REACTION TO THE REFERENDUM
It was plain to see by the stock market’s initial reaction to the referendum result that investors had not expected the UK to vote to leave the EU. While investors may instinctively feel that it is the ‘wrong’ result as far as companies and the economy are concerned, we believe it is important to avoid conflating the belief that the outcome was the less favourable of the two possible ones with a determination that the result is, by definition, cataclysmic.
While 48% of voters at the time of the referendum believed that the UK would be better off by remaining in the EU, 52% clearly believed the country would be better off on its own. Our job as fund managers is to set aside the emotional debate, and to make our assessments on the basis of facts.
As has been widely observed, the UK’s legal status as an EU member remains unchanged until Article 50 of the Lisbon Treaty is invoked. Against this backdrop, in the near term, we believe there are two key considerations for investors, namely inflation (as a consequence of the depreciation of sterling versus other major currencies), and uncertainty.
With respect to inflation, the movements in sterling exchange rates already contain a good deal of information. At the time of writing (29 June), the pound is down just over 8% versus the greenback, year-to-date, having been down as low as 11% year-to-date in the aftermath of the result.
The Bank of England estimates the pass through from exchange rate movements to UK inflation of around 20% to 30% and we think these effects typically take around 18 months to feed through. As such, we should expect inflation to spike towards the end of 2017 and in to 2018. Such a rise in inflation (albeit from a very low base) would, in theory, impact on economic growth, as real purchasing power is eroded. However, it should be noted that the Bank of England has historically tended to overstate the forecast effect of currency moves on inflation, because in reality businesses tend to struggle to pass on higher input costs to consumers in low-growth environments like the one in which we now find ourselves. As such, while inflation may impact on corporate profitability, its detriment to economic stability may in fact be more muted.
The question of the extent and duration of the uncertainty now hanging over the UK economy is harder to answer. The starting point of this debate must be the impact that the UK’s current uncertain status will have on business investment and consumer confidence.
We expect job creation to slow significantly, from the current level of approximately 500,000 per annum to a figure in the region of 100,000-200,000 per annum, as businesses defer investment decisions. Such a scenario would clearly dent consumer confidence, but probably to a relatively limited extent.
We also believe, importantly, that banks will maintain the supply of credit to the economy, meaning that a re-run of 2008 is very unlikely, in our view. Indeed, the uncertainty over the UK’s status is more likely to impact on demand for credit than on supply.
It is worth noting that there is much that any new government can do to stimulate demand, including, for example, implementing a cut to stamp-duty land tax, extending the housing ‘Help to Buy’ scheme, or reducing VAT.
In terms of business investment, we would expect the impact of the uncertainty to be felt over an extended period, rather than as a short, sharp shock, meaning in turn that any downward pressure on GDP should be more manageable. UK GDP had been growing at a rate of around 2% per annum before the referendum; in its aftermath we now expect to see a growth rate closer to 1% in 2017. In short, we expect an economic slowdown, but not a meltdown.
The mid-cap market was especially impacted by the unexpected result of the referendum, initially sustaining a roughly 15% drawdown before recovering somewhat in the following days.
The biggest area of weakness was UK domestic cyclical businesses, including housebuilders, real estate firms, financials and retailers, all of which saw share price declines of between 20-40%. In our view, at such levels, these stocks are pricing a recession. If our view – that the economic growth rate will halve to approximately 1% per annum next year – turns out to be correct, then these stocks are excessively cheap, and have become a buying opportunity. Nevertheless, we recognise that there may be challenges to our base case, and as such within the portfolio we believe it is appropriate to proceed with some caution.
CHANGES TO THE PORTFOLIO IN THE LIGHT OF THE RESULT
Following the announcement of the result, we initially sought to reduce the fund’s exposure to domestic cyclical stocks, and in some cases proceeded with some sales. However, given the pace and scale of share price moves, we subsequently halted our activity, believing that price falls had been excessive, and that if anything, buying opportunities were starting to present themselves.
This activity took the fund’s cash balance from approximately 5% to around 9%. We will look to begin putting this money to work from here, selectively buying as opportunities present themselves. At the stock level, we sold our holding in Dixons Carphone. We reduced the fund’s exposure to Wizz Air, and sold some shares in Barratt Developments at higher price levels.
PORTFOLIO POSITIONING, RATIONALE AND OUTLOOK
We continue firmly to believe that the core of the portfolio is positioned in a manner that is absolutely appropriate for the environment in which we now find ourselves.
For quite some time now, the fund has been positioned with an overweight exposure to structural earnings growth and high cash return stocks. If anything, our conviction that overweighting such businesses in the present environment has been strengthened further by the referendum result.
Indeed, we believe that in the present low UK and global growth environment, where monetary policy looks set to remain loose for an extended period, and with further quantitative easing likely, having an overweight exposure to earnings growth and high cash returning stocks should continue to give the portfolio the potential to generate superior returns.
Based on our own analysis, we believe that the stocks in our portfolio have the potential to generate an average level of profit growth of around 15% in 2016 and again in 2017, against an underlying level of, we think, no more than 3-4% per annum in the broader UK mid-cap market.
Relative valuations between the mid- and large-cap markets are now at levels similar to those last witnessed during 2008-2009, in the darkest days of the global financial crisis.
Clearly, the starting prices of stocks held in the portfolio are now materially lower than they were before the referendum, with performance being negatively impacted by holdings in the housebuilders Barratt Developments and Taylor Wimpey, real estate firms such as Workspace and Capital & Counties, and the challenger banks Shawbrook and OneSavings Bank. Nevertheless, in the event that the UK avoids a recessionary situation, and that our earnings outlooks for the stocks we own in the portfolio prove to be correct, the fund should have the potential to generate substantial upside from present levels.
Meanwhile, consumer names like Card Factory and Pets at Home are fundamentally defensive retail businesses prospectively offering high single-digit dividend yields, based on our analysis. We remain confident that the stock prices of these businesses will recover from here with time.
We also remain optimistic over the prospects for the fund’s two largest holdings, namely Paysafe and Just Eat. Paysafe’s earnings should benefit from a substantial currency-related gain following the weakening of Sterling, although this is yet to be reflected in the stock price.
In the case of Just Eat, although the majority of the company’s profits are derived from the UK, we see the investment case as continuing to be driven by an unstoppable shift in consumer behaviours, from telephone to online-based ordering in the take-away food market. We do not expect the effect of the Brexit decision to have a material impact on Just Eat’s business.
In conclusion, we remain firmly of the view that the portfolio is appropriately positioned for the present environment. We are also confident that the fund’s current relatively high cash levels will enable us to buy into promising businesses at highly attractive valuations given share price weakness in the aftermath of the vote. Given a following wind if our economic outlook is correct, and against the backdrop of a meaningful discount in the mid-cap market relative to the large-cap market, we consider that it is far from unreasonable to believe the portfolio has the potential to perform very strongly from here.