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Monthly Commentary August 2018

The illusive Brexit dividend

There has been much debate about what kind of Brexit will occur, given the limited progress and lack of consistency or transparency thus far around the UK’s negotiating position. There is talk of delaying the effective date of Brexit, or even a second referendum. These are all in the ether of a political crisis in the UK. The only thing we can seriously plan for at this stage is a so called “Hard Brexit”, where leaving the EU without an agreement on the future trading relationship (or transition period), the UK will revert to World Trade Organisation (WTO) rules.  In this article, we take a closer look at how this might affect pension schemes and their members in the UK.

Illusive or elusive?

Although these words sound the same, their meaning is subtly different. “Illusive” derives from illusion, so if something is illusive it is imaginary, or not real. In fact, it’s much more common to say something is “illusory”, as in unicorns, or illusory power. On the other hand, “elusive” means difficult to find or achieve, as in “The elusive search for alpha”. Is the Brexit dividend illusive or elusive? We’ll leave it to the reader to decide for themselves.

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What will this mean for pension schemes?

The effects of this will be: pension liabilities will rise in value where they are linked to gilt yields, making this popular measure of pension funding even less sensible.

In aggregate however, pension schemes have hedged a significant amount of their liability exposure, so the net effect of this on funding levels would likely be muted. Growth assets will benefit strongly from QE and currency devaluation, particularly where they have a bias to UK equities and lower currency hedging ratios. UK property (particularly commercial prime) is likely to take a significant hit. We expect other private markets to be better able to weather the storm (and indeed take advantage) of the coming years.

Overall, we expect funding percentage levels through a hard Brexit to hold steady or rise modestly, despite the absolute value of liabilities rising significantly. But there will be some acute casualties, some schemes will find themselves dealing with covenant shocks, as their individual sponsors may be particularly exposed at a business level to WTO trading rules. The combination of sector impacts and currency devaluation may also present opportunities for M&A activity with the net cost of acquisition of UK companies (and their pension schemes) falling to all time relative lows.

How should pension schemes prepare?
  • Revisit hedging of liability interest rates and currencies: more of the former (up to 100% of assets) and less of the latter (50-75%).
  •   Review exposure to UK equities relative to other markets: focus on large caps, overweight equities relative to domestic property.
  • Pay attention to alpha driven strategies: don’t overpay for inconsistent alpha strategies which could cancel each other out on what is likely to be a binary outcome.
  • And be prepared to think strategically, beyond just market movements: covenant implications; new funding approaches (de-linked from gilts); accelerating de-risking; and preparing action plans proactively together with their sponsors own actions.

Despite the uncertainty that is still the focus of much of the Brexit media coverage, pension schemes can take action now to prepare. The worst thing to do would be to wait, and then react.

“Overall, we expect funding percentage levels through a hard Brexit to hold steady or rise modestly, despite the absolute value of liabilities rising significantly. ”

Nikesh Patel, Head of Investment strategy

What are the likely outcomes?

We can differentiate between the economic impact of WTO rules (medium term, affecting the real economy over years), and the investment impact (short term, impacting portfolios immediately). WTO rules would establish a series of tariffs on trade with the EU and other WTO members, which would increase costs for UK importers and exporters. While the average level of tariffs is low with the EU (c1.5%), certain sectors are heavily protected – the automotive industry as an example has tariffs of 10%, and the agriculture sector is subject to painfully negotiated quotas which will likely lead to food prices rising. The likely implications for the services sector, and financial services in particular, will be even more pronounced. It’s not difficult to imagine that such an outcome would rock financial markets as the changes take effect and new free trade agreements are gradually re-negotiated by the UK.

For pension scheme investors, the investment impact will be much more immediate as we anticipate that the markets will immediately price in the WTO arrangements, irrespective of the political fallout. For pension schemes, unlike most of the real economy, there might truly be a tangible Brexit dividend.

How could markets react to hard Brexit?

We expect there to be significant declines in the value of Sterling relative to the Euro and US Dollar, similar in scale to that seen after the EU referendum (and which would likely see Sterling at or through Euro parity). The decline would lead to a spike in inflation – but this is likely to largely fade after two to three years, and over that horizon we would expect there to be some mitigation to imported inflation. We could therefore expect a significant reaction from the Bank of England – likely to include both a reduction of interest rates to zero, a new and large round of Quantitative Easing (QE) as well as near unlimited liquidity achieved through term central bank repurchase agreements.

The combination of these will be to lead to a flattening of the yield curve and cause long yields to fall; and a substantial rise in ’UK‘ equity markets. This will be driven by the combination of QE and the fall in Sterling, which should lead to the value of FTSE 100 earnings increasing as the majority of these are sourced in US Dollar and Euros, though there will be notable losers within this aggregate rise, particularly in financial services. The more domestic focused stock market – smaller caps – will likely have a mixed reaction by sector but likely to be flat overall. Similarly for the UK investment grade corporate bond market, significant foreign earnings for the main issuers should shield them to a large degree – but spreads are likely to widen from current levels. The impact on global equity markets is likely to be negative as they adjust to a ‘risk-off’ tone by investors, but this is likely to be relatively moderate.

The author

Nikesh Patel


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This document of Kempen Capital Management N.V. is for information purposes to professional investors only. The information in this document is incomplete without the verbal explanation given by an employee of Kempen Capital Management. The opinions expressed are Kempen Capital Management opinions and views as of such date only. Kempen Capital Management is registered in the United Kingdom (BR017904) at Octagon Point, 5 Cheapside, London, EC2V 6AA as a branch of Kempen Capital Management N.V. (FC032822), which is a limited liability company incorporated in the Netherlands, authorised by the Dutch Authority for the Financial Markets (AFM) and subject to limited regulation by the UK Financial Conduct Authority (FCA). Details about the extent of our regulation by the FCA are available from us on request.