Uncertainty is the name of the game in the wake of the Brexit vote. So what factors should investors be examining short- and long-term?
Last week’s historic decision by British voters to pursue Brexit— the termination of their 43-year-old relationship with the European Union—by a 52% to 48% vote was shocking and provocative.
Although headline-grabbing days induce fear, in reality last week’s events left markets close to their mid-June levels, with investors taking prices down in a way consistent with political shocks as opposed to financial system shocks.
This distinction is important as it speaks to scale, scope and speed of the transmission of this event toward the economy and in turn, to the markets. What is critical is the extent to which policy uncertainty affects risk premiums and undermines consumer and corporate confidence. In that vein, the Brexit will be a long process. So what factors should investors be considering in the near and long term?
UK leaders must now agree on an exit policy, which may take many months. Next is a two-year negotiation period with the EU—which, by unanimous consent, can be extended. Thus, Morgan Stanley & Co. believes the UK is unlikely to exit the EU until 2019 at the earliest. It is also likely the UK and EU will seek to enter into separate trade agreements to limit the impact of a UK exit.
Even as the current terms of trade remain in effect until the actual exit, a prolonged period of political and economic uncertainty could be costly. MS & Co. economists estimate the Brexit will result in a 0.3% hit to global growth, a 0.5% hit to Euro Zone growth, and a 1.0% hit to UK growth in a medium stress scenario for 2017.
We don’t believe this is enough to throw the global economy into full-blown recession, but it presents headwinds. That said, the most recent manufacturing data released this week is encouraging, with Markit flash Purchasing Managers’ Indices (PMI) beating expectations. The improvements in manufacturing were broad-based with upticks in the US, China and Japan.
Importantly, Europe showed the highest overall PMI reading and its highest reading of 2016. Gains were paced by Germany, which had its best showing in more than two years. European consumer confidence has held steady at high levels and retail sales growth has been solid, underpinned by improving employment and total income growth that reached a 3.7% annual pace last month. Perhaps most importantly, the European Central Bank’s (ECB) corporate bond-buying program and second long-term refinancing operation have only recently begun, and they could unlock the lending channels to meet growing credit demand.
As far as corporate fundamentals are concerned, analysts have already begun cutting earnings estimates, reversing recent improvements. While we acknowledge there is ample uncertainty, we think there are potential counterweights to the recession narrative.
Specifically, a recent analysis by Graham Secker, MS & Co.’s European equity strategist, found that recent disappointments in European corporate profits are a function of at least three important factors that may be reversing: idiosyncratic issues related to heavily skewed index exposure to financials and commodity-linked industries; weak operating profit leverage linked to declining emerging market sales; and less aggressive use of buybacks, tax optimization and non-operating cost reductions versus U.S. peers.
Currently, the IBES consensus points to a slight year-over-year decline in 2016 MSCI Europe corporate earnings while MS & Co. analysts are looking for a 2% to 3% decline. Without the drags from commodity-linked and financials sectors, the forecasts are 6.4% and 5.9% annual growth, respectively. But MS & Co. estimates are premised on Brent oil prices between $24 and $42 per barrel, while the current price is $48. Operating leverage and profit margins may also be poised to rebound as emerging market demand indicators have begun to stabilize.
Finally, ECB bond purchases are now driving the average cost of investment grade debt to near 1%, and we expect company profits to benefit from lower interest costs, higher buyback activity and more creative use of balance sheet capacity.
Risk premiums are perhaps the most important factor that will determine whether longer-term investors can make money. Currently, in the Euro Zone ex UK, the equity risk premium is already above levels seen in the European debt crisis in 2011 and closing in on the 2009 highs of close to 900 basis points. In the UK, spreads are even more provocative, now close to all time wides.
On more traditional metrics, European stocks are selling at only 13.6 times 12-month forward earnings, half a standard deviation below the 30-year average, a period during which interest rates were on average about 5.5 percentage points higher. The MSCI Europe Index yields 3.9% while the median stock yields 3.3%. These dividend yields are extraordinary, and at historic premiums, when compared with either government bond yields or corporate credit yields. In addition, as you can see below, European large caps are also cheap compared to their small-cap and mid-cap peers, selling at a near 20% discount, among the widest discounts in the last 22 years.
Typically when discounts are this dramatic, large caps beat small caps over the next year by 3% to 10%. While we recognize valuation is often ineffective as an investment tool in the short term, it is the single most important determinant of longer-term returns.
Even though the markets reacted strongly to the Brexit vote, the Brexit itself is more a political shock than a shock to the financial system and market sell-offs leave us only back to mid-June levels. To us, this suggests markets have been discounting the potential for the Brexit outcome for months.
It could be years before the UK actually breaks with the EU, but uncertainty could be a headwind to growth. Watch politicians in the UK, Europe and globally for fiscal stimulus measures and currencies to provide an offset. Long-term investors may want to consider exercising patience and allow the dust to clear. Investors with short-time horizons and wealth-preservation needs should use rallies to lighten positions in non-US assets. Credit markets may provide better risk-reward tradeoffs in the short term while equities could be the outperformers from generationally low valuations in the long run.