Investment Clock insights

How to prepare portfolios for Brexit when you don’t know what Brexit is


Trevor Greetham

20 September 2018

Donald Rumsfeld, US Defense Secretary during the Iraq War, famously digressed in one of his regular press briefings into a long discussion on the difference between ‘known unknowns’ and ‘unknown unknowns’, the things you didn’t even know that you didn’t know.
Brexit is, at least, a ‘known unknown’. 
If nothing changes, the UK will leave the European Union on 29 March 2019. On the face of it you would think it quite reasonable, therefore, when the Financial Conduct Authority said in July 2018 that financial firms need to make sure they understand the implications of Brexit and plan accordingly. 
But how can financial firms or advisors prepare their customers’ portfolios for Brexit when it is still not at all clear exactly what shape Brexit will take or, indeed, if it will even happen?
The legally-binding Withdrawal Agreement under negotiation covers matters such as citizens’ rights, the details of a transition period and the settling of financial dues. It must also set out the minimum conditions needed to avoid the creation of a hard border in Ireland. At the same time, there will be a non-binding “political declaration” describing the final relationship both parties will be transitioning towards, with lots of detail left for subsequent discussions.
It sounds relatively straightforward but with only six months left to go there are many loose ends. I joined a meeting recently at which a hedge fund economist listed the five alternative end states his New York colleagues viewed as plausible. Starting with the most distant future relationship, these were:
1.       No deal (a disruptive breakdown of talks with no transition period)
2.       Canada+ (a free trade agreement, probably not including services)
3.       The Chequers Deal (a cherry-picked hybrid)
4.       Norway (Single Market membership)
5.       Remaining in the EU (as a full member, with rebate)
Getting to one of these end states might involve extending the negotiation period if more time is needed. It might involve a high degree of uncertainty throughout the transition period if the UK government pursues a so-called “Blind Brexit” where it agrees to just enough to leave the EU, but has no firm destination agreed, perhaps even across the Cabinet table.
Theresa May has ruled out a second referendum but she may be tempted to call one if she cannot generate a parliamentary majority for her Chequers deal. Parliament would be unlikely to muster a majority for a motion that put No Deal on the ballot paper as the alternative, so this could be a political route back to full EU membership on current terms. 
If that’s not enough to consider, there could be another General Election at some point during this process. 
So what do we really know? The UK could leave the EU on 29 March 2019 with one of a wide range of future trading arrangements lined up. Or it could leave with nothing firm agreed. Or it might not leave at all. 
The impact on sterling and gilt markets will be very different in each scenario. The more disruptive outcomes would probably see the Bank of England keep interest rates at low levels, triggering a rally in gilts and a further slide in the pound. On the other hand, an outcome unexpectedly close to EU membership could see gilt yields rise and the pound surge on the foreign exchanges. Volatility is likely to pick up as the critical dates approach.
So how do you prepare portfolios for Brexit when you don’t know what Brexit is? We have three pragmatic suggestions for advisers to consider. 
First and foremost, don’t structure portfolios for a particular outcome. The decision will probably come very late and involve last minute compromises that no one can forecast.
Second, ensure that portfolios for investors with a low appetite for risk have a high exposure to the pound. More cautious investors don’t want to see the sterling value of their investments swing up and down if we see large exchange rate moves. We would include UK deposits and bonds in this calculation along with commercial property and any assets hedged back to sterling. But we would be cautious on UK equities. The market is heavily skewed towards companies which earn most of their profits overseas.
Third, it makes sense in portfolios designed for investors with a higher risk appetite that you include growth-seeking investments likely to do well under a range of different scenarios. At Royal London we include commercial property alongside UK equities in our multi asset portfolios. We’d expect property to do well if the UK ends up in a close relationship with the EU, whereas UK equities would probably do better in a more distant relationship most likely accompanied by a weaker pound that would inflate the value of profits earned abroad.
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 in the field of geopolitics and finance. Life has a way of surprising us. A sensible approach to risk appetite and diversification should also help when we’re faced with one of Donald Rumsfeld’s ‘unknown unknowns’.

Donald Rumsfeld, US Defense Secretary during the Iraq War, famously digressed in one of his regular press briefings into a long discussion on the difference between ‘known unknowns’ and ‘unknown unknowns’, the things you didn’t even know that you didn’t know.

Brexit is, at least, a ‘known unknown’. 

If nothing changes, the UK will leave the European Union on 29 March 2019. On the face of it you would think it quite reasonable, therefore, when the Financial Conduct Authority said in July 2018 that financial firms need to make sure they understand the implications of Brexit and plan accordingly. 

But how can financial firms or advisors prepare their customers’ portfolios for Brexit when it is still not at all clear exactly what shape Brexit will take or, indeed, if it will even happen?

The legally-binding Withdrawal Agreement under negotiation covers matters such as citizens’ rights, the details of a transition period and the settling of financial dues. It must also set out the minimum conditions needed to avoid the creation of a hard border in Ireland. At the same time, there will be a non-binding “political declaration” describing the final relationship both parties will be transitioning towards, with lots of detail left for subsequent discussions.

It sounds relatively straightforward but with only six months left to go there are many loose ends. I joined a meeting recently at which a hedge fund economist listed the five alternative end states his New York colleagues viewed as plausible. Starting with the most distant future relationship, these were:

1.       No deal (a disruptive breakdown of talks with no transition period)

2.       Canada+ (a free trade agreement, probably not including services)

3.       The Chequers Deal (a cherry-picked hybrid)

4.       Norway (Single Market membership)

5.       Remaining in the EU (as a full member, with rebate)

Getting to one of these end states might involve extending the negotiation period if more time is needed. It might involve a high degree of uncertainty throughout the transition period if the UK government pursues a so-called “Blind Brexit” where it agrees to just enough to leave the EU, but has no firm destination agreed, perhaps even across the Cabinet table.

Theresa May has ruled out a second referendum but she may be tempted to call one if she cannot generate a parliamentary majority for her Chequers deal. Parliament would be unlikely to muster a majority for a motion that put No Deal on the ballot paper as the alternative, so this could be a political route back to full EU membership on current terms. 

If that’s not enough to consider, there could be another General Election at some point during this process. 

So what do we really know? The UK could leave the EU on 29 March 2019 with one of a wide range of future trading arrangements lined up. Or it could leave with nothing firm agreed. Or it might not leave at all. 

The impact on sterling and gilt markets will be very different in each scenario. The more disruptive outcomes would probably see the Bank of England keep interest rates at low levels, triggering a rally in gilts and a further slide in the pound. On the other hand, an outcome unexpectedly close to EU membership could see gilt yields rise and the pound surge on the foreign exchanges. Volatility is likely to pick up as the critical dates approach.

So how do you prepare portfolios for Brexit when you don’t know what Brexit is? We have three pragmatic suggestions for advisers to consider. 

First and foremost, don’t structure portfolios for a particular outcome. The decision will probably come very late and involve last minute compromises that no one can forecast.

Second, ensure that portfolios for investors with a low appetite for risk have a high exposure to the pound. More cautious investors don’t want to see the sterling value of their investments swing up and down if we see large exchange rate moves. We would include UK deposits and bonds in this calculation along with commercial property and any assets hedged back to sterling. But we would be cautious on UK equities. The market is heavily skewed towards companies which earn most of their profits overseas.

Third, it makes sense in portfolios designed for investors with a higher risk appetite that you include growth-seeking investments likely to do well under a range of different scenarios. At Royal London we include commercial property alongside UK equities in our multi asset portfolios. We’d expect property to do well if the UK ends up in a close relationship with the EU, whereas UK equities would probably do better in a more distant relationship most likely accompanied by a weaker pound that would inflate the value of profits earned abroad.

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 in the field of geopolitics and finance. Life has a way of surprising us. A sensible approach to risk appetite and diversification should also help when we’re faced with one of Donald Rumsfeld’s ‘unknown unknowns’.

Past performance is no guide to the future. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.