Britain has a dynamic and open economy, and in the long run it has the potential to be able to thrive economically either inside or outside the EU. The issues which are likely to make the difference in the referendum are political rather than purely economic in nature. Undeniably there are risks to investments, but these are largely created by the uncertainties surrounding the result of the referendum and what would happen in the aftermath of a no vote, rather than from a clear-cut case that investors will be better off in the long run with one outcome or the other.
Markets hate uncertainty. Bad news can be dealt with; asset prices adjust and once they fall far enough buyers begin to see an opportunity and start purchasing again. Rarely does the adage that “no news is good news” hold in the context of investments however. High levels of uncertainty are pernicious. They lead to fear, and fear leads to volatility. Where investors do not have enough information about the current state of a business or an economy, or about its likely future, they will be afraid of further falls and will therefore be less likely to buy. The resulting lower volumes of trading mean that the effects of any changes in supply and demand are amplified, and prices move further than they would under normal conditions.
Should the uncertainty over the referendum make us concerned about the valuations of UK equities? Probably not to any greater extent than normal. The London Stock Exchange is an international market, a fact which has been highlighted afresh by its current merger plans with its German equivalent, Deutsche Börse. It is regularly quoted that on average the companies in the FTSE 100 index earn three quarters of their revenues outside the UK. Many of these are either multinational companies like Unilever (less than 8% of whose revenues are from the UK) or foreign companies like the Coca-Cola Hellenic Bottling Company (2% of whose revenues are from the UK) which have listed in the UK to benefit from its capital market.
As a result, the FTSE 100 is as much a barometer of the global economy as it is of the UK. A severe shock to the UK economy would of course be likely to have an impact on all London-listed stocks, however we think that any weakness as a result of the referendum is more likely to be localised in certain sectors of the market, as was seen in areas such as housebuilders ahead of last year’s general election. As happened in that case, there is potential for catch-up in the event of an outcome which removes the uncertainty.
A more immediate risk comes from exchange rates. The currency market is one of the largest and most liquid of all, but also one of the most susceptible to influence by sentiment and short-term stimuli. We have already seen a significant weakening of sterling relative to other currencies since the start of the year. This has partly been due to concern over the referendum, though there have been other factors at work too. A short term weakening of sterling versus the dollar and yen would have been expected, as those currencies tend to be attractive to investors during periods of market stress.
Additionally, the rising interest rates in the US have made holding dollars more attractive from a longer-term perspective. In contrast the UK, which once looked likely to be the first major economy to raise interest rates, now seems set to stay at 0.5% for all of this year. The euro exchange rate is possibly the trickiest to forecast. Any upheaval caused by the departure of the UK from the EU will have an impact on the remaining 27 members as well as Britain, and it is therefore not clear that the euro should be a beneficiary from a British exit. Hence the recent weakening of the pound against the euro might not be expected to persist, though the exchange rate is likely to depend on new action by the European Central Bank.
What changes have we made to portfolios?
Over the last two years we have taken an incrementally more cautious and protective stance in clients’ portfolios. As equity valuations rose higher, and companies with dependable or growing earnings have demanded higher premiums, we have gradually reduced the amounts of equities held in portfolios. In their place we have added to alternative assets with a lower level of risk, such as commercial property and hedge funds, and have also built up significant amounts of cash. This has two benefits. Firstly, it reduces the volatility of the portfolio, leading to smaller swings in value in response to market stress, and secondly it gives dry powder for reinvestment if falls in the market create opportunities.
We therefore approach the referendum with a fairly defensive stance and a good amount of ballast in portfolios. The possibility of a British exit from the EU is of course not the only menace to markets in 2016. The US stockmarket has historically tended not to do well in the last year of a president’s second term in office as a result of the uncertainty over who will replace them. China is growing more slowly as it adapts its economy away from reliance on exports and towards a more balanced model of production and consumption. Japan and the Eurozone are still grappling with the question of how to stimulate growth and inflation in their economies.
Back in the UK, we believe on balance that a vote to remain in the EU is the most likely outcome in June’s voting. Referendum results tend to have a bias towards the status quo, and additionally in this case it will be much easier for “in” campaigners to sow uncertainty in the mind of the electorate during the coming months than it will be for the “out” campaign to assuage it.
We are not, therefore, making significant changes to our clients’ currency exposure, believing that there is not a clear cut case for sterling to weaken significantly against all other currencies over a longer timescale. We will of course continue to monitor the situation carefully and will make changes to portfolios if and when it is prudent to do so.
By Matt Hoggarth, senior investment analyst at Thesis Asset Management