At a live event in London on 28 June, Richard Buxton, Simon Murphy and Richard Watts of the Old Mutual Global Investors UK equities team discussed the far-reaching implications of the referendum on EU membership.
Richard Buxton is head of UK equities and manager of the Old Mutual UK Alpha Fund; Simon Murphy is head of UK large cap and manager of the Old Mutual UK Opportunities and Old Mutual UK Equity funds; and Richard Watts is manager of the Old Mutual UK Mid Cap Fund.
They said that while further volatility is likely in asset prices and the economy will probably slow, at least in the short term, the referendum result presents opportunities as well as risks for investors. The fund managers also stressed that cool heads are essential when markets are moving rapidly and uncertainty reigns; indeed, they plan to ‘keep calm and carry on’ as they continue to assess the impact of the vote and seek to add value for clients.
We outline below their views on how the so-called ‘Brexit’ has altered the macroeconomic and market outlook, as well as detailing changes to the portfolios they oversee.
The UK economy, which was already slowing, may grind to a halt, the fund managers believe. Businesses are likely to defer hiring, capital expenditure and investment decisions amid the political and constitutional upheaval and due to the lack of clarity over the eventual nature of Britain’s trading relations with the EU.
This state of affairs will probably continue for some months – at least until there is a new government in place to negotiate the EU exit and formulate a policy response to the slowdown. Unfortunately UK economic weakness will take place against a backdrop of fragile global growth, as the US struggles to keep its economy on track, the euro area remains troubled and China tries to rebalance its economy.
While UK-based businesses are unlikely to abandon the country, there will probably be job losses as positions are shifted to the continent. Financial services may be one of the sectors hardest hit, as the euro area tries to drive business to Paris and Frankfurt.
The devaluation of sterling should boost exporters, but an accompanying rise in inflation may dampen consumer spending. Both fiscal and monetary stimulus is probable at some point, which is likely to add to the pressure on the currency as tax receipts contract and government borrowing grows.
Ensuring the supply of credit to the economy continues will be essential; mortgage approval and housing transaction data over the coming months should indicate the degree to which banks are making credit available and demand is holding up.
THE STOCK MARKET
Further volatility in the UK equity market is to be expected as investors adjust their positions to the evolving political and economic environment, the fund managers believe. It also seems likely that there will be shift in sector leadership, with more defensive areas outperforming.
There are some reasons to be more optimistic, amid talk of another referendum, the prospect of further clarity on Britain’s future trading relationship with the EU and the chances of a decisive policy response before next year. Meanwhile, the ‘search for yield’ continues – especially in light of the compression in gilt yields – so investors will still need to accept a level of risk if they are to achieve their income objectives.
The FTSE 100 index is relatively cushioned, as about 80% of its earnings are derived from overseas, which will flatter company profits in sterling terms. The large-cap market is also more defensive in nature. The smaller FTSE 250 index is more sensitive to the domestic economy, as is evident from its steeper post-referendum declines, with some 50% of its earnings from the UK.
For the near-term, negative sentiment may persist. Even if there are moments of optimism, these are more likely to contribute to a whipsawing effect than to an immediate reversal of losses.
- Housebuilder shares have slid as the market appears to be factoring in price and volumes declining by about 5%, which could impact profit margins by as much as 50%. (There may have also been a degree of indiscriminate selling, though, as the market looked for a pressure ‘valve’)
- Banks have also struggled as investors price in possible interest-rate cuts by the Bank of England (BoE), which would crimp margins, and lenders face a possible rise in impairments. But a re-run of the scenario last seen in the early 1990s, when repossessions rocketed, is unlikely. A decline in profits of about 25% in the big retail banks looks realistic – and this is reflected in the recent reduction in share prices. Anything much beyond this would look ‘overdone,’ and may well represent a buying opportunity
- Life assurers will continue to be impacted by persistently low bond yields, while non-life insurers will suffer much less, as their liability profile is typically very much shorter. All financial services firms exporting services to the EU now face increased uncertainty over the future of ‘passporting’ rights
STERLING AND GILTS
The pound may fall further as signs of the expected slowdown come through, and following any stimulus from the BoE or Treasury. While the trade deficit may improve, the budget deficit will inevitably worsen as the economy deteriorates.
Elsewhere, gilts have shrugged off downgrades by the ratings agencies, with yields dropping across the sovereign curve – in a sign that investor demand for UK debt remains robust. And despite this move, gilts still appear cheap versus the bund market, where many yields are in negative territory.
WHAT TYPE OF POLICY RESPONSE – AND WHEN?
Although monetary policy is likely to be limited in what it can achieve, given the level of accommodation already in place, the BoE may cut rates as something of a token gesture. The central bank is also expected to expand its quantitative easing programme.
More helpful to the economy, however, would be fiscal easing by the Treasury. There a number of steps that, while expensive, could be taken quickly to boost consumer and business confidence; cuts to taxes on petrol and stamp duty on housing, for example.
What we may eventually see is ‘helicopter money,’ whereby the BoE prints money to make direct transfers to the private sector or to finance government schemes such as tax cuts or infrastructure projects. The monetary guardian is likely to wait for the Federal Reserve to take the lead on any such unorthodox action – a real possibility in the event that Donald Trump becomes the next US president.
In any event, coordinated action between the world’s major central banks will probably need to wait until after the US election in November.
Within equity portfolios, the art will now be to balance the overarching macro risks with the risk of being too conservative in the event of more-positive-than-expected news.
- Within the Old Mutual UK Alpha Fund, Richard Buxton has taken some money off the table by selling down life insurance holdings. He has not touched his bank holdings, favouring patience given a lack of the solvency or liquidity issues seen in 2008
- Simon Murphy has not taken material action in his portfolios, which were both defensively positioned ahead of the referendum. The Old Mutual UK Opportunities Fund has performed well by having been short the UK market into the vote. He will reassess positioning as opportunities emerge
- In the Old Mutual UK Mid Cap Fund, Richard Watts has raised cash levels by 3% to 8-9% by paring positions retailers and housebuilders; following the falls in the share prices of the latter, he is now inclined to add exposure. The portfolio is positioned for a relatively low growth economic environment in the UK and globally
THE POLITICAL OUTLOOK
Rarely in living memory has the UK political scene been in such a state of flux: as Conservative MPs jockey to replace David Cameron, the Labour opposition is imploding. The UK is yet to begin negotiating its departure from the EU, for which it would need to trigger Article 50 of the Lisbon Treaty – an event that is only likely to happen once a new prime minister has been chosen.
The contours of the final deal between the Britain and the EU are shrouded in mystery. An ‘EU lite’ status looks remarkably similar to membership of the European Economic Area. There is a precedent for this in Norway, but the UK would still have to contribute economically and agree to free movement of people, while having little or no influence.
The next Tory leader should probably be someone from the Leave camp, and Leave voters can be expected not to look favourably on an ‘EU lite’ arrangement. Nor would they welcome a second referendum on EU membership.
There is also a risk Britain may not end this process in its current form, given the pro-Remain votes in Scotland and Northern Ireland. The Scottish National Party is now considering a second referendum on independence, although it is unclear how much enthusiasm there actually exists for such a vote as an independent Scotland may need to join the euro. The euro area has yet to resolve its structural issues, of which a struggling banking system is a symptom.
The referendum has also underscored some broader themes that run through most developed nations. Voters are hugely disillusioned with politics, but also with globalisation and immigration. The latter two processes are actually in part the consequence of a digital and technological transformation: people use Amazon but bemoan the loss of their High Street. Withdrawing from the EU will not stop this.
Still, the decisions taken over the coming months will bring some clarity to the political and economic outlook. Once the uncertainty fades, the UK will doubtless capitalise on its considerable resources to power ahead; and the Old Mutual Global Investors UK equity managers will remain alert to the opportunities and vigilant to the risks as this story unfolds.