30 June 2016
No man is an island
The post-Brexit buying opportunity
by Frank O’Nomics
The adaptation of the famous stage direction from The Winter’s Tale to “Brexit, pursued by a bear market” seemed to catch the market mood since Friday morning perfectly. The fact that Janet Yellen, the IMF and the OECD were so concerned by the global economic consequences of the UK leaving the EU is more than sufficient to justify extreme caution when looking at the immediate outlook for most asset classes. $2 trillion was wiped off the value of global stock markets last Friday and even China’s finance minister, Lou Jiwei, has said that “Brexit will cast a shadow over the global economy… The repercussions and fallout will emerge in the next five to 10 years”.
It seems reasonable to ask whether we are losing some perspective here. The UK may have ranked 5th the list of the world’s largest economies until this event, but our GDP is less than one third that of China and only a fraction over one sixth of that of the US. Even if the domestic economic consequences are as bad as many economists have predicted, should this really have a profound impact on the value of assets, many of which have little to do with trade involving the UK? It was notable that on Friday and Monday, the FTSE 100, the earnings of which are significantly outside Europe, outperformed both the French and German markets (the performance of the FTSE 250 has been markedly worse). When it comes to assessing the global economic outlook it seems that more important issues elsewhere will have a bigger impact on the value of stock markets, and may help the UK weather the short-term economic concerns of Brexit. Looked at this way, it seems that markets are very conservatively priced and the downside risks implied by the UK situation may already be overstated. Even when we look at the domestic situation the short-term outlook for the UK may already be over discounted in current stock prices
Perhaps the most important driver of the global economic outlook will be China. Markets have been pricing in the impact of a slowdown in Chinese growth for some time, but the outcome for this year is likely to be comfortably within the Chinese government’s target range of 6.5-7%, which is still a significant number and only marginally below last year’s outturn of 6.9%. Weak private investment has been replaced by a more generous fiscal policy and an acceleration in real estate and infrastructure investment, with retail sales looking as if they could rise by 11% this year. These numbers may be modest by historical standards, but are still substantial when it comes to looking at the impact on global demand.
What about the US? Despite her concerns about Brexit, Fed Governor Yellen has continued to hint at further interest rate rises this year, which suggests that the US economy is viewed as being robust enough to warrant official action. US unemployment has fallen to 4.7%, its lowest level since November 2007, and average hourly earnings are rising at 2.5% per annum. With more people in work finding a greater increase in disposable income, the Fed seems to be well justified in preparing the markets for a rate rise. While a slowdown in Europe will undoubtedly have some impact for the US, it may be insufficient to warrant a further re-pricing of the US equity market.
The Brexit debate was dominated by some fallacious and potentially irrelevant economic statistics which were very inward looking. The £350 million per week that Vote Leave claimed would be saved by our departure assumed that the cash coming back from Europe, for farmers and others, would continue; that is clearly very unlikely. Similarly, the £4,300 per household our exit was alleged to cost is based on a slowing of GDP and the application of very dubious economic logic by suggesting that this would apply entirely to households. The key point is that either of these statistics is relatively minor when one looks at the bigger picture of international trade. The speed at which UK replaces current EU trade arrangements with a series of bilateral trade agreements across the globe will be key in this regard and it will take some time before any of this is clear. In the interim it makes sense to price purely UK equities very conservatively, but most FTSE 100 companies carry out significant levels of trade outside the EU already, so to price down these stocks would seem to be over defensive. There is a better case for marking down FTSE 250 stocks, but as we have seen this has already happened to a large extent.
From a domestic point of view one can argue that much of the impact of Brexit is already in the prices. The slowdown that uncertainty causes has already been reflected in much of the economic data of the last 6 months, with lower purchasing manager’s data and a postponement of transactions. New listings on the London stock exchange total just £1.9 billion in the year-to-date, compared with a figure of £4.6 billion in the same period of 2016. While the last Gfk consumer confidence number for the general economic situation in the UK edged up slightly in anticipation of a remain vote, it is still 13 points below its level of a year ago. A great many deals, whether for corporate entities or households, will have been delayed by the prospect of the Brexit vote, but this does not mean that they will not happen. Some will have been waiting for the cheaper opportunity that a fall in the stock market presents, while others, having been reassured that the world has not come to an end, will be comfortable enough to commit. For the consumer there is the obvious danger of price increase that will come from the sell-off in sterling, but much of this may be off-set if import duties are removed from goods that come from outside the EU – and this can be a net positive if we negotiate bilateral deals with EU nations which ensure that we do not raise tariffs with them.
We should also have some faith in the ability and commitment of government institutions to take steps to prevent Brexit prompting a full-blown domestic recession. The Bank of England still has some (limited) scope to cut interest rates – there are some expectations that this could happen as early as August – and quantitative easing could very easily be restarted. Both these measures would be quite likely to prompt a substantive rally in UK equity markets.
It is important not to loose sight of the forecasts that were made by the majority of independent economic forecasters ahead of the Brexit vote, and it seems likely that the UK will suffer an economic slowdown of some significance. Having written about the uncertainty created by leaving the EU it would be disingenuous of me to now downplay the impact. However, this does not necessarily translate into a global recession, and the strength of other major economies can mitigate some of the short-term impact of Brexit. Further, there is a correct price for everything and the combination of caution resulting from the vote and a sharp sell-off since, may be giving us a very interesting buying opportunity. The fall in the broader UK equity market has been savage, but the chart could turn into something that looks like a Nike “swoosh”.
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