Capital has identified the risks to the pound in your portfolio after Brexit, so you don’t have to worry (part 1 of 3)…
You may be forgiven for thinking that the world in general, and the UK specifically, is in a state. There’s certainly lots to be thinking about, Brexit being one of them, and questions linger over how your investment portfolios will be affected. In Part 2, Capital will cover the pound in your pocket. Part 3 of this series will explain how human capital is becoming a key driver of global growth.
It’s not all doom and gloom
A recent study by the OECD projects that global growth (after inflation) will rise by 3.7% in 2019, with major European economies growing from 1% to 2%, including the UK (downgraded from 1.7% to 1.2% by the Bank of England on February 7th). Growth in the US is predicted to be around 3% in 2019. In the UK, employment is at a record high and real wage growth (after inflation) has been positive since 2015. What’s more, the budget deficit is now around 1% of GDP, compared to 10% before the austerity program began.
In return for the money that investors place in the markets, they expect a rising economic return based on global growth and dividends. That’s good news.
The following chart illustrates that markets weather the multitude of world events they experience, rewarding patient long-term investors with growth in their purchasing power.
Source: Albion Strategic Consulting1
Capital’s Investment Committee (CIC), which sits every 90 days, works behind the scenes to look after your portfolio. The CIC have already identified three key risks relating to Brexit and how your sensible portfolio structure can help to mitigate them.
Risk 1: Greater volatility in the UK and possibly other equity markets
In the event of a poorly received deal - or no deal - it is certainly possible that the UK equity market could suffer a fall as it comes to terms with the impact on both the UK and wider global economy.
Risk 2: A fall in the pound against other currencies
In 2016, after the referendum, the pound fell against other major currencies, including the US dollar and the euro. There is certainly a risk that the pound could drop further in the event of a poor or no deal.
Risk 3: A rise in the UK’s borrowing costs
The economic effect of a poor or no deal could put pressure on borrowing costs. In particular, investors in bonds and gilts issued by the UK Government (and UK companies) could demand higher interest rates on these bonds, in compensation for the greater perceived risks to the capital value.
Put simply, if bond interest rates increase, the bond capital value will decrease, which will take time to recoup through the higher interest rates on offer. Think of this as a simple see-saw effect.
Source: The Securities and Exchange Commission
Looked at in isolation, these may appear to be significant risks. Owning a well-diversified and sensibly constructed portfolio, however, can greatly reduce them.
Remedy 1: Global diversification of equity exposure
Despite being the world’s sixth largest economy (depending on how you measure it), the UK produces 3% to 4% of global goods and services, and our equity market is around 6% of global capitalisation.
Many of the companies listed on the London Stock Exchange derive much of their revenue from outside the UK (around 70% to 80%). For example, although HSBC is often thought of as a British bank, it generates over 90% of its revenues from overseas.
Whilst Brexit may affect some UK and European businesses, a well-structured portfolio holding a diversified exposure to many markets and companies will help mitigate this risk. A typical portfolio at Capital holds between 7,500 and 8,000 globally diversified assets.
Source: Albion Strategic Consulting and data from iShares - Global market capitalisation 2018
Remedy 2: Owning non-sterling assets and currencies in your growth assets
In the event that the pound is hit hard, it is worth remembering that any overseas equities that you own via a Capital portfolio come with the currency exposure linked to those assets. For example, owning US shares comes with US dollar exposure, so you will benefit from this.
In short, a fall in the pound will have a positive effect on non-UK assets in your Capital portfolio. The chart below illustrates the effect that currency in unhedged non-UK assets has had over the past decade. As you can see, at times of market crisis the pound has fallen against other safe-haven currencies such as the US dollar.
Source: Morningstar Direct 2018. All rights reserved. Data derived from MSCI world index in GBP, MSCI World Index in Local Currency and MSCI UK Index.
Remedy 3: Owning short-dated, high quality and globally diversified bonds
Any bonds or gilts you own should be predominantly high quality to act as a strong defensive position against falls in equity markets. This is what you own in your Capital portfolio. Avoiding over-exposure to lower quality (e.g. high yield, sub-investment grade) bonds makes sense as they tend to act more like shares at times of economic and stock market crisis.
Your Capital portfolio also offers you bond holdings that are diversified across various global bond markets. This allays the risk of a rise in UK interest rates (and thus falling prices), as the cost of borrowing in other markets may not be affected in the same way, at the same time.
Some thoughts to leave you with
Even if you cannot avoid watching, hearing or reading the news, it is important to keep things in perspective. The UK is a strong economy with a strong democracy. It will survive Brexit, whatever the short-term consequences that we must bear, and so will your portfolio.
At Capital, we believe that if there are any post-Brexit speed bumps, they are there to test the spring in our step.
1 Global balanced portfolio: 36% MSCI World Index (net div.), 26%-Dimensional Global Targeted Value Index, 40% Citi World Government Bond Index 1-5 Years (hedged to GBP) – no costs deducted, for illustrative purposes only. Data source: Morningstar Direct © All rights reserved, Dimensional Fund Advisers. Past performance is not indicative of future performance.
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This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily Capital and does not represent a recommendation of any particular security, strategy or investment product. The information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
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