Brexit

Risk-off sentiment prevails as the market reaction quickly prices in the uncertainty

24/06/2016

Rory Bateman

Rory Bateman

Head of UK & European Equities

There are so many issues and permutations to be considered in the event of today's Brexit vote, it's impossible to list them all here. We have decided on ten key points that UK and European investors should consider on this historic day.

1. Will "Remain" voters shun risk assets?

Many investors in the Remain camp will have taken the view that the economic uncertainties are too great to consider voting for Brexit. The UK has chosen to leave the EU, therefore many Remain voters may well decide that the risks to the economy are too great and may subsequently decide to liquidate their equity positions.

The extent of this response will determine the market reaction in the following days and weeks but there is a real danger that the negative sentiment could feed on itself to create a substantial market correction. Having said that, equities have been weak this year in the run up to the referendum so some of the negativity is already 'priced-in'.

2. The UK stockmarket fall is a de-rating not a fundamental earnings decline.

Given that over 78% of FTSE 100 revenues are derived overseas, as well as the incremental effect from weaker sterling, it seems unlikely that there will be a significant earnings hit, despite the expectations that the UK economy will suffer post the Brexit result.

We have seen the UK mid-cap FTSE 250 underperform the FTSE 100 by around 3% so far this year, so mid-cap domestically-focused businesses are already partially factoring in the anticipated weaker UK economy. Today's result is likely to continue that trend but long term investors should be responsive to excessive price moves driven by poor liquidity.

3. Value opportunities could emerge and firms with global exposure may outperform.

European equities are now trading at all time lows relative to the US, both in local and US dollar (USD) terms. The vast majority of Europe’s underperformance versus the US since the Global Financial Crisis is due to the significant earnings differential between US and European corporates. However, the recent substantial underperformance is very much related to concerns about the EU.

At some point there will be a compelling value opportunity for European equities, induced by the market rapidly pricing in a worst case scenario driven by Brexit. Quite often in times of market stress correlations are very high with indiscriminate selling, and should this happen, global companies with exposures outside of Europe may well provide the most upside potential.

4. Contagion to other equity markets is possible, especially to Europe’s periphery.

The UK is the second largest EU economy, accounting for 16% of GDP, so the withdrawal will be very significant for the remaining countries. Subject to the political and monetary policy response, many investors will question the sustainability of the remaining EU structure. Peripheral countries may experience a widening of their credit spreads as the market fears more EU fragmentation.

5. Uncertainty means Federal Reserve (Fed) may delay further interest rate hikes.

The Brexit result may well result in a stronger USD given its safe haven status funded by the weaker sterling and euro. In turn, this may feed through to lower commodity prices and negate the need for further Fed action, given the tightening effect of an appreciating USD.

As an aside, mining and resources are large constituents in the FTSE 100 which may place incremental downward pressure on the UK benchmark.

6. David Cameron to step down as leader of the Conservative party

Having lost the vote, Prime Minister David Cameron has announced he will step down in October. Any turmoil from within his party could create additional political instability and possibly contribute to an increased UK equity risk premium and therefore further de-rating.

Markets continue to function perfectly well during periods of political turmoil but lack of unity and a leadership challenge would create market uncertainty as we have seen in Spain for example over recent months.

7. Will the EU countenance a free trade deal without free movement of people?

Whilst there genuinely appears to be no Brussels ‘Plan B’ for the Brexit outcome, we may well receive rapid notification from the EU authorities that a Free Trade Arrangement is unacceptable without free movement of people.

However, the UK is unlikely to accept free movement of people given that immigration has been the central tenet of the Brexit campaign. On the manufacturing side therefore we may well adopt World Trade Organisation (WTO) tariff arrangements which will at least be quantifiable across different sectors, e.g. 10% for the car industry etc. Where possible the market will quickly ‘price-in’ the consequences of the tariff change.

8. Service sector under pressure if Brexit implies leaving the EU single market.

There will be pressure from businesses throughout Europe to negotiate a deal that allows trade to continue between the UK and Europe without major disruption given the importance for both sides, the sticking point being the movement of people problem.

Questions for the financial services industry around ‘passporting’ services to Europe from the UK will be monumental if we leave the single market given that in 2014 the UK ran a trade surplus of almost £20 billion in financial services and insurance. One assumption may be that many companies could choose to relocate parts of their business from the UK to Europe rather than risk market share loss in anticipation of a trade deal being struck.

9. The period of uncertainty could be shortened if the UK invokes Article 50.

Invoking Article 50 of the EU Lisbon Treaty simply means the UK has two years before leaving the EU. It doesn’t mean trade negotiations will be agreed within the two-year period. There are 27 other countries in the EU: on some occasions a majority can pass changes in legislation, on other issues unanimous agreement is required - such as an extension of the two-year period itself.

It would seem remarkable given previous trade negotiations that the majority of legislation can be changed with such a short time frame and WTO standard trade agreements would therefore apply after the two-year period.
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This has simply never been done before so market uncertainty and the higher equity risk premium may apply for a number of years. To add to the confusion, it is worth noting that the UK has had little experience in trade negotiations over many decades given the EU has conducted those discussions on the UK’s behalf.

10. Big overseas earners should benefit from the improved competitiveness of sterling.

For the UK specifically, at the sector level the big overseas earners should benefit from the improved competitiveness of sterling.

From a sector perspective many of the internationally exposed industries should benefit from sterling weakness. These include consumer staples, pharmaceuticals, capital goods, resources, software etc.

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