How To Brexit-proof A Portfolio

All options are still on the table, ranging from 'no deal' to 'soft' Brexit, or even no Brexit at all. 

While we are stuck in Brexit limbo, markets might not react that much. However, on confirmation of a certain path, things could move quickly. 

As investors we should be prepared for this, even though we won't know which way it will go.

Unhelpfully, on top of the outcome being uncertain the timescale is unknown. Normally 'event risks' like elections or political decisions have quantifiable timeframes.

FCA devotes more than 300,000 man-hours to Brexit

Brexit, as we have learnt, does not. The can may be kicked down the road for a long while.

Furthermore, Brexit potentially opens the door to a change of government and a very different regime if the Labour party were to win.

Given this is all outside our control, how do we address shorter-term 'Brexit risk' in a portfolio? Fortunately, the basic template for market reaction has been firmly set out in the aftermath of the referendum and during newsflow since, therefore providing some useful scenario building. 

No-deal scenario

In any scenario much of the immediate action takes place in currency markets. In the event of a 'no deal' or 'hard Brexit', sterling is expected to decline, causing an unwelcome rise in inflation and squeezing real incomes. 

Overseas assets rise in value, and UK companies with primarily overseas earnings benefit. 

Certain UK companies that generate much of their earnings from the domestic market may ultimately fare well, as imported goods are likely to attract tariffs, whereas companies reliant on imported goods may struggle as they are likely to be affected by tariffs and disruptive border checks. 

Overall, however, there is likely to be a detrimental impact on the UK domestic economy and UK-focused equities would be marked down.

This scenario is straightforward to hedge through currency or diversification into overseas assets.

UK investors move £62bn into Luxembourg and Dublin funds on Brexit fears

Gilts would also probably serve to protect, with the Bank of England likely cutting the base rate, looking through any rise in inflation and focusing instead on the downside risk to the UK economy. 

The behaviour of investments in the aftermath of the referendum result is relevant guidance here and this clearly shows the short-term divergence of UK equities, especially small cap, from global assets.

Soft Brexit/staying in scenario

In a 'soft Brexit' scenario where the UK keeps a closer alignment with the EU, potentially remaining in the single market and/or customs union, there is likely to be less disruption to the UK economy and it probably avoids the need for a hard border with Ireland. 

Expect higher base rates, higher gilt yields and a substantial rally in sterling. Large-cap equities would likely underperform and many domestic UK equities would outperform - perhaps significantly so. 

A soft or no Brexit poses as many risks, if not more, to the asset allocator. Overseas assets would likely fall in currency terms and many FTSE heavyweights as well as UK bonds could be under pressure. 

The number of asset classes that would benefit is relatively small with UK small cap and commercial property the two probable stand-outs. 

Shunning these areas to avoid hard-Brexit fallout, which fund flows suggest is what many investors are doing, means taking a fair amount of political risk in the opposite direction.