EU-UK Saga

EU-UK Saga

Volatile times till UK votes on EUROZONE

  

With six weeks to go before Britain’s EU referendum, which is scheduled to be held on 23rd June there are many political as well as financial implications for Britain’s growth, demographics and currency. Hence it is imperative to look at rebalancing/ re strategizing the overall portfolio at the macro and micro level.

The possible options for the investors, rising uncertainty over whether the UK will leave the EU is putting your wealth at risk. With little over a month to go until Britons decides whether to back a Brexit or remain in the union, the polls are close, sterling has taken a pummeling and the UK economy appears to have paused for breath.

 As time comes closer, more adventurous investors are seeking to take advantage of the uncertainty by placing strategic bets on what the markets will do in the event that the UK stays, or leaves.

Investors in the FTSE 100 have been largely sheltered since; this is due to the large proportion of companies listed in the leading share index who make profits outside of the UK.

But those owning shares in companies with a high UK exposure have not fared so well, with the likes of Lloyds Banking Group and fashion chain “Next” having dropped substantially in the last six months.

Far from seeing this as an opportunity to bail out, many investors who are confident that Britain will vote to remain in the EU see this as a short-term buying opportunity.

The wide consensus so far has been that UK will remain as a part of EU then the hope is that the UK will bounce back to business as usual, with Brexit-sensitive shares and assets rallying in relief.

However, fear that a vote to leave the union could cause at least two years of volatility in the value of your investment portfolio and in the wider UK and European economy.

Brexit would increase the chances of the British pound weakening against the dollar and the euro by as much as 20 per cent, That would not only increase Brits’ cost of travel and doing business abroad, but also make it costlier for British investors to buy European or US shares or bonds in their home currency.

  

This will also result in the job market in UK in a tight spot with the uncertainty

Businesses expansion by companies in the UK would be very uncertain. One of the sectors that would be hit the hardest would be the financial services industry.

With this kind of uncertainty in the near future it is important for professional fund managers to carry out what is referred to as “hedging” and rejig your portfolio to minimize the risks of both outcomes.

The possible options in the coming weeks could be as follows:

·      Hedge your risks

So what should investors do about all this Brexit uncertainty? Investors should simply batten down the hatches, ignore the expected market volatility and simply make sure they are as globally diversified in their investments as possible. This long-term view is especially skeptical of one tactic, namely to insure your portfolio of investments against risk by in effect insuring the potential downside risk in form of hedging.

The benefits and costs of hedging a portfolio of long-term investments, there are some benefits in the short term in insuring against market swings, but over time, the costs outweigh the benefits. As any insurance always comes at a cost.

Nevertheless, hedging against market volatility could work for investors with shorter time horizons. For adventurous types, the best hedge is to make a profit from a big contrary move that impacts your portfolio. The simplest strategy might be to invest in mainstream ETFs what’s called a currency hedging “overlay”. Many active managers in international funds have already built this into their strategy especially in the much more volatile markets of Asia, for instance but now also buy mainstream ETF trackers that are either monthly or daily hedged.

A typical example from the biggest ETF issuer could be if you want to carry on investing in euro-zone equities but don’t want the risk around sterling falling you could track the MSCI EMU index — a basket of large-cap Eurozone blue-chips. It’s possible to do this via an ETF with the ticker EMUU. Its total expense ratio (TER) is 0.38 per cent while the non-hedged version (ticker CEU) has a TER of 0.33 per cent, implying that the hedge costs 5 basis points a year.

It’s important to understand with a hedging strategy that volatility either way is removed so you might protect yourself on the downside, but you also miss out if the foreign exchange rate moves in a more favorable way.

·      Take the Gamble:

Alternatively, investors may be tempted to try to profit from the possible turbulence and mayhem. This involves a much more adventurous take on the markets and requires you to be opportunistic and tactical there is an absolutely need to protect against the downside of making the wrong call on inherently unknowable outcomes. In simple terms, keep any “speculation” or “bets” to a minimum and constantly watch your position, and be ready to use stop-loss positions to cut your losses if the market moves the wrong way.

Spread betting can be simple and cost effective but losses can spiral out of control quickly. Many exchange traded products especially short and leveraged trackers can be invested in, but they come with their own costs and they usually track daily volatility of markets which means that you could lose out on a big trend if the market moves violently up and down in a short period of time.

 

·      Bet on Brexit

In order to take an out on the market, let’s look first at a vote for Brexit, the first big call would be to short sterling against the dollar. The logic here is simple.US investors might panic about holding sterling and local assets and sell the pound.

The markets will initially over react. A pound currently buys around $1.45. It could fall abruptly after a “leave” vote, so that one unit of sterling might purchase only $1.30. However the same logic may not be able be applicable between the Sterling and the Euro.

Brexit could be perceived as being bad news not just for the UK but also the Eurozone, possibly even accelerating the collapse of the union. In this eventuality, with a very high possibility that the Eurozone equity could also fall sharply with mid sized and small companies being hit the most also resulting in the overall equity risk off sentiment which would affect emerging markets like India.

Sticking with the equities theme, most traders are likely to take risk off the table, and sell UK equities the FTSE 250 index being most vulnerable with certain sectors hit very badly anything in the consumer discretionary spending area and house building could suffer as investors worry about consumers postponing spending decisions.

In the medium term, it would result in much more cautious about the UK financial services sector, also car manufacturers and engineers would be at a high risk of disruption but that the chances of regaining EU access would also be high. For financial services, the risk of disruption was high but the chances of regaining access low. That’s potentially bad news for those financial services firms with big European operations.

One last counterintuitive trade could be the UK government bonds or Gilts. Foreign investors might panic at first, selling off these gilts but the Bank of England is unlikely to sit idly by and not intervene.  It could start aggressively buying Gilts, pushing prices up as foreign investors sell.

·      Bet on No Change

If the UK votes to stay? In most cases we can expect a reverse of the above, with a relief rally in many key asset classes.

Sterling could strengthen markedly with the cable rate between sterling and the pound possibly pushing past $1.50 and maybe even moving within spitting distance of $1.55.

The dollar is already looking vulnerable as uncertainty about the pace and number of rate rises in the US grows, so a resurgent sterling could add to the turmoil. It’s also worth noting that since 2010, sterling has rarely traded much below $1.50.

Investors might also react enthusiastically about risky assets such as UK equities and consumer-focused sectors the most likely to benefit as well as house-builders and financial services firms. Over in the Eurozone whether might also see a sharp rally in small-cap equities as investors stop worrying about the break-up of the Eurozone? And maybe we will see a small gilts sell off.

Finally the most difficult scenario to plan for in investment terms is the “leave, but then re-enter” scenario. This would involve the UK voting to leave, but then renegotiating a new deal to re-enter the EU at some later date after umpteen concessions are agreed. This presents numerous obstacles not least prolonged uncertainty spanning many years. If this suddenly starts to seem like a distinct possibility the best idea for investors might be to accelerate their international diversification and batten down the hatches.

_Farzan Ghadially