How to win at Brexit

Britain’s secession is not as dire as the 1861-65 conflict that cost 600,000 American lives, but at its heart is a struggle of narratives. The difficulty for investors lies in understanding where Brexit creates game-changing operational challenges and where problems have either been over- or understated to suit political arguments. The opportunity lies in identifying good companies that have been afflicted by uncertainty but have potential to rerate once their management is given a sense of clarity.

Rip-off Britain? Hardly!

Since asset managers began underweighting for referendum risk in early 2016, UK-listed shares have been increasingly overlooked. Quoting the Bank of America Merrill Lynch Fund Manager Survey (12 February 2019), UK fund managers at Schroders highlight that the consensus position is to hold UK equities at a level 25 per cent under their global benchmark weighting by market capitalisation, as the chart below shows. Furthermore, just before Christmas, Morgan Stanley research noted that the UK stock market was at a 30 per cent discount to peers, a 30-year low.

Just because something is cheap doesn’t mean it can’t get cheaper, but worth considering is the fact that FTSE All-Share companies make 73 per cent of their revenues outside the UK. This was a point made by managers of the UK-focused Schroder Income Growth Fund and they didn’t detail what proportion of those overseas revenues were thanks to trade with the EU. Nonetheless, there is undoubtedly a strong case to be made that the share prices of companies with a global focus are being overly marked down due to Brexit, which Sue Noffke, Schroders’ UK equity fund manager, describes as a “local, not a global problem”.

At current valuations, it’s not only overseas earners that are beginning to look attractive. In March 2019, companies with predominately UK earnings were on a price/earnings (PE) valuation less than 0.9 times as expensive as that of FTSE All-Share peers with mostly international revenues. This compares with UK earners being roughly 1.3 times as expensive at the end of 2015 before Brexit fears kicked in. This type of disparity in valuation has encouraged Ms Noffke and her team to add UK revenue exposure relative to the benchmark index. The companies held now give the Schroder Income Growth portfolio 35.5 per cent UK revenue exposure, compared with 27 per cent for the FTSE All-Share. 

Why the UK discount and is it illusory?

Warring over control of the Brexit narrative, both Leave and Remain camps have cited the behaviour of financial markets in support of their views. The FTSE 100 recovered its sterling value remarkably quickly after the referendum, which was seized upon by Leave as evidence that Project Fear had been a fantasy. Remain countered that the index was denominated in sterling and that, in dollar terms, the UK market was flat in 2016.

Sterling has long played a central role in the saga of the UK’s strained relationship with its continental partners. When George Soros and other speculators enriched themselves to the tune of billions at the UK’s expense on Black Wednesday in 1992, it was thanks to the arbitrage opportunities created by the exchange rate mechanism (ERM). By 2001, then-leader of the Conservatives, William Hague, made “Save the Pound” a central slogan in a fruitless general election campaign. The New Labour juggernaut swatted Mr Hague’s Tories aside to win a second term but, even at the peak of their pre-Iraq power, they knew better than to try to take Britain into the euro.

Twenty-four years after the ERM debacle, the drastic sell-off in the pound following the EU referendum result was instant affirmation for Remain supporters that Britain had made a calamitous decision. Yet there is vast potential for froth in currency markets and the pound’s valuation was already stretched. Arguably, sterling was due a correction against the dollar, which in 2016 was on a powerful bull run against most currencies. Against the euro, sterling had been strong thanks to the eurozone’s weak economic performance and the effects of the huge programme of quantitative easing (QE) undertaken to stimulate growth. The addition of uncertainty to the UK outlook was enough to bring the GBP:EUR cross down to a level more commensurate with the enormous trade deficit in goods between Britain and the rest of the EU.

Equity markets don’t represent industries most at risk from EU tariffs

Operationally, companies are most affected by tariff and non-tariff barriers to trade. Parliament has effectively taken ‘no deal’ off the table, but had the UK headed down the route of World Trade Organization (WTO) rules, then the biggest tariffs faced would be on dairy products (36 per cent), confectionery (21 per cent) and animal products (15.5 per cent). Agriculture is virtually unrepresented in the FTSE All-Share, so these levies are not of direct concern to equity investors.

Industrials have a weighting of around 9 per cent in the FTSE All-Share, although the figure is 20 per cent in the FTSE 250, which isn’t skewed by megacaps. In these more significant industries for equity investors tariffs are not inconsequential – chemicals (where charges are 4.6 per cent) and electrical machinery (2.5 per cent), for example – but for global businesses, there is the possibility that the impact of EU tariffs could be offset by improved trading terms elsewhere.

Of course, this is only half the story. UK companies rely on EU imports for their supply chains (they’d suffer if the UK placed tariffs on goods and components from the continent) and WTO rules don’t cover many key areas. Around 80 per cent of UK economic activity is in tertiary services industries, which are far more affected by non-tariff restrictions such as regulation and cutting off a ready supply of skills and cheap labour (facilitated by freedom of movement). The first point for investors, however, is that the London stock market is dominated by many industries where the immediate issues Brexit poses for the UK’s real economy might not be felt as keenly.

Dismal science makes dismal predictions

Any business will suffer if there is recession or a slower rate of gross domestic product (GDP) growth in countries where sales are made. Trying to quantify the effect Brexit has already had on UK growth, and what it will be going forward has been one of the key battle grounds in controlling the political narrative.

On 13 March, the Office for Budgetary Responsibility (OBR) reduced its estimate for the UK’s rate of GDP growth for 2019 to 1.2 per cent, down from the 1.6 per cent it had forecast in October 2018. The uncertainty around Brexit plays a role in these calculations as companies delay investment until they are given a steer on future trading relationships. The medium-term trend in the OBR figures reverts to a GDP growth rate of about 1.6 per cent by 2022-23 (the same rate forecast last October), so the figures are certainly not predicting economic Armageddon for the UK, but they do suggest that damage is being done to business this year by political bumbling.

Much was made of the Bank of England’s report in November 2018, where worst estimates for 2024 UK GDP were 10.5 per cent lower than the level based on a continuation of pre-referendum growth from mid-2016. Predictably, this provoked a barrage of criticism from prominent Brexit advocates, with Jacob Rees-Mogg accusing the Bank of England (BoE) governor Mark Carney of being “a failed second tier politician” for trying to spread fear ahead of crucial parliamentary votes on the UK’s withdrawal. Likewise, in the Remain camp, commentators were screaming hysterically that the BoE was predicting Brexit could be as damaging as the global financial crisis.

Inevitably, reports by public bodies get politicised, but such hullabaloo overrides the original purpose of analysis. The BoE’s role is to manage monetary policy and, via the Prudential Regulatory Authority (PRA), ensure the stability of the UK financial system. The quoted report created models for stress tests. It might not be helpful to Mr Rees-Mogg’s cause, but it is quite reasonable for the BoE to base from a time before a major cause of uncertainty (and surely everyone can agree the Brexit process is uncertain) in benchmarking new assumptions that underlie its policy strategy. Given the decisions this research must support, it is only prudent to err to the downside.

Despite the controversy caused by pessimistic data modelling, companies and investors should be more sensible than politicians and click-baiters. True, companies may reappraise investment plans made pre-referendum based on a less rosy outlook, but for other decisions made in the here and now, the figures to take note of are deviations from recent forecasts. Since the November 2018 BoE report, these have been revised downwards, but the worst estimated impact was GDP being 7.75 per cent below the then trend. That was for a ‘cliff edge’ Brexit, which parliament has voted not to accept, and the most optimistic of forecasts had GDP growth accelerating, although falling short of 2016 projections. 

Like the Bank of England, investors’ policy will depend on their impact assessment

As an investor, the task is to look beyond the arguments. It is important to study the Brexit impact assessments and then ask whether there is adequate compensation for risks baked into share prices. The questions are twofold: 1) How much will the scenarios mooted affect the earning power of companies? 2) What is the range of potential reward implied by the valuation?

Brexit must have an impact on the UK’s GDP outlook, but the expectation is for growth picking up after initial disruption, rather than deep recession. Depending on their earning exposure to the UK economy, companies’ prospects should be assessed through the lens of various growth scenarios. This is the job of professional analysts and will be reflected in earnings growth forecasts. As well as the internationally focused companies whose earnings are less dependent on the UK, there will be some shares that have been heavily discounted by the market thanks to Brexit worries, even though the consensus on their business prospects is positive.

For stockpickers this is an opportunity and it stems from principles of risk and reward. Whether you believe Brexit will go badly or that it will go well, there is no certainty. As plenty of people do think there are significant downside risks, a Brexit premium exists. There are some companies that have a reasonable growth outlook, but they are being overlooked due to concerns for the UK economy. Other shares could see price gains if analysts revise earnings estimates once there is more clarity for businesses post-Brexit.

The UK market’s unloved status means that some of the biggest companies in the world are offering investors a significant risk premium. Taking analysts’ growth forecasts for earnings over the next two years, valuations imply returns ahead of the long-run average, especially when dividends and buybacks are considered. While buybacks especially can be lumpy, they are worth including in estimates for returns over the next two years, as if share prices stay relatively cheap (especially for companies with large revenues in currencies other than sterling), then it would not be a surprise to see more of them (see table, below).

Valuations and estimates imply wide risk premiums 

Source: S&P Capital IQ and Investors Chronicle

Many of the big UK-listed companies are committed dividend-payers and the high yield the UK is offering is another reason the market is starting to look attractive to several fund managers despite the political uncertainty. Simon Gergel of the Merchants Trust points out that the UK market yields 80 per cent more than the global average and that over 30 per cent of FTSE 350 companies offer a dividend yield of 5 per cent or more. In the past 30 years UK dividend yields relative to the rest of the world have only been higher at the height of the tech bubble and the 1991 recession, says Schroders’ Ms Noffke.

Are current high yields a warning sign? Payouts fell drastically over the financial crisis, with a peak-to-trough decline of 15 per cent, although the Schroders team say dividends would have to fall by 25 per cent for the yield to drop to the long-run average of 3.5 per cent over 30 years. Alternatively, the market would have to rise by 37 per cent.

It’s not all about shares, asset allocation to hedge your risks

Ultimately, the tempting rewards on offer are compensation for all risks, which are not confined to Brexit. Globally, there is far less certainty than there was in 2016, with new concerns over China’s debt, Europe’s precarious growth and the unpredictability of US trade policy. The UK market is heavily weighted towards resource and financial companies that could be badly hit in a global recession or debt and liquidity crisis. Sadly, Brexit isn’t the only problem investors must consider.

One of the dangers of a disorderly Brexit is a reason to stay invested, however. Should the pound fall further, compounding higher tariffs on imports, then prices will rise. If the UK suffers inflation as an idiosyncratic consequence of Brexit, shares will be the best thing to own, especially if the international economy is doing well and overseas earners are thriving. The nightmare scenario is a world recession at the same time as Britain’s businesses and households are finding their pounds not going so far – the freakish combination known as stagflation.

The value of cash savings is devoured in any period of high inflation, which is a significant price to pay for the insurance of being out of the markets, although it becomes worth it in a savage downturn. The sensible approach is always to ensure you have plenty of cash on hand for emergencies and a reliable income, but beyond this it is best to remain invested if you can and spread risk with other asset classes.

The US yield curve is still suggesting uncertainty over the mid-term economic outlook, with the yield on six and 12-month government bonds higher than on two and five-year maturity debt. While a bad sign for confidence – and therefore equities – this does present an opportunity for liquid safe-haven investments that have scope for price gains if other assets sell off.

Gold remains a hedge against price volatility in other asset classes and while in the long run it is an investment that pays no income and is subject to rapid price falls when out of favour, it is likely to do well in the type of scenarios that could spook global stock markets. A small exposure via an exchange traded fund (ETF) would help mitigate portfolio losses in a bear market for shares.

Overall though, the UK-listed companies are on such a discount to global peers the risks seem to be well compensated and it remains worth having exposure. The impact of Brexit may yet be hard on the UK economy, but as the additional discounts to UK earners show, investors are being incentivised to take the chance that Britain will leave the EU in an orderly manner.