Britain's vote to leave the European Union (EU) could significantly prolong subdued trading conditions across the largely cyclical UK capital goods sector - if forecasts from some of the world's leading economists are anything to go by. Yet the market reaction suggests investors are prepared to stomach the risk of another global recession in exchange for greater exposure to equities capable of profiting from the plummeting pound.
Over the past few decades, the nation's industrial giants deliberately diversified to protect against geographical and market shifts. In the days following the referendum these international characteristics were highly sought after by investors, many of whom took immediate action to distance themselves from UK-centric stocks.
Dollar earnings come up trumps
Topping most investors' shopping lists were companies generating sizeable profits from North America. Given the widening gap between the US dollar and sterling post-vote, those that earn a large chunk of their revenues across the pond quickly became flavour of the month.
Aside from engineering conglomerate Smiths Group (SMIN), the most dominant greenback earners are mainly aerospace and defence companies that work closely with the US Department of Defense. The sector's newfound popularity may also be closely tied to the World Trade Association's historic deal to eliminate import duties on all aircraft and related products. The long-cycle nature of aerospace - ie once parts designed in platform changes become cost prohibitive - could similarly prove to be preferable.
But before retail investors completely rejig their portfolios, they'd be wise to remember that general trading patterns remain largely uninspiring. Boeing (US:BA) and Airbus' (FR:AIR) recent warning at the Farnborough Airshow of further order weakness served as a timely reminder that global economic uncertainty isn't an ideal backdrop for companies involved in the supply chain.
The biggest takeaway from the trade show was that Airbus plans to halve production of its A380 wide-body jets to just 12 a year by 2018. Senior (SNR) and GKN (GKN) emerged as the biggest victims of this expected, yet equally painful, update.
Sanjay Jha, capital goods analyst at Panmure Gordon, reckons plenty more aerospace companies will be hit by delays and cancellations once the industry fully digests the severity of Brexit. "Banks, which provide 28 per cent of aerospace financing, have been hit hard since Brexit," he says. "Quite how the market expects the commercial aerospace delivery schedule to stay on course while buyers and financiers are in turmoil is not clear to us."
Mr Jha believes these conditions could endanger Rolls-Royce's (RR.) already fragile balance sheet, particularly as the troubled engine maker is banking on a strong showing from its aerospace division to revitalise is fortunes. And while a recent spike in the group's share price suggests that the surging US dollar can help to ease the blow, Mr Jha thinks otherwise.
"Rolls has a total hedge book worth $29bn at an average dollar to pound exchange rate of 1.59. It will probably be 2022 before it benefits from the recent drop in that exchange rate, assuming any transaction gains are not offset by rising raw materials costs."
Spanner in the works
Earlier in 2016, Rolls-Royce was one of several companies hoping for a much stronger second-half to meet full-year guidance. If the views of several prominent economists are anything to go by, these targets have suddenly become much harder to hit.
While the majority of companies specialise in cutting-edge, non-commoditised technologies, several of which cater to legislative measures, business cycle fluctuations still largely mirror the operating performances of capital goods companies. With that in mind, the International Monetary Fund's (IMF) recent warning that the EU referendum result has "thrown a spanner in the works" of the global recovery is a worrying prospect.
Economists at Barclays (see chart below) predict that the current uncertainty will hamper confidence, erode consumer spending and eventually trigger a globally damaging UK recession. Add to that the potential risk of new trade restrictions or tariffs emerging and the outlook for this group of international traders becomes even more unsettling.
Global GDP forecasts post-Brexit
Unfortunately, nervy investors will have to wait beyond the upcoming company results season to fully gauge what damage Brexit will inflict on these companies. New prime minister Theresa May has already confirmed that the government plans to take its time negotiating new contract terms, while customary summer shutdowns suggest initial responses will only start to become apparent when order book activity returns in September. When the gates reopen, it's likely that customers will grow more jittery about the increasing probability of a withdrawal from the single market.
Brammer sounds the alarm
Sentiment won't have been improved much by Brammer's (BRAM) stinging profit warning. While business at the distributor of industrial repair kits was hardly booming beforehand, its reference to plummeting sales after the referendum results provided a first glimpse into a wider market slowdown across the continent.
Other key takeaways included confirmation that uncertainty breeds capital expenditure deferrals, and that a weak pound will push debt dangerously close to its loan covenants - most of its borrowings are denominated in euros. According to analysts at Peel Hunt, Fenner (FENR), Low & Bonar (LWB) and Oxford Instruments (OXIG) could face similar issues.
Meanwhile, the fact that Brammer generates about 60 per cent of sales and profits from Europe won't have gone unnoticed. True, sourcing and transporting industrial clobber is more cyclical than the production of niche, specialist kit. Yet, given the economic backlash that's expected to be felt across the UK and the eurozone in the coming years, those with big customer bases there, such as Xaar (XAR), Hill & Smith (HILS), TT Electronics (TTG), XP Power (XPP), IMI (IMI), Spirax-Sarco (SPX), Bodycote (BOY) and GKN, may equally be in for a rocky ride.
If recent warnings about the automotive industry are to be believed, the latter two names look particularly vulnerable. Both Bodycote and GKN, which following the Brexit-inspired plunge in government debt now also has a hefty pension deficit to contend with, have relied on rampant demand for their car parts to compensate for disappointing trading in other divisions.
Two-thirds of vehicles produced in Britain are exported to the EU, where improving consumer confidence has provided a welcome growth spurt. However, Brexit may soon weigh on its inhabitants buying power, and eventually threaten access to European markets.
IC VIEW:
The recent surge in share prices requires careful reflection, particularly when considering the underlying risk that Brexit could tilt the global economy back into recession. But volatile times can also reward alert stockpickers, including those who quickly recognised that Hill & Smith's hefty UK exposure is mainly linked to a previously signed pledge to upgrade the nation's motorways. Approach with caution.
Favourites
If it's safety you're after, Halma (HLMA) is your best bet. However, in times of uncertainty its defensive pedigree is in high demand - the shares currently trade at a whopping premium to peers on 24 times forecast earnings. A cheaper alternative is Smiths Group. While the engineering conglomerate doesn't boast the same safe-haven status as Halma, its ability to capitalise on US earnings, rising geopolitical tensions and the resurgent medical outsourcing market do give it access to encouraging market trends. The shares, which currently trade on 14 times forward earnings, should also be lifted by falling gilt yields and the subsequent flight to equities paying decent income.
Outsiders
Like many exposed to the commodity sector, shares in US dollar earners Rolls-Royce and Weir (WEIR) have surged since the Brexit referendum. We'd question the logic behind this change in sentiment, particularly as trading conditions may deteriorate even further in the coming year. For now, investors are attracted by non-UK-weighted earnings. Yet Rolls, for the reasons outlined above, isn't likely to benefit from the US dollar rally as much as some anticipate, while Weir's lack of oil and gas revenues suggest greenback income will be lacking. Given the level of debt it holds in that currency, we continue to believe that a sharp dividend cut is imminent.
