Brexit: Deal or no deal
Brexit uncertainties are making stockpicking a difficult task
The meeting of stock-picking and important geopolitical events is never an easy one. Managing the effects of Brexit on continental European stocks is no exception but is nevertheless something that investors are having to grapple with.
Brexit’s impact has been feeding through into corporate behaviour for some time. Prior to any agreement, continental European suppliers have seen a commensurate increase in demand as UK companies increase their inventories faster than order books, hunkering down for a worst-case scenario. However, says Maarten Geerdink, head of European equities at NN Investment Partners, “as a soft Brexit becomes more likely, such UK companies will run down their inventories rather than maintain their purchases, and suppliers will see a reduction in demand over one or two quarters”. On the other hand, if negotiations are prolonged, inventories will likely stay high, so a trail-off in demand will be slower, he adds.
Naturally, how this plays out will be determined by the terms of any deal – if, indeed, there is a deal, which was unclear at the time of writing. Investors now seem more optimistic that some resolution will be reached between the UK and EU, says Lars Kreckel, global equity strategist at LGIM, with the risk of a no-deal Brexit priced out by the market – “although this was very different a few months, or even weeks, ago”, he adds. Geerdink concurs: “It’s looking more and more unlikely that there will be a hard Brexit and a benign scenario is being priced in to equities”.
Another factor in this is how Brexit is affecting where companies invest. A recent study published by the UK’s Centre for Economic & Policy Research found increased investments into the EU at the expense of the UK by more than 10% of new investment since the 2016 referendum. Interestingly, the study found “a sizeable increase in outward FDI [foreign direct investment] for the services sector but none for the manufacturing sector. This suggests that the aggregate effect.… is entirely driven by services”. This aligns with the expectation of Stephen Macklow-Smith, head of Europe equity strategy at JP Morgan Asset Management, that “Brexit could be mildly positive for European equities in the medium turn, as they offer a greater degree of certainty,.
Indeed, says Macklow-Smith, “earnings expectations for Europe are actually better than many areas; the US, Asia and Japan have all seen steep negative earnings revisions”.
Kreckel says that LGIM attempts to quantify the effects on European equities “using a reasonably simple framework: does the company or sector have direct exposure to the UK; what is the direct impact on the euro-zone of different Brexit scenarios?”
So, within this context, what is the outlook for specific stocks and sectors in the event of the different Brexit outcomes?
Geerdink argues that some small European names are particularly vulnerable to a hard Brexit. He gives the example of continental engineering and construction firms, some of which have more than a quarter of their revenues coming from the UK: “There’s more risk in the less-liquid small caps,” he says, “and we’ve consequently been moving up the cap scale from the very small names.”
It is no surprise that companies with the greatest direct exposure to the UK are expected to be hit hardest, a case in point being the auto industry, says Kreckel, “which has done poorly recently”. Nevertheless, this is only one of a series of woes that the industry faces, coming further down a list of negative factors, “including China’s slowdown and WLTP [Worldwide Harmonised Light Vehicle Test Procedure] standards,” affecting emissions.
In the event of any Brexit-driven downturn, investors should expect cyclicals with a strong European orientation, as opposed to being globally diversified, to fare worst. “So, for example, discretionary retail, travel and leisure, European-focused construction and banks look vulnerable,” says Kreckel.
Geerdink also says that it is “easy to see how Brexit will be incredibly disruptive for transportation firms, such as the operator of Eurotunnel”. Indeed, board meetings at Eurotunnel operator Getlink must be grim at present.
Macklow-Smith says JPMorgan is particularly mindful of currency effects at the stock level: “We map stocks on their vulnerability to euro-sterling exchange rate volatility, rather than try and make overarching sector calls. Those stocks that exhibit the greatest vulnerability to such volatility will likely be most negatively impacted by Brexit.”
That said, there are nevertheless particular sectors that are more exposed than others, he says: “For instance, logistics, where we would be cautious until we know how they’re affected.” International Airlines Group, which owns BA, is a particular example he identifies.
Financials is another area to be wary of, as Macklow-Smith worries that Brexit could trigger a credit crunch, “although central banks will likely step in, in the event of this”.
The timeframe one considers affects whether, and to what degree, Brexit is a negative for a stock. So, staying with the example of financials, they are sensitive to a hard Brexit, as this entails potentially significant reallocation of resources, leading to equally significant short-term cost increases.
- UK companies increasing inventories from continental European suppliers have produced an increase in demand for the latter
- Equity managers see small-caps, autos, construction and financials as being particularly negatively affected by Brexit
- On the other hand, logistics and telecoms companies able to structure their businesses to take advantage of increased cross-border complexity could benefit
- The stress is on risk-management rather than alpha-generation in this situation
Where, then, should investors be placing their bets on European equities? Macklow-Smith advises: “Consumer staples such as pharma and beverages are likely to be safe havens, as their earnings are broadly spread.” This ties in with Kreckel’s warning on companies with more regional earnings profiles.
Other potential beneficiaries include integrated solutions providers for logistics: “So, by way of example, Deutsche Post/DHL can offer services that address the increased complexity in shipping across borders. Telcos could also benefit, as they may be able to charge roaming fees again, and so increase charges,” says Geerdink.
How to play
However, for LGIM, this is all relative, as Kreckel does not see any absolute beneficiaries from a hard Brexit, and the asset manager has been reducing long-sterling positions: “It’s a question of avoiding the negatives rather than creating positives. There will be relative beneficiaries, rather than absolute ones.” One way to play this, he says, is to employ long-short strategies to create value – for example, going long exporters, while shorting domestic-cyclicals.
Likewise, for Macklow-Smith, “Brexit is a risk event rather than an alpha event, with the outcome difficult to predict. Positioning to take advantage of a particular scenario is therefore not an effective way to add value.
“We would only take risk where we understand the outcome.” And that outcome, unless you are reading this with the benefit of hindsight, is anyone’s guess.