Understandably, we were trying to hold back on our Brexit commentary until as late in the day as possible. A year-and-a-half on from the referendum decision, the situation remains so fluid, so politically charged, that short of the final sign-off (assuming there ever is one) any formulation on the final terms of our exit from the European Union (EU) – and its likely impact on the UK economy – will rest largely on conjecture.
Nevertheless, investors will need to monitor the negotiations to gauge sector-specific risks through regulatory issues and/or changes to the tariff regime. Brexit will have an impact on political policy-making and economic performance across Europe, so while the EU Commission has appeared largely intransigent thus far in the negotiating process, it should be remembered that the UK will remain part of an economic area that is heavily interdependent. So, the longer they drag on without resolution – or without any real prospect of resolution – the more pressure that will be brought to bear by Europe’s industrialists – particularly those from Bavaria. The mounting domestic pressures in Germany following the recent general election are reflected in a power struggle under way in Bavaria’s Christian Social Union (CSU), which is hampering Chancellor Merkel’s attempts to form a workable coalition government.
External influences: Germany, US stimulus and interest rates
Pressure from Germany’s most powerful economic region is just one of the many variables that will play out prior to the ultimate agreement. However, we shouldn’t lose sight of other factors that will have a marked influence through 2018 and beyond. The Bank of England recently voted to raise interest rates for the first time in 10 years, which is doubly significant when you consider the results of a study by Legg Mason Global Asset Management which showed that investors are more worried about a prolonged low interest rate environment than the knock-on effects of our exit from the EU.
It’s also worth remembering that President Trump’s proposed tax cuts and infrastructure spending increases have yet to play out, which could trigger a significant rise in aggregate global demand. And what impact could the switch from monetary to fiscal stimulus have on valuations for UK equities?
Although we’re mindful of wider external influences, the Brexit negotiations will undoubtedly throw up specific industry challenges. Since formal talks began midway through this year, both sides have been working to establish a common approach to dividing up their relationship with other members of the World Trade Organisation (WTO). No one is downplaying the importance of the UK’s economic relationship with its current partners in the EU, but it’s worthwhile gaining perspective. Around £240bn out of a total of £550bn in UK exports went to the EU in 2016, although some argue that figure is overstated because a significant proportion of goods pass through ports such as Hamburg and Rotterdam before shipping to other destinations outside the EU. Whatever the reality, we’ve put together some thoughts on Brexit implications (as they now stand) for a handful of chosen sectors.
UK engineering: flexible labour arrangements and non-tariff barriers
By the time we run next year’s Christmas issue, you might reasonably expect that HM Government would have set out a clear framework for the UK engineering sector in the post-Brexit era; the only problem is that you might have expected a good deal more clarity 18 months on from the referendum. Matters have not progressed according to plan.
Businesses, above all else, crave certainty, particularly businesses that are dependent on complex supply chain arrangements that can lock in significant levels of capital. So, it’s little wonder that the Royal Academy of Engineering (RAENG) has identified both tariff and non-tariff barriers, together with the UK’s ability to attract a high level of foreign direct investment (FDI) as key areas in the ongoing negotiations. Other specific issues need to be thrashed out, such as the UK’s ongoing relationship with the European Investment Fund, which has supported dozens of venture capital and private equity funds in the UK.
That’s saying nothing of the ability of companies to hire European engineers once we leave the single market. One suspects that government policymakers will opt for flexible labour arrangements once we exit the single market, but we just don’t know yet. Certainly, the structural imperative seems obvious enough; figures from the RAENG show that demand for occupations most likely to require intermediate or higher engineering skills is approximately 182,000 per year, with the situation “particularly acute” in infrastructure sectors, which are “highly competitive and operate on low profit margins”.
Yet we mustn’t forget that the UK engineering industry already competes successfully in the global marketplace. Engineering companies play a pivotal role in fuelling UK exports. Engineering-related sectors account for nearly half of all UK exports, with more than double the share of gross value added – that represents a huge boost for the nations’ current account. Engineering also accounts for a sizeable proportion of business R&D investment.
The ‘Great Repeal Bill’ – extending harmonisation
On the issue of non-tariff barriers, the government’s decision to initiate the so-called ‘Great Repeal Bill’ seemed a perfectly pragmatic measure to ensure that the UK remains in line with the member states of the European Union on industry standards that define our products and services. However, even this seemingly innocuous piece of legislation, which simply seeks to reinforce the status quo from a practical angle, has attracted political opposition.
The fact is that the negotiations were always likely to be hamstrung by narrow political considerations, whereas business remains in search of clarity. And the longer they drag on, the more difficult it is for manufacturers to make informed decisions on new plant and machinery. However, for the moment we are seeing signs that activity in the the wider manufacturing sector is being supported by improved global demand, particularly from European markets, while the increase in commodity prices is driving growth across the manufacturing supply chain. The EEF/BDO Manufacturing Outlook Q4 survey shows both output and total orders remained in positive territory at +34 per cent (+34 per cent in Q3) and +30 per cent (37 per cent in Q3) respectively.
Outside the EU, the imperative for a co-ordinated industrial response from government will only intensify; a point borne out by the recent release of a white paper setting out its new industrial strategy. Meanwhile. UK heavyweight Rolls-Royce (RR.), which has privately lobbied the Department for Business, Energy and Industrial Strategy (BEIS) over its small nuclear power station technology, received a boost after Whitehall confirmed that central government will give backing to the first generation of modular reactors. The planned transition to hybrid/electric motoring – another structural driver of UK engineering – will place increased pressure on the OK power stations, so the reactors could become an integral feature of the national infrastructure. MR
UK financial services: the central consideration for many
The UK financial services industry employs 1m people and accounted for more than 7 per cent of the value created within the economy during the second quarter of this year. Meanwhile, HM Revenue and Customs attributed £27.3bn of tax receipts to the banking sector during the 2017 tax year. It is therefore unsurprising that London’s financial institutions are keen to know where they stand when it comes to selling services into the European market, as well as the regulatory framework they will need to operate under.
In November Brexit secretary David Davis pledged to seek a deal putting in place a transition period by next January, as well as securing a durable long-term co-operation agreement between London and the EU. Many financial institutions have argued for a transition period of at least two years after Brexit in March 2019, to enable them to adjust to life outside the EU. The EU Withdrawal Bill – or informally, the Great Repeal Bill – seeks to mitigate some of this uncertainty. Under the bill, all existing EU legislation will be copied over to the UK’s statute book to avoid a ‘black hole’ in domestic law. The UK parliament could then ‘amend, repeal and improve’ individual laws.
Some of the financial regulations governing the UK’s financial services sector are global standards, including Basel III, which sets a framework for capital adequacy, stress testing and market liquidity risk. However, other regulation has come via EU directive. This includes Solvency II regulation, which governs the amount of capital EU insurers must hold to reduce the risk of insolvency. However, in this case withdrawal from the EU may bring opportunity for more favourable terms for UK insurers. The Prudential Regulatory Authority (PRA), which oversees the largest insurers, is consulting on changes to Solvency II after industry and politicians lobbied for change post-referendum. These include reducing the scale of reporting requirements for insurers. Then again, with talks stuttering, it is still uncertain about the extent to which the UK can diverge from EU regulation while maintaining access to the trading bloc.
There are a couple of options for financial services to keep access to the bloc. The first would be retaining the EU passport, which allows financial entities based and regulated in one EU country to do business in other member states. However, the options available to do this make it seem unlikely. The UK could remain a member of the single market, similarly to Norway. However, European Economic Members must maintain freedom of movement and accept rulings from the European Court of Justice – Theresa May is against both. The other option would be for London-based institutions to establish subsidiaries in member states, which could increase the legal and regulatory burden on companies. A system of ‘equivalence’ seems the more likely method for financial services to maintain access. That would facilitate cross-border trading between markets that choose to recognise each other’s standards. However, not all EU financial legislation accepts the principle of equivalence, for example there is no provision for commercial banking. A detailed agreement would be required for equivalence to work in practice.
Leaving the EU without a deal in place – which the government is keen to avoid – would have implications for the country’s financial services sector. In response to the House of Lords EU committee inquiry on the matter, industry body TheCityUK said that in a situation where the UK’s relationship rested on WTO obligations, up to half of EU-related financial services activity and between 31,000 and 35,000 jobs could be at risk. It would also be likely to increase the compliance burden for UK financial services companies considerably. EP
Pharmaceuticals: an uncertain prognosis
The rising cost of medicines, a mass exodus of top scientists, delay in the supply of vital drugs. The list of potential repercussions Brexit may have on the pharmaceutical industry provide excellent material for the ‘Remoaners’ among us. However, the truth is, at present it is difficult to know exactly how our drug makers, hospitals and medical device companies will fare when we finally leave the EU.
What we do know is that we are very good at making medicines. In GlaxoSmithKline (GSK) and AstraZeneca (AZN), Britain houses two of the world’s largest pharmaceutical companies and these conglomerates are leading the charge to ensure our life sciences industry will not come unstuck, even in the event of a messy Brexit. Emma Walmsley and Pascal Soriot, chief executives at the two groups, have recently met Theresa May and her team to explain how the transition can be made as smooth as possible for pharmaceutical and medical device companies.
Top of the agenda is securing an easy regulatory environment. At present, when global drugs companies seek approval of new medicines in Europe they turn to the European Medicines Agency (EMA). Normally, they are required to perform a clinical trial in Europe which, if successful, means they can apply for EU-wide approval. Britain’s own pharma regulator, the Medicines and Healthcare Products Regulatory Agency (MHRA), is allowed to use the data from the EMA to permit sales of the new drug in the UK, without the need for an extra clinical trial or application.
Retaining this type of regulatory environment is very important for Dr Patrick Vallance, the current chief scientific officer at GSK, who is set to become the government’s head science adviser in 2018. “We would prefer the UK regulation of medicines to be aligned to the FDA [US Food and Drug Administration] and EMA,” he told the BBC’s Today Programme.
In an ideal scenario, global drugs companies would not have to submit two market applications for the same drug. But failure to negotiate such an attractive regulatory environment could result in the UK “becoming a less desirable place for investment and development”, according to Rachel Reeves who chairs the Business, Energy and Industrial Strategy committee. The upshot could be that global pharmaceutical companies first look to Europe for drug approval and then to the UK, which could result in cost increases, a subsequent rise in the price of UK medicines and a delay to the approval of new drugs.
The future of funding is also creating jitters for British life sciences researchers. At present the UK benefits from the Horizon 2020 pot of cash (it is in fact a much greater receiver than it is giver to this research and innovation programme) but will “cease to be eligible” for grants if the UK leaves the EU without a satisfactory deal, according to the European Commission. Pessimistic scientists and business people have theorised that this could leave the UK vulnerable and unable to compete in the global pharmaceutical market. In practice, things don’t seem to be so bad. Until the UK leaves it will still be entitled to Horizon 2020 funding and beyond 29 March 2019 the government has promised to cover the cost of any projects formerly funded by the EU.
Meanwhile, Britain’s science is still catching the eye of international investors. Two global pharma companies – America’s Merck (US:MRK) and Germany’s Qiagen (Ger:QIA) – have recently announced they will be setting up research and development headquarters in Britain due to the strength of its scientists. A US-based life sciences company is planning to invest up to $1bn in early-stage projects, with the view to create a new large UK biotech company. And GSK has agreed to join the government’s industrial strategy push with a £40m investment in genetics, to help fast-track the development of personalised medicines. MB
Travel & leisure: empty skies?
The countdown to March 2019 is well under way, but UK-listed airlines are no closer to clarity on how aviation rules will look post-Brexit. A recently leaked presentation made by the European Commission to EU member states shut down airlines bosses’ hopes of a bespoke arrangement for the industry. Instead, the document suggested that in the case that Britain were to leave the single market, UK-based airlines would automatically lose their rights to fly within Europe and “third country restrictions” would kick in. If the UK were to be classified as a third country it would lose all the benefits of the Open Skies Agreement with no WTO rules to fall back on.
This is no doubt bad news for British airlines. Ryanair (RYA) chief executive Michael O’Leary has not been shy in his opinions that Brexit was a bad idea to begin with, and has urged negotiators to come up with a bespoke arrangement for the airline industry. These hopes now look to have been shattered by the European Commission presentation. If an agreement is not reached by the end of 2018, when airlines including Ryanair tend to start to schedule routes and sell tickets for the next year’s all important summer holiday season, travellers may not be able to make reservations or could turn to alternative means, like coach or rail.
Mr O’Leary also has a more personal reason to push for an aviation deal. Leaving the single market would mean that ownership restrictions, whereby at least half of shareholders need to be European citizens, would kick in. As of now British shareholders count towards this threshold, but this would no longer be the case post-Brexit. Mr O’Leary could be forced to sell down his personal holding in the company to European buyers in order to satisfy these rules. As of last count, 54 per cent of Ryanair shares were owned by EU citizens, 20 per cent of which are British.
Another chief executive who’s been vocal in their disdain for the ownership rules is Willie Walsh of International Consolidated Airlines (IAG), owner of British Airways and Aer Lingus. Mr Walsh has previously urged the European Parliament to overhaul the ownership rules so that UK citizens still count towards the EU total. IAG has never revealed what proportion of its shares are held by non-EU investors, but analysts have speculated that if the UK was no longer counted, it would fall short of the 50 per cent threshold.
One airline that looks better placed to deal with Brexit fallout is easyJet (EZJ). It’s established a subsidiary business, dubbed easyJet Europe, based in Vienna thanks to the Air Operator Certificate it was granted by Austria’s Federal Ministry for Transport, Innovation and Technology. This will allow easyJet to continue to fly within Europe and between the UK and Europe even in the case of a hard Brexit. The £10m price tag on the air operator certificate looks well worth the cost since around a third of the budget airline’s routes are within continental Europe.
Wizz Air (WIZZ) appears to have done the opposite, though equally sensible, to easyJet in regard to Brexit preparation. The Budapest-based airline applied for a UK Air Operator Certificate in October so that it can continue with its plans to expand further into the UK. Over the past financial year it added 1m seats to routes to and from the UK, and is planning to add another 1m during the current financial year. If all goes according to plan, this would increase its capacity by nearly a quarter by the end of FY2018 and its load factor by 1 percentage point. JF
Food and agriculture: they need us more than we need them
Bring up EU regulation to someone who voted for Brexit and you’ll very likely get a rather sour response. But one area that has been affected by the EU lifting trade restrictions in recent months has been one that is sweet.
In October the EU lifted the quotas on how much sugar can be produced within its member countries, and so now sugar producers are free to make and sell as much as they like. From a volumes perspective, this sounds like great news. But consider that a surge of supply into the sugar market will inevitably drive down the price of the white stuff.
John Bason, finance director at Associated British Foods (ABF), brushed off concerns that a fall in sugar costs could hurt the Illovo business, and Paul Kenward, managing director of the company’s UK sugar division, called the removal of the quotas an “opportunity” for his business as well as the wider industry. While this all seems very optimistic, there could be cause for concern. At the time of the full-year results in September, sales in the AB Sugar business had increased by more than a fifth at constant currency to £2.2bn, with adjusted operating profit up a dramatic 374 per cent to £223m. This was thanks to the higher prices demanded for sugar, which gave a boost to group revenue. If prices plummet, this could hurt the business as a whole.
Another company boss that’s taking a more laid-back approach is JD Wetherspoon (JDW) chairman Tim Martin. Not an update goes by without a dig at people he feels are making too big a fuss about how much food costs could increase. In the most recent trading statement for the first quarter, Mr Martin’s first target is David Tyler, his counterpart at J Sainsbury (SBRY), who has in the past warned that a “no deal” exit from the EU would be necessary to avoid higher food prices. Instead, Mr Martin believes that the lowest food prices can be secured without the need for an arrangement with the EU or any third party.
A “transitional deal” would, in the opinion of Mr Martin, be detrimental as it would just keep EU rules in place for longer. He argues that under WTO rules, tariffs would not then be charged on imports from the EU. This is in contrast to what’s been reported in our sister paper the Financial Times, that tariffs of “13 per cent on salmon, 14 per cent on wine, 40 per cent on cheese and 59 per cent on beef…. must apply to all countries outside the customs union, unless a free-trade agreement is in place”. However, given the relative size and importance of food exports from EU member states such as France and Italy (Britain is a huge end market), there would be much greater political pressure in those countries to strike a trade deal than in the UK, which could easily subsidise its domestic producers.
If the latter does prove to be true, this would no doubt be an issue for an array of London-listed companies, from supermarkets to pubs to restaurants. Even the Brexit vote itself has had an impact on some company numbers. Domino’s Pizza (DOM) reported in October that like-for-like sales in the third quarter were up 8.1 per cent on the year before, but analysts at Liberum were quick to point out that the previous year’s figures had been adversely affected by the aftermath of the referendum, making for an easy comparator.
Whether or not the UK’s exit from the EU discourages people from ordering pizza or not remains to be seen, as do the terms on which the UK leaves and the corresponding tariffs. The only factor with some correlation to Brexit could arguably be the weakening of sterling in relation to the euro, among other currencies. This alone makes purchases from abroad, including food and ingredients, pricier both now and in the future – but free food markets as envisaged by Mr Martin could conceivably more than offset any additional currency-related costs. JF
