UK View: The UK equity market after Brexit
In the wake of the UK’s vote to leave the EU, David Docherty assesses the immediate impact on UK equities and discusses the longer-term implications.
Unstructured Learning Time
Prime Minister Harold Macmillan, when asked what a premier most feared, famously responded, “Events, dear boy, events”. If ever David Cameron disagreed with this analysis, it is unlikely that he does now. Indeed, there are many investors who have also grown to fear events after a referendum result which turned the market consensus on its head. A few eventful weeks on, we thought it would be a good time to discuss the impact of the referendum on UK equities and how we are shaping our investment strategy in the months ahead.
The morning after the night before
As bleary eyed investors arrived at their desks early on 24 June, the FTSE 100 and FTSE 250 fell around 9% and 12% respectively before rallying later in the day. The weakest sectors were largely those of a cyclical or financial nature operating domestically. These included General Retailers, Travel & Leisure, Food Retailers and housebuilder-dominated Household Goods & Home Construction; all impacted by the sense that consumer confidence and spending would be impacted by post-referendum uncertainty. Within the financials arena, sharp falls were seen in Real Estate Investment Trust (REIT) Services, Life Assurance, Financial Services, REITs and Banks as investors concluded that these areas would be hurt by a slowing economy and a fall in asset prices.
That the FTSE 100 did not fall further on the first day of trading after the poll was a function of investor appetite for international stocks with foreign, in particular US dollar, earnings. In this context, defensive sectors such as Pharmaceuticals, Tobacco and Healthcare Equipment outperformed the wider market. A number of more cyclical sectors such as Oil & Gas Producers and Mining also outperformed since they were viewed first and foremost as beneficiaries of sterling weakness against the greenback. We will return to these performance divergences later.
Figure 1: Sterling versus US dollar exchange rate
Source: Bloomberg, 18 July 2016
Running the numbers
Economists are forecasting that the uncertainty and sterling weakness caused by the referendum vote will lead to a downgrade in growth and an elevation in inflation. For 2017 the consensus prior to the poll had been for GDP growth of 2.1%. This has now fallen to 0.3% but the range of outcomes is large, spanning -1.5% to +1.4%. As for consumer price index (CPI) inflation, the pre-Brexit consensus of 1.7% has been replaced by a post-Brexit consensus of 2.1%, once again sitting in a comparatively wide range of forecasts with a low of 1.4% and a high of 2.8%. For our part, Schroders estimates GDP growth of +0.8% and inflation of 2.5% for 2017.
Figure 2: Economists’ forecasts for GDP growth and inflation
Source: Focus Economics survey, Schroders Economics Group, 29 June 2016
In short, economists, perhaps not unreasonably, are finding it a challenge to quantify the impact of a single event such as Brexit on economic confidence and activity. There is also much heated political debate on the effect of Brexit on the economy. Whatever the difficulties in forecasting, it does seem probable, however, that the corporate sector may delay investment and hiring decisions as it seeks to assess the nature of a post-Brexit British economy. If households should in turn cut back spending on a perception of reduced job security, then consumption, at just over 60% of UK GDP, might fall somewhat.
Indeed, survey data on corporates’ hiring, purchasing and capital investment intentions have suggested a weakening in boardroom confidence dating back to 2014 (see figures 3 and 4). This may have been driven by other political events such as the Scottish referendum and UK General Election. An underlying slowdown in economic momentum may also have been at work suggesting that Brexit fears may have accentuated already existing trends (see figure 5).
Figure 3: UK CFO survey on uncertainty
Source: Deloitte CFO Survey, June 2016
Figure 4: Net balance of CFOs expecting more hiring/capital expenditure over 12 months
Source: Deloitte CFO Survey, June 2016
Figure 5: UK composite purchasing managers’ index
Source: Markit, Bloomberg and Citi Research, June 2016
As investors in UK equities, the key challenge for us is to calculate how far these issues are already priced into stock valuations and the market as a whole. The chart below shows an index of policy uncertainty alongside the UK equity risk premium1 and is relevant for the attractions or otherwise of UK equities as an asset class.
Figure 6: Equity risk premium and policy uncertainty
Source: ASR Ltd, Thomson Reuters Datastream, June 2016
The uncertainty measure shown in the above chart has been created by the University of Chicago Booth School of Business and it quantifies media references to economic policy, uncertainty, deficits and the like. In essence, the chart shows that policy uncertainty is high at a time when the equity risk premium is low and this is generally an unappetising cocktail.
At the stock level, investors have moved quickly to price this uncertainty into the domestic stocks discussed earlier, many of which have been traded in so-called Brexit baskets established by a number of investment banks. It is interesting, though, that the performance of financials, retail, real estate and consumer services had already been slipping over the last 12 months. As shown in figure 7 below, it appears that Brexit has magnified a downward trajectory in certain sectors which was already underway because of slowing economic momentum.
Figure 7: Underperformance of domestically-oriented sectors
Source: ASR Ltd, Thomson Reuters Datastream
A global market
As touched upon already, the UK equity market is not exclusively domestic in terms of its earnings base and this explains why its performance has confounded many observers’ worst fears. Indeed, Citigroup has calculated the market’s aggregate revenue exposure to the UK as being 30%. As shown in figure 8 below, there is a large divergence between domestic sectors with REITs, Food Retail and Fixed Line Telecoms the most domestically exposed and Mining, Tobacco and Pharmaceuticals the least.
Figure 8: UK stockmarket and sector revenue exposure
Source: Worldscope and Citi Equity Strategy Research
Chalk and cheese
In the aftermath of the vote, as shown in figure 9 below, the international sectors delivered significant relative outperformance while the domestic sectors were violently sold off.
Figure 9: Relative sector performance since Brexit vote
Source: ASR Ltd, Thomson Reuters Datastream, 4 July 2016, from COB 23/06/16 to 04/07/16. Past performance is not a guide to future performance and may not be repeated. For illustrative purposes only and not to be considered a recommendation to buy or sell.
Having witnessed these price moves, the predicament for investors is that sentiment and valuations have moved accordingly. A sentiment barometer prepared by ASR (see figure 10) suggests that investor optimism for sectors such as Oil & Gas Producers, Personal Goods, Tobacco, Healthcare Equipment and Pharmaceuticals is now at excessive levels. In contrast, Support Services, Travel & Leisure, Life Assurance and Real Estate seem to be viewed with excessive pessimism. Historically, times of excessive pessimism tend to be followed by significant share price recoveries while the opposite is true for stocks and sectors where over-optimism prevails.
Figure 10: Sector sentiment barometer
Source: ASR Ltd, Thomson Reuters Datastream
The valuations of the UK sectors are consistent with the market mood in so far as stocks perceived to be safe are currently highly rated. Consumer staples, for example, offer visibility but price to earnings (P/E) multiples are high with the beverages sector, for example, trading at over 20x. In contrast, the ratings of domestic cyclicals are low with travel and leisure, as an example, trading on about half the rating of beverages, currently 11x.
Figure 11: UK sector valuations
Source: Lazarus, as at 1 July 2016. The price to earnings ratio (P/E ratio or PER) is a ratio for valuing a company that measures its current share price relative to its earnings per share.
Headline multiples for a number of financials also look low but confidence in asset values is somewhat fragile.
Looking for mispriced opportunities
In order to find attractive opportunities in the market, our investment process for our core UK portfolio emphasises the importance of the implied market valuation of a stock. In other words, we seek to understand what is priced in and how far our forecasts on growth, profit margins and returns differ from what is implied in share prices.
Our analysts then look for inflection points which help us to invest at an opportune time. In this respect, we may be looking for management change, restructuring, re-allocation of capital, acquisitions and disposals, changes in dividend policy or improved trading prospects.
This process helps prevent what we call ‘thesis drift’ and reduces the risk of either buying into so-called value traps or of buying strong but over-priced companies. Given the recent volatility of markets and the extreme price moves of a number of sectors we believe that this approach should serve us particularly well.
Figure 12: How we invest
Source: Schroders, June 2016
With our bottom-up process2 at the forefront of our minds, we have a number of thoughts as to our priorities. We are currently attuned to opportunities in stocks within the sectors most impacted by the Brexit vote. In this respect, we are reviewing stocks in the Travel, Retail, Household & Home Construction and Support Services sectors to see if there are any valuation anomalies with potential inflection points to trigger outperformance. We are circumspect on financials where operating conditions are challenging but discounts to underlying asset values certainly merit further investigation. Consumer staples now look fully valued but a further re-rating is possible in selected stocks if companies use their operational strength and strategic optionality to improve their already high returns on capital.
More generally, we are assessing the effect of sterling weakness on UK companies. For some it means an increase in input costs; for others it provides a boost to competitiveness. It also has implications for dividends in so far as US dollar pay-outs will now be worth more to sterling shareholders. Strategic assets will now also look cheaper to foreign bidders and we would expect mergers and acquisitions, already seen in bids for Poundland and ARM Holdings, to continue.
In terms of recent investment activity in UK equities, we have added to a number of stocks with potential inflection points which we consider to be both high quality and cheap within Media, General Retail, Banking and Life Assurance. We have also established a new holding in a competitively strong medium-sized housebuilder where we believe the market’s expectations are excessively pessimistic.
Crystal ball gazing
The words of one of Harold Macmillan’s successors, Harold Wilson, were immortalised in the political lexicon with his pithy observation that “a week is a long time in politics”. His observation could have been designed for what we have just seen in Westminster and the magnitude and pace of recent events demonstrate that definitive predictions can quickly be found wanting. Nonetheless, most observers would agree that the implications of Brexit will be complex and long lasting. In this respect, markets are only just beginning to address the likely nature of Brexit negotiations under Theresa May’s new government while the impact on European domestic politics could be material. In short, we believe that politics will remain front and centre. There is a very full European election timetable ahead of us as well as the US presidential election while the failed coup in Turkey underscores the unpredictability of geopolitical events.
Figure 13: Forthcoming elections in Europe
Source: Citi Research, as at 8 July 2016
The global economic outlook, as previously, is also far from clear. Economic data releases out of the United States, for example, have been volatile as seen in recent inconsistent labour data. The Japanese economy continues to struggle, a problem made worse by the recent jump in the yen after the UK referendum result. Closer to home, the precarious state of the Italian banks is a major concern just as the country approaches its constitutional referendum. Meanwhile, on the monetary policy front, predicting the actions of the world’s major central banks continues to be a favourite parlour game for investors with increasing talk about the possibility of ‘helicopter money’. Fiscally, the concept of ‘bulldozer money’ is also gaining traction as governments consider accelerated public works programmes as a means of stimulating economic activity. How all of these things play out will affect the performance of UK equities in the coming months.
In the meantime, UK equities have bounced back usefully from their post-referendum lows, albeit that for international investors sterling is still 10% lower on a trade weighted basis. As discussed above, the heavyweight FTSE 100 has benefited from the strength of international earners and blue chip defensives, more than making up for weakness in the domestically-biased FTSE 250. The UK equity market now stands on a valuation which looks a little above its historic average. For 2017 it is on a P/E of 14.5x and it is projected to deliver earnings growth of 7% and 15% for 2016 and 2017 respectively; the outer year driven by a bounce in commodity sectors’ earnings. It is expected to yield 4.1% for 2017, delivering dividend growth of 6% and 5% to 2016 and 2017 respectively with a dividend payment pay-out ratio of 59% for 2017.
While investors have welcomed the relative resilience of UK equities, we would expect further volatility in due course. Analysts are busy taking the red pen to their estimates for the profits of many listed companies and economists are downgrading economic growth and increasing their forecasts for inflation. These changes in expectations will add to volatility but in so doing they will throw up valuation anomalies which, through disciplined application of our investment process, we are determined to exploit.
Stocks and sectors mentioned are for illustrative purposes only and not a recommendation to buy or sell.
1. The equity risk premium is the extra return that investing in the stockmarket provides over a risk-free rate.↩
2. Bottom-up investing is investment based on analysis of individual companies, whereby that company's fundamentals (e.g. history, management and potential) are considered more important than general market or sector trends. This is in contrast to top-down investing which finds the best sectors or industries to invest in, based on analysis of the corporate sector as a whole and general economic trends.↩