Europe comes to terms with Brexit
Regardless of the UK vote, the world is facing a period of geo-political instability. The referendum took place against a backdrop of low global growth and rising political risks. Anti-establishment sentiment is increasing in the US and Europe, the Fed is quickly back-tracking on further rate hikes, and emerging market uncertainty remains unresolved. Now investors have yet more risks to consider: economic and political risk as the EU faces further disruption and foreign exchange volatility in the aftermath of the Brexit decision.
The FTSE 100 remains above pre-Brexit levels, as defensive stocks and those with dollar earnings lead the way. Even in euro terms the FTSE 100 is holding up well, still out-performing European indices despite Brexit. Consumer staples, energy and utilities are performing well, while banks (like their peers across Europe), insurance, real estate and consumer discretionary stocks have been marked down.
European investors have to cope with a UK political vacuum as they await the announcement of a new Conservative leader and prime minister, and there is still uncertainty about the manner and timeline of Britain’s exit. The sheer number of variables makes it difficult for investors to have any visibility on growth. We believe investors must look for resilient companies, those capable of growth in fragile markets, with robust business models and the ability to control costs. For the same reason, we believe it’s still too early to buy macro dependent stocks, including banks and housebuilders.
Looking through the short-term volatility, some of the consequences such as the devaluation of sterling, could be very positive for the British economy. Other stimuli (such as [chancellor of the Exchequer] Osborne’s pledge to cut corporation tax) could well be introduced if the post-Brexit reaction is too harsh.
While Europe rocks from the political fallout of the UK’s vote, we look ahead to October, when we believe Italy’s constitutional referendum could be even more problematic for the EU. Prime minister Renzi has staked his career on pushing through constitutional change – and as discontent spreads through the electorate in Italy, a failure for Renzi could cede political ground to populist parties, creating further instability.
In the short-term, Italian banks find themselves in an increasingly difficult situation regarding their ongoing non-performing loans, which are equivalent to around 22% of the country’s GDP. Last week we heard rumours of the Italian government bailing out the banks, but this would contravene EU rules which stipulate bail-in of equity and bond-holders prior to such a rescue. Italy is less keen on this option, given that many of those that would be ‘bailed-in’ are retail investors (more than 50% in some cases). In the meantime, Italian bank shares continue to plunge and capital positions remain light.
At the healthier end of the eurozone economy, the German economy remains robust and many German exporters are benefiting from the increased competitiveness of a devalued euro. However, the auto sector may remain under pressure given two additional headwinds: weaker sales in a slower growth Europe, and uncertainty of easy access to the UK market following Brexit. Around 45% of auto sales in the UK are from German manufacturers. Meanwhile, consumer discretionary stocks have been hard hit, as many fear consumer confidence will take a sharp dip given lack of clarity in Europe.
In euro terms the DAX has underperformed the FTSE 100, in spite of the Brexit anxiety and the pound’s significant fall. For all the investor and media focus on the UK right now, we believe a bigger worry for investors in the coming months could be the sustainability of the eurozone.
Underlying all of this is that the UK and EU both have a lot to gain from reaching a new trade agreement, and, as such, pragmatism ought to win through. The re-introduction of tariffs and trade barriers is to no-one’s benefit, and is unlikely in today’s global economy. Longer-term, for the optimists there is the prospect of trade deals for the UK directly with major economies such as the US and China, deals that were only possible before within the EU. In addition, the accommodative comments from the BOE and the ECB have also helped provide reassurance by providing liquidity to markets.
While the markets wait for clarity, sentiment-driven, indiscriminate sell-offs can create opportunities for long-term investors like ourselves in new or existing stocks. We continue to forensically analyse stocks, selecting those firms benefiting from structural growth themes or self-help which can generate growth in an uncertain economic climate.
Economies have a way of recovering from a shock, and business is adept at surviving, so we should not be overly pessimistic about the immediate aftermath of the Leave vote. This is definitely a time for long-term thinking and recognising that value is created amidst upheaval.
Martin Todd is European Equities portfolio manager at Hermes Investment Management