Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, sterling-based investors should not change their currency hedge ratios or their allocations to sterling-denominated assets based on potential Brexit outcomes. Few investors have an edge in predicting political developments, and Brexit is especially unpredictable. Hedge ratios should factor in spending and liquidity needs, institutional risk tolerance, and cost of hedging, rather than potential currency movements, particularly when short-term political machinations are determining the exchange rate.
It’s true that recently passed UK legislation has effectively taken an October 31 crash-out scenario off the table. In theory, it could also compel Parliament to finally come together behind the existing withdrawal agreement, or some slight variation thereof. Yet, it seems more likely that, come late October, Prime Minister Boris Johnson (or Jeremy Corbyn, if Johnson resigns and the opposition leader is invited to form a caretaker government) will be forced to seek the EU27’s blessing for another short-term Article 50 extension. Such a scenario would make way for UK snap elections to try to break the Brexit impasse. Should that play out, all bets would be off, given a polarized electorate, an increasingly fragmented party structure, and the United Kingdom’s first-past-the-post electoral system. Nearly 40 months after the historic Brexit referendum, a wide range of potential outcomes remain in play.
Arguably, the British pound currently prices in much of the potential impact of a “hard, but orderly and prolonged” Brexit deal like what former Prime Minister Theresa May’s government negotiated with the EU27. Today, the pound’s valuation remains very low versus its long-term historical average on a real effective exchange rate basis, but this decline is primarily due to its exchange rate with the pricey US dollar. In contrast, the pound’s real exchange rate looks less depressed versus the euro or Japanese yen. Given the difficult-to-predict political dynamics, it’s clear that sterling still faces tail risks not just to the upside, but also to the downside. Tail-risk scenarios aside, and assuming Brexit in some shape or form eventually happens, increased trade frictions and expectations for prolonged uncertainty regarding the ultimate Brexit end state are likely to continue weighing on the pound, irrespective of the final divorce terms.
Some UK investors with high levels of sterling spending or income-only spending rules tend to tilt their portfolios more toward sterling-denominated assets. These investors should ensure their sterling asset exposure is well-diversified among domestic asset classes, as returns will diverge sharply depending on the Brexit outcome. Sterling cash, gilt, and linker yields are paltry today, but all could offer important ballast to any sterling-denominated asset portfolio if the United Kingdom and EU27 cannot come to terms on Brexit. In contrast, market prices for UK equities and credits would likely suffer from a “no-deal” Brexit; however, their underlying exposures are in effect partially hedged, given the significant presence of globally oriented multinationals in these indexes. Therefore, their yields would be resilient in an adverse Brexit scenario. As a result, income-reliant UK investors whose portfolios are heavily biased toward sterling-denominated assets will only be in the clear if they take steps to diversify their sources of income among domestic asset classes.
Some UK investors maintain hefty exposures to UK property, either directly or through listed trusts, and that is worth a mention as well. UK property offers higher yields than other sterling-denominated asset classes, and spreads relative to sterling investment-grade bonds remain well above average. Yet, on an absolute level, cap rates remain near historical lows, and UK property is heavily exposed to adverse Brexit scenarios due to its fully domestic exposure.
Brexit should not drive decisions on currency hedging, even when Brexit stress may have peaked and the pound is weak versus some major currencies. Instead, UK investors should both continue to ensure their portfolios are adequately diversified, while maintaining enough liquidity and domestic currency exposure to meet anticipated spending needs, and be ready to take advantage of any future Brexit-driven market dislocations. When determining an appropriate hedge ratio, investors must consider their institutional risk tolerance, liquidity posture, and the cost of hedging. UK investors whose spending is heavily reliant on earning sterling-denominated income need to be mindful of the potential impacts of an adverse Brexit scenario on various domestic asset classes generating that income and diversify accordingly.
Senior Investment Director on Cambridge Associates’ Global Investment Research Team