As Brexit beckons… what’s in store for the market?

It’s been just over three years since the EU referendum but it’s still not clear what Britain’s exit from the EU will really look like - assuming, of course, that it happens at all.

This week, as we edge closer to the next notional departure date on October 31st, we might learn more about the details. And from that, it may just be possible to make a few predictions about how the stock market will react (although there are still plenty of unknowns).

Brexit has been an enigma for equity investors since the starting gun was fired in June 2016. Back then, the 52/48 victory for ‘leave’ wrongfooted the market and caused sterling to slump and index prices to tumble.

Stocks sensitive to the UK economy were hit very hard the day after the vote. Banks like Barclays and Lloyds saw their prices fall by around 20 percent. There were similar swings in cyclicals like the housebuilder Persimmon, recruitment group Hays and the car dealer Pendragon.

But the effects were short-lived and the FTSE All-Share, although volatile, has gone on to rise by 23 percent since then.

Among the many questions now - with an exit possibly just days away - is how much of the impact of Brexit is priced-in to the market? And what kind of upside or downside could be on the cards in the weeks ahead?

Reality starts to bite

Trying to infer anything from the morass of political briefings, media reports and ‘expert’ commentary (let alone social media) is hard work when it comes to Brexit. But as the clock ticks down, there is evidence that the market is paying close attention to the mood music around the negotiations.

One important barometer here is the value of sterling, which has tended to be sensitive to which way the Brexit wind is blowing. The prospect of a deal between the UK and the EU, with the relative certainty that would bring to the domestic economy, has generally lifted the value of the pound. Indeed, with the possibility of a deal in sight, there’s been a relatively sharp rise in the value of sterling over the past week. That said, if a deal fails to materialise, it’s arguable that the pound will come under pressure. But what does all this mean for shares?

Source: IG Group

Well, in tandem with the rise in sterling in recent days, the mid-cap FTSE 250 index has seen the strongest gains versus the FTSE 100 and FTSE SmallCap. Part of the reason for this is down to the nature of the stocks in that index.

You sometimes see the FTSE 250 described as a proxy for the UK economy. It’s fair to say that it’s nowhere near as internationally exposed as the FTSE 100. But revenues across the FTSE 250 index are actually evenly split between domestic and international sources. So there’s an argument that the FTSE 250, as a whole, has a lot to gain from a deal because of the certainties over international trade that would come with it.

By contrast, the FTSE 100, with its financial strength and international outlook, is perhaps generally better insulated from a no-deal event. After all, it’s home to a number of stocks that aren’t overly-exposed to the UK and derive a large proportion of their revenues in foreign territories.

Another reason why the FTSE 250 may have picked up on the prospect of an agreement is that it’s more cyclical in nature than the FTSE 100. John Kingham (UK Value Investor) has done an excellent summary on the sector weighting of the UK market’s main indices.

In essence, the FTSE 100 is a naturally defensive index given its exposure to sectors like healthcare, tobacco, beverages and utilities. By comparison, the FTSE 250 is much more heavily weighted in cyclical and sensitive sectors like support services, financials, retail and construction. These sectors, among others, would benefit from the pound holding up and the economy remaining relatively unscathed by Brexit.

Being precise about how things may go is tricky, but some researchers have given it a shot. Work by the index provider MSCI last week, stress-tested different potential scenarios that may follow Brexit. It found that a disruptive no-deal could weaken the UK stock market by 15 percent and see the pound fall by 10 percent against the dollar. But in the case of a last-minute deal between the two sides, the UK market could bounce by 10 percent, with the pound rising by eight percent against the dollar.

Taking a defensive position

So what is the market saying right now? The classic safe haven stocks in times of economic strife tend to be those defensive names that don’t do so well in booms, but hold up a lot better in uncertainty. You can find them among the healthcare, consumer defensives and utilities sectors.

In this screen table you can see the fastest moving defensive stocks in the FTSE 100 over the past month (on a relative price strength basis). Selecting those with a RiskRating of either Balanced or Conservative (the lowest volatility stocks on the RiskRatings spectrum) it’s the usually unremarkable utilities stocks that are leading the pace in the current conditions. With reasonable yields, utilities are probably among the most defensive of safe havens when it comes to shares.

But are are other trends. Recent signals of a possible Brexit deal saw shares in housebuilders, banks, insurance groups and even some retailers rise sharply. You can see a flavour of that in this screen table, which looks for the strongest 1-month performers in FTSE 350 cyclical stocks with Balanced, Adventurous and Speculative RiskRatings. Despite the unpredictable conditions, some cyclical stocks are seeing strong gains.

Ready for anything?

Putting politics to one side, the prospect of Brexit (or whatever follows from negotiations between the UK and the EU) presents some interesting challenges to stock market investors. These could be short-term in nature or have longer-lasting repercussions, but anticipating the prospect of volatility could be a helpful way of managing it. Over the coming weeks, the market could be in for an unpredictable ride - so it’s worth considering whether your portfolio is ready for it.