UK shares get an early taste of Brexit risk

As global markets continued to extend this week’s ‘risk rally’ on Thursday, the UK’s FTSE 100 was a laggard.

Whilst being wary of reading too much into moderate one-day divergences, it is still worth noting UK investors have begun to turn their attention to specific risks closer to home.

One trigger on Thursday was the EU Summit, the outcome of which could give a boost to the ‘Out’ campaign when the UK’s referendum on EU membership takes place, perhaps as early as June.

The main topic of discussion in Brussels is Britain’s “New Settlement” with the EU, over proposed reforms of the Lisbon Treaty, the latest agreement that is the basis of European Union.

 

This agreement will “self-destruct”

Discussions were continuing as this article was being completed.

As per recent negotiations, the pattern of hard-faced lack of compromise mixed with implicit concessions—often from the same state—continued on Thursday.

One new development was that France and Belgium pressed for a “self-destruct” clause.

That refinement would prevent any further EU negotiation in the event of a win by the ‘Out’ campaign.

Such a clause would raise the stakes for UK Prime Minister Cameron, who is at the forefront of maintaining Britain’s formal place within the trading bloc—i.e., he’s anti-Brexit.

 

Uncertainty is a certainty

Risks to investors in UK shares relating to ‘Brexit’ are of course largely unquantified and, hotly debated.

But it is the uncertainty inherent in those risks that has arguably begun to concern UK financial markets.

That uncertainty relates to both the outcome of the referendum and, in the event of an ‘Out’ vote during the plebiscite, the consequences.

Before that, investors face the uncertainty inherent in the fact that a date for the referendum has not yet been formally set, although the PM has stated it will happen before the end of 2017.

If voting takes place in 2016, it is most likely to be in June or September.

 

We will of course examine the possibilities thoroughly in various articles in the run-up to the vote.

 

 

For now, we see three major, closely-related risks

1) Political instability: Prime Minister David Cameron would probably resign and there would be increased chances of a second Scottish independence referendum.

2) Uncertainty and slowdown in the UK economy from weakened corporate and consumer confidence.

3) Sterling would drop.

 

 

Sterling chances

It is clear that the risk to sterling is most obvious, as noted by my colleague Matt Weller earlier this week.

But a weaker currency presents broad potential advantages and disadvantages to the corporate sector, which could impact the UK stock market in diverse ways.

The first question to ask is ‘how much may the pound fall’?

Well consider the 30%-plus drop in the Bank of England’s Sterling Currency Index between late January 2007 and January 2009.

(Hint: there was a global financial crisis in between.)

Also, note the index fell 18% between 1st September 1992 and the end of February 1993.

(Hint: there was an ERM crisis between the latter dates, including Black Wednesday.)

 

Winding these potential ‘worst case’ scenarios back might suggest a (notional) c.15% to 20% GBP fall in the first post-Brexit year.

 

 

UK Plc. at home

Then we have to work out how such a hit to sterling might affect UK corporate earnings.

Calculations are complicated by the fact that according to Thomson Reuters Worldscope, UK listed corporate revenue exposure to the UK itself is currently just 30%.

That suggests a fair chance of export-driven revenue offset from a weaker pound.

Even so, as suggested earlier, broader stock market risks are still difficult to quantify.

That’s partly because impacts to stock market sentiment from weakness in specific sectors can still have disproportionately large secondary effects.

According to Worldscope, British sectors with UK revenue exposure higher than 40% include:

• Property development
• Food/general retail
• Fixed-line telecom
• Non-Life Insurance
• Water/Energy Utilities

Banks are not far behind.

Lenders may also be a special case due to worries about their ability to ‘passport’ services into the EU if trade/regulatory agreements are renegotiated.

 

 

Finally, there is another dimension to investor worries to consider: dividend growth rates.

 

The chart below suggests that whilst share price growth has trended lower since peaking in 2012, pay-out ratios are enjoying a period of absolute annualised growth in the UK.

This recently revived dividend growth rate looks vulnerable to endogenous risks.

 

 

 

Please click image to enlarge