The “long goodbye” to Europe

UK has voted to leave the European Union (EU). Following the result and the ensuing uncertainty, we can expect heightened volatility in the markets.

British voters, particularly in the Midlands and North of England, have shown their anger regarding the effects of globalisation, austerity and an increasingly London-centric country. The full process of leaving the EU involves revoking Article 50 of the Treaty of Lisbon, but the official process will only start once the Conservative party has a new leader to replace David Cameron (who resigned hours after the result was confirmed). Matthew Elliott, the chief of the official Vote Leave campaign, stated he sees no rush to trigger Article 50. UK Independence Party leader Nigel Farage is pushing for a pro-Brexit government to be established quickly.
Economists are cutting forecasts for UK economic growth, going into negative territory for 2017. We estimate this will impact European growth as well, by 0.5%.

Macro
Input-cost inflation will be provoked by sterling weakness, although output pricing power of goods & services in a weak economy remains to be seen. Eventually, less immigration will tighten the supply for low-end jobs and could create some wage inflation. It is our view that there will be a recession in the UK in 2017, driven by weaker business investment. As a result of the referendum, we believe there will be pressure to reduce Europe-led austerity, which could be a major positive catalyst. The weak euro and relocation of Foreign Direct Investment away from the UK to Germany will help the German economy.

Credit
The Bank of England (BoE) will certainly act to buy UK government bonds (gilts). Market speculation is that quantitative easing (QE) may rise. The BoE has said that an additional £250 billion is available through its normal facilities. Initially, yields on 10-year gilts have fallen while yields on 10-year German bunds have fallen below zero. An environment of falling yields and flattening yield curves does not stimulate banks to lend and is bad news for bank earnings. Other central banks are also ready to act, as noted by the Bank of Japan governor Haruhiko Kuroda.

Corporate earnings
It is too early to know exactly how corporate earnings will be influenced by slower European growth. We expect economically sensitive companies in the UK with low margins, stretched balance sheets in fragmented markets and relying on a positive investment cycle, to suffer the most. On the positive side, there will be companies where earnings benefit from currency weakness, which in turn boosts profit translation & transaction effects.

M&A
UK assets will look cheap, due to the decline of sterling. We would expect an increase in takeover activity, notably by both US dollar-based and Asian companies. The same is likely to apply to continental Europe, given the euro weakness.

Our response
Despite much negativity around European equities, there can, in fact, be grounds for optimism and an economic recovery might eventually be helped by this referendum, as austerity disappears. Our qualitative ‘traffic light’ system, which allows us to take a strategic view on the economic outlook, shows that some of our indicators are moving away from a neutral stance to more bullish territory. Corporate costs are well managed, investor exposures are underweight and credit spreads are low.
We will be looking to increase both long and short holdings and have been researching a list of names over the last few months that would be attractive to us in this new environment. Our research focus is on European-centred business models, particularly those which are growing at a faster rate than GDP, with strong market share, pricing power and a low risk of being affected by problems from emerging markets. We are also looking to buy those companies which are now over discounting risks to their business models.

To conclude
First and foremost, we have focused on protecting capital by reducing the balance sheet and net exposure through this initial period of uncertainty. As a pan-European strategy we have the flexibility to focus on those countries and companies which are either less exposed to impact of the Brexit, or will benefit from it, looking for opportunities to buy decent companies and take short positions on those that will see increased challenges driven by the economic impact of this landmark event.

Michael Browne, Steve Frost – Portfolio managers – Legg Mason Martin Currie European Absolute Alpha Fund