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Latest News  27/06/2016

Brexit – What now?

The ‘Leave’ campaign’s assertion that there will be no economic disruption from a leave vote is about to be tested. Investors have reacted swiftly and brutally to the surprise ‘Leave’ EU referendum result, clearly believing that material economic harm will result from the outcome.

Brexit – What now?

 The ‘Leave’ campaign’s assertion that there will be no economic disruption from a leave vote is about to be tested. Investors have reacted swiftly and brutally to the surprise ‘Leave’ EU referendum result, clearly believing that material economic harm will result from the outcome. Whilst share price moves at the market open on Friday, 24th June were extraordinary, with severe dislocations apparent across many sectors, as the day wore on a more rational response was exhibited. Companies in sectors with significant overseas earnings and little domestic exposure, such as pharmaceuticals, performed strongly closing up on the day as investors recognised the potential benefits of a weaker currency on their earnings. Stocks which are predominantly exposed to the domestic economy significantly underperformed the markets, however.  As a proxy for this, it was interesting to note that whilst the more global FTSE 100 Index fell ‘just’ 3.1% on the day, the FTSE 250 Index, whose constituents are generally more exposed to the health of the UK economy, fell 7.2%.

 Overall, sectors most badly affected included banks (-10%), retailing (-10%), insurance (-11%), real estate (-14%) and homebuilding (-25%). Within each of these sectors there was a wide range of performances, none more so than in banks where the global banking giant, HSBC fell just 1%, whilst the domestically focussed Lloyds Banking Group fell 21% (despite having the protection of an exceptionally strong balance sheet).

 So is it credible to believe that the outlook for UK economic growth has deteriorated so sharply to justify these share price moves? After all, at face value nothing will change in the short term as we will remain in the European Union for at least another 2 years and will have full access to the single market during that time.

 In assessing this question, it is necessary to consider the potential transmission mechanism that may result in the very poor economic outcome which investors are anticipating as at the close of business on Friday, 24th June.

 A weaker currency will import inflation making goods ‘on the shelf’, holidays and petrol more expensive to buy, thus diminishing purchasing power.

  • Listed retailers tend to purchase a lot of their goods overseas and sell them in Sterling and therefore retailers’ margins will be under pressure from the weaker currency, whilst demand may suffer as consumers may have less disposable income to spend.
  • Despite the weaker currency making the UK a more competitive place to manufacture goods for export, foreign direct investment will be curtailed due to uncertainty over future access to the single market. This could have an impact on employment and therefore consumer confidence.
  • Diminished consumer confidence and headlines trumpeting an acceleration of house price declines in London (as employees in global financial service companies, buy to let and international investors shy away from the market) could undermine house prices nationally.
  • In such an environment, banks may make it more difficult for borrowers to access mortgages and loans, although interest rates should remain lower for longer.
  • Whilst occupational demand and supply for commercial real estate in London is tight currently, the demand side of the equation may soften thus reducing build activity and the upward pressure on rents. This may signal a turn in the cycle leading to reduced demand from investors and lower prices.
  • If economic growth dips materially in the coming months as a result of the above, the tax take will undershoot whilst the demands on social payments will rise, thus exacerbating an already large budget deficit. A future government may have to take some unpalatable decisions concerning taxes and spending which could undermine growth still further.

 

If the above held true, then the immediate future for the UK economy would be bleak. Crucially however, investors bought, rather than sold, gilts (UK government debt) on the day of the referendum result demonstrating that international investors believe that UK policy makers will continue to manage the economy prudently. These investors, therefore, are looking at the current weakness in Sterling as an opportunity to invest and seem to be prepared to provide the capital required to fill the current account deficit and shore up the currency.

 Therefore we believe that the moves in the share prices of many domestically focussed, economically sensitive companies listed on the London Stock Exchange look overdone and we have been actively topping up those holdings where we believe there is a strong case that the market has over-reacted to the referendum news.

 It must be stressed, however, that confidence must be maintained and this will be difficult where the two main political parties are in turmoil in terms of leadership and policy. We will continue to watch closely for evidence to suggest that this trust is diminishing, and if we see such signs will act decisively.

 It is also worth noting that commentators seem to be unanimous that an exit from the EU is now a given, but should the economic impacts of the leave vote be of a scale currently being discounted by investors then there is an appreciable chance that public opinion will swing against the result. Particularly as the British union is now threatened and our ability to solve the migrant issue by ‘going it alone’ is far from clear.

 A second referendum seems a remote possibility today, but it worth remembering that the Irish voted ‘no’ in a referendum recommending the ratification of the Treaty of Lisbon in June 2008 by a margin of 53.4% to 46.6%, but sixteen months later, after securing a number of concessions, held a referendum which adopted it by a margin of 67.1% to 32.9%.

 By managing global, multi-asset portfolios on behalf of our clients we diversify risk and dampen the volatility of returns. The benefits of such an approach have been amply demonstrated over the past weeks, months and, indeed, years. We believe that by bringing to bear our philosophy of active management (constrained only by our clients’ appetite for risk) and adjusting the level of risk taken in portfolios as the investment cycle evolves, we are well placed to achieve our investment objective, which has always been to protect and enhance our clients’ real wealth over time.

 

 

Hector Kilpatrick
Chief Investment Officer

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