BREXIT Woes: UK Markets Looking Interesting in Wake of EU Elections

As a global relative value or growth at a reasonable price investor, I’m always looking around the world for the best potential returns adjusted for risk. One of the formulas I use for calculating return relative to risks consists of 3 parts.

  1. Capital Gain\Loss potential
  2. Yield
  3. Currency Impact

The sum of these three parts are then compared to downside risks.

When investing globally, it turns out that currency fluctuation often define the vast majority of your returns in any given year. Going back to 1971 when currencies started to float after the Bretton Woods Agreement was broken, the absolute value of the average change per year versus the Canadian dollar was about 10% annually. It was either a tailwind or a headwind to your returns. The recent weakness caused by BREXIT in the past few years offers an opportunity for currency gains in the next few years. We see about 20% upside potential in the next few years as they figure out the BREXIT details. A hard BREXIT is not fully priced in, and you would want to hold some back for a bad outcome. A hard BREXIT or a Jeremy Corbin Prime Minister in the next elections, but those are lower probability outcomes.

The reason to think globally is simple. Canadian markets represent about 3% of world equities and about 5% of world debt markets. We also have very concentrated markets with a massive overweight in Financials and Energy. Looking into the future, I would argue that Technology, Healthcare, and the Consumer are the three key growth sectors where Canada is significantly lacking. For most Canadians, focusing your portfolios more globally is a move in the right direction.

When you invest globally, the dividend yield has a foreign withholding tax and is treated as income in your portfolios, so most global investing should be done in registered accounts. More domestic investing for dividends should be done in taxable Canadian accounts. How big should the position be in your portfolio. The UK is (currency adjusted) is about 5% of the world index. We think it should be closer to the 8% it was historically. The two ETFs we are using in our portfolios are EWU (iShares MSCI UK ETF) and EWUS (iShares MSCI UK Small Caps ETF). Canadians tend to have as much as 50% of their portfolios in Canada, which is an awfully big bet on our poorly diversified equity markets that a not set up well for future growth. We are accumulating on weakness in these markets they are not an outright BUY!

Keep in mind that these trade wars have a lot to do with currency levels. Quietly, last week The Trump Administration floated a new policy idea. We think the trade wars are potentially leading to another Plaza Accord type of summit, but our bet is that it is an early 2020 agenda item owning to the political calendar in the US. We doubt China folds before the next US election. Ultimately, a currency based agreement (that may include the demise of the euro) may be the ultimate outcome of these trade wars.


2 thoughts on “BREXIT Woes: UK Markets Looking Interesting in Wake of EU Elections”

  1. Avatar
    Gary says:

    In the blog posting above (May 28, 2019, Brexit Woes: UK Markets Looking Interesting in Wake of EU Elections) you advocate “focusing your portfolios more globally” and say that “Canadians tend to have as much as 50% of their portfolios in Canada, which is an awfully big bet on our poorly diversified equity markets”. This, to me, implies that you consider a 50% investment in Canada to be far too risky.
    I have been looking into your Sleep-at-night portfolios, the three BMO Mutual Funds (271, 734, and 738) plus the ETF (ZZZD) as potential investments. What surprised me were the geographical allocations of these fund portfolios (49.2%, 56.5%, and 59.8% respectively, invested in Canada) given the recent comments and the observation that “Canadian markets represent about 3% of world equities and about 5% of world debt markets”. The ETF at around 18-20% invested in Canada appears to more closely coincide with your views. Is there some requirement that I am unaware of that is affecting the fund portfolios’ allocations?
    Followed you for years and like your thoughts on and approach to investing, which is why I am curious as to the reason for this apparent cognitive dissonance.

    1. Avatar
      Larry Berman says:

      Unfortunately, the back office systems have not adapted to the rapid growth of ETFs. The problem is complicated with ETFs of ETFs. Most investment dealers use an IBM back office to calculate the fund sheets. What happens is that you get a look through the first layer and not the second. For example, it shows a holding that trades in Canada, but with foreign exposure as a Canadian holding. Because of this issue, I produce a weekly report for the funds I manage at the link below. This should answer your questions and have more accurate holdings exposures.

      Hope this helps. Larry

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