Market effects of possible Brexit throw up investment questions

Politicians turned up the heat on Brexit last week, and with just 17 weeks to go until the UK votes on its future in the bloc increasing uncertainty looks set to dominate the short-term outlook.

Volatility has already set the tone for the market since the start of the year, but David Cameron’s announcement of the date for the referendum, combined with the jostling of rebel Tories, saw sterling plunge this week.

It would be better to do something strategic that you can live with in the long term – if that suits the Brexit situation as well then so much the better

Kevin Frisby, LCP

With this in mind, trustees must think carefully about how continued volatility and worsening sentiment could impact both scheme assets and the covenant of sponsoring employers in the run-up to June’s vote, in the immediate aftermath of a vote in favour of Brexit, and over the longer-term.

Integrated risk management

Francis Fernandes, senior adviser at covenant specialist Lincoln Pensions, said schemes should adopt an integrated approach to risk management and undertake scenario testing to consider the risks to scheme assets, sponsor covenant and funding levels.

This may include a review of asset and liability allocation models, typically structured around historic factors, he said.

Swift-moving boards could also take tactical steps to close funding gaps during the coming months by taking advantage of further depreciation in sterling and implementing short-term protections on interest rate positions and equity holdings, he added.

“If trustees are holding investments in non-sterling and then there’s a drop due to uncertainty over the period to June, when they convert it back to sterling, they will have made some unexpected gains on their asset value in cash terms,” Fernandes said.

“There may be some schemes who decide to take off hedges... in the expectation that sterling may depreciate over this period.”

But David Will, senior investment consultant at JLT, said Brexit is just one of a number of risks to the global economy that could have a very significant impact on markets – among them the US election, continued unconventional monetary policy and commodity prices.

“Equity markets are impacted by various factors; putting in place [protections against] equity volatility or implied volatility may be quite expensive, particularly for small schemes,” he said.

Credit risk

Assessing the medium-term outlook, Matt Tickle, partner at Barnett Waddingham, said a vote to leave on June 23 would usher in a more prolonged period of uncertainty and negotiations during the next three to five years.

In the short term, Tickle said a UK exit could cause a temporary spike in gilt yields if overseas investors flee gilts – a potential opportunity for fast-moving pension funds.

“Most schemes want to hedge and buy more gilts – that’s an opportunity for those who are able to move quickly,” he said.

Tickle said widening spreads in sterling credit is a genuine risk for schemes and “passively sitting” on these assets is a “great big exposure” to financials, particularly insurers and banks, heavily weighted towards the asset class.

“[Giving] their credit managers greater freedoms than they have generally over the last few years is probably something schemes should look at if they haven’t done that already,” he said.

Strategic thinking

Kevin Frisby, partner at consultancy LCP, also said trustees should think about their hedge ratios and ensure their portfolio is well diversified to withstand the risks of widening corporate bond spreads and worsening sentiment on UK equities.

“Having some exposure to overseas currencies unhedged… can actually be a buffer and shock absorber in troubled times,” he said.

But practical steps should be based on strategic thinking that goes beyond the short term, he said.

“It would be better to do something strategic that you can live with in the long-term – if that suits the Brexit situation as well, then so much the better.”