LAPF Investments analyses the potential impact of the result of the UK’s referendum on membership of the EU
How will the UK’s historic decision on June 23 to leave the European Union affect pension fund investment?
There is a view that it falls into the category of political events which do not change investment fundamentals, despite the headlines and a certain amount of short-term volatility. Against this, there are voices warning that Brexit, as it is known, could have major investment implications. Still others see it as another sign of rising populist opposition of the economic policies of austerity and financial repression that have followed the global financial crisis. Ashmore head of research, Jan Dehn, is an observer who reads a wider significance into the Brexit result, saying: “Political leaders in developed economies understand only too well that there is an enormous price to be paid to fix their economies from the excesses that led to the Developed Market Crisis (DMC) of 2008/2009 and its aftermath.” Dehn added that the political cost of the reforms needed to deal with government debt and other liabilities, such as unfunded pension liabilities and rising healthcare costs, are almost insurmountable.
Consequently, developed governments like the UK’s have adopted the politics of denial, or use QE and other palliative measures, to avoid taking more radical action to tackle the underlying problems. Unfortunately, this approach led to stagnation, with many people feeling worse off and blaming that on certain groups, such as the wealthy or immigrants. Dehn warned that the path we are now on is leading to the rise of populism, as seen by the success of UKIP and a shift to the left by the Labour party, the candidacy of Donald Trump in the US and the emergence of far-right parties in other countries in Europe. So in this sense, Brexit is part of a worrying development globally. Dehn commented: “The politics of denial clearly has echoes to the politics in the aftermath of the Great Depression in the 1930s. Nationalism is on the rise in the US, Europe and Japan, and there is a longing for more stable and safer societies. This desire is likely to morph into calls for a stronger and more interventionist state to deal with economic uncertainty, income inequality and perceived threats from abroad.”
While Brexit can be seen as symbolic of wider forces, a more immediate concern for investors is its impact on the UK economy. The view that the UK economy will suffer, at least in the short term, as a result of Brexit is widespread. The Bank of England warned before the referendum that a vote to leave could lead to a 3.6% fall in GDP over two years, 520,000 fewer jobs, a 10% fall in house prices and higher government borrowing. Those calling for a vote to leave dismissed such warnings as “project fear”, but most economists and investment experts believe that there will be uncertainty and volatility, if not a fall in growth, in the UK and also Europe, following Brexit. Valentijn van Nieuwenhuijzen, head of multi asset at NN Investment Partners, said: “We believe that Brexit will have a substantial negative impact on the UK economy, which could easily fall into recession next year, and impose additional headwinds for European growth momentum over the next 12-18 months. The impact on global growth will mainly be drawn from increased uncertainty rather than a direct negative one. NN IP has reduced its expectations of earnings growth in the Eurozone from 4% to 2% this year and from 8% to 3% for 2017.”
Another consideration is what Brexit implies for the UK and Europe. The UK’s new prime minister, Theresa May, has said that “Brexit means Brexit”, but as yet, no-one is entirely clear what Brexit means for Britain’s future relationship with the EU. Hermes Investment Management group chief economist, Neil Williams, commented: “Getting to the end game on Brexit looks a long, drawn-out can of worms, offering uncertainty for UK assets and markets. The extent of the damage will probably rest on the manner of the exit. The mark-down on assets would surely be greatest in the case of a ‘hard exit’ – entailing acrimonious departure, lower trade, lower migration and recession – than the more probable ‘softer’ version.” Others also expect to see market volatility as a result of Brexit and other geopolitical factors. SSGA global investment officer, Rick Lacaille, said: “Longer term, volatility is likely to remain a feature of markets as they contend with broader global growth concerns, the capacity of central banks to stimulate economies and other geopolitical events including elections in the US and across Europe.”
Looking at the outlook for various asset classes, one expectation is that the Bank of England will now seek to stabilise the economy by further QE and other measures to stimulate growth. So far, the Bank of England has delayed changing the UK’s interest rate and Peter Michaelis, head of investment at ATI, commented: “The decision [not to cut rates in July] may be negative for large-cap FTSE 100 stocks that earn and report in US dollars, as a rate cut would have led to a weaker pound. As the dust settles, however, very little will have changed for the UK economy or UK markets.” However, other pundits disagree that the equity will not be affected by Brexit. A spokesmen at independent economic research firm Fathom Consulting said that the argument that the recent performance of the FTSE 100 is an endorsement of Brexit is incorrect. “A more sobering explanation is the fact that firms listed on the FTSE 100 derive most of their earnings from outside the UK. Given the large fall in sterling since 23 June, these earnings are now worth more in sterling than they were before the referendum. This has nothing to do with the outlook for the UK economy.” Fathom Consulting’s spokesman added: “When converted into US dollars, the FTSE 100 and FTSE 250 have underperformed major equity indices in the US and Japan. The FTSE 250 – which derives a greater share of its earnings from the UK – has fared particularly poorly and even worse than Greek equities. Investors are giving the thumbs down to the UK’s decision to leave the EU.”
If markets become more volatile, this could benefit hedge funds. Lyxor Asset Management senior cross-asset strategist, Jean-Baptiste Berthon, commented: “Brexit is likely to keep asset volatility elevated and result in greater differentiation across European markets. This should be generally beneficial for hedge funds, for relative value and nimble styles in particular.” Looking at different hedge fund styles, Lyxor said that in July 2016, CTAs did well, benefiting from their defensive positioning, while merger arbitrage funds were reasonably isolated from the Brexit shockwave.
Emerging markets could be negatively affected by Brexit if it leads to prolonged risk aversion in global markets, according to NN IP senior emerging markets strategist, Maarten Jan Bakkum. He commented that large parts of the emerging markets are suffering from weak fundamentals, with poor growth prospects, high debt levels and high reliance on foreign capital. Bakkum added: “Brexit has also increased the likelihood of an extended period of US dollar strength, which is never good for emerging markets. Global trade was already weak but Europe is the main trading partner for central Europe and Asia.” But on the positive side, Bakkum said that supportive policies from central banks in the developed world will continue, partly due to Brexit. “This should help capital flows to emerging markets and lead to an easing of their financial conditions,” Bakkum commented.
Ashmore’s Dehn took a more positive view on the emerging market outlook, once developed markets use devaluation and inflation to deal with their debt and productivity challenges. Dehn said: “This bodes well for growth in emerging market countries, because declining QE currencies will channel capital back into emerging markets. While some emerging market exporters may find it challenging to cope with stronger currencies, the majority of emerging market countries readily reform when required to do so. Others, such as China, are far more proactive, reforming well ahead of time. They will emerge as the big winners of tomorrow.”
Perhaps the biggest market change from Brexit could be a move away from cutting the deficit to a policy of issuing bonds at low rates to finance investment in infrastructure and other real assets. This could benefit pension funds by increasing the supply of liability-matching assets and creating better yields and a deeper, broader market in real assets and infrastructure investments. Local government pension scheme (LGPS) members will also want to see if there are any changes to the policy of asset pooling, as this was driven by the outgoing chancellor, George Osborne. Could this initiative be hit by Brexit uncertainty? As with the future trajectory of equities and other assets, time will tell but it is likely to involve plenty of twists and turns on the way. For pension funds, Brexit could mean a host of changes, from new regulations, to a different investment climate. But the ultimate goal, of accumulating sufficient assets to provide pensions to the plan members when they retire, will continue. Much may change outwardly, but pension funds outlive governments and have to cope with the conditions created by government policies and by referendum results.