ANALYSIS

Post-Brexit uncertainty reigns

For many institutional investors, the short-term impact of the United Kingdom’s decision to leave the European Union was positive.

The £20.9 billion ($25.5 billion) medical charity Wellcome Trust reduced its sterling exposure to a record low ahead of the vote, in a strategy that helped the fund return 19 per cent in 2016.

The €12.3 billion ($13 billion) German pension fund Ärzteversorgung Westfalen-Lippe (ÄVWL) Brexit-proofed its portfolio with a large US dollar exposure. Dollar holdings accounted for about 12 per cent of its assets last summer, offsetting weakness from a moderate sterling exposure and making the fund a net gainer from the Brexit decision.

Nine months on and a ‘soft Brexit’ – which would give the UK continued access to the single market based on the free movement of goods, capital, services and people throughout the bloc – is unlikely. Instead, the UK is set to leave not only the single market but possibly the customs union as well.

The customs union sets a common external tariff for countries within the bloc, and leaving it would free the UK to sign trade deals with the rest of the world. The timeline is fraught with unknowns, none more important than the fact an eventual tariff deal would need to be ratified by parliaments in all 27 member states. A protracted split could encourage other members, particularly those with elections this year, to leave. With a hard Brexit in the offing, what are the long-term investor challenges and opportunities?

Selective optimism in real estate

The UK’s real-estate market is looking vulnerable, particularly London’s financial sector. The big question is whether UK-based institutions will hang onto the ability to sell their services throughout the EU, via existing ‘passporting’ rights, once Britain leaves the bloc. If they can’t, many could relocate to Europe, dragging down real-estate values in their wake.

“The area we see as most vulnerable is tenants in the financial sector. It is unclear how the new trade regulations might affect their business,” says Dale MacMaster, chief investment officer of Canada’s Alberta Investment Management Corporation, (AIMCo), the C$90.2 billion ($69.4 billion) pension fund with a $12.4 billion real-estate portfolio, of which 11.8 per cent is in the UK.

Nevertheless, AIMCo still views UK real estate “in a positive light” and MacMaster notes steady demand for office space from tech and media tenants, as well as leasing demand from industrial groups.

“We will pursue opportunities in areas such as modestly priced housing projects and logistics warehousing projects for firms supplying the UK market,” MacMaster says. “Moreover, the depreciation in sterling against the Canadian dollar is a chance to add assets.”

Other investors share his selective optimism.

PFA Asset Management chief investment officer equities and alternatives, Henrik Nøhr Poulsen says, “We believe the UK is still likely to be the most attractive real-estate market in Europe in 10 years. However, the long-term attractiveness of UK real estate will depend on how attractive a country the UK is for business in the future. We don’t know if the level of demand is going to be 90 per cent of what it is today or 120 per cent.”

PFA Asset Management is the investment arm of Denmark’s DKK550 billion ($78.2 billion) PFA Pension, where strategy is focused on building an alternatives allocation from 2 per cent to 10 per cent of assets under management over the next five years.

Others funds have a more negative outlook on UK real estate, and have been quick to shape their allocations to benefit from demand for office space in rival European financial capitals, such as Frankfurt and Paris.

Lutz Horstick, head of securities and loans at ÄVWL, says: “There is opportunity in Frankfurt’s office market from banks relocating from London to European cities. A lot of money from the Far East and Middle East headed exclusively to London but this is starting to change. We have been very sceptical of the London property market for a while.”

Ilmarinen, Finland’s third-largest pension fund, has an 11 per cent allocation to real estate and has also cooled on the UK market. Despite plans to boost investment in Europe, the fund has put investment in UK real estate on hold since Brexit.

“There are so many open questions about Brexit for investors,” Ilmarinen chief investment officer Mikko Mursula says. “We don’t know the time schedule, or what will happen in the end.”

Canada’s appetite for UK infrastructure

Canadian pension funds have poured into UK infrastructure, buying stakes in the High Speed 1 railway line that connects London to the Channel Tunnel, critical energy infrastructure and landmark London property, ports and airports – including London City Airport, in a deal closed a few months before Brexit.

Appetite at AIMCo, which has more than a quarter of its $5.2 billion infrastructure portfolio in the UK, will cool going forward. But MacMaster, who likes UK infrastructure for its links to inflation, especially as sterling weakens, doesn’t attribute this directly to Brexit, but more to the fact that the portfolio is already weighted towards the UK.

“The ongoing focus is now on Euro-denominated investments, regardless of Brexit,” he says. “One investment area we are interested in exploring longer term is new infrastructure opportunities potentially put forward to help the UK compete more effectively post-Brexit.”

Active management in equities

Investing in UK stocks post Brexit could introduce a new phase where funds embrace active management and stock picking over passive, cheaper investment vehicles.

Chief investment officer Salwa Boussoukaya-Nasr, at France’s €36.3 billion ($38.4 billion) Fonds de Réserve pour les Retraites (FRR), thinks this strategy has already paid off. Nearly 60 per cent of equity investments are actively managed at FRR, in a strategy that has helped shield the fund from enduring structural weakness in the euro zone and the Brexit fallout.

Going forward, Boussoukaya-Nasr says, active strategies will position the portfolio for new trends, particularly slower UK growth and a normalisation of valuations as euro zone earnings improve. FRR increased its exposure to the euro zone from 2012 to 2015, with its allocations to the region’s investments rising from 41 per cent to 49 per cent during that time.

ÄVWL’s Horstick says: “The fall in sterling offers a window of opportunity for investors to build exposure in UK equities.” UK companies with a global customer base and dollar earnings, say, tech companies, won’t be affected by any domestic downturn and look cheap.

AIMCo’s MacMaster says companies that could feel the fallout are those dependent on strong UK demand.

“At the moment, AIMCo tends to underweight sectors where, on average, companies derive a larger portion of their revenues from the UK,” he explains. Sectors dependent on an immigrant workforce, like farming and hotel services, and companies focused on trade with the EU also face a more uncertain future.

Uncertainty is the abiding theme of Brexit.

“The most obvious impact of Brexit is uncertainty,” says Ian Scott, head of investment strategy at the UK’s Pension Protection Fund, the £23.4 billion ($28.4 billion) lifeboat fund where post Brexit strategy included scaling back of risk in the growth portfolio.

An LDI strategy cushioned the PPF from the shock of Brexit, in contrast to many other UK funds which have been hit by gilt yields falling, pushing up their liabilities. “Because we are fully hedged the impact of Brexit on our balance sheet is mirrored by the impact on our liabilities. Brexit does mean, however, we are managing the risk on our growth portfolio differently.”

The $188.8 billion California State Teachers Retirement System (CalSTRS) will navigate Brexit uncertainty via tilts. The fund has been developing an asset allocation away from its home-country bias and towards a more global asset mix since 2015.

“CalSTRS will continue to move toward our long-term allocation policy and may take short-term tilts allowed in the allocation policy, given our market outlook,” fund spokesman Ricardo Duran says. “We continue monitoring the impact of Brexit on the European market for these tilts, and the implementation of our long-term asset allocation policy.”

For now, few funds are factoring in much lower EU growth, or further exits from the bloc; moreover, the UK’s loss is Europe’s gain. Most are unlikely to increase investment in the UK, and those that do will be highly selective and opportunistic.

“In general,” MacMaster concludes, “AIMCo believes that where there is uncertainty, there is always opportunity.”

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