Could A “Soft Brexit” Trigger A Hard Rally In U.K. ETFs?

U.K. Prime Minister Theresa May just pulled off one of the greatest political blunders of the modern era. Her call for early elections was aimed at deepening support for a tough stance as she negotiates the U.K.’s exit from the European Union. An unexpected poor performance at the polls now means her party has lost its majority in Parliament. In response, the odds are rising that a less restrictive deal with the EU Brexit deal will be struck, keeping goods and services freely flowing across the English Channel.
 
Since the Brexit vote was held on June 23, 2016, the U.K.’s economy has been under strain. The British pound, for example, has slumped more than 10 percent against the euro and the U.S. dollar. The falling currency led to a spike in import prices, which triggered a sharp slowdown in consumer spending. In the first quarter of 2017 the U.K. economy grew just 0.2 percent, which according to Eurostat was the lowest growth rate in the EU.
 
But last week’s snap election may sow the seeds of an economic and currency rebound. The U.K. and the EU are set to open Brexit negotiations on June 19 with a deadline for a final agreement by March 2019. And a highly-disruptive exit from the EU is no longer a foregone conclusion.
 
Bloomberg News reports that May’s own senior ministers are plotting to soften her approach to leaving the bloc, potentially keeping the country in the single market and customs union.
 
Moreover, to build a majority coalition in Parliament, May’s party appears likely to link up with Northern Ireland’s Democratic Unionist Party, which has publicly affirmed a desire for a softer version of Brexit.
 
A Growth Catalyst?
 
If a milder version of the Brexit comes to pass, then U.K.-focused exchange-traded funds may be benefit from some clear positives.
 
For example, the British pound would likely move back towards levels in place before last summer’s Brexit vote. And that could help dampen import prices, reduce uncertainty and boost consumer spending. After all, continental Europe is experiencing an economic renaissance these days, and to paraphrase an old cliche, a rising European tide could lift Great Britain’s boats.
 
Perhaps no sector would breathe a greater sigh of relief than the financial services sector, which would have seen the City of London lose its status as the “Wall Street of Europe” in a hard Brexit scenario. The iShares MSCI United Kingdom ETF (EWU) has a 21 percent weighting in financial services, which is among the highest of the U.K.-focused ETFs. The fund's expense ratio is 0.48 percent.
 
Do the shifting winds in the U.K. create an opening for ETF investors?  And if so, what kind of currency approach is best suited? Unhedged portfolios would clearly benefit from a rebound in the British pound if the softer version of Brexit grows increasingly likely. But if the U.K. political environment descends into gridlock and the nation is unable to effectively negotiate the terms of the Brexit, then currency volatility would be heightened and perhaps push the pound yet lower.
 
Both the iShares Currency Hedged MSCI United Kingdom ETF (HEWU) and the WisdomTree United Kingdom Hedged Equity Fund (DXPS) remove currency impacts from the equation. That’s been the wise approach since last summer. The iShares Currency Hedged fund, for example, has gained around 25 percent in the past year, well ahead of the iShares MSCI United Kingdom ETF’s roughly 10 percent gain in that time.