Brexit is the gift that keeps on giving when it comes to political risk. Every day has been as unpredictable and fast moving as the last and yet nothing has been resolved. The UK missed its scheduled departure date of 29 March after Parliament failed to vote in favour of the prime minister’s deal – or, in fact, anything else. The European Union has presented a new ultimatum – work out what you want to do by 12 April and ask for a longer delay, or leave on that date with no deal and no transition period.
In an unprecedented move, Parliament has taken control from the government in order to explore alternative options through a process of indicative votes. Much remains to be decided and uncertainty remains high.
The Brexit trilemma
Theresa May was dealt a poor hand, but made matters a lot worse by announcing a series of politically rational but incompatible red lines in her Lancaster House speech at the start of 2017.
- First, she pleased hard liners in the European Research Group wing of her party by saying the UK must leave both the Single Market and the Customs Union, ending freedom of movement and allowing the UK to make its own trade deals with non-EU countries.
- Secondly, she gave a nod to the Democratic Unionists supporting her minority government by insisting that Northern Ireland be treated the same as the rest of the UK, with no customs checks for trade crossing the Irish Sea.
- Lastly, she insisted there would be no hard border between Northern Ireland and the Republic in accordance with the Good Friday Agreement that ended armed conflict.
It is impossible to keep more than two of the three promises simultaneously, as pointed out by Daniel Kelemen, professor of political science and law at Rutgers University, in his ‘Brexit Trilemma’ diagram:
To pass a Withdrawal Agreement without opposition help, May needs the support of both the ERG and the DUP. The EU’s Irish border backstop ensures she cannot keep these groups happy by breaking the Good Friday Agreement, in effect keeping the UK in the Single Market unless and until a technological solution is found that would allow customs checks without a hard border. The open-ended nature of this commitment was the undoing of the fragile coalition she needed to approve her deal.
It is very late in the day but amazingly all options remain open. It is impossible to rule out leaving without a deal as that is the default position if no other solution is found. It is also impossible to rule out staying in the EU. The government may end up calling a confirmatory referendum as part of its rationale for a longer delay to the Article 50 process. The form of Brexit chosen by MPs would most likely be put to the people against the option of remaining on current terms. In those circumstances the public might vote to revoke Article 50 notification since no single form of Brexit commands universal support among Leave supporters, let alone Remainers.
These extreme outcomes would have radically different impacts on markets. A ‘no deal’ Brexit could lead to a further devaluation of sterling by 10 to 15 per cent, whereas a deal in which the UK remained close to, or in, the EU may lead to strengthening over time by a similar magnitude. It is highly unusual for investors in a developed economy to face a 20 to 30 per cent range of possibilities over where the exchange rate might be on the basis of a series of political votes.
Hedging Brexit risk
Since the ultimate outcome of Brexit is fundamentally unknowable, we consider the most sensible course to be hedging against extreme outcomes. This can be done in different ways, depending on the investor’s appetite for risk.
- If you are a UK investor with a lower appetite for risk, you should probably have most of your investments in sterling based assets, including UK government bonds and cash. Exchange rate swings create volatility most intensely in overseas assets, as well as UK equities; which generate 75 per cent of their revenues overseas on average.
- If you are a UK investor with a higher appetite for risk, you could build in a natural hedge by investing in asset classes that are likely to react in opposite ways in different Brexit scenarios. We would expect UK property to underperform in harder Brexit scenarios, but associated sterling weakness would probably boost equity values.
One way or another, the Brexit crisis must be resolved, but we only take tactical views in the funds we manage when we have a high level of conviction and believe we have an edge over the market. Brexit will be hard to predict with the final outcome depending on last minute backroom deals and knife edge political votes. While we watch developments closely, our aim is to take a neutral view in our portfolios until clarity emerges. That does not stop us from expressing high conviction views based on the ebb and flow of the business cycle, as we have over the last year. Volatility is here to stay and we expect to see plenty of opportunities to add value away from the Westminster bubble.
Trevor Greetham is head of multi-asset at Royal London Asset Management