Justin Waine's view on the Impact of Brexit on AIM and the UK economy
Any discussion of BREXIT and its impact on the stock market and economy is dependent on the nature of the deal negotiated and the resulting economic impact. In the discussion below I will try and set out the impact of what I believe will be the most likely path to BREXIT.
The current situation
Let us first start by assessing what has already happened since Brexit. The UK currency has fallen considerably against most major peers most notably the Euro and the US dollar. After an initial fall the markets have rallied strongly and are now up considerably. Looking on a 2016 year to date basis the FTSE All share is up 10.50% driven by a 12% rise in the FTSE 100. The FTSE 250 has only risen 2%. Smaller company indices have performed well with the FTSE Smallcap up 8% and the FTSE AIM All Share up nearly 12%. However, if one looks at these indices in Euros or US dollars all of them would be down. The strong performance of the UK market can then be seen almost entirely as driven by two factors. The first and most important factor is currency as companies’ dollar and Euro earnings are repriced to reflect a weaker pound exchange rate. The second is economic concerns and a further Bank of England rate cut has led to further demand for perceived secular growth stocks. In addition an ongoing rally in commodity prices from recent lows has also been a factor especially as commodities tend to be dollar denominated.
In the case of the FTSE 100 the currency factor has been the most important. In the case of the AIM market the secular growth factor has been more important with companies like ASOS, Boohoo.com and Fevertree performing strongly during the year, despite starting the year on what I would regard as elevated multiples. The FTSE 250 with its high weighting of more UK centric housebuilders, retailers and challenger banks has commensurately performed relatively weakly.
The future impact of BREXIT
Let me start by saying that any general prediction of what the stock market will do in different BREXIT scenarios is likely only to make the forecaster look stupid. This is particularly the case as the behaviour of the stock market in the short term at least appears tied up with the volatility of the currency. Predicting the short term and even medium term currency movements of the pound after such a large fall versus its major peers is equally foolhardy.
Since the result has been announced I have taken the view that a hard BREXIT scenario will be the most likely outcome. Indeed on the 28th June 2016 I wrote the following:
“The decision of the UK to leave the European Union in a referendum has answered a question that successive British governments have avoided since the 1950s. That is what the historian and Conservative Peer Max Beloff described as “the dialogue of the deaf”. In his book on the subject he set out to find out if British political leaders had wilfully mislead the British Public about the federalist ambition of the EU and it precursors; or whether UK leaders believed they could persuade EU to adopt a looser structure from the inside. This has explained the UK’s tendency to view the EU as a primarily economic project and the tendency of the EU and certainly its six founder members to see it as a political project.
The differing reactions of British and Continental European politicians to the referendum result indicate that this mutual misunderstanding is still in force. The EU will view these negotiations more from the political importance of the keeping the remaining 27 members together than from the economic costs of lost trade with the UK. It is likely the UK will struggle to understand this. Assuming that the free movement of people and contributions to the EU budget are the two areas which any UK government negotiating team cannot move on then full access to the single market for the UK is unlikely to happen.
Therefore it makes sense for the UK to move as rapidly as possible to completing the Brexit negotiations. Once the UK has left the EU it can then move rapidly to de-regulate the economy and encourage business formation which will hopefully offset the loss of full access to the single market. The longer any exit negotiations take the greater the negative impact on the economy is likely to be.”
Seen in this context the decision by the government to opt for a hard BREXIT is actually positive as it shows realism about the likely outcome. A soft BREXIT is not an option available to the UK as that is not what the UK voted for and is not something the EU was ever willing to offer. The assumption still posited by some Brexiters both those advocating hard and soft BREXIT that the EU will be forced into a trade and services deal due to the UK trade deficit with the EU fails to read the willingness of EU politicians to sustain economic damage to preserve their political project. While I would be hopeful that some sort of trade and services deal will be cobbled together before BREXIT takes place in Q1/Q2 2019 this may not be the case.
The economic impact of BREXIT is likely to result in a short term and long term reduction in the growth of the UK economy. In the short term the degree of impact will be dependent on the willingness of the UK consumer to keep on spending. The decline in the value of the pound will also positively impact UK based manufacturers both in aiding exports and providing less competition from imports. There is likely to be a modest step-up in inflation as the UK continues to import goods at higher prices that it cannot substitute with domestic production.
How negative the impact of a hard BREXIT is on the economy is dependent on the overall deal achieved and the policy response of the government. Prior to BREXIT the government and Bank of England will need to show a willingness to follow a continued lax monetary and fiscal policy. This includes keeping interest rates low and materially upping spending on infrastructure and housebuilding in the run up to BREXIT. Post BREXIT the government must move as rapidly as possible to get trades deals in place with the EU and other countries. In particular re-establishing former trade links with Commonwealth countries. Finally the government will have to repeal or remove many of the economic impediments in terms of EU social and economic regulations as quickly as possible.
Impact on AIM and portfolio selection
An investment in AIM stocks due to their size and UK focus has always been more risky (if you measure risk as volatility) than a traditional discretionary portfolio spread across a broad range of geographies, sectors and market cap sizes. BREXIT has potentially increased this risk as it means that the UK stock market and currency are likely to be most exposed to the vicissitudes of BREXIT.
In terms of our approach we have made no changes to the portfolio with our focus on quality, growing businesses, bought at sensible prices. This includes companies with significant international or export business. It also includes companies who are entirely dependent on the UK for their business.
On balance I take the view that the impact of BREXIT is to reduce the long term economic growth of the UK economy. This will have a negative impact on more UK focussed companies, though given the relative strength of the UK economy compared to the rest of the world this does not necessarily provide options to target investments elsewhere.
AIM remains a market where one can buy long term growing companies at sensible prices which I would expect to provide an investor with a decent investment return in the long run. If one looks at risk in terms of volatility of a portfolio then AIM investments may appear risky. If one looks at risk in terms of permanent loss of capital then a portfolio of AIM stocks if invested in good quality companies over the long term should deliver a good return to investors.
In addition if a BPR qualifying AIM portfolio is held for two years and at the time of death then the investor’s estate will benefit from a 40% Inheritance Tax mitigation on the portfolio invested in AIM stocks. This benefit is not available in a traditional discretionary portfolio services.
26th October 2016
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