Im Fokus - 2018
Brexit: 23 answers to investors’ questions
There remains much uncertainty as negotiations between the UK and EU enter a crucial stage. Sue Noffke, UK equities fund manager, provides some clarity for investors.
The UK’s scheduled departure from the EU is fast approaching. Many observers are hopeful for an orderly withdrawal; however, there remain plenty of potential pitfalls between now and Brexit-day which could result in a chaotic divorce.
The only near-certainty at present is that the UK will cease to be a full member of the EU on 29 March 2019. It is possible that Brexit could be delayed, a second referendum called, or UK parliament abandon the project, but at this late stage, and as things stand, these scenarios seem unlikely.
Negotiators are currently working on a “withdrawal agreement”, to be followed by a transition period to run from the end of March 2019 to the end of December 2020. During the transition period negotiations would focus on the permanent future UK/EU relationship, including any potential agreement on trade.
Most aspects of the UK’s EU membership would remain in place until December 2020 under this scenario, including free movement across borders and inclusion within the customs union and single market. However, in the event of no agreement, or a so-called “no deal” Brexit, what happens after 29 March 2019 is uncertain.
Amid the uncertainty Sue Noffke, UK equities fund manager addresses some of the most pressing questions for investors.
1. What are the key dates for investors to watch out for?
While deadlines for talks are flexible, most commentators believe a withdrawal agreement needs to be in place by the end of 2018 at the latest. This would allow the individual member states enough time to ratify the agreement once the EU and UK leaders have signed off the final text. While the majority of the agreement’s text has been settled upon, there remains some distance between the two sides, particularly around the Irish border. This has led to questions over whether the text will be ready ahead of October’s European Council summit. There is the potential for a summit in November and the scheduled meeting in December is widely seen as the last practical date for an agreement to be signed off by EU and UK leaders.
2. In addition to EU member states ratifying the agreement, does UK parliament also need to approve it?
Yes, UK parliament will vote on the withdrawal agreement. The Conservative government lost its parliamentary majority at last year’s general election and the market is agonising whether it can rally sufficient support to get an agreement passed. An uncertain UK domestic political situation has also added to market fears that the country may end up with a “no deal” Brexit.
3. What does the withdrawal agreement cover?
Citizens rights', the UK’s financial commitments to the EU and the Irish border. Only during the transition period will the details of the permanent future relationship between the UK and EU be negotiated, including trade arrangements. In the event of “no deal”, in extreme circumstances the UK and EU would revert to World Trade Organization (WTO) trade arrangements on 29 March 2019.
4. The type of Brexit we get will have consequences for the UK economy, but how important is the UK economy to the UK stock market?
For the market overall, less than a third of its revenues are derived from the UK, so what is going on in the rest of the world is often more important. There are sectors that are more exposed to imported goods and/or the UK consumer, where sterling weakness would be a potential negative.
5. How do you look at the UK stock market in terms of Brexit and other “top-down” factors?
We take a “bottom-up” perspective, looking for companies that have strong balance sheets, enjoy robust market positions and are serving resilient end markets. We seek to avoid those suffering the effects of disintermediation – the internet is increasingly allowing the manufacturers of products or providers of services to communicate directly with end customers – or exposed to structurally challenged markets. We then carry out a sense check of top-down considerations, asking ourselves if a company is too exposed to moves in sterling and political risks, say.
6. What has been the market impact of Brexit to date?
In the period from mid-2013 through to the end of 2015, the UK economy outperformed the global economy, sterling was strong and UK domestic companies outperformed UK overseas earners (see below). Then, as Brexit fears set in and the UK voted to leave the EU, UK domestics significantly underperformed. Exchange rates were a major driver of this, as the market discounted the beneficial translational impact of weaker sterling for companies with significant overseas earnings. However, it was also in large part due to UK domestic companies suffering a “de-rating” (see below for explanation) amid fears the UK economy would grow at a lower rate going forward outside the EU.
7. Has Brexit negatively impacted the whole of the UK stock market?
Yes, investors have indiscriminately shunned UK stocks as a consequence of Brexit, and the market overall has suffered a de-rating. Prior to the EU referendum investors had been prepared to pay approximately 15x the UK stock market’s expected aggregate earnings for the year ahead. Today, this multiple, or “rating” is around 13x, which compares very favourably to the global stock market, trading on approximately 15x expected 2018 aggregate earnings. The graphic below expresses these same ratings as price-to-earnings (P/E) ratios, being the markets’ current levels divided by their respective expected aggregate 2018 earnings. It also reveals how, regardless of their international exposure, the majority of UK sectors trade on attractive ratings versus their global equivalents.
8. How might sterling react depending on the possible Brexit outcomes?
Sterling has been an effective mechanism for either expressing confidence or fear in Brexit and the fate of the UK economy. Our economists have polled a mix of investment banks and economic consultancies and asked where they thought sterling would trade against the US dollar when it became apparent which scenario the UK was heading for: "no deal" Brexit or a withdrawal agreement. Sterling is currently trading around $1.30 and the graphic below illustrates the responses, with the majority expecting significant downside in a no deal scenario, the average estimate being around $1.10, downside of approximately 15%. In the event of a withdrawal agreement, the average estimate is for the currency to appreciate to approximately $1.40.
9. In the event of a withdrawal agreement how might the UK stock market perform?
If we did get a withdrawal agreement, there would likely be an upwards movement in sterling and a re-rating of the whole market, particularly benefiting those UK domestics that have been severely de-rated over the last two and a half years. That would include the UK-focused banks, property companies, housebuilders, consumer discretionary areas (general retailers and leisure companies), food retailers and media agencies. Because of the Brexit-related risks the valuations of the UK-focused banks (Lloyds Banking, Royal Bank of Scotland and Barclays) are very attractive versus their EU and international peers – this is a significant component of the UK stock market (roughly 5%) which could perform very well.
10. In light of the risks of a “no deal” Brexit, are banks more robust than they were 10 years ago?
Yes. UK banks are financially stronger than they were prior to the global financial crisis (GFC) given improved “capital adequacy” standards. Banks are required to hold more capital to cover possible losses on loans, and the definition of what counts as capital is much tighter. The regulatory framework governing banks is more robust, with a greater number and more diverse range of rules, supervised by new oversight bodies and they are subject to regular reviews, or “stress tests” to ensure compliance with latest regulatory standards. Meanwhile, the Bank of England (BoE) is better able to step in and provide short-term funding, or “liquidity”, when required. The failure of the interbank lending market (where banks with surplus funds lend to those in need of short-term funding) was a major contributory factor to the GFC.
11. Would companies have scope to mitigate higher import costs should sterling fall sharply?
There tend to be lags built into the system which could help to soften the immediate blow. Companies importing goods, whether finished product (consumer electronics, clothes and food, for instance) or components (vehicle parts for assembly within the UK, say) have financial methods of shielding themselves in the short term against adverse movements in exchange rates, known as currency “hedging”. In addition, they will have a certain amount of finished product in stock or “inventory” which can be run down, to be replenished with lower-spec product to maintain price points i.e. new TV models may not have all the bells and whistles. Companies may also face challenges in terms of disruptions to their supply chains – car manufacturers, clothing and food retailers (particularly retailers of fresh foods) may be most at risk in this regard.
12. Presumably companies will not be able to mitigate the impact indefinitely?
No, and should sterling fall by 15%, I am sure that the UK economy would slow down. Where it is possible for them to do so, companies would raise prices, or, where customers are unwilling to pay up, absorb the pain of higher costs themselves at the expense of profits. Despite the robust UK jobs market and the return of real wage growth, it is uncertain how consumers might react as higher prices erode their spending power. They have been spending at above-average rates, as reflected in the low UK savings rate (relative to historical levels) and we suspect consumers would cut back and make choices.
13. Which sub sectors of the stock market would be most at risk from the return of inflationary pressures?
Certain parts of the consumer discretionary space. Within the general retail sector sellers of “big ticket” items, including cars, white goods, or household fixtures, such as kitchens and double-glazing units. Specialist retailers of smaller-ticket luxuries, such as cosmetics could also be at risk. Within leisure, tour operators might be vulnerable as consumers favour “staycations” in place of more expensive overseas holidays, while restaurant and pub companies would likely see less trade as people eat and drink out less.
14. How might a “no deal” Brexit influence UK monetary and fiscal policy?
In the event of a no deal we would not expect the BoE to change interest rates but instead look through the possible negative impact on the economy of sterling weakness and increased inflationary pressures. We could, however, see a repeat of other elements of the central bank’s policy response following the 2016 EU referendum result, when, in addition to cutting base rates to 0.25%, the BoE injected liquidity into the financial system and used forward guidance to reassure the market over the future path of base rates. It may be that fiscal measures are used in place of monetary ones, but this year’s Budget has been moved forward to October, so any measures would likely be unveiled at a later date, once there is more clarity over Brexit. Measures could include tax breaks in order to stimulate capital investment by companies, or stimulate investment into small and medium-sized companies. The government has also raised the prospect of a significant reduction in the rate of corporation tax in the event of no deal. We could also see sector-specific policies, such as additional support for the government’s Help to Buy scheme.
15. What would you expect to happen to UK interest rates should there be a withdrawal agreement?
In that event we are more likely to see a rise in interest rates. The BoE increased base rates in August to 0.75% as it judged the slowdown in the UK economy in the first quarter of 2018 to be temporary, and related to the very cold weather at the beginning of the year. This subsequently transpired to be the case, with preliminary GDP data from the Office for National Statistics revealing growth had bounced back in Q2, albeit, in part, helped by the very warm summer and World Cup. Higher-frequency indicators suggest that the positive momentum has continued into Q3. All other things being equal, should there be a withdrawal agreement we would expect interest rates to move up gradually.
16. How important is it to maintain a global perspective and not just focus on Brexit?
More often than not global developments set the tone for the UK stock market. At present, US-China trade relations and fears around the stability of emerging markets (EMs) are key considerations. EMs have come under pressure as global financial conditions have become tighter. Since the GFC the world economy has enjoyed the benefits of 10 years of low interest rates and quantitative easing (QE). QE is effectively central banks pumping money directly into the financial system by way of asset purchases (buying mainly bonds) to keep lenders lending and corporates spending. QE however, is now giving way to quantitative tightening (QT) as central banks globally turn net sellers of bonds to remove money from the financial system.
17. Why is the health of emerging markets important to the outlook for the UK stock market?
The financials and materials sectors are major components of the UK stock market and both have significant exposure to EMs. In addition, there are many other multinational companies quoted on the UK stock market which have significant EM operations in South Africa, South America and Asia. Currency crises in Turkey and Argentina have provoked new questions around the wider stability of EMs against the backdrop of a resurgent dollar. This is at a time when global financial conditions are becoming more restrictive – the US Federal Reserve is tightening monetary conditions through QT and higher base rates (raising base rates by 100 basis points over the past 12 months to a target of 2-2.25%) and the European Central Bank is on course to end QE later in 2018.
18. Is the backdrop of 10 years of rising markets another consideration?
Yes. It is always worth remembering that economic activity waxes and wanes and the period of time in which an economy moves from a state of expansion to one of contraction, before expanding again is known as the economic, or “business cycle”. Since the GFC many major economies have experienced a long period of uninterrupted growth and, as a result, expectations are rising that they are due a downturn at such a mature stage in the business cycle. Stock markets also tend to approach their peaks late in the business cycle and so the longevity of the current bull market could also be seen as a potential source of concern.
19. Merger and acquisition (M&A) activity has been picking up globally, with UK-quoted companies of particular interest, why?
M&A1 often becomes a more prominent feature as the business cycle becomes more mature and corporates start to exhaust their organic growth opportunities, while also wanting to make the most of readily-available cheap debt financing. UK M&A has picked up as overseas corporate buyers of assets have exploited the UK’s attractive relative valuation and the weakness in sterling. This has acted as somewhat of a counterbalance – the majority of “inbound” M&A (certainly by value) has been overseas companies or global private equity investors targeting world-leading UK-quoted companies. There has been a bidding war for broadcaster Sky, culminating in a blind auction won by US cable group Comcast, while fellow FTSE 100 company Shire has recommended an offer from Japanese pharmaceutical peer Takeda.
20. We’ve recently seen M&A targeting UK domestic companies – what can be read into this?
Deals need to be analysed on a case-by-case basis. Coca-Cola’s bid for Whitbread’s Costa coffee chain is largely about the US soft drinks group taking the target’s machine technology, and specialist knowledge of the hot drinks industry and rolling it out globally. However, the bid for John Laing Infrastructure Fund (JLIF) by infrastructure fund managers Dalmore Capital and Equitix Investment Management can be viewed in a different context. JLIF invests in public-private partnerships (PPPs), predominately in the UK covering a whole array of sectors from roads, rail, schools and hospitals. JLIF has been among the key PPP backers of the Intercity Express Programme, which has delivered new high-speed trains on the Great Western mainline running out of London Paddington. Following the bid for JLIF many of the other UK-focused infrastructure funds bounced back from prior weakness – the bid gave comfort that, on a longer-term view, suppressed valuations of more domestic oriented businesses are offsetting the risks related to Brexit.
21. Will London remain an attractive base for global companies after Brexit?
To deal with the potential Brexit scenarios many companies with bases in London are establishing footprints in other European capitals, whether Paris, Berlin or Dublin, for example. There have, however, been positive stories in favour of the UK, whether that be Google pushing ahead with plans to develop its new UK HQ at King’s Cross St. Pancras, or luxury goods makers Chanel opting for London as the location of its new global HQ. While the Chanel HQ is not going to be create large numbers of jobs, the choice of London has potentially wider significance in light of speculation that the company’s owners may be preparing to float the business on the public markets. Chanel cited the UK as important for its central location in relation to end markets, the use of English language in international business and strong corporate governance standards.
22. How has Brexit affected dividend payments over the past couple of years?
Approximately 40% of UK stock market dividends are declared in overseas currencies, mainly US dollars, but also a significant proportion in euros. As a result, currency moves can have a major impact on the level of sterling distributions. Dividends have risen due to a combination of weaker sterling resulting from Brexit and good underlying dividend growth, in the mid to high-single digits. The dividend cover of the UK stock market, a ratio which measures the number of times the market’s aggregate dividends can be paid out of its aggregate earnings, has improved over the past couple of years. This has occurred against the backdrop of higher commodity prices, largely related to the pick-up in the global economy, which has driven a recovery in earnings of the significant oil and mining sectors.
23. And what about the prospects for the other big engine of UK dividends, the banks?
Because of the higher capital adequacy requirements future returns from banks are expected to be lower than they have been in the past. However, as banks pursue more conservative business models and grow more slowly it is likely they will return a greater proportion of any “excess capital” to shareholders, rather than reinvest it into the business. This could be returned to shareholders in the form or ordinary dividends, special dividends or share buybacks. We have seen this happen with Lloyds Banking and Royal Bank of Scotland has recently indicated that it is in a position to follow suit.
1. Mergers and acquisitions, or M&A for short, is a general term that refers to the consolidation of companies or assets through various types of financial transactions.↩).