The decision to leave the European Union (EU) is likely to push the U.K. economy into recession as business and consumer confidence plummets. Few pundits expected a “leave” result in the so-called “Brexit” referendum, so there were no plans in place to deal with the financial and political fallout that has followed the vote.
But uncertainty also can create opportunities as the prices of shares in solid companies drop by more than is justified. Still, “it’s not a market for the faint of heart, as there is likely to be big downs in share prices, as well as big ups,” cautions Wendell Perkins, senior portfolio manager at Manulife Asset Management (U.S.) LLC in Chicago.
One positive aspect is the rapid handover of power following the resignation of David Cameron, the U.K.’s prime minister. With new leader Theresa May becoming prime minister on July 13, some of the confusion created by the leave vote has been addressed.
“The surprising and quick rise of May has been good for the global markets, as it reduces the duration of uncertainty,” says Perkins. “While May was a supporter of the ‘remain’ campaign, she has made it clear that she will respect the voters’ wishes and will work for an orderly withdrawal of [the U.K.] from the EU.”
Charles Burbeck, co-head of global equity portfolios at UBS Asset Management (U.K.) Ltd. in London, agrees: “Whilst [May’s appointment] does not eliminate all uncertainties and concerns, it does provide some short-term relief, in the sense that a credible government now can be re-formed.”
Nevertheless, there remain many unknowns that will affect how deep and long the U.K. recession will be. These include:
1. What will happen to workers from the EU living and working in the U.K.? How many will go through whatever process may be required to allow them to stay? How many will leave?
2. Will large financial services companies based in London but doing a lot of business in the EU move large numbers of staff to the Continent? Banks and other financial services companies need a “financial passport” to serve customers in EU countries without setting up local operations. London is a huge global financial centre, so it’s unlikely to be gutted – but significant job losses are probable.
3. Will some manufacturing companies move production to the Continent? Setting up new plants is much more difficult than moving people. However, if a firm has significant sales in the EU and also uses imported materials, the prices of which will rise with the depreciation in the pound sterling (£), those companies may consider moving.
Given the uncertainties, business investment in the U.K. has started to dry up and consumer confidence is falling. It’s hard to see any U.K.-based company expanding in this environment. Thus, global investment managers aren’t recommending U.K. financial services, real estate, industrial or consumer discretionary stocks.
The biggest beneficiaries of the Brexit vote are global multinationals, due to the sliding £ pushing up their non-U.K. revenue when it is translated into £. Most of these companies have seen their share prices rise. The Financial Times Stock Exchange (FTSE) 100 index, which tracks the 100 biggest companies in the U.K., recovered quickly after the Brexit vote. The FTSE 250, which includes the next 250 largest companies, fell by more and still was below its June 23 level at press time.
However, non-U.K. investors, including Canadians, don’t benefit from this situation because their portfolio returns for U.K. investments will be reduced when translated into their home currency. Or, if clients buy stocks on non-U.K. exchanges, those share prices immediately will reflect any changes in exchange rates. From June 23 to July 14, the U.S. dollar was up by 10.7% vs the £; the euro, up by 8.1%; and the loonie, up by 9.6%.
For example, the share price for GlaxoSmithKline PLC increased by 13% from June 23 to July 14 on the London Stock Exchange, but rose by only 3% on the New York Stock Exchange.
Thus, you need to look for U.K.-based companies with earnings that are likely to rise for non-currency reasons. Here are three possibilities:
– easyjet plc. Perkins doesn’t normally recommend airline stocks, but he thinks the plunge in easyJet’s share price – down by 24% from the Brexit vote to July 14 – has been overdone. This discount airline has strong market share in many European countries, so revenue will benefit from the drop in the £. easyJet has leases but no debt and has cash on its balance sheet. The stock is trading at eight times forward earnings and has a dividend yield of more than 5%. Perkins thinks earnings will be better than expected if the U.K. avoids a deep recession.
– kingfisher plc. This “do it yourself” home-improvement products company is suggested by both Perkins and Philippe Brugère-Trélat, portfolio co-manager in New Jersey of Franklin Mutual European Fund, offered by Franklin Templeton Investments Corp. in Toronto.
Kingfisher gets 46% of its revenue from the U.K., 40% from France and the rest from Poland, so more than half the firm’s revenue will be enhanced when translated into £. In addition, Kingfisher is in the midst of a major restructuring under a new president.
Kingfisher has some debt, but is in a net positive cash position, thanks to strong cash flow. The stock’s dividend yield is around 3% and is trading at around 13 times forward earnings, which is cheap compared with other European retailers.
– tesco plc. The U.K. is a net importer of food, so food prices will rise with a lower £. Supermarkets’ earnings usually are enhanced when prices are rising, notes Burbeck. (The lower £ also will hurt Germany-based discounter Aldi GmbH & Co., which has been taking market share from U.K. grocers.)
Tesco also has been undergoing major restructuring, including selling off unsuccessful overseas operations and cutting costs elsewhere. Burbeck says Tesco has been “under-earning and should recover quite a lot in the next two to three years.”
Tesco’s dividend has been suspended, but, Burbeck says, it should be reinstated if earnings recover as he expects.
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