Christopher O’Dea reports on the implications for institutional investors arising from the UK’s referendum on European Union membership
At a glance
• Reaction to the Brexit vote will be immediate – placing a premium on early preparation.
• Despite the chance of a sterling decline on Brexit, the currency’s strong recent run mitigates against placing passive hedges now.
• With Remain holding a slight edge a month away from the vote, pension plans should also consider that sterling might rally.
Preparing for a hurricane entails a flurry of activity – boarding up windows, stocking up on batteries and securing supplies of fresh water. Bracing for Brexit is more stressful, because aside from the precise date when the storm will make landfall, investors have less certainty about the course, duration and strength of the disruption expected in the wake of a Leave vote than satellites can provide about a tropical storm.
Taking at face value the arguments about membership, either leaving or remaining would plunge the nation, its businesses and its pensioners into dire straits. The reality of a Brexit will be more drawn-out than most expect, taking years to renegotiate international agreements and commercial contracts while offsetting economic consequences play out against fluctuating interest rates, inflation and currency values.
Just weeks from the 23 June vote, consultants, economists and investment advisers point to several considerations that should be on the storm readiness checklist for the pension investment sector. In particular for UK pension funds that have a passive currency hedge in place for global equity allocations.
First, says Stephen Saint-Leger, managing director of Cambridge Associates, pensions funds, foundations and other institutional investors “should keep a 24-hour watch on the polls, the betting odds offered by gambling shops, and the increasingly volatile news cycle in the weeks leading up to the referendum”.
Sterling will serve as a “volatile thermometer” of Brexit sentiment, Saint-Leger says. The currency will be the first asset class to adjust to the results. If the decision is to go, “the pound will be down big-time,” he adds. “This will happen relatively immediately,” he says. “As a fund, you won’t have time to react to it.”
However, investors may not have to react – in April voters were leaning in favour of remaining in the EU. But that does not mean they do not need to be prepared. There are several issues pension fund managers and boards should be considering, although the overall guideline is that there’s no single solution, says Guy Plater, senior consultant at Punter Southall Investment Consulting. “All pension schemes are very different from each other,” he says.
In general, Brexit preparations should cover four areas, Plater says. Pension plans should consider reducing existing currency hedges to take advantage of the expected sterling weakness, and extend that analysis to consider reducing UK equity exposure in favour of global equity. Pension funds should also anticipate lower interest rates for longer – as the Bank of England is expected to ease monetary policy in the wake of an exit vote – and review investments accordingly. Funds should also anticipate volatility in UK corporate bond markets, and review passive exposures to the sector.
Those areas of focus reflect the prevailing allocations of UK pension funds, and the general impact currency volatility might have on assets, says Plater. About a quarter to a third of UK funded pension schemes invest overseas, with the vast majority in global equities; from 2014 to 2015 the proportion of UK-quoted equities in UK funds’ total equity holdings fell from 29% to 24%, while the proportion of shares quoted on exchanges outside the UK rose from 62% to 65%.
While that shift reflects decisions to diversify portfolios and seek higher returns in non-UK equities, rather than an attempt to capture currency movements, currency fluctuations will affect the value of equity portfolios. “If you expect volatility in a currency, you expect that to feed through to the holdings themselves,” Plater says.
Global equity mandates seek to add returns through stock and industry selection, but currency hedging can make sense when currency values are near the extremes of historical ranges. Some UK pension funds have adopted low-cost passive hedges of about half of their currency exposure as a way of protecting themselves against a rise in sterling by locking in its prevailing level against another currency at certain times. During periods of sterling weakness – such as the 20% decline late in 2008 – the cost of the hedge rises; a drop in the value of sterling following a Brexit would similarly increase the cost of a hedge. Establishing a hedge now to lock in current values as protection against a Brexit decline would also leave potential gains on the table and reduce the contribution of overseas equities for UK-based pension schemes.
“If you expect volatility in a currency, you expect that to feed through to the holdings themselves”
Between 2009 and 2010, sterling was at an historical low, says Plater, and with a higher chance of it moving upward over the long term, it made sense for several clients to establish passive hedges. These proved useful as it appreciated against leading currencies over the next five years. By early 2016, Plater says, there was value in reducing those hedge positions. But he notes that currency hedging of global equities remains the exception. “We give that advice once every two or three years,” he says.
While investors and economists agree that a vote to leave would depress the currency, it is a challenge to determine the potential range of valuation that sterling could experience in reaction to the vote. David Page, senior economist at AXA Investment Managers (Axa IM), has developed a model to assess whether the sterling rate is deviating from the ‘normal’ path it would be on if there were no referendum.
In January, Page suggested sterling could fall to between 1.25 and 1.30 against the dollar if the UK were to leave the EU. As polling and betting data has accumulated in the past few months, Page has devised what he calls “an interesting counterfactual approach,” trying to correlate market movements in sterling’s value with changes in whether the stay or leave campaign was winning the perception battle.
Page establishes a fundamental valuation for sterling using a model that combines a two-year interest rate differential with a proprietary measure of global market risk appetite and oil price trends, and ascribes deviations in value from that path to political risk – that is, Brexit. “While it would be heroic to assume you could use that sort of metric to arrive at a precise figure,” says Page, “it’s an instructive exercise to see what the market seems to be implying.”
In early May, with sterling at just over 1.46 to the dollar, the Axa IM model suggested sterling could fall to 1.32 if the vote went in favour of exit. While that seems a large decline, Page notes that the spread-betting market indicates a 70% chance the vote will favour staying in the EU. “So there’s a significant discount already priced in,” he says, which suggests an uptick in sterling with a remain vote. “Either way, stay in or stay out, we would argue there’s going to be quite a significant move coming through” in the sterling-dollar exchange rate, Page says. “Our view is that the UK will vote to remain in the EU and therefore we will see sterling appreciation come through which will probably push it significantly over 1.50 as we get though the referendum.”
Another indication that the pound might well see a summer rally is the difficulty the Leave campaigners have had adducing facts to support their position, says Cambridge’s Saint-Leger. As the vote approaches, “there’s been more of an attempt to look at economic data,” he says. “The Leave campaign has had tremendous trouble coming up with hard data and arguments.” That does not mean the Remain campaign will win, and Saint-Leger says the perception that it is ahead has prompted “a lot of complacency on the Remain side.”