UK REIT and Financial ETFs still at risk post Brexit vote?

Sep 26th, 2016 | By | Category: Alternatives / Multi-Asset

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Exchange-traded fund investors are not out of the woods post the Brexit vote as the UK still faces a “challenging period of uncertainty and adjustment” in the wake of the referendum, says the Bank of England (BoE).

UK REIT and Financial ETFs still at risk post Brexit?

The iShares UK Property UCITS ETF (LON: IUKP), which crashed 8% in the three days following Brexit, has not fully recovered since 23 June and is down more than 9% year to date (23 September 2016).

The bank’s Financial Policy Committee said in a statement last week that although immediate capital market volatility has calmed down since June, there remain elevated risks, such as the threat of a “sharp adjustment” in the commercial property market and the danger that foreign investors could divest from the UK.

Commercial property prices and transactions are at their lowest level since 2009, the statement read, with uncertainty around the near term macroeconomic outlook.

The iShares UK Property UCITS ETF (LON: IUKP), which slumped 8% in the three days following Brexit, has not fully recovered since 23 June and is down more than 10% year to date. IUKP invests in mostly commercial-oriented real estate investment trusts (REITs) with major sector holdings being industrial & office REITs (35.8%), retail REITs (32.5%), real estate & holding developments (15.5%) and speciality REITs (9.4%).

There are also risks to UK financials due to the concerns over the health of the European banking system and mounting debt in China, said the BoE statement.

“European bank equity prices reflect continued concerns over banks’ profitability and, particularly in Italy and Portugal, high levels of non-performing loans,” it read.

It added that market valuations of major UK banks were well below their book value.

There is no ETF that solely tracks UK financials. The broader SPDR MSCI Europe Financials UCITS ETF (LON: FNCL), which holds 10% in HSBC and a third in UK banks, is down 14.5% in euro terms year to date.

The BoE statement comes less than two months before the UK banks undergo their annual stress test review, to see how they would deal with major market shocks.

Despite uncertainty and risks to certain sectors such as financials and commercial property, overall returns from the main UK-listed companies have not hit a downward spiral thus far in 2016.

The Vanguard FTSE 100 UCITS ETF (LSE: VUKE) is up 10% year to date and recouped its losses incurred just after Brexit, rebounding more than 12% since 27 June in GBP terms. In terms of the general UK equity market, the SPDR FTSE UK All Share UCITS ETF (LON: FTAL) has also returned more than 12% since 1 January, regaining above and beyond the losses sustained in June.

Equity returns may be in the black but GBP has not recovered versus other currencies since it fell to a 31-year low in June. Versus the US dollar, its high of $1.49 on 23 June crashed to $1.30 by 23 September. Against the euro, the exchange has tanked from €1.30 to €1.15 over the same period.

A falling currency could deter foreign investment, but ETF investors betting against the pound would have seen strong returns recently. The ETFS Short GBP Long USD (LON: USD2) is up 28% in the last three months alone.

Similarly, the ETFS Long EUR Short GBP (LSE: GBUR) is up 12% over the same period.

After Brexit, the BoE said a range of bond prices were elevated. Prices react inversely to yields, and the 10-year gilt yield has fallen by 62% year to date to just 0.73%. On the corporate bond side, prices have risen more than 10% in that time, according to the Bloomberg GBP High Yield Corporate Bond Index.

“Term and risk premia in bond markets are compressed despite heightened domestic and global uncertainty. This creates a vulnerability to a sharp adjustment that could prove disorderly – for example, if asset price falls triggered fund outflows and dealers were unable or unwilling to hold additional bonds as inventory.”

Shortly after the referendum, the BoE promised to make £250bn of emergency short term funding available to prevent a sell-off from wholesale funders. It also decided not to increase the capital buffers required of UK banks to encourage them to continue lending.

Mark Carney told the Treasury Select Committee in September that the swift response from the bank and the cutting of rates to 0.25% in August – the first time in seven years – was one reason why the shock of Brexit was less dramatic than some had anticipated.

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