Parliament will eventually back Prime Minister Theresa May’s deal on Tuesday, paving the way for sterling to rally through the rest of 2019, according to JP Morgan’s Karen Ward.
PM May’s Brexit deal, struck with Brussels in November, will be voted on next week, having already been postponed for more than a month as defeat loomed. It still seems unpopular across the board, but Ward, chief market strategist at JPMorgan, sees compelling reasons for her party to back it.
“The Conservative backbench have a choice,” Ward explains, “either support the PM and get this deal through, or not support her and face either a referendum or a general election, which the latest polls suggest there may not be Brexit at all.
“Yes, they hate the deal. No, there’s probably nothing that Brussels can give us to make that deal any more palatable to them, but it doesn’t change the fact that that is the risk they are taking if they ultimately don’t support her.”
In addition, the risk of a no-deal Brexit seems to have receded: “We think there’s a clear majority in Parliament against no-deal.”
Therefore, after some “grandstanding” and a rejection of the deal initially, the deal should go through. Should this come to fruition, the pound will recover immediately, regaining the 4% it lost when the Cabinet fell apart two months ago.
But that’s not where sterling’s re-rating will end. Ward thinks it will be a “multi-stage process”. A material change in the Bank of England’s outlook is likely to give the currency a further leg up.
It’s not clear what course the Bank will take once the Brexit uncertainty clears, but Ward thinks it’s likely, in her scenario, that interest rates rise faster than anticipated currently.
She adds: “The Bank of England has been in a tricky position where unemployment’s at a multi-decade low and wage growth is picking up. This economy is at full capacity, yet they’re not going to raise rates. Why? Well, obviously it’s because of Brexit.
“Post an initial deal and some resolution in the uncertainty, or at least the prospect of no-deal being removed, then I think that changes the outlook for the Bank of England this year.”
Clearly, there are other considerations, not least the health of the global economy. But, Ward continues, “on my Brexit scenario and the global economy slowing not stalling then I think we should see the Bank of England raise 50 basis points higher by the end of the year”.
“That should give you another 5% rise in sterling on top of the 4%.”
Investors Should Go Defensive
For the past quarter, JP Morgan have been advising clients to position their portfolios to be more defensive. While Ward isn’t “desperately worried about the US or the global economy falling out of bed” in the near term, there are potential risks to this scenario, not least the US-China trade war.
“We think we’re going to maintain that level of uncertainty, that level of geopolitical risk,” Ward says. “We’re not running for the hills, but we’ve been thinking very hard for the last couple of months about how we make our portfolios more defensive.”
The process of making multi-asset portfolios more balanced begun in around September, says global market strategist Mike Bell. It was an opportune time, as markets began to correct the following month.
“It was quite a significant change in view,” he explains. “For the last nine years, with stock markets going up, we’ve been optimistic and overweight equities as a house in many of our multi-asset portfolios.”
But risks, both to the upside and the downside, now look heightened. As a result, it makes sense to dial that risk back a bit without going underweight or short risk assets.
The starting point for investors is to take their overweight to equities back to neutral, “both on a headline equity-relative-to-bond basis, but also on a regional basis”.
It may also be prudent, Bell suggets, to rotate away from growth areas. That includes taking both small and mega-cap exposures down to neutral.
While this naturally leads investors to running more of a value bias, a focus on quality within that could be a rewarding strategy: “It’s important to have a quality focus because some stocks are cheap for a reason.”
Quality Stocks to Outperform
Companies with strong balance sheets and good free cash flow should remain resilient to a global slowdown and combining this with valuation discipline should avert overpaying for that quality. “What you’ve seen historically is that those quality stocks tend to be the stocks that outperform if the downside risks for the economy materialise.”
Of course, the next question is what to buy if we’re rotating away from equities? “The traditional answer to that is fixed income,” Bell asserts. But investors should be selective within fixed income markets.
A global approach is recommended first and foremost, and Bell thinks that “owning some US duration should add a good hedge to your equity portfolio”. On the corporate side, some areas of both the high-yield and investment grade markets should be avoided.
Kelly Prior, part of BMO GAM’s multi-manager team, agrees and suggests looking at strategic bond funds where managers “truly are moving around these various different asset classes and yield curves”.
A final building block in portfolios would be an allocation to alternatives funds that have the ability to hedge out equity risk without buying fixed income. “Basically things that can buy put options, that can go long volatility, that can short the market,” suggests Bell.
For US investors, too, holding cash should work nicely, with rates on US cash looking much more attractive than they have at any other time since the financial crisis.
