Brexit has been a contentious topic for UK equities for a number of years as UK politicians failed successively to articulate an exit plan. This has weighed on the real economy as both business and consumer confidence plummeted resulting in weakening economic data.
The newly elected UK Prime Minister Boris Johnson had his fair share of controversy as he shut down the UK parliament until 14th October 2019. This came on the back of a ruling by the Scottish inner house showing that the UK Prime Minister misled HM the Queen.
This was deemed to have been done in order to prevent sufficient time for proper consideration by the UK parliament on the UK’s withdrawal from the European Union. The Prime Minister insists that by 31st October 2019, the UK will exit the EU. Even though the date is close, the same stumble blocks remain in place, namely, the Irish back stop.
The much dreaded ‘Hard’ Brexit risk can come to fruition if no accord is found up until the end of October. An easily accessible indicator to determine the uncertainty surrounding Brexit is the EUR/GBP currency performance. A stronger Sterling currency against the Euro means that Brexit risk has softened and vice-versa.
As observed last week, Jean Claude Juncker (European commission president) struck a positive tone on the current Brexit negotiation proceedings, the Sterling jumped c. 1% against the Euro.
Conventional finance predicates that valuations are based on the present value of future cash flows. In order to determine the present value (i.e. fair price of a company), there are two key determinants, i.e. growth and cost of equity. This varies per company depending on the specific business risk and macroeconomic environment.
How does a ‘Hard’ Brexit feature in a valuation?
Invariably, Brexit uncertainty has a direct impact on the total capital investment carried out by UK companies. An inverse relationship between Brexit uncertainty and capital expenditure exists for UK companies. Interestingly, data for the first half of 2019 shows that FTSE 100 companies spent the most on capital investment, since 2016.
The possible cause could be that UK companies were bound to increase their capex following years of underinvestment with favourable financing conditions in Sterling terms (as year-to-date yields fell in line with global yields).
Capital investment is an essential tool for future business growth, as it serves as the basis to maintain and/or grow the return on the company’s capital. In an environment where longer-term capital investment is down-trending, the economy is bound to feel the brunt in line with corporate earnings. Capital retention and allocation play a key role for corporate expansion.
Brexit undermined this process, resulting in a slowdown in corporate earnings growth. The slowing growth factor on corporate valuation translates in lower valuations. On the other hand, the cost of equity is positively related to Brexit risk.
Specifically, Brexit could be viewed as a risk premium in addition to the other normalised risk premium factors accounted for in traditional corporate valuations. This means that as Brexit risk increases, the cost of equity for UK-based companies’ increases resulting in a fall in the company’s equity returns.
Mitigating Brexit risks for the investor’s equity portfolio …
A glance towards price to earnings multiple, the FTSE 100 remains cheaper compared to other developed markets. This is the result of the Brexit saga which crippled both economic and business data.
Although opportunities lie ahead as developments change the overall equity positioning, investors in UK equities have to immunise their risk from any Brexit fallout by regionally diversifying their equity exposure. Investors have to keep in mind that politics is often an unknown and is unpredictable. In setting equity positions, particularly in this case, always hope for the best, but prepare for the worst.
This article was issued by Jesmar Halliday, Discretionary Portfolio Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.