The morning after Brexit

I often wonder if my parents and other people living in Europe at the time realised the full implications of Hitler’s command that set the tanks rolling into Poland. How life as they knew it would change for many years – in fact forever.

I do recall from dinner conversations that apparently my grandfather had consistently warned beforehand that Hitler would also invade Holland, “Hitler needs Rotterdam to get access to the North Sea”…. And when it happened life in Holland was changed forever.

World War II was inflicted on Europe and the world by an external party, but Brexit is internally inflicted by it seems [ds_popup_explanation data=’17 million voters voted to leave, 16 million voted to remain. 27 of the 30 areas with the most elderly voted to leave with 28 of the areas with the fewest graduates doing the same. Source: BBC.com ‘]17 million mainly elderly, rural and uneducated Brits [/ds_popup_explanation]. For Britain and Europe, the vote has set in motion a train of events that seem as unstoppable as the German tanks that rolled into Poland.

We know from experience that the only constant is change, yet humans and even more so investors dislike change and the uncertainty it brings and the violent reactions of markets reflect that.

When considering the investment impact of Brexit it is important to be unemotional. Approach it as you do your Suduko puzzles.

Some Facts:

• History shows that the most significant political and social changes occur during times of economic stress (Refer our article on Scapegoat economics, 6 April 2016). It is in times of economic stress, uncertainty and increasing unemployment that change seems attractive (“less or nothing to lose”) to the “masses”. The factors causing the unhappiness are often not understood, and hence the economy and current crop of politicians become scapegoats, and voted out. I think one can confidently forecast more such “unexpected” election outcomes whilst global growth remains low (Sadly, the newly elected are often worse…).
• Europe’s fear is that Brexit sets in motion similar sentiment in France, Italy, Netherlands, Greece and others and that it could have set Europe on a slippery slide towards break-up.
• Hence Europe will make UK’s exit as unpleasant and hard for them as possible. The notion of the Brits having the option of invoking [ds_popup_explanation data=’Article 50 deals with the exit from the European Union; it seems that a referendum is not binding, and that parliament must still decide whether to enact the vote, so the Brits do have a sneaky (unlikely) way out.’]Article 50[/ds_popup_explanation] only in October/November has been squashed by Europe. The talk already is: “invoke Article 50 and start the exit process by Tuesday”.
• Economically, Britain will be the big loser – its exports to Europe are much larger than its imports . The reduction of its exports to Europe on top of an already large trade and current account deficit and an overvalued pound makes it easy to predict that further weakening of the pound is a certainty.
• A huge task lies ahead: Renegotiating 80,000 pages of treaty and trade agreements. Britain walking out of the largest free trade market in the world will have negative effects on exporters, property prices (international banks relocating staff/offices to Europe) and unemployment in the short-term. Besides, future exports to Europe  will be less profitable (reduced margins to compensate for higher tariffs).
• Worse: Cameron’s resignation means a vacuum in the short-term. A new leader has to be elected in a very acrimonious atmosphere and his/her big task will be to oversee Brexit, increased unemployment, higher tax rates and a recession.
• The remote possibility of a second (Remain) referendum and the hopes and fears that surround that will only further increase uncertainty and volatility. A second referendum will make them look silly and considerably reduce Britain’s bargaining power. The future New Britain will be divided and considerably less important than the Brits thought. After a partnership accommodating Britain for 43 years, Europe sees the “No” vote as a big slap in the face. It will most probably decide it doesn’t want the headache the UK has become.
• Europe?  Europe will face increasing nationalistic pressure from within. The uncertainty this brings about will not be conducive to convincing capital to invest. Europe remains on the “low expectations” list when it comes to growth and the euro.

Market Reaction

And so, just as we were getting used to “the new normal” (as Bill Gross coined the low growth low interest rate environment) we potentially now enter a “new world” of anti-globalisation or increasing protectionism. Free movement of capital and labour will not happen.

Protectionism means less trade, increased administrative costs (borders), decreased efficiency, higher tax rates and lower returns on capital. No wonder markets reacted so viciously. We’re entering a new world of lower growth, higher costs, and for quite a while, uncertainty and change.

What does one do?

The facts I wrote are by now well understood by the market. The key to finding the solution is to decide whether the market has overreacted.

Figure 1 below highlights that despite the worst US banking and housing crisis since the 1930’s as well as the European Sovereign debt crisis, the S&P500 and MSCI World Indices both delivered a compound return (with dividends reinvested) of 6.2%. Crises like the current one have less impact on earnings power than thought.

That’s why Warren Buffett loves pessimism:

“The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”

Warren Buffett, 1990 Berkshire Hathaway Chairman’s Letter

But let the buyer beware

The question is not whether to invest now, but where. Over many years we’ve learnt not to place excessive focus on unforecastable macro factors but rather focus on the DNA and valuations of the companies we’re invested in. The temptation to buy those shares that have fallen the most must be resisted. Figure 2 shows, by way of example, the difference in shareholder value created by JP Morgan and Citigroup over the 14 years to Dec 2015. The low P/NAV of Citi has been a value trap for many years. After 14 years your $1.00 invested in Citi is worth $1.29 vs. the $4.85 invested in JP Morgan.  When markets fall you want to invest in quality, not buy challenged businesses.

Advice?

Once Hitler gave the order that set the tanks rolling into Poland a process was started that was difficult if not impossible to reverse. Friday’s vote might have set into motion a process that will go on for a longer period than we think and of which we cannot yet see the end result. We could be in the equivalent of March 2008, but this time the financial sector is strong and much better capitalised and the banks don’t have Lehman’s type gearing or trading positions. Despite the cautious outlook we’ve painted, it feels as if markets are over-reacting. Besides, in January 2008 markets were very expensive, whilst now we’re spoilt for choice in terms of quality companies.

Figure 3 highlights the massive impact dividends have over time. Hence for risk adverse clients the best advice I can give now is to use this opportunity to invest in funds like the SIM Global Equity Income Fund. Douw and his team are invested in businesses on which Brexit will have limited impact. The dividend yields available in all our funds after this weekend’s price falls are mouth watering. If you want to add risk at very attractive valuations the Sanlam Global Financial Fund is the obvious choice.

South Africa?

At bed time on Thursday evening conviction levels were high that the “remain” vote would win.

The shock outcome on Friday morning meant many players had to reverse/change positions. So one can understand the large fall in the pound, British banks and homebuilders and London property values. But why did the rand fall? And does this present an investment opportunity?

As explained above, Brexit has created uncertainty, increased political risk throughout Europe and possibly the world, lower growth and it also means the probability of an increase in US interest rates in the next few months has been reduced. And in times of uncertainty investors tend to first withdraw and sit on the sidelines. Safety was sought in the US$, Japanese Yen and gold. The initial “risk off” response lead to selling of assets that were perceived to have risk and so South Africa, already a fairly risky investment at this stage, fell into this category.

In this regard it is interesting that the currencies and markets of countries like India and Indonesia weren’t much affected as they’ve got their own growth engine and hence the Sanlam Global Financial Fund was down far less than the market (measured in US$) due to its very low exposure to UK and European banks, the pound and euro.

But the direct impact on earnings of the majority of South African companies is limited. Ricco and the portfolio managers have expounded on this as well as setting out the impact on the different funds managed by Denker Capital, click here to read more.

In conclusion

• The Brexit vote reflects a changed and uncertain world,
• The immediate outlook for Britain (pound and growth) and Europe (uncertainty in an already low growth environment), is not good
• But this is not 2008 – growth prospects have diminished, but the financial system is healthy (healthy enough to withstand the shock)
• The flight to safety (plus what seems to be a panic repositioning of portfolios) creates an excellent opportunity to improve the quality and yield of portfolios.
• The sell-off is creating mouth-watering dividend yields that will generate cashflows for investors for many years to come.

By Kokkie Kooyman
Portfolio manager

For comments on our individual portfolios and more detail on the impact on South Africa, please click here.