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Magazine Issues » July-August 2015

EQUITIES: Brexit strategies

BrexitAfter the Conservative victory in May’s general election, Britain’s future in the EU is uncertain. Alix Robertson looks at what a ‘Brexit’ could mean for equities in the UK and mainland Europe.

When it comes to membership of the European Union, all eyes have been fixed on Greece. Its struggle to reach an agreement over €9.2 billion in loan repayments to the International Monetary Fund has dominated headlines for weeks.

With banks closed and proposals for another bailout under scrutiny from Eurozone finance ministers, economists and ratings agencies alike viewed a ‘Grexit’ – Greece leaving the Eurozone – as a growing possibility, until a last-minute Greek capitulation to the European Commission’s demands averted disaster – at least for the time being.

But following the British government’s decision to call a referendum on whether the UK should remain in the EU, the spectre looms of a much larger economy’s exit. This plebiscite is due before the end of 2017 and will be the first of its kind since 1975, when the UK electorate voted 67% in favour of remaining in what was then the European Economic Community. 

A ‘Brexit’ would be very different from the Greek saga. Eurosceptics in the UK call for greater autonomy on issues such as immigration, and to be freed from the economic burden of less successful EU member states. 

Geoffroy Goenen, head of fundamental European equity at asset manager Candriam, says prime minister David Cameron may be able to push for changes to the UK’s position in Europe. “He will put a lot of conditions forward to favour the ‘yes’ and then it’s more a question of power between the centralisation of Europe and the power that UK wants to keep or even change. 

“That will be a very interesting discussion not only for the UK in or out, but for all the construction of the European Union.”

Reactions to the referendum plan have varied. US president Barack Obama has emphasised his support for the UK’s presence in the EU, while in Europe, France has shown concern about indulging Cameron’s calls for “a better deal for Britain”. 

The response from businesses has been similarly mixed. According to reports, Deutsche Bank was thinking of moving some of its UK operations to Germany in the event of a Brexit, while in the asset management industry, Vanguard chief executive Bill McNabb told the Financial Times that his firm would continue investing in the UK even if it voted to leave, adding that the EU would be the one to suffer if Britain pulled out.  

Bruno Taillardat, investment director at Unigestion, believes that without a free trade agreement with Europe, a Brexit would have a much greater impact on the UK than the EU.

“The EU would experience minimal economic consequence, while the UK would likely see a sharp fall in the pound, a drop in exports and London’s prominence as a major financial centre lessen,” he says.

However, given the issues with Greece, he says it is easy to understand why European politicians might want to avoid another country’s exit. German chancellor Angela Merkel and Jean-Claude Junker, the EU president, “seem to be keen to negotiate some relaxation and reforms to the UK’s role within the EU”, Taillardat says.

So, how would equities be affected? Taillardat says that the impact on stock markets could be considerable. “A Brexit would lead to a significant increase in market volatility in the short term, mainly for the UK but also for the rest of Europe. 

“In the medium to long term, a less robust financial services sector caused by a Brexit would definitely weaken Britain’s economy, current account balance, currency and stock market,” he adds.

Brian Jacobsen, a chief portfolio strategist at Wells Fargo Asset Management, expects a firm vote against a Brexit, saying the impact of leaving the EU would be “traumatic” for the UK.

Looking at UK and European equity markets, he says the UK is in a good position, but the outlook for Europe is more optimistic. He anticipates a return of around 7% over the next 12 months from the FTSE but expects twice as much from the Eurozone, putting the MSCI Eurozone index at around 14-15% higher. 

“My concern is that if the UK decides to try to exit the EU, that could be very jarring to the economy and the market as a whole because the UK’s most important trading partner is the EU. To try to withdraw from that I think is almost self-defeating. I don’t know what they would stand to gain by exiting.” 

Paul O’Connor, co-head of multi-asset at Henderson Global Investors, says that once campaigning starts in 2016 the public could become more pro-EU. “I think you’re going to see the government voting in favour of it, you’re going to see all the major parties voting in favour of it, and most importantly you’ll really start to see the corporate sector speaking,” he adds.

Colin Graham, chief investment officer for multi-asset at BNP Paribas Investment Partners, sees the issue from a different perspective. His focus is on the impact on currency.

“Sterling is an overvalued currency relative to the euro across many valuation metrics and a Brexit could be the catalyst for why we see significant weakness on a relative basis,” he says. He adds, however, that UK companies on the stock market have been more cheaply valued compared to their Eurozone peers for quite a while, and have continued to get cheaper.

“From that valuation perspective, one can suggest that some of this Brexit risk and uncertainty is partially reflected in the price of UK corporate assets on a relative basis to Eurozone corporate assets.”

Overall, Graham sees disadvantages for both sides if Britain were to leave the EU. 

“The UK is the fifth-largest economy in the world. The EU as a trading bloc would go from being joint-largest group with the US from an economic perspective to be significantly smaller … Europe would lose some clout in terms of its wealth power and trading relations.”

Graham says uncertainty about the UK financial sector’s ability to passport into the single market has major ramifications. 

“The longer term implications for the service industry are the real concern,” he says, adding that small-cap equities, which tend to trade between the UK and EU, would be more likely to suffer than large-cap, which are more involved with North America and emerging markets.

At RBC Global Asset Management, chief investment officer and senior portfolio manager Dominic Wallington says that with a complex subject like Brexit, it is difficult to untangle fears and ‘spin’ from the underlying facts. 

“Either way, the closest we can come to a judgement on the subject is that our favourite UK companies are unlikely to be dramatically impacted. 

“The desire to obtain a Brexit is driven by factors other than trying to prevent the neo-liberal framework that allows freedom of capital flows, and in general the kind of environment in which international corporations are flourishing.”

Michael Clements, head of European equities at Syz Asset Management and manager of the Oyster European funds, is confident that opportunities will arise from the discussions around a Brexit.

As a contrarian investor, he says that uncertainty and the volatility it causes are not necessarily bad things. 

“My job is to try and take advantage of this. Suddenly, if you can buy good companies much cheaper than they were say three months or six months ago, simply because people are nervous about something like a Brexit, then it might give me the chance to add a good company to my portfolio, with a long-term view.”

He says the most interesting way to play a Brexit is through UK stocks, but adds that there is a need to be careful and understand which companies would be likely to suffer the most, either from sentiment or from deterioration of their trading or competitive advantages.

 He expects that if a Brexit were to happen, those who still wanted to be in the UK would sell export-orientated companies in favour of safer domestic ones.

“We’ll probably do the opposite and ignore the domestic stocks, because they’ll be seen as a safe haven and everyone else will rush for those. 

“We’ll keep an eye on those stocks which are probably where the maximum pessimism and noise will be and see if the market gives us an opportunity,” he says.

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