As we write, it is the morning of 13 December 2019 and the results of the general election are in. The Conservatives have won a landslide victory. The pound has rallied. The FTSE 100 index – which comprises a number of large multinationals, generating a significant proportion of revenues overseas – is up by 1.9 per cent. The FTSE 250 index, which is dominated by UK-focused companies, has ascended by a more substantial 4 per cent.
Any investor concerns about the possibility of a hung parliament have been assuaged. As – at least for now – have fears about falling into a deeper mire of uncertainty over Brexit. Meanwhile, Labour’s defeat has put an end to the suggestion that some industries and services could face nationalisation.
Guy Foster, head of research at wealth manager Brewin Dolphin, commented that: “The potential for a smooth Brexit removes some of the downside risk for the UK economy. This should be positive for both business and consumer confidence, at least in the short term, with a gradual acceleration in GDP growth and confidence.”
It follows that those sectors that arguably had the most to lose from an even more chaotic or prolonged Brexit process – or from the aforementioned prospect of nationalisation – have surged on the news of Boris Johnson’s win. Housebuilders Taylor Wimpey (TW), Persimmon (PSN) and Barratt Developments (BAR) led the risers following the result, all climbing by well over a tenth. Meanwhile, retail banks – with Virgin Money (VMUK) at the helm – also soared. Utilities groups such as Pennon (PNN) have rocketed too – as has telecoms giant BT (BT.A), with all such companies ostensibly fuelled by the news that they are no longer at risk of being brought into public ownership.
These constitute just a few examples. And it remains to be seen how such stocks – along with all UK plcs – will fare over the approaching weeks, months and indeed the entirety of next year. While the election is behind us, that doesn’t mean that there’s a clear, concrete path ahead. Far from it.
Mr Foster noted that “a lot can change over the coming months as the finer detail of the UK’s future trade relationship with the EU is negotiated. This is still, after all, just the beginning of the exit process.”. He added: “Even with the passing of the withdrawal agreement, the UK could still leave the EU without a deal at the end of 2020 if trade negotiations don’t proceed successfully.” We don’t yet know whether we will have tariff-free trade or will operate under the terms of the World Trade Organization (WTO).
For Jefferies – in a research note from 1 December – a comfortable Tory majority would see a 60 per cent chance of Mr Johnson’s deal going through, and a 20 per cent chance of ‘no deal’. The broker called this the ‘Home Alone’ scenario – one of four different Christmas movies that could play out on election day (at the time, it noted that “unfortunately It’s a Wonderful Life is not among them”).
Herein, the IC’s specialist writers explore what the next 12 months could have in store for a selection of the industries that are – or that have been deemed to be – among those most affected by the UK’s divorce from Europe. Beyond these case studies, there are, of course, various other businesses and industries to be mindful of, and we will continue to monitor for developments in the new year. HC
Brexit and domestic banks
On 10 October, Boris Johnson and his Irish counterpart Leo Varadkar emerged from a hastily organised meeting at a country hotel on the Wirral, and declared a “pathway to a possible Brexit deal”. Over the next 10 days, as European leaders signalled their acceptance of the tweaked terms, the share prices of Royal Bank of Scotland (RBS) and Lloyds Banking Group (LLOY) jumped by a quarter and a fifth, respectively.
By this point, it almost goes without saying that investors’ views of the UK’s domestic banks are inextricably linked to the country’s departure from the EU. The political surprise of the Wirral meeting – rather than a revision in economic forecasts – soon laid the ground for market reratings and analyst upgrades.
Put differently, attitudes to domestic retail banking stocks are highly sentiment-driven. Relief, however temporary, from the prospect of the country bailing out of the bloc without a working deal was enough to drive the busiest day of trading in the shares of Lloyds, the country's largest retail bank (see chart below).
Since then, the sector has held on to those gains, seemingly undeterred by the prime minister’s initial attempts to force a deal through, or the uncertainty created by a general election.
To banks, and the financial services sector writ large, it is difficult to overstate the importance of the likelihood of a deal, and the diminished prospects of no deal. This time last year, we outlined how financial services exports could collapse were so-called ‘passporting’ rights for market access to vanish. Lots of shareholder capital rests on the success of lobbying in the next stage of negotiations.
But it is also easy for investors to get bogged down in the near-term political drama. To the domestic banks, Brexit’s greatest long-term impact is on the outlook for UK economic growth, which has been dampened by weaker trade volumes and inward investment. That dials down banks’ opportunities to borrow and lend, further squeezing the litany of pressures facing domestic lenders such as Lloyds, RBS and Virgin Money UK (VMUK). AN
Offices expect occupancy boost
Despite rising occupancy levels and rental increases across UK offices, shares in landlords have traded at sharp discounts to net asset value (NAV) as fears abounded of a downturn in the domestic economy and for businesses. Some of that gap closed on the news that a Conservative majority had been secured, with the rising certainty that the UK will leave the EU on 31 January and the political malaise will be broken. In turn, the expectation is that businesses – which have been hesitant to put capital to work – will increase investment levels.
That would be good news for the UK’s office landlords and developers, which should stand to benefit from rising occupancy rates in an already supply-constrained market, particularly in London. That could feed through to rents being agreed at levels increasingly above estimated rental values (ERV) and a rise in asset valuations. Our top pick within the sector remains Helical (HLCL), whose portfolio is centred on high-quality Manchester and London offices. The group was already managing to agree new rents at almost 6 per cent above ERV just prior to the election, while the shares – at 453p – still trade at a 12 per cent discount to forecast NAV at the 2021 year-end. EP
Recruiters looking for clarity
The UK has been through the political wringer since 2016, and the only constant throughout the turmoil has been the accompanying uncertainty. As bellwethers for the health of the wider economy, the UK’s recruiters have felt the brunt of subdued client and candidate confidence. The likes of Hays (HAS), PageGroup (PAGE) and Robert Walters (RWA) have reduced their exposure to the domestic market, now deriving more than three-quarters of their net fee income from overseas. But that hasn’t stopped nervous investors punishing the shares in the face of sluggish growth at home. A bright spot for the industry has been the resilience of recruitment in technology and this has particularly benefitted specialist SThree (STEM) – it focuses on the science, technology, engineering and mathematics (STEM) sectors. Contrasting its competitors’ profit downgrades, SThree is guiding to a record adjusted pre-tax profit for 2019.
With the election breaking the parliamentary deadlock, all the recruiters (along with every other industry) will be hoping this brings an end to the Brexit limbo. Alan Bannatyne, chief financial officer of Robert Walters, believes passing the withdrawal agreement will bring welcome clarity, but he remains cautious: “‘Getting Brexit done’ is only chapter one. We still have to do chapter two and beyond.”
A predominantly international focus means the recruiters’ future outlook could rest more on developments abroad. Brexit has shared the stage with the US-China trade war, the threat of a European economic slowdown and ongoing unrest in Hong Kong. With trade tariff uncertainty hitting its larger international clients, PageGroup saw gross profits from China drop by 24 per cent in the third quarter of 2019. The uncertain global macroeconomic backdrop also led Robert Walters to guide that full-year pre-tax profits will be flat on 2018. Despite this, Mr Bannatyne remains upbeat about the group’s prospects next year. “I personally think a US-China trade agreement is far more important to our global business and I’m optimistic that it will happen. If so, I think we will have a good 2020.” That being said, with all the recruiters’ shares jumping on the election result, a positive Brexit resolution would certainly not be unwelcome for both the companies' and investors' confidence. NK
Defence trade looks secure
Europe is not a significant export market for the UK’s defence companies, so Brexit’s impact on defence trade is unlikely to be significant. The UK's biggest defence business, BAE Systems (BA.) which is the world’s largest arms producer outside of the US – regards the UK, the US, Saudi Arabia and Australia as its principal markets. “There is relatively limited UK-EU trading and movement of EU nationals into and out of BAE Systems’ UK businesses,” its 2019 annual report says. “The resulting Brexit near-term impacts across the business are likely to be limited.” Avon Rubber (AVON), a world leader in respiratory masks for defence personnel, earned 76 per cent of its 2019 revenues in the US, compared with 21 per cent in Europe. It says that its US bias has helped to reduce its exposure to the political instability and any trading impact of Brexit.
Defence exports appear safe, then. But the industry isn’t totally immune to Brexit fallout. Independent defence and aerospace analyst Howard Wheeldon expects the Ministry of Defence (MoD) to carry out a strategic defence and security review (SDSR) soon, and observed that the UK’s departure from the EU will have implications for government funding. “Brexit will create such huge change in how the government is able to move forward,” he says. “It will have an impact on defence spending.”
Some of our defence businesses may lie at risk, then. Defence engineer QinetiQ (QQ.) has a 25-year support contract with the MoD worth £1.3bn in revenues, which will last until 2028. Babcock (BAB) has a long list of contracts with the government, such as a recent £1.25bn deal to build five Type 31 frigates for the Royal Navy. Though their contracts are locked down and they have revenue streams from other nations (Babcock has since won a £1bn contract to design weapons systems for the Australian Navy), these companies are likely to be exposed to a Brexit-driven fall in government defence spending – albeit an unlikely possibility. AJ
Frictionless trading would be tariff-ic for automotive sector
Prior to the EU referendum, the UK market was a dream for EU car manufacturers. The UK imported €35.8bn (£29.7bn) worth of cars in 2018, of which 88.9 per cent were from the EU, according to the European Automobile Manufacturers Association. What’s more, the UK manufacturers also rely disproportionately on overseas trade. The domestic market accounts for 18.5 per cent of the UK’s more than 1.5m annual car output, and 50.7 per cent of units go to Europe.
Since the referendum result was announced, the UK’s Society of Motor Manufacturers and Traders has consistently warned that a no-deal Brexit – or indeed any end to all but frictionless trade – would “add billions to the cost of importing and exporting”, putting jobs at risk. Preventing the imposition of tariffs will be the priority for the industry as the UK negotiates its exit.
In light of this, Mr Johnson’s decisive majority could go either way for the auto sector. On the one hand, the size of the Conservative majority will make him less beholden to the hard-Brexit elements within the party and beyond, and therefore more likely to negotiate a ‘softer’ deal. The market has interpreted the result as a signal that the difficulties the sector has faced in recent years are tailing off, sending shares in the auto retailers up in response to the election result. Two of the largest jumps were seen by Pendragon (PDG) and Lookers (LOOK), the companies hardest hit by the difficult trading environment. TD
Brexit is an administrative headache for airlines
Brexit doesn’t appear to have deterred UK air passengers. Of the 1.1bn passengers who travelled by air in the EU, 272m were UK passengers, while Heathrow was the EU’s busiest airport. But airlines are prepared should Brexit trigger volatility in demand for air travel. “Most airlines have built in quite a high level of fleet flexibility,” says Peel Hunt transport analyst Alex Paterson. Airlines have options on purchasing aircraft, as well as leases on jets that they can choose to renew or let expire. “If they wanted to, they could reduce the actual size of their fleet over the next two or three years,” he adds, should negative economic consequences from Brexit hamper demand for flights.
There are more pressing administrative hurdles. Airlines have to be owned by a company or shareholders that are based in the region where they are flying from. Wizz-Air (WIZZ) has therefore had to set up a UK airline, while easyJet (EZY), which already had a UK airline, has had to register a ‘European’ airline in Austria. “There’s a lot of duplicated cost in doing this,” Mr Paterson says.
These ownership rules have implications for shareholders in airlines, which have set out contingency plans in advance of a possible no-deal Brexit. Ryanair (RYA) has said that non-EU-27 shareholders would lose voting rights in the event of a hard Brexit. International Consolidated Airlines (IAG), which is a Spanish company, has capped the level of non-EU-28 investors at 47.5 per cent. “If there isn’t a big enough increase in EU-27 shareholders, then they will have to take away voting rights from non-EU-27 shareholders,” Alex Paterson says. AJ
Brexit comes behind business rates for retail, pubs and restaurants
The timing of the election in the middle of the peak shopping season is hardly ideal for general retail, but with the “stonking” majority returning Boris Johnson to Number 10, the reduced uncertainty is likely to provide a boost for consumer confidence and therefore spending – welcome news for food retailers, pubs, bars and restaurants.
The British Retail Consortium (BRC) joined many others in calling on the government to secure “tariff-free, frictionless trade with the EU”. However, both the BRC, the British Beer and Pub Association (BBPA) and UK Hospitality called on the government to take action on business rates, which the Conservative manifesto pledged to cut.
Analysts from both Jefferies and RBC Capital Markets have been saying a Tory majority would be a boon for retailers, with sterling strengthening against the dollar and euro feeding through to lower import costs. However, a tougher immigration system could mean a challenging environment for UK food producers, hurting the domestic supply chain.
The BBPA has raised similar concerns, saying any future immigration system should take into account the staffing requirements of UK pubs and supports “the necessary levels of staffing”. Nevertheless, shares in pub groups such as City Pub Group (CPC), Young & Co (YNGA) and – perhaps unsurprisingly – JD Wetherspoon (JDW) were all up sharply following the election result. TD
UK farmers still in the dark
The election result may have been decisive, but the future of UK farming remains unclear. Post-Brexit trade arrangements have been a key concern for the agricultural industry, with fears that farmers could lose frictionless access to the key EU export market and see tariffs imposed on their goods. If trade barriers were to be erected, this could also limit the availability of vital farm inputs such as veterinary medicine, fertilisers, animal feed and machinery.
At the same time, if the new government strikes trade deals offering tariff-free access to foreign exporters, an influx of cheaper food produced at a lower cost could see domestic farmers priced out of the market. The National Farmers’ Union (NFU) is looking for high production standards to be enshrined in any future agreements and is calling on the government to create a trade and standards commission “as a matter of urgency”. Consumers could find that imported products do not adhere to the same levels of animal welfare, environmental standards or traceability.
The industry is also looking to make sure it can continue to fill the gaps in its workforce, not just for harvesting produce but also throughout the wider food supply chain. “The labour issue is massive for our industry,” says Stuart Roberts, vice president of the NFU. “A lot of people think we will be able to use technology, and yes, maybe in five, 10, 15 years’ time. But as we sit here at this moment we still need labour.”
Then there’s the question of funding. UK farmers receive around €4bn (£3.3bn) a year under the EU’s Common Agricultural Policy (CAP). Participation in this scheme will come to an end when we exit the EU and the government had previously pledged to match these payments until 2022. What happens beyond that point has yet to be decided – much like Brexit itself. NK
Future pharma arrangements far from certain
The first order of business for government negotiators will be to determine those areas that will require little or no primary legislation to ensure that the UK achieves regulatory consistency with the EU in relation to the pharmaceutical industry. The UK accounts for around a quarter of all clinical trial applications in the EU and is a leader in early-stage clinical trials. The industry is worth billions to the Exchequer, so resolution on the regulatory front will be a priority for negotiators, although the complexity of the existing regulatory regime guarantees this will be a drawn-out process.
The domestic market will no longer fall under the jurisdiction of the European Medicines Agency (EMA), with marketing authorisations from the EMA’s centralised approvals procedure no longer applicable in the UK. Few concrete proposals are in place, but it’s probable that the Medicines and Healthcare Products Regulatory Agency (MHRA) will become the main industry regulator in the UK. The government has pledged that all existing therapies approved under EU law will have their status automatically maintained following our formal departure from the EU. UK companies could eventually be faced with a more complex, costly and time-consuming approvals process, particularly if the UK leaves without a formal trade treaty. It promises to be one of the more fraught areas of negotiation. MR
