By the time the end of 2016 rolls around, readers will be forgiven for not wanting to read another article on the Brexit vote. But we can’t escape the fact that, perhaps only excluding Donald Trump’s election victory, this was the defining political event of the year – maybe even the decade. It was unpredicted, and its effects on markets, currencies and companies has been wide-ranging. More importantly, it’s still a matter of debate.
Until the UK government triggers Article 50 – an unclear event in itself – the true extent of the effect on the UK’s different industries is pure hypothesis. Or is it? The sudden devaluation of sterling post-referendum is already causing havoc for companies that book the majority of their costs in foreign currencies, while those industries that depend on the single market are already trying to invent new arrangements, just in case.
Not recession, this is a pound problem
The weakness in sterling against the US dollar has sent shockwaves through the British retail and consumer sectors. True, weaker sterling is an issue for companies in any sector booking costs in a foreign currency. But this is a particularly pertinent problem for consumer-facing stocks, which have to buy and source significant amounts of inventory at a certain price, before deciding what price those items are sold at to customers. In a fast-moving and competitive market that can quickly put the squeeze on profit.
We’ve written extensively on this subject as the currency situation developed this year, but what does the current position of the pound mean heading into 2017? Well, price increases look highly likely. This doesn’t just affect investors in retail stocks, but consumers across the country – you and me – as we head to the shops to buy everything from food, clothing and homewares to everything in between.
So far, there’s little evidence to suggest shoppers have been deterred from spending money as a result of the Brexit vote. The idea that a recession could develop in the same way as in 2008 still sounds pretty far-fetched. But that doesn’t mean that demand won’t slip should retailers pass on their inflated costs to customers. Of course, all retailers face a choice: either raise prices or take a hit on margins. High-street chain Next (NXT),
for example, has been resolute in its strategy. It will raise prices as modestly as possible in the defence of margins and, thus, profits. But what effect this will have on its value-conscious customer base is still an important question, especially when one considers the ongoing decline in full-price sales at the company so far this year.
Others, particularly on the travel and leisure side of the industry, are no strangers to shrinking margins. Volume businesses who believe they can make up the margin dent in higher top-line sales are insistent on keeping prices – and so customer loyalty – stable.
In short, next year will truly sort the wheat from the chaff. Those retailers with loyal core customers should experience little disruption to trading, price increases or not. But this means retailers worth investing in – those with a good track record from the last downturn – are demanding toppy ratings and investors will be forced to dig deep for a good return. HR
Top picks in retail: Our picks for the sector include high-street retailers such as Ted Baker (TED) and SuperGroup (SGP) for their international outlook and seemingly solid customer loyalty. We also see potential for market newcomers Joules (JOUL) and Hotel Chocolat (HOTC), although investors will be forced to dig deep in those pockets for quality retail growth stories like these at the moment.
Property: rates, rates, rates
The key governing influence for the housebuilding sector in 2017 is the economy. At the moment, buyers are enjoying the cheapest mortgages ever, along with a string of government incentives to help first-time buyers on to the first rung of the housing ladder. This looks set to continue, although there is growing evidence that sterling’s weakness will push up inflation.
However, it’s hard to see the Bank of England raising interest rates in response, given that this could easily derail economic growth at a time of great political uncertainty surrounding the move to leave the EU. That uncertainty will prevail, but buyers are unlikely to be more than mildly deterred, and will be more influenced by factors such as unemployment. This only appears as relevant if the economy falters, and the government and the Bank of England will be working hard to maintain economic growth.
The falling pound is unlikely to have much effect as few raw materials are imported, but any move to restrict labour movement could increase wage costs at a time when there is already a significant shortage of skilled labour. While any or all of these conditions could become an issue, the most likely scenario is that they will stay largely dormant, leaving housebuilders to continue improving output and driving profits higher. JC
Top picks in property: Housebuilders have been generating significant amounts of cash, and we like the way that Berkeley Group (BKG), Persimmon (PSN) and Taylor Wimpey (TW.) are rewarding shareholders with a series of big dividend payouts. We’re also keen on London focused builder Telford Homes (TEF) with its exposure to the fast-growing build-to-rent sector.
Banking on banking?
During the month following the referendum, banking giants Lloyds (LLOY) and Royal Bank of Scotland (RBS), as well as their challengers Shawbrook (SHAW) and Aldermore (ALD), suffered tremendous falls in their share prices. These banks have the largest retail operations and exposure to the UK housing market. While some have recovered, what is likely to hurt banks in the longer term is the 25 basis point cut in interest rates by the Bank of England. Banks are already battling to maintain and grow their net interest margins in a global low rate environment. Lloyds has cut jobs and branches as a result.
Arguably the most awaited element of the Brexit negotiations for the sector will be to what extent banks are able to secure passporting rights. These give UK banks the right to provide financial services in any EU country – as well as those in the wider economic community, such as Norway and Iceland – without the need for licences in individual countries. The head of Germany’s central bank, Jens Weidmann, has said UK financial institutions would lose their passporting rights if the UK is not at least part of the European Economic Area.
However, Moody’s has said the loss of such rights would be “manageable”, but varied across different companies. The concept of “equivalence” under Mifid II regulations – where market access can be retained through existing compliance with EU regulations – could allow larger investment banks to continue operating in areas such as currency trading within Europe. However, it is worth noting that these rules are untested and dependent on a ruling by the European Commission. For now, we’re sticking with well-capitalised Lloyds as our buy tip. Unlike RBS, the bank has come good on its promise to resume dividend payments and is also moving in the right direction by simplifying its structure and reducing costs. EP
Top picks in banking: Domestically-focused banks have become more cheaply rated following the summer’s referendum. For the likes of RBS there are reasons for particular caution given the fact it is still locked in legal dispute with two shareholder groups over its 2008 rights issue. Our favourite remains Lloyds. Trading a little over its forecast net tangible assets per share, the bank is the most well-capitalised of the UK-listed banks and has come good on our hopes that it would grow dividend payouts.
Another good year for gold?
None of this year’s events were expected a year ago, and it’s no coincidence that the uncertainty they’ve collectively sewn in markets has been a fillip to the price of gold and silver, which investors often treat as a non-cash-based insurance policy.
As we pointed out just before the Brexit vote, the 2016 bet on gold wasn’t just about political risk, but the relative cost of holding capital. For large funds, negative interest rate policies have added a hitherto non-existent cost to parking capital in cash and billions of dollars’ worth of government and corporate debt. For all its volatility, many have found precious metal tracker funds to be the next best thing.
But opportunity cost also explains why the gold rally has stalled since Donald Trump’s US election victory. Why? Because bond yields and equities are rising and the dollar has strengthened considerably. So while the world waits for greater clarity on Mr Trump’s economic plans, investors have found themselves with better short-term offers elsewhere.
At the same time, it’s hard to square the growing backlash against globalisation with the expectation that global economic growth is guaranteed. And with the dollar index at unprecedented highs – and Europe facing a raft of serious electoral and political challenges – there are signs that 2017 could again be a good year for gold, and therefore gold miners. AN
Top picks in gold mining: Among the gold miners, our picks include Pan African Resources (PAF) for its dividend and the quality of its assets, Egypt-based Centamin (CEY) for its cash generation and low valuation, and junior explorer Mariana Resources (MARL), whose spectacular recent drilling results could make it a takeover target.
On the defensive
Where better to look in times of turbulence than companies whose products are going to be in high demand come rain or shine and reward you with attractive dividends? That sentiment has favoured pharmaceutical and tobacco giants in 2016. In the weeks after the referendum GlaxoSmithKline (GSK), AstraZeneca (AZN), Shire (SHP), Imperial Brands (IMB) and British American Tobacco (BATS) were flying, their high dollar earnings serving them well as the pound crashed.
But both sectors have also had to contend with issues from foreign shores. For big pharma it’s been drug pricing battles driven by former presidential candidate Hillary Clinton. In retaliation to the price gouging from US companies such as Mylan and Valeant, she vowed to shake up the industry, sending share prices reeling. But the biggest political surprise of the year has favoured big pharma, and in the days after the recent US election, London-listed pharma stocks were riding high. With drugs pipelines looking better than ever and policymakers on their side, 2017 could be a good year for the sector.
Tobacco’s issues may be more enduring. In late November the UK government ruled in favour of plain packaging for cigarettes and have started to phase out packs of five and 10. Both Imperial Brands and British American Tobacco fought strongly against this decision, although they now both claim the decision will have little impact on sales. Consolidation is another theme likely to feature in 2017 as US and Japanese tobacco companies seek world domination, although we reckon an acceleration in research and development to keep ahead of the trends in ecigarettes could come at a cost to earnings. As income stocks, BATS and Imperial still look attractive, but with more high-yielding companies emerging, their key investment point could soon cease to be. MB
Top picks in pharma and tobacco: As defensive stocks in times of turbulence, we don’t think any of these five companies are bad holdings. But for those looking to bag a bargain we point to Astra and Shire. Both of these companies have extensive drugs pipelines with multiple launches expected in 2017. But after a tough 2016 they are both very attractively valued at present.
Expect a step up in defence spending
Although it’s highly unlikely that the President-elect would ever seriously contemplate severing ties with the US’s strategic partners in Nato, there’s every chance that Uncle Sam won’t go on underwriting the organisation indefinitely. The incoming President’s main criticism is that few of the 28 member states are meeting the minimum 2 per cent defence spending commitment (as a percentage of GDP).
The US would be entitled to turn the screw on its Nato allies, but Nato has recently made efforts to bolster its presence in eastern Europe as part of an effort to deter Russia after the annexation of Crimea in 2014. And there are new commitments from some of Europe’s biggest economies; the French parliament recently approved a €600m (£506m) increase to the country’s 2017 defence budget above current-year levels, to €32.4bn, a 1.8 per cent increase over 2016. Meanwhile, Germany has earmarked an additional E1.7bn for defence – a 6.8 per cent rise on planned spending for the current year. Under the proposals, the German armed forces will receive €36.6bn in 2017. The European Commission also recently confirmed that a plan is in place to reverse a decade of defence spending cuts by EU members, amounting to nearly 12 per cent in real terms.
The step-up in spending by our allies on the Continent is obviously positive for the UK aerospace and defence industry, which remains one of the world’s leading exporters. It would be surprising if the eventual Brexit negotiations provide a stumbling block given the extent of our shared involvement with defence contractors on the European mainland. We suspect that European negotiators would be less inclined to play hardball in this area than, say, the issue of passporting for financial services. The UK defence and aerospace sector is also well placed with the Pentagon as it is one of only five countries that meets the Nato guideline on defence spending. MR
Top picks in defence: With market-leading technology in growth segments such as unmanned aerial combat, next-generation maritime technologies and advanced cyber-defence, BAE Systems (BA.) is our pick of the sector – its strategic emphasis on value-added technologies makes it well placed to capture share in what are likely to be highly targeted national defence spending rounds.
