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UK assets may hold renewed appeal despite Brexit blowout

James Gard  |  04 Nov 2019Text size  Decrease  Increase  |  
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With the EU agreeing to a Brexit extension until next January, UK investors’ quest for certainty has been put on hold again and the prospect of a December General Election complicates matters further.

The pound and UK-focused stocks have gained in recent weeks after Boris Johnson secured a deal with Brussels, but a range of possible options remain in play. Each scenario poses risks and opportunities for UK investors in different ways. 

Some UK-based fund managers think Britain has been out of favour for too long and have been positioning their portfolios for a rebound. Jamie Hooper, portfolio manager at Axa Investment Managers, argues that “perhaps now asset allocators will look to revisit their self-imposed UK exile” and buy back into “unloved and under-owned” UK equities.

No Brexit/Soft Brexit

  • Back: UK-focused companies exposed to sensitive sectors such as the housing market and retail, micro-cap/small/mid-cap focused funds

  • Avoid: FTSE 100 shares with dollar earnings, large-cap funds

At the current juncture, no Brexit at all looks the least likely of the potential scenarios, especially as it involves some wishful thinking about the UK economy bouncing back strongly and the world avoiding a recession. Also, could politicians overturn the result of the 2016 referendum?

An election defeat for the Conservative Party would doubtless provide a relief rally to UK assets such as sterling and domestically focused stocks away from the FTSE 100. Sectors such as housebuilding, banks, leisure and retail have been dogged by Brexit fears since 2016: investors have assumed that Brexit will trigger recession or a prolonged downturn, consumers will have less money to spend on moving house, going on holiday, taking out car loans and buying new clothes.

Plenty of UK-focused fund managers, such as City of London manager Job Curtis, have positioned their portfolios for an expected bounce in domestic stocks such as Lloyds Banking Group and Taylor Wimpey. Lloyds has been under pressure because it is UK focused and is expected to take a hit from a UK slowdown without the international presence that rivals such as HBSC and Barclays have to soften the blow. Housebuilders' share prices have tracked the slowdown in the property market and stagnation in house prices.

Ian Forrest, investment guidance analyst at The Share Centre, says Aim-listed fashion house Boohoo could be a good proxy for returning consumer confidence if no-deal is ruled out.

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Rebecca O'Keeffe, head of investment at interactive investor, argues that UK smaller companies could be some of the biggest beneficiaries of a no Brexit, especially if it is supported by second referendum. The TB Amati UK Smaller Companies fund, which has a Bronze rating from Morningstar, would likely benefit under this scenario, she says. The fund, which has been managed for nearly 20 years by Paul Jourdan, has a focus on Aim-listed and cyclical stocks, which are likely to react more strongly than their larger-cap counterparts.

UK equities have underperformed their global counterparts since the 2016 Brexit vote, but the FTSE 100 has remained resilient because of the number of dollar earners in the index, like HSBC and BP. But ruling out Brexit would push the pound higher and make it harder for the FTSE 100 to make progress as it’s become so dependent on sterling weakness in recent years. The Share Centre's Forrest thinks that the FTSE 100 will also struggled to shake off the effects of a global slowdown.

Is soft Brexit still possible?

A softer version of Brexit seems unlikely at the moment but can’t be ruled out in some form in the future. The effect could be similar to “no Brexit” in that there would be a “relief rally” among investors that a no-deal and hard Brexit had been avoided. O’Keeffe thinks investors would be better off avoiding the large caps in this scenario.

“Anything focused on FTSE 250 or UK smaller companies including Aim may work out well,” she argues. Here she picks Henderson Smaller Companies Investment Trust (HSL), which has a Silver-rating from Morningstar.

This trust, like many others focused on UK companies, is trading at discount to its net assets. This means that its share price does not fully reflect the value of the trust’s portfolio; this goes back to what Axa’s Jamie Hooper says about UK shares being unloved and unbought.

Forrest, meanwhile, suggests LF Miton Smaller Companies as an open-ended fund that would "be more aligned with the growth prospects of the UK domestic economy and may provide a buffer against a volatile global economy".

A Corbyn Government

  • Back: dollar earning companies, global funds and investment trusts

  • Avoid: utilities, UK income funds with utility stocks

If the Conservatives lose the election, the Brexit project in its current form will have been derailed, but at what cost? A Corbyn Government has certain sectors in its sights for nationalisation and that could hit exposed stocks like BT (BT.A) and National Grid (NG.). Colin Morton, manager of the Silver-rated Franklin Equity Income fund, argues that the market may have over-priced the “Corbyn risk” anyway, and that he may not be able to achieve the more extreme plans he has nurtured in Opposition.

Hard Brexit/No Deal Brexit

  • Back: dollar-earning large-caps, defensive shares, gold, gilts, global funds/investment trusts

  • Avoid: consumer-focused shares, housebuilders, retail shares, UK-focused funds

While this scenario seemed unlikely in 2016, investors have started to take it seriously, especially with the change in Prime Minister. Boris Johnson’s version of Brexit is a “hard” one and he is also prepared for no deal. Sterling and UK shares, especially those on the FTSE 250, climbed after Johnson’s deal was agreed with the EU. This suggests that investors are now focusing on avoiding a “worst-case scenario” rather than hoping to wind the clock back to 2016.

O’Keeffe argues that a no-deal Brexit would be very unpleasant for UK investors in the short term and recommends a flight to safety – in this case into gold, via the iShares Physical Gold (IGLN), which is up 18% so far this year as global investors pile into safe havens.

"If the deal does not get passed and the UK crashes out of the EU without a deal, the damage could be substantial," argues Forrest.

In this case, he recommends investors focus on global themes that are non-Brexit related such as robotics and infrastructure. Infrastructure is a choice for lower risk investors, he says, pointing to two globally diversified and income-focused funds: Legg Mason IF RARE Global Infrastructure Income, which has a four-star Morningstar rating, and the Bronze-rated, First State Global Listed Infrastructure fund.

Brexit is likely to affect some stocks more than others as sterling weakness would boost dollar earners such as oil and pharma companies. One company that has put a lot of thought into the impact of no-deal or hard Brexit is AstraZeneca, which also features among our FTSE top dividend payers. It has adjusted its supply chain already to prepare for Brexit dislocation and has plenty of overseas exposure, not least in China, where sales are up 40% year-on-year. Morningstar analysts think the company has a “wide economic moat”, or strong competitive advantage.

Its defensive qualities have not gone unnoticed by the market this year, and shares have hit record highs - its dividend yield is above 3 per cent too. Pharmaceutical companies tend to prosper in an economic downturn because the demand for medicines is usually fairly constant.

In the event of a hard or no-deal Brexit,  Forrest backs AstraZeneca for its resilience as well as drinks maker Diageo because most of its sales come from overseas.

What next?

With more than three years since the Brexit vote, investors may be forgiven for just “getting on with it”, ignoring the politics and making their investment plans regardless of what happens. 

Investors should , of course ignore the short-term "noise" of markets - and there has been plenty of noise since 2016 - but with more uncertainty, an investor could be forgiven for sitting on the sidelines, especially with the global outlook so murky.

The popularity of cash and fixed-income funds in recent months shows that many individuals have been parking their money in less risky assets – but this comes at a cost, as tiny and negative yields on bonds show. There is also a danger that private investors may miss the big turning point in the UK market after it’s happened already. Many professional investors are trying to get ahead of this by buying UK-focused stocks and hoping for a rebound.

This article originally appeared on Morningstar.co.uk

is senior editor for Morningstar.co.uk

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