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Thomas Verbraken

Thomas Verbraken
Vice President, Risk and Regulation Research

Breaking up is hard to do: Brexit and institutional portfolios

Ten months after the United Kingdom voted to exit the European Union, the negotiations over the U.K.’s departure are about to begin. While the process could take up to two years, institutional investors may seek to assess how Brexit may affect their portfolios.

Using MSCI’s stress-testing capabilities, we examined three hypothetical scenarios that we summarize as a rough Brexit, a smooth Brexit and a Brexit that benefits the U.K.1 The scenarios produce possible outcomes that range from globally diversified portfolios (60% equity, 40% fixed income) losing nearly 8% of their value to the same portfolios gaining 3.5%.

Note that each scenario below imagines a series of shocks that we describe in the setup. We then apply those shocks to a globally diversified portfolio. Markets would price in new perceptions in a short period of time.

 

A Rough Brexit: Negotiations Fail

This scenario envisions the U.K. being unable to conclude new agreements and customs rules with its major trading partners within the two-year period set by the treaty that established the EU. A failure to negotiate trade pacts leaves the U.K. isolated in the World Trade Organization and produces a wave of uncertainty in global financial markets. A vote by Scotland to leave the U.K. fits into this scenario because it would further separate the U.K. from its trading partners.

Over the year that ensues, the U.K. experiences net outflows of talent, capital and foreign direct investment, while investment and spending slow. Investors price a deflationary recession into U.K. assets that generates spillover effects worldwide.

In our scenario, the pound weakens 16% against the dollar and the euro. Equity markets in the U.K. and EU fall 37% and 21%, respectively. The risk of default for sovereign debt in the U.K. and across Europe boosts 10-year yields by 20 basis points (bps) in the U.K. and 60 bps in countries at the EU’s periphery. Corporate credit spreads widen, which exacerbates systemic risk.

Potential implications for this scenario:

  • A globally diversified multi-asset-class portfolio could lose as much as 7.8%. A risk-parity portfolio with enhanced exposure to global bonds might mitigate the impact, losing 5.8%
  • Globally diversified equity portfolios could lose 11%, on average
  • Globally diversified fixed income portfolios could lose 2.8%, on average
  • Cyclical equity sectors could lose 12%, whereas defensive sectors would not fare much better, with a loss amounting to 10%.

 

A Smooth Brexit: UK Concludes Trade Deals

This scenario envisions investors gaining confidence that the U.K. will forge trade agreements with the EU but that the pacts provide fewer benefits than the U.K. enjoyed previously. Spending by the government and weakening of the pound boost expectations for inflation. Though the U.K. diversifies its trading partners in the long term, the country endures a bout of stagflation initially.

The pound changes little. U.K. equities lose as much as 12%, and the 10-year U.K. bond yield rises 120 bps. European equities fall 4%.

Potential implications for this scenario:

  • A globally diversified multi-asset-class portfolio could lose as much as 1.6% of its value. A risk-parity portfolio could lose 1.1%
  • Globally diversified equity portfolios could lose 2.3%, on average
  • Globally diversified fixed income portfolios could lose 0.5%, on average
  • Cyclical sectors could lose 2.5% whereas defensive sectors could fare slightly better, with a loss of 2.1%.

 

A Brexit that Benefits the UK: Anti-EU Parties Gain Power

This scenario envisions social and political shifts across Europe that propel anti-EU parties to power. Investors perceive the U.K. as an island of safety, thanks in part to its bilateral trade relations with the U.S., China and others.

The pound rises 16% against the dollar. Growth and inflation pick up. Though U.K. equities gain 4.2%, stocks across Europe slide as much as 11%.  Yields on 10-year U.K. bonds rise 10 bps. Investors price in a higher risk of default in Europe, including peripheral and non-peripheral countries, sending Italy’s 10-year yield up 60 bps relative to the German bund.

Potential implications for this scenario:

  • A diversified, global, multi-asset-class portfolio could gain as much as 3.5% of its value. A risk-parity portfolio could lose 3%
  • Globally diversified equity portfolios could lose 4.3%, on average
  • Globally diversified fixed income portfolios could lose 2.2%, on average
  • Cyclical sectors could lose 4.7% worldwide, whereas defensive sectors could lose 3.6%.

 

1Analytics from MSCI include RiskManager, BarraOne, and MSCI’s Macroeconomic Risk Model and Scenario Analysis Service. Clients will find guidance on how to implement the stress tests in RiskManager and BarraOne at our client support site.

 

Further reading:

MSCI’s Brexit site

How Brexit may impact your portfolio

What the rise in populism may mean for your portfolio

 

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