In some ways, the next two weeks will provide us with our first glimpse of clarity over the post Brexit landscape as the interim results reporting season gets into full swing. This week alone, almost one third of the FTSE100 Index’s constituents will report on trading. Whilst the sales and profit numbers themselves will be almost exclusively based on pre-Brexit activity, we will have more colour on current trading in the month since the EU vote than at any time before now.
The reporting season may well help in further calming some of the more hysterical share price reactions post the vote, as the short term realisation that the sky has not fallen in morphs into received wisdom. It is entirely possible to believe in both the positions: that the UK would have been much better off remaining in the EU, yet still realising that its future is perfectly credible outside the trading bloc. Indeed, the Leave camp have used the rise in overall stock market values since the vote as a foretaste of the sunlit uplands that come with Brexit. For Remain, it is vindication that Britain is still open for business.
But it would be wrong to be complacent. There is a lot of water to flow under the bridge, and it will take a long time to get there. There are two key issues that we need to get our heads around. The first is, where are the short term risks to economic activity? In contrast to the initial stock market view – which focused mainly on marking down UK consumer related companies – we believe that the first signs of weakness are likely to be felt in the corporate space. Hiring and capital expenditure decisions are likely to be delayed or postponed in many board rooms across the country as executives wait for the landscape to clear. At the level of the individual, however, excluding large-ticket, medium term purchases things are likely to carry on pretty much as they were. Key determinants of what drives consumer expenditure is employment, real wage growth, and the cost of servicing debt (mortgages). Whilst we feel that new hiring might wane, there is much less risk of unemployment rising materially. Equally, real wage growth may moderate, without actually going into reverse, and the MPC’s actions at the next policy meeting are likely to put further downward pressure on interest rates. In our opinion, we are unlikely to get a severe consumer-led recession, but business investment will (at least in the short term) remain behind where it should be at this stage in an economic cycle.
The second issue relates to overseas activity. Before Brexit dominated everyone’s consciousness, there were legitimate worries over the rate of monetary policy tightening in the US, and its consequent impact on capital flows in emerging markets – particularly on a Chinese economy with an increasingly debt laden financial structure. These concerns may be further to the back of our mind – but the reality of the challenge they pose has not altered.
At the time of writing, the UK equity market has delivered some 8% return since the start of the calendar year. However, in US Dollar or Euro terms it is still circa 3% below the level on the first day of the year. As UK investors, we have simply benefited from converting foreign currency assets back into a weaker pound. Similarly, other markets that have shown positive returns this year (the US and Germany) owe much more to falling bond yields than rising earnings in generating these returns. This is not a basis for high quality equity investment returns, and remain vulnerable when (if?) bond yields finally revert back to a course of normalisation.
Politically, we have taken some comfort from the speed at which the Conservative Party resolved its leadership position, and the governing political landscape looks as if it could be settled until 2020. That is in contrast with the other main economies. In the next 15 months we will see Presidential/Chancellor elections in the United States, France and Germany, and an Italian referendum on constitutional reform that will see its government fall if it does not get the result it is pushing for. Overarching this will be the UK’s negotiations with the EU over the terms of its departure. Our baseline case is that the UK will start the process with “We want access to the single market, but want to limit free movement of labour”. The fairly swift response will be “Non”, “Nein” etc. And at that point, a game of chicken will ensue for the two years following the triggering of Article 50, with both sides believing that the other will blink. Only as the 2 year deadline approaches (and probably passes) will we see frantic, but substantive, work on what Brexit really means.
So, political clarity is some way away. The phrase “new normal” has been used to describe many scenarios since the onset of the Great Financial Crisis. This is another one. Economic agents (businesses, consumers, governments) are going to have to get used to an uncertain political landscape that is going to last for some time.
There is an upside. Businesses may sit on their hands for a quarter or two, but it is not in the nature of capitalism to rest idle. The pressure to act – to invest, to innovate, to streamline, to acquire, to build – is irresistible. Managements typically do not have the luxury of sitting out their markets until investments are fail proof. Competitive pressures mean companies need to keep going.
Which is why the next two years still offer upside. We have a tendency to be monotonous in our claims that long term equity investment is best placed in businesses with strong market positions, high internal rates of return, and above all with strong cash generation. It is no guarantee of quarterly outperformance; but over the medium and long term, the compounding up of internal investment and the strategic optionality conferred by strong cash flows makes a difference. As we have seen with recent corporate activity, it also makes them very attractive.
Politically, in the UK the last month has been earth shattering in the way EU referendum has rent political faultlines open. The economic impacts, whilst not downplaying them, will be played out much more slowly. As a result, previous concerns are still pertinent. Excessive valuation in certain sectors and systemic risk from dislocation in developing markets probably do not get the attention they should at the moment. In the UK, it is time to start working out who is best placed to capitalise as the fog of uncertainty gradually clears.