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Macro Letter – No 124 – 20-12-2019

The Beginning of the End of Uncertainty for the UK

  • The UK election result was a clear mandate for Brexit
  • A UK/EU free-trade agreement may not be ready by December 2020
  • Uncertainty remains but real economic progress can now begin

For traders and investors in financial markets, risk and reward are two sides of a single coin. There are, of course, exceptions and geopolitical risk is one of them. The difficulty with geopolitical risk is that it is really geopolitical uncertainty. As Frank Knight observed back in 1921 in Risk, Uncertainty and Profitrisk is can be measured and forecast, uncertainty, cannot: –

Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated…. The essential fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating…. It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.

I have kept this in mind throughout my investing career and it is for this reason that I have avoided investing in the UK stock market since the Brexit referendum. The uncertainty surrounding Brexit has not disappeared, but I now have sufficient confidence in the decisiveness of the incumbent administration to believe that progress can at last be made. To judge by the immediate reaction of financial markets in the wake of the UK election result, I am not alone in my optimism.

To begin, here is a chart of G7 GDP since Q2 2016: –

GDP comparison since 2016

Source: OECD

The UK has fared better than Japan and Italy but its momentum has diminished relative to the remainder of G7.

A more nuanced view of the relative underperformance of the UK is revealed by comparison with Eurozone growth. The chart below, which starts in 2014, shows the switch from UK outperformance to underperformance which began even before the Brexit referendum in mid-2016: –

GDP UK v EU

Source: Eurostat, Full Fact

Whilst there are many factors which have contributed to this change in the UK growth rate, the principal factor has been uncertainty relating to Brexit.

Of course, the direct impact of the Brexit referendum was felt by Sterling. The chart below shows the (Trade-weighted) Sterling Effective Exchange Rate since 2016: –

Sterling Effective Exchange Rate since 2016

Source: Bank of England

The rise since August 2019 appears to predict the outcome of the election, but the currency still has far to rise if it is to return to pre-financial crisis levels, as this 20 year chart reveals: –

Sterling Effective Exchange Rate since 2000

Source: Bank of England

The strong upward momentum which began in 2012 was swiftly terminated by the political morass which culminated in the UK referendum. The unexpected outcome of the 2016 Brexit vote only served to exacerbate the malaise.

The weakness of Sterling merely accelerated the deterioration in the UK terms of trade. The UK has run a continuous trade deficit since 1998 but, as the chart below reveals, the deficit has become structural: –

UK Trade Balance

Source: ONS

Any significant imbalance in trade makes an economy sensitive to changes in the value of its currency. The fall in Sterling since 2016 has had a knock on effect on the rate of UK inflation: –

united-kingdom-inflation-cpi since 2016

Source: ONS, Trading Economics

Viewed from a 10 year perspective, the reversal is even more pronounced. UK interest rates would probably have been substantially lower during the last four years had it not been for the uncertainty surrounding Brexit: –

united-kingdom-inflation-cpi since 2010

Source: ONS, Trading Economics

Is optimism now justified?

Aside from the trade balance, the charts above are a reflection of the discount financial markets have imposed on the UK. This month’s election justifies a rerating. Whilst the markets have not been overly enamoured with the latest Tory Brexit deal they have been craving certainty. A working majority of 80 allows room for any Conservative dissenters to be quashed. Then there is the ‘Corbyn Factor.’ Promises of widespread nationalisation, without clarity about the price with which private investors would be compensated, did not sit well. Neither did the proposed tax increases required to fuel the £80bln increase in fiscal spending. That threat has now passed.

Finally there was clarification of the nation’s opinion on Brexit itself. Labour lost ground almost everywhere; to Tories and the Brexit party in England and Wales, whilst in Scotland they ceded ground to the SNP.

This summation of the UK situation is an over-simplification, but from a financial market perspective the UK political landscape has improved. Suffice to say, there remain many challenges ahead, not least the Brexit transition period (end 2020) during which a free-trade agreement (FTA) needs to be agreed to avert unnecessary trade disruption. After four years, one might hope there has been behind the scenes preparation and that much of the deal will be a slight amendment to current access arrangements. In reality to complete a deal by year-end 2020 it will have to be an ‘FTA-lite’ affair, which may prove less than satisfactory. A swift trade deal should, nonetheless, reduce uncertainty which is also in the interests of the EU. I remain sceptical, there may be many a slip twixt cup and lip.

Conclusions and Investment Opportunities

Four years of deferred investment and consumption will now gradually be unleashed. This should bolster Sterling. As the Pound rises inflation should fall. Assuming they do not give up on their inflation target, currency strength should prompt the Bank of England to ease monetary conditions. Gilt yields will decline, forcing investors to seek longer duration bonds or higher credit risk to compensate for the shortfall in returns. Companies will find it easier to issue debt in order to fuel capital expenditure: although I expect it may lead to more share buybacks too. UK equity markets will rise, driven by an improved outlook for inflation, a lowering of interest rates and expectations of stronger economic growth.

For equity investors, this rising tide will float most ships, but not all companies will benefit equally. Those firms which were at risk of nationalisation have been immediate beneficiaries. The chart below tracks their relative underperformance: –

UK Nationalisation Tragets v FTSE 350

Source: Bloomberg, The Economist

A longer term investment opportunity should be found in the FTSE 250. The four year picture is found below (FTSE 100 in blue, FTSE 250 in red): –

FTSE 100 vs 250 - 4yr

Source: AJ Bell

It might appear as if the FTSE 250 has already caught up with the FTSE 100, but this next chart reveals a rather different picture: –

FTSE 100 vs 250 10yr

Source: AJ Bell

The FTSE 250 is much more closely entwined with the fortunes of the domestic UK economy. For the past four years many business plans in the UK have been on hold, awaiting clarity on Brexit. Now that a deal will be done and an FTA with the EU will follow, we may have finally reached the beginning of the end of uncertainty.

Which parts of the UK economy and which stocks will be the winners from Brexit?

400dpiLogo

Macro Letter – No 63 – 14-10-2016

Which parts of the UK economy and which stocks will be the winners from Brexit?

  • Sterling has fallen to its lowest since 1985 on fears of a “Hard Brexit”
  • UK stocks, led by the FTSE100, have rallied sharply
  • Sectors such as IT and Pharmaceuticals will benefit long-term
  • Even construction and financial services present investment opportunities

If you are in the habit of reading the mainstream financial press you will see headlines such as:-

The Times – Leak of gloomy Brexit forecast pushes pound to 31-year low – 12th October

The Economist – The pound and the fury – Brexit is making Britons poorer, and meaner – 11th October

Over the last three months, this has been typical of almost all financial media commentary. Sterling, meanwhile, has fallen, on a trade weighted basis, to a low not seen since the effective exchange rate index was recalibrated in 1990. At 73.79 it has even breached its close of December 2008 (73.855):-

sterling-effective-excahnge-rate-1990-2016

Source: Bank of England

The recent weakness in Sterling has been linked to the publication of parts of draft cabinet committee papers, suggesting UK revenues could drop by £66bln. From a technical perspective the “Flash Crash” in Cable (GBPUSD) last week has exacerbated the situation, creating the need for the currency to retest the low of 1.18 during normal market hours – the market reached 1.2086 on 11th – more downside is likely:-

gbpusd-2014-2016

Source: DailyFX.com

As the two charts above reveal, Sterling has weakened by 16% versus the US$ and by 18.5% on a trade-weighted basis.

Here is the chart of GBPUSD since 1953. It reinforces my expectation, from a technical perspective, that we will see further downside:-

cable-since-1953-fxtop

Source: fxtop.com

Given the seismic impact of a “Hard Brexit” on the UK economy, it would not be surprising to see a return to the February 1985 low of 1.0440.

I am not alone in my expectation of further weakness, Ashoka Mody – who organised the EU-IMF bailout of Ireland – told the Telegraph this week that Sterling was between 20% and 25% overvalued going into the Brexit vote.

Trade

The EU is the UK’s largest trading partner, accounting for 44% of goods and services exports in 2015 – though this was a decline the on previous year. Of greater concern to the neighbours, is the 53% of UK imports which emanate from the EU. In theory Sterling weakness should benefit UK exports; the impact has been minimal, so far:-

united-kingdom-exports-5yr

Source: Tradingeconomics.com, ONS

Similarly, imports should be falling – they are not:-

united-kingdom-imports-5yr

Source: Trading Economics, ONS

I discussed the prospects for UK growth and the effect of Sterling weakness on the balance of trade in Macro Letter – No 59 – 15-07-2016 – Uncharted British waters – the risk to growth, the opportunity to reform – quoting in turn from John Ashcroft – The Saturday Economist – The great devaluation myth:-

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary.

…1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4 Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5 Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

If Sterling weakness will not improve the UK terms of trade, what will happen to growth? Again, in Macro Letter 59  I quote, Open Europe’s worst case scenario – that UK economic growth will be 2.2% less, on an annual basis, than its current trend, by 2030. Trend GDP growth between 1956 and 2015 averaged 2.46%. Is the media gloom justified and…

Are there any winners?

I concluded my July article saying:-

Companies with foreign earnings will be broadly immune to the vicissitudes of the UK economy, but domestic firms will underperform until there is more clarity about the future of our relationship with Europe and the rest of the world. The UK began trade talks with India last week and South Korea has expressed interest in similar discussions. Many other nations will follow, hoping, no doubt, that a deal with the UK can be agreed swiftly – unlike those with the EU or, indeed, the US. The future could be bright but markets will wait to see the light.

The UK stock market has already jumped the gun. The chart below shows the strong upward momentum of the FTSE100, dragging the, less international, FTSE250 in its wake; yet UK property has been hit hard by expectations of a slowdown in foreign demand:-

ambrosebexit

Source: Daily Telegraph

The obvious winners in the short term are companies with non-Sterling earnings – the constituents of the FTSE100 have an estimated 77% of overseas revenues – 47 of them pay their dividends in US$. The FTSE250 is not far behind, its members have 50% of foreign revenues. This is not dissimilar to the French CAC40 and German DAX. The table below lists the top and bottom ten FTSE350 companies by Sterling revenues:-

10 FTSE 350 companies with lowest sterling revenues
Company Sterling revenues
Vedanta Resources (VED) 0%
Hikma Pharmaceuticals (HIK) 0.20%
BHP Billiton (BLT) 0.30%
Antofagasta (ANT) 0.40%
Mondi (MNDI) 0.40%
Tate & Lyle (TATE) 0.60%
Rio Tinto (RIO) 0.70%
British American Tobacco (BATS) 1%
Laird (LRD) 1.60%
Victrex (VCT) 1.80%
10 FTSE 350 companies with highest sterling revenues
Company Sterling revenues
Saga (SAGAG) 69.80%
Capita (CPI) 70.40%
Wm Morrison (MRW) 70.60%
Booker Group (BOK) 70.80%
Intu Properties (INTU) 71.60%
Home Retail Group (HOME) 72.10%
OneSavings Bank (OSBO) 72.50%
Standard Life (SL) 88.90%
Grainger (GRI) 96.30%

Source: S&P Global Market Intelligence

Some of these companies are not exactly household names. Below is a table of the top 30 stocks in the FTSE100 by market capitalisation as at 28th September. The table also shows the year to date performance by stock as at 12th October:-

Company Ticker Sector Market cap-£mln (28-09) YTD (12-10) >50% Non-£ revenue % of non-£ revenue
Royal Dutch Shell RDSA Oil and gas 149,100 16.33% Yes 85%?
HSBC HSBA Banking 113,455 15.97% Yes
British American Tobacco BATS Tobacco 92,162 28.58% Yes 99%
BP BP Oil and gas 81,196 25.99% Yes 85%?
GlaxoSmithKline GSK Pharmaceuticals 80,629 32.02% Yes 91%
AstraZeneca AZN Pharmaceuticals 64,771 18.72% Yes 93%
Vodafone Group VOD Telecomms 59,259 6.10% Yes
Diageo DGE Beverages 55,931 20.41% Yes
Reckitt Benckiser RB Consumer goods 50,446 20.66% Yes
Unilever ULVR Consumer goods 46,917 32.18% Yes 85%?
Shire plc SHP Pharmaceuticals 45,899 16.56% Yes 96%
National Grid plc NG Energy 41,223 15.14% Yes
Lloyds Banking Group LLOY Banking 39,634 -29.62%
BT Group BT.A Telecomms 38,996 -15.03%
Imperial Brands IMB Tobacco 37,677 13.35% Yes
Prudential plc PRU Finance 35,544 -3.61% Yes 60%
Rio Tinto Group RIO Mining 34,715 6.72% Yes 99%
Glencore GLEN Mining 30,135 94.96% Yes
Barclays BARC Banking 28,089 -34.34% Yes
Compass Group CPG Food 24,528 37.40% Yes
WPP plc WPP Media 23,330 16.44% Yes 87%
BHP Billiton BLT Mining 23,169 5.18% Yes 97%
CRH plc CRH Building materials 21,314 50.45% Yes
Royal Bank of Scotland Group RBS Banking 20,799 -46.12%
Associated British Foods ABF Food 20,481 -27.11%
Standard Chartered STAN Banking 20,403 -9.76% Yes
Aviva AV. Insurance 17,925 -3.27% Yes 60%
BAE Systems BA. Military 16,698 16.87% Yes
RELX Group REL Publishing 15,842 27.83% Yes 85%?
SSE plc SSE Energy 15,548 -1.75%

Source: Stockchallenge.co.uk, Financial Times

The table indicates where non-Sterling revenues exceed 50% and, where I have been able to glean current data, the most recent percentage of international revenues. These 30 names represent 70% of the total market capitalisation of the FTSE100 Index. The positive impact of the fall in Sterling on the performance of the majority of these stocks is unequivocal.

On a sectoral basis this is a continuation of the price action evident in the week following the Brexit vote. The chart below was published by the FT on 29th June:-

ftse350-sectors-29-06-2016

Source: Bloomberg, FT

The underperforming sectors are not difficult to explain. Banks and Insurance companies, despite having international revenues, have been hurt by concerns about the loss of access to EU markets after Brexit. Real Estate remains nervous about a collapse in international demand, now the UK is no longer the gateway to Europe. Meanwhile, the retail and household sectors are likely to suffer as UK economic growth slows, consumer spending declines, inflation – driven by higher import prices – squeezes corporate profit margins and the Bank of England is forced to respond to higher consumer prices with monetary tightening.

Yet, looking at the table below, the dividend cover of the consumer sector is robust and the data we have seen since Brexit – retails sales +6.2% in July and 6.3% in August, combined with the rebound in consumer confidence – suggests that the consumer is what might be deemed serene:-

dividend-cover-ftse350-q4-2015

Source: Daily Telegraph, Highcharts

Other UK economic indicators also seem to be rebounding. Manufacturing PMI was 55.4 in September –its highest level since the middle of 2014. Services PMI, at 52.6, is still expanding and Construction PMI, at 52.3, has returned to growth. Rumours of the death of the consumer may be grossly exaggerated. Even consumer credit, which dipped in July, rebounded in August.

The “Sterling Effect” on stock valuation has more to deliver in the near-term, but once the currency stabilises this one-off benefit will diminish.

Who will the longer term winners be?

It is difficult to assess the long run impact of a “Hard Brexit” without reviewing the WTO – Most Favoured Nation – Tariff schedule for the EU. The trade weighted average tariff for 2013 was 3.2%, but on agricultural products it was a much higher 22.3% whilst it was only 2.3% on Non-Agricultural products:-

wto-eu-mft-tariffs-2015

Source: WTO

A “Hard Brexit” will probably entail a reversion to Most Favoured Nation terms with the EU under WTO rules.

The 18.5% decline in the Sterling Effective Exchange Rate means the cost to the UK of exporting, even agricultural products – excepting dairy – has been priced in. No wonder economists are busy revising their 2016/2017 growth forecasts higher – until Brexit actually happens, UK exports to the EU, and the majority of our other trading partners, will remain incredibly competitive.

Developing beyond this theme, a recent speech – The economic outlook – by Michael Saunders, a Bank of England MPC Member, reminded the Institute of Directors in Manchester:-

…we should not lose sight of the UK economy’s considerable supply-side advantages, with relatively flexible labour and product markets, openness to foreign investment, low-ish tax rates, strength in knowledge-intensive services and hi-tech manufacturing…

And the winners are…

This by no means an exhaustive list – some sectors are an obvious response to the decline in the currency, others are rather less certain.

Tourism – with the UK suddenly an inexpensive destination for tourists from around the world. In 2015, 7.3mln tourists visited the UK, of which 4.6mln were from the EU. Tourism Alliance estimates the UK tourist industry was worth £126.9bln in 2013. The chart below shows the volatile but upward sloping evolution of tourism revenues:-

united-kingdom-tourism-revenues

Source: Trading Economics, ONS

Here is an edited table of the Leisure and Travel constituents of the FTSE350, it excludes bookmakers, travel agents and airlines:-

Ticker Company
CCL Carnival
CINE Cineworld Group
CPG Compass Group
DOM Domino’s Pizza Group
FGP FirstGroup
GNK Greene King
GOG Go-Ahead Group
GVC GVC Holdings
IHG InterContinental Hotels Group
JDW Wetherspoon (J.D.)
MAB Mitchells & Butlers
MARS Marston’s
MERL Merlin Entertainments
MLC Millennium & Copthorne Hotels
NEX National Express Group
RNK Rank Group
RTN Restaurant Group
SGC Stagecoach Group
WTB Whitbread

Source: Shareprices.com

There should also be a positive impact on construction, as many operators, particularly within the unlisted sector, upgrade their facilities to capture the increased demand.

Not all the omens are positive; many of the jobs created by tourism are temporary and seasonal, the impact of a “Hard Brexit” is likely to lead to an increase in average earnings – good for employees, though not necessary for employers:-

united-kingdom-wage-growth-average-weekly-earnings

Source: Trading Economics, ONS

The trend in wage growth has been steady for several years, but as inflation picks up and UK immigration declines, wages will rise.

Value Added Industries such as IT, Technology, Pharmaceuticals – these are growth industries in which the UK has a comparative advantage. Typically their growth is delivered through productivity enhancing innovation. That they will also benefit, from a structurally lower exchange rate, is an added bonus.

Property and Construction should recover strongly – according to the Nationwide, UK house prices increased again in September. Only in central London, where stamp duty increases on higher value properties has undermined sentiment, have prices eased.

The UK has a shortage of residential property. Whether interest rates remain low or not, this situation will not change until there is genuine planning reform. The three largest housebuilders Barratt Developments (BDEV) Taylor Wimpey (TW) and Persimmon (PSN) are all trading with P/E ratios below 10 times. The only real concern is the difficulty these companies may experience in securing skilled manual labour – Barrett Developments source between 30% and 40% of their current workforce from mainland Europe.

There are other companies in the construction sector such as Balfour Beatty (BBY) Carillion (CLLN) and Kier Group (KIE) which will benefit from increased public investment in infrastructure projects. Monetary policy is nearing the end of its effectiveness – although the central banks still have plenty of stocks they could buy. The next step is to pass the gauntlet back to their respective governments’. I believe fiscal stimulus on a substantial scale will be the next phase.

Banking and Financial Services may seem like the last place to look for performance. The regulators have been tightening the noose since 2008 – as the current crisis at Deutsche Bank highlights, this trend has yet to run its course. However, challenger banks and shadow banking institutions, including hedge funds, are beginning to fill the void. In the days before the financialisation of the economy, banking was the servant of industry. The real-economy still needs banking and credit facilities. The oldest of the Peer to Peer lenders (unlisted) Zopa, announced their first securitisation this summer. After a decade of development their business it is finally coming of age.

The CMA – Making the Banks Work Harder For You – August 9th is certainly supportive for the digital disruptors of traditional banking. Government support is no guarantee of success but it’s easier to have them on your side.

You may argue that the success of companies such as Zopa are based on technological advantages but the recent history of banking has been about harnessing technology to increase trading volumes and reduce the costs of financial transactions. Growth in the profitability of financial services is integrally tied to advances in technology.

A final argument for Banks is the FTSE350 Banks Index:-

big

Source: Bigcharts.com

The high in 2007 was 11,263, the low in March 2009, 2,782 – a 75% decline. The index nearly doubled in in the next six months, reaching 5,224 in September of the same year. This June the index failed to break to a new low after the Brexit vote. A base is forming – the banking sector may not have seen the last of fines and regulation but I believe the downside is limited.