Be careful what you wish for…..

27 Jun Be careful what you wish for…..

The UK population has spoken and once again confounded both bookmakers and pollsters with a vote to leave the EU.

The initial reaction was of course negative, with Sterling reaching lows against the US Dollar not seen since 1985, whilst the FTSE 100 was initially off -7%.  This has moderated somewhat as the realisation set in that with a large proportion of FTSE 100 earnings being generated overseas and therefore benefitting from a weaker currency, perhaps the “bad news” is not quite as bad.  That said, it is certain that Markets will be volatile for some time to come.

The Market has struggled a little on Monday falling just over 1% at the time of writing.  RBS and Barclays shares were suspended from trading this morning after falling 14% and 10% respectively, as financials continue to be badly hit by the impact of the UK’s decision to leave the EU.   The shares were offline for five minutes according to the London Stock Exchange who instigate a circuit breaker when shares fall more than 8%, with the affected shares placed in an auction to recalculate the value of the stock.

Politically, we now have a large amount of uncertainty.  David Cameron stated that he would remain in post for three months in order to steady the ship but to use his own words he “would not Captain the ship” into negotiations over an exit, rightly in our opinion, preferring a new PM to begin the Article 50 withdrawal.  Who that may be will be subject to many column inches, but the list of contenders is woefully short.  In our opinion the pre Brexit favourite, Boris Johnson, whilst perhaps showing himself to be a canny political operator in recent times, may well lack the credibility in Europe to ably represent the UK and achieve the best possible outcomes in the exit negotiations.

It is also uncertain as to what shape the negotiations will take.  Article 50 states that unless agreed otherwise by the EU, the UK will have two years to negotiate the terms of an exit, however, there is obviously no evidence to suggest that this is even possible.   The only recent precedent for a negotiation on a market by market basis is Switzerland which took seven years to negotiate a very much more limited set of arrangements.  Therefore once the process does begin, it is likely to be protracted with hard bargaining on both sides.

This vote has shaken the EU project to its core and with the potential for other countries to demand their own referendum votes, Brussels will be in no rush to provide the UK with preferential trading terms and will not want to show that an exit from the EU is a comfortable, straightforward and easy thing to do.  If they were to accommodate the UK, then it is clear to see that the populist policies that won the referendum here, would play out across the swathe of European elections coming over the next twelve months and therefore potentially spelling the end of the EU project as a whole.

Additionally, we look over the results and note that within the UK itself there were some material differences with Scotland and Northern Ireland very clearly in favour of the EU, whilst England and Wales voted out.  Even within England itself there were very marked differences with the North East and North West, along with the West Midlands preferring to leave and London, perhaps with the most to lose in terms of City Jobs, clearly voting to remain.  This demonstrated wide regional variations that can do nothing to unite the country as we move forward in this new world and perhaps will prompt further referendums closer to home, with Nicola Sturgeon stating a second independence referendum (“indyref2”) is “on the table” and “highly likely”.

Over the weekend, the huge number of resignations in opposition has done nothing to reduce the uncertainty.  We now have a Government who may not be well equipped to carry out the public’s wishes nor an opposition that is appropriately staffed to challenge them once the process begins.

Calming words, as ever, were provided by Mark Carney the Governor of the Bank of England.  In his early speech on Friday, he reiterated the efforts the Bank has put in to ensure a battle plan was in place if indeed we did see a leave vote.  Our suspicion is that the BoE never thought those plans would need to be enacted, however, Mr Carney was unequivocal in that it has the ammunition (a £250bn war chest) available to help stabilise and support the economy in the near term.  We believe that this will mean further interest rate cuts along with a resumption of Quantitative Easing.

There is however a very clear dilemma for the BoE.  The blow to private consumption and investment, domestic and foreign could be strong enough to push the UK economy back into recession. A tumbling currency will lead to associated inflationary pressure and therefore would demand higher rates. But with the short-term pain after a referendum shock, the UK has entered a period of extreme economic and political uncertainty and therefore we may see a period of “stagflation”, ie stagnant growth combined with inflation – not a comfortable position at all and one the BoE will attempt to avoid.

Also George Osborne attempted to limit damage with his early speech this morning, picking up the nautical theme he stated that “it will not be plain sailing ahead” but the British people and the Global community that robust contingency plans were in place and that Britain was “ready to confront what the future holds for us from a position of strength”.

Whilst the wider macroeconomic and political ramifications of this vote are fascinating we, as ever, must be laser focussed on client portfolios.

We have previously explained that our portfolios are outcome focussed, but also what we term as “All Terrain”, in that they are designed to participate as fully as possible when Markets are rising but also to protect when Markets are falling.  In that respect we have some impressive participation ratios for each of our model portfolios and your adviser will be happy to talk you through those figures.

Additionally, we have a great deal of experience in operating in volatile periods.  Indeed CDC was formed just eighteen months prior to the greatest financial crisis since the 1930’s, however, we have weathered the storms well and protected clients’ interests well when things have become difficult.  By way of an example, if you look at the note we issued in August last year when over the summer the FTSE 100 was down 11% peak to trough, on average our portfolios experienced just 25% of that downside, something we are rightly proud of.

Turning to the implications for your portfolios in this recent volatility, the market last week was in fact positive despite the falls seen on Friday meaning the market (and (Y)our portfolios) produced a positive return over the course of referendum week, but what of the longer term?

Over the last year the FTSE 100 is down -5.44% with CDC portfolio returns given below:

So whilst it has been a tough twelve months for portfolios, we have been very successful in sheltering investors from the worst the Market has thrown at us, with our Income portfolio experiencing the highest percentage of the downside but still only with an impressive 23% participation. To put that into some perspective, the same portfolio has on average captured 103% of the market upside on a monthly basis since June 2012.

In summary, given that Article 50 will not be invoked until a new Conservative leader is in place, scheduled before the October Tory conference, the government will then have two years to negotiate its new relationship with the EU before its EU membership lapses, although it is likely to take much longer than that depending on the model adopted. Therefore with economic and political uncertainties set to continue for quite some time we must resign ourselves to volatility.

That said, we can console ourselves that the “All Terrain” approach has a proven track record, it has sheltered portfolios and we will continue to monitor both the structure and performance of portfolios to ensure that continues.