Only a few weeks ago we saw global banks anxiously await the results of the latest European stress tests. The mixture of doubt and optimism, echoed by many, alluded to hopes that the bleak memories rising from the 2007/2008 financial crisis remain safely in the past.
For most under scrutiny, the results came as a relief, with the banks’ ability to weather financial turmoil up on results from previous years.
Yet banks are not the only ones who could see a benefit from stress-testing. Testament to their rigour and ability to withstand current financial climates, asset managers must undergo similar preparatory actions if they are to facilitate their continuing success. Highlighted by the UK’s vote to leave the European Union in June this year, there is no better time to stress-test portfolios in the wake of economic uncertainty – for better or for worse.
Some would argue that extensive testing, similar to those undertaken by the banks, may not be entirely necessary – indicated by the recent shelving of the Financial Stability Boards’ stress-testing regulations. However, given the volatility rife within the financial industry, asset managers must install confidence in all parties through the water-tightening of investment portfolios, leading investors and asset managers alike to ask: how can investment portfolios weather the fallout from Brexit?
On Friday 24 June, after the British people took to the polls to vote in their EU referendum, sterling was heavily impacted by the vote to leave, selling off over 10 per cent from the pre-vote highs to the US dollar. With a continued and prolonged fallout, it would be safe to say that sterling could come under further pressure. It is therefore of paramount importance to gain a thorough understanding of the potential impacts this may bring to a client’s portfolio.
A globally diversified sterling-reporting portfolio should not be heavily impacted over the shorter term by a further sell off in sterling; in fact most portfolios should be set to gain in the event of a further sterling weakening. Aligned to this, understanding where a client’s current and future liabilities are likely to be and in which currencies they are likely to be in, also plays an important part in determining how a client should invest.
Understanding how much a portfolio will be impacted by further fallout will be mainly governed by how domestically-orientated a portfolio is positioned. Investors in the UK, like many countries, suffer from a home country bias (see below), when the UK stock market only represents a small proportion of the overall global economy. Furthermore, a disjointed and disorganised UK exit from the EU will present opportunities to other countries and companies as a result.
Brexit, if nothing else, has served us with a timely reminder that the old rules of ensuring that a portfolio is appropriately diversified provides valuable risk control – one of the most important contributors to ensuring a portfolio’s stability. The equity market sell off on Friday 24 June and Monday 27 June saw a spike in the prices of safe haven assets such as gold and government bonds. Advising on how a properly diversified portfolio should be structured requires an understanding of the individual client’s or families’ overarching risk appetite and the risk budget that they feel comfortable with at this time in the market. The two may not be necessarily the same and some clients may feel less inclined to using all of their risk budget at this time and are happy to sacrifice some of the potential upside.
