With Brexit headlines dominating the European news, equity investors face an ongoing challenge. Building resilient portfolios requires a clear view of the long-term outlook for European companies that also reflects major short-term political uncertainties.

Political risk has been a feature in European markets for years. Lately, from Italy’s fiscal squabbles to turmoil in the streets of France, it feels like the volume of political noise has risen. Yet for equity investors, the Brexit saga is probably the number one political headache today.

So how can investors develop long-term conviction in European stocks even as political risk clouds the short-term outlook? We think the key is to understand how different political outcomes might affect the earnings of individual companies, and to use that analysis to help avoid excessive portfolio exposure to different political outcomes.

Three Major Brexit Risks

Brexit is creating three major risks for companies. The first is trade disruption: firms that must move parts or finished goods across the UK border could be vulnerable to severe, though probably temporary, disruption in the event of a no-deal Brexit.

Currency risk is the second major concern. Many UK-domiciled companies are global, with relatively little business exposure to the British economy (Display). As a result, their earnings rise when the pound falls, as it did immediately after the referendum result in 2016, and their share prices can actually benefit from rising Brexit anxiety. But recently this dynamic has shifted, with some worrying signs that investors have marked down both sterling and shares in large-cap global UK companies when the perceived risk of a hard or chaotic Brexit has increased.

The third risk is to UK economic growth. In the worst-case scenario, many forecasters believe that a no-deal Brexit could tip Britain into recession. And even if the eventual outcome is more benign, continued uncertainty could lead to investments being postponed and consumer sentiment depressed. Banks and consumer companies operating primarily in the UK are most vulnerable to these risks.

Research Questions for Stock Pickers

When researching stocks in the UK and across Europe, we ask whether a company is exposed to the specific risks that we’ve identified. Then, we assess whether those risks are threatening its future cash flows and, if so, to what extent they’re adequately priced into the company’s stock.