British citizens will be going to the polls on June 8 in a surprise snap election that could shape the way the nation’s exit from the European Union plays out.
While most people will be discussing Brexit as it relates to the election, investors should be paying attention to how the election will affect the global financial markets since the result could impact how their portfolios should be positioned going forward.
In case if you are wondering whether mutual funds are right for you at all, you should read about why mutual funds, in general, should be a part of your portfolio.
What the June 8 Election is all About
In April, UK Prime Minister Theresa May called for a special snap election following repeated public statements that she would not. May’s Conservative Party holds a narrow four-seat majority in Parliament. The prevailing sentiment is that May feels her party is in a position to add additional seats in Parliament and, therefore, improve her negotiating leverage heading into Brexit discussions. The risk in calling a snap election is that it gives the “Remain” faction an opportunity to strengthen its case as well in the negotiation process.
The Economic Scene in the UK
The UK’s economy is generally in good shape right now, although there are some mixed data signals. The unemployment rate dropped to 4.5% in January 2017, the lowest level the nation has seen in decades, while the annual GDP growth rate has remained steady in the 1.5-2% range for the past couple years.
On the other hand, the housing market is showing signs of a slowdown. UK housing prices dropped last quarter for the first time in two years and could remain under pressure for the remainder of 2017. Wage growth has been tepid and fell behind the inflation rate for the first time in over two years, meaning that workers are actually starting to experience a decline in purchasing power. What the final Brexit agreement ultimately looks like it could continue to impact any one of these numbers.
A “hard” (or “clean”) Brexit would essentially involve a complete withdrawal from the EU. It would give up any trade benefits and access to the bloc. The UK would be reestablishing itself as an independent entity free to make its own trade rules and policies on immigration. A “soft” Brexit would allow the UK to exit the EU but keep many of the trade, tax and travel benefits that come with membership. A final Brexit agreement could also be anywhere between these extreme options.
The UK’s Equity Market
The United Kingdom stands as the fifth-largest stock market by market cap at roughly $3 trillion. Investors fled UK equities last year following the surprise vote to leave the EU, but 2017 has provided more optimism. A relatively strong economy coupled with the general belief that Brexit may not be as economically impactful as was feared has drawn investors back in.
There’s not much in the way of UK-focused mutual funds available to investors, but on the ETF side, the largest fund by far, the iShares MSCI United Kingdom ETF (EWU), has seen inflows of nearly $500 million thus far in 2017, following outflows of around $300 million in 2016.
Investment Themes to Watch For
The UK’s stock market sold off hard following the June 2016 Brexit vote, with the United Kingdom ETF dropping more than 11% the next trading day. Despite the initial setback, UK stocks have rebounded strongly and are now up more than 5% since the vote. Some of the biggest winners have been consumer goods companies. Unilever (UN) is up almost 24%, Diageo (DEO) has gained 12% and British American Tobacco (BTI) is up 15%. Energy companies such as BP (BP) and Royal Dutch Shell (RDS.A) have underperformed, but that may be primarily because of global oil prices rather than Brexit.
Once the UK exits the EU, it loses any trade advantages it has with other EU member nations (assuming there is a hard Brexit in which the UK cuts all ties). It’s estimated that this trade loss could cost UK businesses around $82 billion, while slashing GDP by several percentage points annually. A soft Brexit on the other hand could mute much of that loss, although the degree to which losses could be minimized is unclear. Those in favor of the soft option argue that the UK can recoup EU trade losses through newly negotiated free trade agreements with other nations.
Mutual fund investors looking for exposure to the United Kingdom might be best served looking at European equity options with large UK allocations. Examples include the Vanguard European Stock Index Fund (VEUSX), the Franklin Mutual European Fund (MEURX) and the T. Rowe Price European Stock Fund (PRESX). Each of these funds has a 25-30% allocation to the UK.
The Bottom Line
The final outcome of Brexit is largely a guess at this point, although clues exist that can help point us in the right direction. Brexit will no doubt cost the UK in trade with other EU nations, but the degree to which that revenue can be recouped is not yet known. The June 8 election could go a long way in helping clear up the uncertainty.
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