Now that Article 50 has been invoked by the UK government, a period of intensive negotiations with the EU is set to begin. And what is the economic backdrop for these talks? While the performance of the UK economy has been robust since the referendum, sterling has weakened significantly and has caused inflation to spike. However, investor sentiment has remained resilient despite the uncertainty faced by Brexit. Looking ahead though, losses could be on the horizon for UK-based investors.
The wrong assets
As mentioned, inflation has increased to 2.3% in a matter of months. This is mostly because of a depreciation of the pound, which has been caused by uncertainty surrounding the UK's economic outlook. Inflation is expected to rise yet further, with a rate of 3% or above becoming increasingly likely. This could cause investors who have purchased assets which do not cope well with higher inflation to experience losses over the medium term.
For example, interest rates remain at historic lows. This means that the return on cash balances is negative, with the best high street accounts offering little more than 1% unless money is tied up for an extended period. Similarly, bonds are unlikely to cope well with higher inflation. Their returns are already at or below inflation due to their prices having risen as interest rates have fallen in recent years. As such, investing in cash or bonds could lead to real-terms losses over the coming years.
The wrong stocks
While the FTSE 100 has risen by 7% in the last six months to reach a record high, many UK-focused stocks have struggled to make gains. If higher inflation causes the UK economy to move into a recession, UK-focused companies in the FTSE 350 and All-Share could experience a challenging period which would see their sales and profitability coming under pressure. This could lead to share price falls and losses for their investors.
Similarly, if negotiations indicate a deal will be signed prior to the end of the two-year negotiation period, sterling could strengthen and cause the FTSE 100 to post losses. In many cases, the FTSE 100's gains have been due to a positive currency translation. If this ceases or reverses, investing in large-caps may mean losses for investors.
Of course, with the uncertainty facing investors, it may be tempting to adopt a cautious approach in the coming months. However, history shows that the best times to invest can be during the most uncertain periods. As such, buying shares during the Brexit negotiation period could lead to high profits in the long run.
Likewise, moving into lower-risk assets such as cash and bonds may mean investors miss out on the potential gains which may be on offer in future years. While this may not be a tangible loss, the opportunity to generate high returns could be missed.
As such, the logical stance to take this year could be to buy diversified stocks in a range of sectors when they are trading at fair valuations. Doing so could lead to strong portfolio performance in the long run.
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