18 April 2016
Listening to the two sides bashing each other reminds me of one of my favourite Churchill quotes: “A fanatic is one who can’t change his mind and won’t change the subject”.
But trustees should focus on the economics of Brexit because it could have a significant impact on their pension fund.
In April the poll by Opinium puts the Stay Vote at 39% and the Leave Vote at 43%. But this should be viewed in context; the Financial Times has tracked the last 204 opinion polls and 35% of them have been in favour of leaving the EU which is (interestingly) consistent with the odds quoted by the bookmakers, which suggests that there is about a one-third chance the leave the EU camp will win.
The impact of Brexit so far
By the time the European Union Referendum Act 2015 received Royal assent on 17 December 2015 the markets were undoubtedly already pricing-in a chance of Brexit into Sterling levels, UK equity market prices and into bond yields.
Analysis by JP Morgan suggests that the markets have “priced in a 50% probability of Brexit” – in other words the markets could be overestimating the “Brexit risk”. It wouldn’t be the first time markets have overreacted to emerging news.
And what if we do leave?
It’s hard to say what the impact on the UK economy will be if we do leave the EU but in my view the following seems most likely:
- Interest rates - it is likely that short-term interest rates could stay lower for longer (or even go lower still) as the Bank of England attempts to stimulate the economy after the possible shock of leaving and this could be combined with further monetary easing. There is no evidence for this in the market data though. Although 10 year gilt yields have fallen since 17 December 2015 by 0.3% pa suggesting the markets are indeed expecting lower interest rates over the next 10 years, they have fallen by about the same amount in the US and in Germany so this is a global change and not just a Brexit effect.
- Sterling is suffering however. It has fallen by 4% relative to the US Dollar and 8% relative to the Euro. If all of this is down to Brexit then we might well expect similar falls again if voters do decide to leave the EU. On the other hand, perhaps this can be partly explained by the recent weak UK trade figures?
- UK equity markets are actually up since 17 December 2015 and in local currency terms are ahead of the US and the Eurozone. Whilst at first glance this might seem like the opposite of what you’d expect from Brexit, it’s worth remembering that an awful lot of UK corporate income comes from overseas. When Sterling is weak (as it has been recently) this overseas income actually increases in Sterling terms – so perhaps the rise in UK equity markets can be explained by Brexit, at least in part.
- UK corporate bonds have suffered. It has been a rollercoaster ride since 17 December 2015 with credit spreads rising by 0.4% pa which could represent a significant increase in the expected default rates, but this has eased off to around 15bp pa now. This does look like a Brexit effect as the credit spreads in the US and the Eurozone have also been on the rollercoaster but they are now at similar levels today as they were in December.
A key issue for UK pension funds is what happens to the UK government debt that is held by overseas investors – as the yield on these bonds impacts the returns that pension funds can earn on many of their investments, as well as being a key input into actuarial funding discussions. At the start of 2013 some 31% of our government debt was held by overseas investors, but by September last year only 26% was still held so it appears overseas investors have been gradually selling their holdings and if this process speeds up because of Brexit risks then gilt prices could fall causing the value placed on pension liabilities to fall too, and that will be good news for most UK pension funds.
So what does all this mean for Trustees in practice?
As ever, it is always good advice to understand what investment risks you are running and be sure that they are risks you want to run. So here are the three things to add to your Trustee agenda for the next meeting:
- Ask your consultant what proportion of your overseas assets are currency hedged and unhedged, and is this is the right level of protection?
As a rule of thumb I would expect overseas bonds to be mostly hedged, overseas equities to be partially hedged and emerging market investments to be unhedged unless there is a good reason to do something else. In terms of Brexit, this horse has already somewhat bolted so think carefully before altering currency hedging levels now.
- Make sure you’re poised and ready to exploit any Brexit opportunities if gilt yields start to rise.
Ask your consultant how you could potentially exploit and lock-in this bit of good news.
- Take care if you are implementing any changes to your strategy during the run-up to and aftermath of the referendum.
Markets are likely to be unusually volatile; it may be wise to press pause for now.
For more on how UK markets might react to Brexit, read issue 4 of LCP Vista magazine