their international corporate peers.

What would a more expansive government intervention look like? Government spending and a formal end to austerity would be one sign. There may of course be a limit to how much the government can spend – although a commitment of between 3 and 5% of GDP per year should be manageable in the short to medium term. If spending money that’s solely been raised from tax receipts is unthinkable, there are other options. For example, to ensure public funds are invested in commercially sound infrastructure schemes, the government could partner with private sector investors that live or die by that yardstick. Certainly, the current low-interest environment means that investors are willing to consider supporting long-term investments, although this picture is coloured a little by Brexit uncertainty. Projects could include big ticket infrastructure improvements such as expanding the transport network, increasing energy capacity via carbon neutral initiatives, a renewed commitment to improving the housing supply, boosting internet speeds by incorporating 5G technology, and a cash injection for tertiary education establishments/the research sector with a view to positioning the UK as a world leader in science and technology.

Opinions on how the FTSE All share will fare in a no-deal scenario are varied. The FTSE 100 fell by 12.5% to 6,728 in 2018, wiping out more than £240bn of shareholder value. This was its worst performance since the global financial crisis. Of course, it has recovered in 2019, along with the many global indices, by almost 10%. Dissecting the numbers; since the referendum, the financial sector has been one of the poorer performers. Led by the banks, the sector is likely to remain under pressure, in a persistent low or zero interest rate environment following a no-deal scenario. This could remain the case at least until there are macro tailwinds of support emerging for the UK economy, or signs of inflation appearing.

Insurance and property stocks have also been laggards over this period. In addition, there have been a number of consumer-related industries, like tobacco (a global development), food, retail and leisure, alongside the utility sector, which have the spectre of a change of government hanging over them. The best performers in the weaker pound environment have predominantly been ex-UK or international earners like the mining stocks (although they are negatively exposed to slowing global growth), and selected food technology and healthcare names. Having said that, there’s one key area to remain focused on in a period of uncertainty – a low rate environment, which may yet lead investors to high yielding stocks. The FTSE 100 yields 4.7% and is one of the highest yielding indices in the world. In 2018, over 10% of the FTSE 100 constituents paid out ‘special dividends’ in addition to their traditional quarterly dividend. That figure totalled over £6bn in payouts and that is a high watermark level for these ‘special dividends’. Three FTSE 100 stocks worth highlighting as strong yield plays would be: Legal & General, DS Smith and AVEVA Group. Three international earners that have lagged since 2016 but are worth highlighting would be Johnson Matthey, Reckitt Benckiser and Carnival. Aerospace stocks, with cross-border EU exposure, should continue to be avoided, whist smaller cap companies would likely feel the heat from a potential short-term UK-specific economic downturn.

Looking at other outcomes, it is fair to say that an agreed withdrawal deal with the EU by 31st October would be a far less volatile scenario to forecast. From a currency perspective, the initial reaction to the British pound is likely to be favourable, with a move in the British pound/US dollar rate towards 1.30, and with pre-referendum levels in mind, may even overshoot. It was trading as high as 1.48 before the UK opted to leave the EU). 10-year Gilts would enjoy a higher yield than the current offer of 0.5%, which would also support a stronger local currency. Finally, the risk of a move to lower interest rates to bolster the UK economy would subside substantially. In general terms, the UK economy would not find itself subjected to a unilateral economic slowdown. Rather, we should expect that inward business investment into the UK would renew with some vigour. In this scenario, domestic exposed sectors/companies would be the best performers, whilst international earners would lose the ‘outperforming’ status they have enjoyed for the past three years within the FTSE 100, when analysed against a rising local currency. With a withdrawal deal in place, banks and financials would be more likely to reverse their underperformance. Perversely, the FTSE 100 index itself would struggle to make any headway overall given the preponderance of international earners.

A further delay to an agreement to leave the EU beyond 31st October would likely leave the UK economy rudderless well into 2020. Inward investment would continue to contract, and the political backdrop would likely deteriorate further, which would create additional uncertainty. The slowing of the economy could well trigger an interest rate cut from the Bank of England, assuming inflation remains benign, and 10-year Gilt yields would remain very unattractive when compared with their historical performance.

The most difficult scenario to predict would probably be an attempt to revoke Article 50. Some commentators might argue that there would be a return to a pre-referendum investment environment. That would entail a sharp rally in the pound; however, the political fallout of revoking Article 50 and a probable follow on second UK referendum could be immense and paralyse the UK for an as yet unforeseeable stretch of time. It would undoubtedly leave inward investment on the sidelines and domestic investment at a standstill until a stable government were to emerge. In this instance, the UK economy could be dragged further into a recession in the short term, whilst the pros and cons of a second referendum are talked out on in public and in parliament.

Inward investment

When reviewing the UK economy, it’s important to recognise that inward investment remains a very important ingredient. At the end of 2018, inward investment stock was worth $1.89tn (£1.48tn), more than Germany ($939bn) and France ($825bn) combined. However, according to official data, foreign investment into the UK’s most productive industries has dropped sharply since the 2016 Brexit referendum. This suggests that uncertainty over future trading arrangements with the EU is undoubtedly stopping businesses from committing to the UK. According to a report published by the UK’s Department for International Trade, the number of foreign investment projects in the UK dropped by 14% to 1,782 in the fiscal year ending March 2019, marking the lowest level in six years. It was shown to be the second consecutive annual fall since March 2017. The report also showed the fall in foreign investment had a knock-on effect for employment, with a 29% decrease in jobs created in the year ending in March compared with the previous year.

In key sectors for the UK economy, such as financial services and automobiles, the number of jobs created fell by about a third. The contraction was even larger in advanced engineering, environment and infrastructure, which saw job creation shrink by about 40%. Under any of the EU withdrawal scenarios outlined here, and in order to deliver a sustained recovery and long-term stability to the UK economy, the drop in inward investment will have to be reversed. The UK government can introduce a number of short-term measures to promote such a reversal, however, it is clear that the removal of uncertainty around Brexit, in whatever form it takes, will be paramount to making a strong recovery. In short, monitoring and nurturing inward investment into the UK will be a key factor when considering the potential investment outcomes beyond 31st October.

As the CBI director-general, Dame Carolyn Fairbairn, has already highlighted, the Brexit message from UK business is to get a UK withdrawal deal or suffer a long-term paralysis to the UK economy – not just a short sharp shock. The key theme is that being prepared for a no-deal may not be enough. For investment into the UK, where plans are on hold, a definite outcome, even if it is unpalatable in the short term, can initiate the process of recovery towards a more stable UK economy that thrives on being a world leader in many important sectors. It is a big leap but certainly not an impossible one.


Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.


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