Brexit – Approaching the End Game

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With Brexit uncertainty having ratcheted up a number of notches since Prime Minister Boris Johnson sought to prorogue parliament, yet again investor attention is focused on what impact a hard Brexit could have on sterling assets, and how to best protect themselves from associated volatility. Since the Brexit referendum in 2016, our view has been that safely capturing the ‘Brexit premium’ priced into many sterling assets was a way to enhance value for investors. However, we have always had a cautious view on what Brexit could ultimately look like, and currently it seems clear that the chance of a hard Brexit has increased significantly.

Right now, the chance of a general election before October 31 appears to be very high, and we think the chance of a hard Brexit has risen to around 40%, though the likelihood of each of a range of outcomes seems to change on a daily basis, so we would advise double checking the Best Before Date on everything you read.

So what investors expect from a hard Brexit? First, if it becomes a reality, it’s certainly not just a UK problem. It will be a major problem for Europe as well, and would almost certainly cause a recession in various core European countries (though arguably that appears likely with or without a hard Brexit), as well as in the UK. We expect negative growth would probably appear in Q1 2020, with stockpiling and other mitigating measures from firms helping to support growth in the immediate aftermath of a no-deal exit, and we doubt that any amount of monetary policy easing or even fiscal expansion could fully offset this shock to the system. How long it lasts will very much depend on how parties engage with one another post exit.

How might investors prepare for the impact? Like many macro events, a hard Brexit is predominantly considered from the top down, in a similar way to the ongoing US-China trade war, for example, and other geopolitical events that have the ability to negatively impact global growth. With these macro events hanging over markets, and given the outcomes are both unpredictable and potentially very negative, balancing risk is going to be critical. Holding more risk-off assets that are negatively correlated to riskier assets, and making sure they have sufficient duration to be effective, will be one tactic investors are likely to deploy. On the risk side, the credit quality of the credit assets should probably be higher than ever before, and keeping the duration of those assets very short should help keep mark-to-market volatility low.

From the bottom up, when selecting individual credits, investors of course need to consider Brexit, but they must also consider trade wars and other geopolitical risks as part of a much broader credit review. If we felt that a credit would come under severe stress as a result of a macro issue, of course we would not invest in it. As regards Brexit, a “worst case” outcome has been built into our credit assessments for quite some time now. The biggest negative impact will probably be felt in sterling, where parity with both the euro and the dollar is getting closer and closer. However, this risk is easily mitigated through FX hedges and needn’t be a risk to investors.

The next few weeks should be fascinating from a political point of view, with numerous outcomes possible after the dust settles. However, we expect that for many fund managers, Brexit is just one of the global macro risks that they have already considered in their portfolio construction.

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