What are the economic implications, potential market impact, and consequences for UK pension schemes of Brexit?
In my previous post, I discussed the timeline for Brexit, should it happen, and split it into three periods: pre-referendum, post-referendum negotiations and post-negotiations.
The purpose of establishing these divisions was to emphasize that leaving the EU would not elicit an immediate step-change for the UK economy. The change would be gradual and the economy would behave differently in each period.
With that in mind, let’s consider (briefly!) the economic implications of a vote to leave.
Brexit would create new, more expensive, trade relations with Europe and (at least initially) the rest of the world. Foreign Direct Investment (FDI) would fall for two reasons:
The EU represents 50% of the UK’s FDI.
Non-EU investors would reduce their FDI, as the UK’s access to the EU’s single market would be inhibited. Indeed, foreign investors would be less likely to hold Sterling assets in general. Sterling would fall sharply on the news, although we would expect it to recover later.
Domestically, business investment and hiring would decline as trade and market regulations remained uncertain. Sterling’s depreciation would increase inflation, reduce real incomes, and hurt consumer confidence and spending. Higher government funding costs would mean, ceteris paribus, lower government spending and/or higher taxes in future, further denting private sector confidence.
Given this economic background, how might markets respond?
The forecasts below are based on research by banks, fund managers, the government, and other research institutes.
For the reasons mentioned above, we would expect Sterling to bear the brunt of the impact. We saw this in February when Sterling had its largest one day fall since 2009 as Boris Johnson announced he would support the Leave campaign and Moody’s warned the UK’s credit rating would be at risk. Depending on who you listen to, Sterling is expected to fall anywhere up to 15% against the Dollar, and by about half as much against the Euro, as the Euro would also depreciate on the news. Sterling could remain weaker in the post-referendum period if lower rates are required to stimulate growth.
The implications are not so directional for interest rates.
The MPC would be forced to weigh higher inflation against lower growth. It is likely that they would look through higher inflation, regarding lower growth as the greater risk. Bank rate rises would be pushed further out, while a rate cut and additional Quantitative Easing would become possibilities. This would leave the front of the yield curve pinned down.
The yield curve would steepen as long-end rates would increase as the market netted the effect of lower expected growth, against higher inflation, higher issuance, and higher downgrade risk. Gilt sales could send Z spreads higher again.
So in the short term we expect steepening, but in the long term the curve might flatten. The front of the curve would be higher as a weaker Sterling and less flexible labour market mean structurally higher inflation and therefore higher interest rates, while the long end can only go so high before more pension schemes take the opportunity to de-risk.
Put simply: the yield curve would probably be higher in the long run, and liabilities correspondingly lower.
Companies large enough to be included in Sterling credit indices have significant overseas revenue so the sell-off in credit would be muted. Spreads might widen by 20-40bps for UK domiciled credits (i.e. not just GBP denominated) and by 10bps more for UK financials, but the effect is likely to be temporary. As yet, there is little evidence that Brexit has been priced in UK spreads, suggesting that the likelihood and/or the impact would be minor.
A similar conclusion holds for equities.
FTSE 100 constituents derive 75% of their revenue from abroad so they may benefit from earnings growth. The remaining FTSE All Share companies, being more domestic-facing, would do worse. Particular sectors may perform better than others (e.g. commodities vs financials) but the impact on index levels would be mixed. We would certainly not expect a 2008 scenario.
There is the possibility of some contagion to European markets, as Brexit may provide succour to nationalist parties in other Member States. The threat of further referenda to leave the EU would hurt European equities in the short run, but the full effect would depend on election timetables in other countries.
Finally, what does all of this mean for UK defined benefit pension schemes?
Is a temporary 50bps sell off in Sterling credit spreads, or a 5% fall in the FTSE All Share worth protecting? Should Trustees consider potential consequences for European equities? Or should higher long-term rates and gains on foreign assets be welcomed?
It’s difficult to see clear strategic changes that would improve a scheme’s position in the long run.
Moreover Brexit risk works in both directions.
If we were to create a Brexit scenario test, a “Bremain” scenario test should also be considered. The market has been pricing the likelihood and impact of Brexit. We can see this most clearly in Sterling’s depreciation since the start of the year. If the UK was to vote to remain in the EU we would expect this Brexit “risk premium” to be unwound. Sterling, for example, would bounce.
So if investors are considering changes to their asset allocations in anticipation of Brexit, they should also consider how these changes would perform if the UK voted to remain.
In any case, over the life of a DB pension scheme, many economic and political shocks will be endured. Knowing that we may be less than a month away from another, investors may feel compelled to act.
Instead, they should heed Peter Ustinov’s famous admonition: “Don’t just do something, stand there!”.
The reward from attempting to profit from these shocks is greatly outweighed by the benefits of sound long-term investment principles, among them clearly-defined goals, prudent investment constraints, and meaningful portfolio diversification. Effective risk management, expressed through both the strategic asset allocation and the decision-making process, will protect schemes from the markets’ vicissitudes, and that is where our physical and intellectual capital should be focused.