Foreign investment will hold key to post-Brexit prospects
By Andrew Wilson
22 July 2016
It is a truth bordering on cliché that markets are averse to uncertainty. It is, however, a commodity in plentiful supply across the globe, with the Brexit vote just one of several potentially destabilising situations. Fresh crisis in the Italian banking system, Japan's perennial battle with deflation and the looming prospect of a bitterly contested US presidential election are all likely to impact global investment markets in the months ahead.
The UK's decision to leave the European Union and the fracture of political leadership it caused continue to grab the headlines. It was undoubtedly a shock to investors, whose confidence that Remain would win the day led to pre-referendum rallies in both sterling and UK equities: much of the immediate market reaction to the poll was the unwinding of positions taken in anticipation of a comfortable vote for continued membership.
By avoiding a protracted leadership battle, The Conservative Party lifted concerns that lengthy internal wrangling could prolong a period of stasis before negotiations begin. It is positive that the leadership question has been promptly resolved, but the Government now faces an extensive set of challenges that must be navigated quickly and carefully to avoid lasting damage to the economy.
Against the backdrop of a result that could be interpreted as an anti-austerity message from many voters, Theresa May directly addressed that constituency, promising not to govern in the interests of the "fortunate few". This suggests that some form of fiscal easing is likely and investors will be looking carefully for indications as to how this will be carried out. Clarity on this, and on whether George Osborne's mooted cut to Corporation Tax will see the light of day, will help us form a longer-term view on the UK economy in this new chapter of its history.
Investors in the UK will have to get used to the large question mark hanging over the economy. The new Government has indicated that it will not begin negotiations before 2017 and even if that means Article 50 is triggered within a year from now, it remains possible that a full settlement may not be in place at the end of the two-year negotiating period. As with the EU legislation drafted in response to the financial crisis, a phase-in period of implementation is likely to follow, meaning that markets will have to wait a number of years before the "new normal" has been firmly established.
This does not mean that we are condemned to extreme volatility until this happens. Because of their extended timescale the negotiations, once they've begun, are likely to fade into the background as other important global events compete for investors' attention. Economic data will be key to the market reaction in the weeks and months ahead. We currently have very little hard data from this side of the referendum, so fresh statistics on factors such as inflation, house prices, investment - especially foreign direct investment - and export levels will determine how investors behave, rather than the minutiae of civil servants’ negotiations on the terms of the UK’s departure.
Investors will spend the next three to six months trying to gauge who are the winners and losers, and how that plays out in UK economic activity. We're hearing stories, for example, about how the depreciation in sterling is flowing through to higher prices, but will want to see that reflected in the official inflation numbers before taking a view in investment terms.
There are of course potential benefits - if you're exporting to countries outside the EU, the weaker pound could represent a windfall and investors will want to pick up the opportunities that result. There certainly will be some positive offsets of this nature, but our instinct is that these will take longer to become evident than the immediate costs of the Brexit vote. Exporters tend to hedge currency exposure in their near-term sales, for example, so we may not see a benefit in export figures until the second half of next year.
Given this kind of lag, it is difficult for any investor to take a long-term view in the UK, especially based on the negative market reactions we saw in the days and weeks immediately after the referendum. We still see downside to the pound, but the time horizon for that kind of trade is two to three months, and we could well take a long position when the pound hits what we regard as a natural floor.
Activity in the M&A market can denote a similarly mixed picture. News is emerging of potential post-referendum interest in UK companies from offshore, but this is not necessarily growth-positive as purchasers could be motivated by a correction in valuations. The statistics for foreign direct investment will be much more relevant to the UK's economic prospects: if someone builds a new car plant, for example, it will always be a boost.
S&P's decision to cut the UK sovereign rating earned some headlines, but it's important to see it in context. Ratings tend not to drive the sovereign market and S&P's decision brought it into line with the other rating agencies rather than setting a precedent for them to follow. We certainly do not see Brexit as a sovereign default issue. The UK is still a very solid credit, with pricing reflecting global yields and the projected path for UK economic activity.
In the bond market, UK corporates will of course be affected, and it's possible to do very well as an investor by positioning to anticipate the winners and losers, but we do not envisage a sweeping, directional change that puts the UK on a different trajectory to that of the corporate market globally. It's perfectly possible for an event to cause UK corporates to trade differently to the rest of the world for a short period, but it's highly unlikely that the correlation between markets would break down for long.
Stock-pickers will of course be looking closely at likely winners and losers in the UK equity market. 80% of revenues in the FTSE 100 are derived offshore, making the fall in sterling very supportive of those companies. The FTSE 250 came under more sustained pressure, but has bounced back in the last week or so in line with other stock markets around the world. While US valuations look pretty stretched, those in Europe - including the UK - have a lot more potential upside. This kind of environment is a fertile one for active managers: there will be differing impacts from Brexit across industries and companies, identifying those stocks that stand to benefit or face headwinds as a result will make a big difference to portfolios.
The Brexit vote came as an undoubted shock, and big announcements on the negotiations for withdrawal will inevitably move markets, but this is just one of a number of globally important events likely to dictate trading conditions in the months ahead. Investors who are able to focus on the data rather than the noise, should still be able to navigate through the post-referendum market.
Andrew Wilson is EMEA chief executive officer of Goldman Sachs Asset Management