Fuelled by a collapse in the oil price and escalating concerns over China’s slowdown, the upcoming Brexit referendum on 23 June is giving investors yet something else to think about.
In my view, the worries over Brexit for the UK equity market – and small and mid-caps in particular – have been overstated. While I am keeping a close eye on the issue, and believe that some overstretched areas of the UK domestic market are at potential risk, overall I view any volatility in the lead up to the vote as an opportunity rather than a sell sign.
First things first, how likely is Brexit? Given how conservative and change-resistant recent electoral outcomes have been historically, I do not expect the UK to vote for Brexit. Fear of uncertainty is hardwired into human psychology, and levels of uncertainty around the global economy – and the UK’s place in it – are already heightened, irrespective of Brexit concerns.
That said, for as long as Brexit remains a possibility, I would expect to see some volatility in certain areas of the UK market in the lead up to the vote. The Scottish referendum in 2014 and the UK General Election last year showed us that even the prospect of political upheaval can have an impact on stock prices. In my view, certain domestic cyclicals are most at risk, particularly those sitting on elevated valuations.
If the Leave campaign is victorious, a worrying feature of the UK economy would likely come into greater focus: the UK’s current account deficit. It is the largest ever outside wartime, and is heavily financed by external investment. Foreign investment has gone a long way in plugging the deficit, but if we leave the EU there is no doubt it will be less appealing to do business with the UK. New trade agreements will have to be drawn up with not only European countries but also the likes of the US and Japan, which could take many months, if not years.
Speaking to the chief executives of companies I meet on a regular basis, some are postponing expansion plans until clarity is achieved. We can expect this to happen far more frequently if Brexit does happen, which could have a big knock-on effect while these trade agreements are redrafted. Recent studies show that a key reason for foreign direct investment (FDI) into the UK is because it is seen as a bridgehead into the EU. Brexit could endanger this as a motivation for FDI into the UK, and thereby risk financial outflows by international investors in the UK. Sterling will have to weaken considerably in order to boost export revenues, helping to fill the void left by exiting foreign investment@Image-a6c92e3f-5091-48a9-81c7-0cc9caa697a3@.
Longer term, a key concern highlighted by the Brexit debate is the fragility of the EU. Both sides of the argument typically share a common acknowledgement: the EU is a flawed construct as it currently stands. Those arguing for Brexit suggest that the UK should sever ties from a burning boat. Those arguing to remain say that Britain needs to have a place at the table and be involved in ongoing reform. Given the importance of Europe to the UK’s prosperity, the existence of structural flaws is perhaps as big a concern as the whole Brexit debate.
A vote for Brexit would likely diminish the EU in the eyes of the wider world and increase the risk of the EU project disintegrating. Recent centuries of history – obviously preceding the EU concept – have taught us that the fortunes of the UK are inextricably linked with those of continental Europe. A peaceful and prosperous Europe is clearly in the best interests of the UK, especially at a time of rising geopolitical tension globally.
I believe that responsible investors need to appreciate the short-term risks to economic and financial stability caused by even the prospect of Brexit.
The impact on asset prices in the short-term is speculative and hard to predict, but there are certain areas where I do not believe the risk/reward dynamic is in investors’ favour. The Bank of England has already suggested it will intervene and engage in aggressive monetary easing in the event of Brexit, which could support asset prices and even lead to financial asset price inflation. For example, the illiquid housing market in London, which is already at elevated valuations, is potentially at risk. Housebuilders and other industries associated with the sector have performed very strongly of late, but could come under considerable pressure if the chances of Brexit increase.
More generally, sterling weakness is another potential headwind to look out for. We have already seen significant weakness in recent months – notably immediately after Boris Johnson made his loyalties known – and there is a good chance we could see more if momentum behind the Leave campaign increases. Domestic-facing companies are more exposed to this theme than UK-based exporters exposed to euro and US dollar revenues. While the FTSE 250 is often seen as a domestic-facing market, investors are able to get exposure to a number of interesting global growth themes. Take Devro for example – a world leader in sausage skin production, which is benefiting from increased pork consumption in China. Renishaw, at the forefront of the 3D-printing revolution, is another truly global company.
Concern about the UK’s domestic recovery in the event of Brexit has contributed to the weakness seen in the small and mid-cap indices so far this year. While caution is needed in expensive areas with significant exposure to the domestic economy, small and mid-caps should subsequently benefit the most from what I believe will be a non-Brexit outcome. I believe prudent investors could be rewarded for taking advantage of potential volatility in the coming weeks and months.
Mark Martin is head of UK equities and manager of the Neptune UK Mid Cap Fund
Key points
The upcoming Brexit referendum on 23 June is giving investors yet something else to think about.
A vote for Brexit would likely diminish the EU in the eyes of the wider world.
Sterling weakness is another potential headwind to look out for.
