One step forward, two steps back. As if the shaky economic foundations were not bad enough, the government’s inability to negotiate, execute, or even to articulate, Brexit has created a new threat to the British economy.
We have voted with our feet, reducing UK economic risk in our portfolios to a bare minimum. There are other reasons for this: UK investors already have substantial undiversifiable risk linked to the UK economy and the last thing we want to do, given current circumstances, is to give them more exposure through their savings. It would be a different matter if valuations of UK assets had dipped enough to make them interesting but, like several other asset classes currently, some obvious risks have yet to be priced in.
Most Brexit-related portfolio risk is not emanating from UK assets, however, but from sterling. Specifically, the effect a rise in sterling would have on foreign currency assets and UK-listed mega-cap stock prices. The currency-related gains investors in these assets experienced last year will, at some future date, be lost. That might happen in the near term if the government throws in the towel on a hard Brexit; if the EU indicates it might take a more flexible negotiating stance; or if the government falls (or simply falls apart). A further deterioration in UK economic growth expectations might trigger weakness in sterling in the short term but could, ultimately, turn public opinion against Brexit. Sterling might then rise in anticipation of an abandonment of the process via a second referendum.
Positioning the opposition
The most significant downside risk to sterling occurs if the hardline Brexiteers in the government are able to successfully cast the EU as the enemy, making Brexit a matter of us-against-them nationalism. In this scenario, foreign politicians and foreign media would turn against the UK, transmuting the whole Brexit project into an ugly war of words. Both sides would have justification for a hard Brexit, causing a substantial amount of economic damage. Sterling would plunge, but multi-asset portfolios would be protected by their natural exposures to foreign currencies and large, UK-listed companies.
It is often overlooked that it would not take much of a swing in public opinion to undermine the Leave vote’s 1.3 million advantage. Moreover, because Leave voters skew much older than Remain voters, demographics alone suggest the margin is likely to have narrowed since the referendum. According to some estimates, by the time of the next election it will have evaporated completely. That is before we even consider the fact that young people are discovering how to vote.
The point here is the government’s electoral calculus is changing. How can it accomplish a Brexit that will appease the hardliners and simultaneously win the next election? Crucially, the harder the Brexit, the more likely it is there will be economic damage, teething problems and other unexpected embarrassments, making the chances of winning the next election even more remote.
A softer future?
Hardline Brexiteers may not care much about this. After all, they were willing to split the Conservative Party over the EU issue before the referendum. But they are not the majority of Tory MPs. In order to have a chance of winning the next election, the government will have to cut them loose. The recent shift in the government’s Brexit strategy, towards a transition phase, accepting payments into the EU and a potential role for the European Court of Justice tells us that the direction of travel is ‘soft.’
Chris Darbyshire is chief investment officer at Seven Investment Management.