Capital allocation post Brexit: Into the unknown

A blog by Mark Gregory and Michel Driessen, Partner & Markets Leader, Transaction Advisory Services, EY

There is no precedent to guide capital allocation post Brexit, so don’t rely on the standard macro response, look beneath the surface for the long-term opportunity.

Brexit is unique…

There is no previous event for us to compare Brexit to. No developed country has chosen to inflict a shock of the nature of Brexit on itself.  While there is currently a great deal of noise about what the UK can and can’t do and what the impact of Brexit might be, the reality is that no-one can be sure.

…so don’t rely on the markets’ reaction…

The financial markets appear to have stabilised after the initial shock of the referendum result. But don’t be fooled. There is currently very little post-vote information on which to develop an accurate view of the future. The markets are guessing just like everyone else.  As we saw, after stabilising post-vote, sterling soon came under pressure when the first release of PMI data after the referendum painted a negative picture.

It will be the end of the summer before we have sufficient economic and financial data to develop a clear view on the state of the economy and our prospects. Now is as good a time to have a holiday, sudden decisions based on little information are as likely to destroy value as they are to create it.

…as their initial response was not very sophisticated…

The early market reaction was exactly what we would expect: a traditional response to a forecast economic slowdown:

  • Sectors and companies reliant on domestic growth were marked down;
  • By contrast, companies with exposure to export markets, especially emerging markets, were seen as benefitting from the falling pound;
  • Large cap stocks were favoured relative to smaller companies.

Chart 1

Chart 2

Things have moved a little as shown below but the market continues to favour defensive sectors and companies likely to benefit from a lower exchange rate. There has been some adjustment as demonstrated with the relative repositioning of healthcare and telecoms, possibly reflecting the potential risks of lower migration on staffing from the former and possible regulatory pressure on the latter. Deeper analysis is still required.

Chart 3

…failing to reflect the specifics of Brexit…

At first sight this appears rational, it is certainly conventional. However, Brexit could well be different as the changes in trade, migration and regulation that will come as a result will impact sectors in different ways and these may not be the same as the traditional impact that results from a general economic slowdown.

… And other potential major shifts in policy.

Brexit is a political rather than economic shock and the political shock may turn out to be more significant for capital allocation than Brexit itself. The change in UK Government policy post the referendum vote may turn out to be at least as dramatic as the move to leave the EU, if not more so.

Reflecting on the nature of the vote, the new Prime Minister has signalled her intention to make the UK economy work for everyone. In so doing, she explicitly acknowledged that more intervention in the economy than has been the case in recent years may be needed to achieve this. The new Chancellor of the Exchequer has also indicated that he would be willing to adjust the UK’s fiscal strategy to support the economy if required, another significant departure from the past.

It is possible therefore that fiscal policy will be able to mitigate other forces that are slowing UK growth. While a more ambitious industrial policy will stimulate growth in selected sectors and regions. Brexit may be an economic shock but Government policy may mitigate this and help the UK adjust more effectively to a changing world. The key implications for investment are:

  • Government spending and intervention may have a differential impact on sectors; and
  • It is not yet clear there will be a full scale economic slowdown, consumer spending may hold up better than business investment anyway, especially if public spending mitigates any slowdown in business investment.

…and Brexit is not the only change in the global economy…

The UK leaving the EU is not the only source of change and uncertainty in the world today:

  • Overall global growth has slowed driven by a significant slowdown in the emerging markets;
  • China is embarking on a major reshaping of its economy and its growth has slowed, although it remains relatively high;
  • The BRICs are no more, Russia and Brazil are both facing difficult economic conditions but India is growing strongly;
  • Capital has started to move back to the developed world as investors rebalance their portfolios.
  • The UK referendum result is just one example of an increasing challenge to globalisation and its perceived consequences.
  • Digital technology is increasingly being used to disrupt traditional business models

Focus on the future.

The future opportunities for UK based businesses will be determined by the interplay between the Brexit negotiations, Government policy and the UK economy against a backdrop of change in the global environment. A traditional macro view of M&A based on the key macro drivers alone and failing to take policy shifts into account may provide the wrong guidance.

Key investment themes

There are a number of themes for investors to explore in this complex UK landscape:

  • Infrastructure: existing assets may benefit from higher inflation which will support increased end user charges under price cap regimes, as well as lower financing costs. There is, however, a risk of higher staff costs if immigration controls restrict labour supply.
  • Government & new infrastructure: In an era of low inflation and relatively cheap finance, if the public sector does become more interventionist and commissions new projects and infrastructure schemes, there could be significant opportunity. A new runway in the South East, more road and rail schemes are possible and offer investment potential. Businesses with a presence in the sectors supplying these infrastructure projects could offer interesting opportunities.
  • Longer term exports: Global growth is slower than in the past but the recovery in the USA remains robust and India and China are both posting healthy GDP growth figures relative to other countries. It is likely that the UK will be able to secure trade deals with at least some of these countries on leaving the EU and hence the potential trade benefits go beyond the short-run gain from a fall in sterling already factored in to market valuations – there is potential upside. Now might be the time to consider acquisitions or joint ventures to create or increase exposure to these export markets ready for life after Brexit.
  • Industrial policy: The UK Government has indicated it will be pursuing a more active industrial policy. That policy is likely to favour capital intensive, knowledge based sectors that have the potential to use technology to enhance the UK’s competitiveness relative to labour intensive countries. Sectors that offer the potential to create employment opportunities outside of London could find public support is available because of the desire to rebalance economic activity geographically. Our regional economic analysis has identified Electronic and Optical products, Motor Vehicles, Machinery, Clothes, Paper and possibly Food as sectors which could provide the best regional growth opportunities.
  • Industrial supply chain: With the new lower level of the pound likely to be the norm for a significant period of time, favourable financing, and additional support, such as incentives or changes to business rates, reshoring and import substitution could become attractive propositions. If this can be allied to export growth to new markets there could be a win-win for certain sectors. Our previous work on Reshoring suggests Electronic and Optical products, Aerospace, Paints and Varnishes, Pharmaceuticals, Chemicals, Motor Vehicles and Paper were all interesting sectors worthy of consideration.
  • Digital enabler: Digital is not a new theme but there is potential for a new focus post-Brexit. If policy does move to a greater focus on industrial development then digital technology will become very important as an enabler. While there is a major focus on “the internet of things”, digital businesses that offer the potential to transform industrial processes and help address potential labour shortages if immigration is reduced would be potentially very attractive.
  • The new consumer: The outlook for consumers is uncertain. Some of the early post-referendum confidence data suggested a slowdown in consumer spending is imminent. On the other hand, Ipsos Mori reported that consumers were less negative about the short-term impact of Brexit and more positive about the long-term than before the referendum. Policy may soften the slowdown in spending, welfare reform appears to have been pushed back and more support may be forthcoming in the Autumn Statement. If the government is able to mitigate the impact of the initial Brexit shock then consumer and retail sector valuations may have fallen too far.

Look to the long-term for Brexit opportunities

Brexit is a major shock and there is significant uncertainty about the immediate outlook for the UK economy. However, the picture is becoming clearer as the new administration finds its feet and senior level meetings with other European leaders take place.  Despite the short-term uncertainty, we can begin to paint a picture of some of the likely long-term developments around trade, industrial policy and other policy initiatives. These do lead to potential opportunities which look different to the short-term market signs. There is clearly risk attached to any long-term strategy but moving now to create future options is worthy of consideration.

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