K2 Asset Management : Brexit Commentary

June 2016

Now that the people of the United Kingdom have voted to leave the European Union we need to consider the consequences of this action and how it will impact equity prices over the coming months.

There are many permutations that could eventuate before the UK's actual withdrawal from the EU can be formalised. Some of the considerations include understanding the intricacies of the legal route to exiting the European Union. Article 50 of the European Union Treaty deals with procedures should a Member State decide to withdraw. Accordingly one needs to understand;

• The timeline for invoking Article 50 of the EU Treaty
• Whether Article 50 can be invoked before a new UK Prime Minister is chosen
• The formalities for selection of the new Conservative Party Leader (Party Conference isn't until early October)
• If UK trade negotiations can be entered into before Article 50 triggers
• Whether another referendum could be called if the public changes their mind

Ultimately it will be difficult to assess the timing of the UK's eventual departure from the EU. However, we can use the movements in the UK Sterling and estimate the impact on the broad economy and how this will influence the profit trajectory of listed UK companies. One thing that is clear is that the political instability within the UK will mean that the Bank of England must take on the effective leadership role.

The Bank of England (BOE) has been mandated by Parliament to, among other things, maintain price and financial stability. To date the BOE has "looked through" the recent currency weakness in its assessment of price stability. However, now that the referendum has concluded, the BOE has the unenviable task of dealing with concurrent tides of higher inflation expectations and increased financial vulnerabilities. The BOE does not have a lot of room to move regarding direct monetary policy, (official rates are already just 0.50%), but it does have the capacity to support the functioning of markets with £250b of funding facilities. Additionally, significant improvements in UK banking capital adequacy ratios and heightened usage of high quality liquid assets will go some way to avoiding a systemic banking crisis. In our view, the BOE will have enough levers to pull to ensure that a debt crisis is avoided.

The UK Sterling has already dropped 11% against the Euro this year thus impacting the UK's costs of importation. The UK currently imports more than 50% of goods and services from EU members, and exports around 40% to the EU. Accordingly, the drop in the Sterling will be inflationary for the UK economy. Offsetting this is the UK's improved export competitiveness into foreign markets. Although the UK exports just over 40% of goods and services to EU members, the UK also carries a large current account deficit of about 7% of GDP. As a result one of the key issues for the UK's economic health will be the direction of net financial capital flows from foreign entities. The majority of financial capital flow into the UK is through Foreign Direct Investment (FDI) and is approximately £1 trillion; about 40% and 30% respectively comes from EU and US investors. It is worth noting that UK companies have tended to be a significant component of most global equity income strategies. Hence future movements in FDI will most likely reflect foreign investors comfort regarding the solvency of the UK banking system. Therefore the Bank of England will play a pivotal role in the direction of the UK's economic fortunes.

The UK economy has performed relatively well since the European crises of 2011. Net long term migration into the UK rose from 150,000pa to almost 350,000pa. The unemployment rate improved from 8.4% to 5.1%, residential property prices rose 24%, commercial property prices grew 50% and the UK equity market improved 30%. However looking forward, net long term migration flows into the UK will clearly diminish. As a result it is likely that population growth will subside, the labour participation rate will most likely decline and the unemployment rate will rise. In fact the UK Treasury produced a report in the lead up to the referendum concluding that a vote to leave the EU could result in;

• The number of unemployed rising by 520,000
• The unemployment rate rising 1.6%
• Average real wages falling 2.8%
• House prices dropping 10%
• GDP growth falling 3.6%

We are not as bearish as UK Treasury. We are comforted by the fact that since 2012 the major UK banks have lifted their Basel III common equity Tier 1 ratios to 12% from 7%. We believe that the BOE's commitment to supporting the functioning of markets will soften the impact of financial capital outflows from the UK. We also believe that the recent weakness in the Sterling will mitigate some of the economic drag emanating from the uncertainty of the departure from the EU.

The UK equity market currently trades on 15.5x next year's expected EPS. However we would point out that the current UK EPS is 30% lower than December 2011 and is at a similar level to what was experienced during the GFC. Accordingly we feel that market participants have already been adapting to significant weakness in UK profitability. Hence we feel that EPS projections will most likely prove to be more resilient than the broad economy. We can see UK's nominal GDP growth declining to around 2%. If EPS projections decline another 10% and payout ratios hold at 68% then the UK equity market is trading on a dividend yield of 3.9% next year's DPS. At the height of the European crises the UK equity market traded on a dividend yield of 4.6% whilst the UK 10 year bond yield was 2%. Today the UK 10 year bond yield is just 1.08%. We believe UK equities are reasonably priced at these levels.

UK equity exposure for the K2 Select International Fund and the K2 Global Equities Fund is 9.9% and 6.5% respectively. The K2 Select International Fund and the K2 Global Equities Fund are 2.9% and 2.3% respectively short the UK Sterling. Importantly the K2 Select International Fund and the K2 Global Equity Fund are holding 20% and 18% respectively in cash. The K2 Australian Fund holds close to 10% cash.

We are currently underweight the UK equity market and are watching for further buying opportunities. We do not feel the current situation warrants panicked selling.

DISCLAIMER: The information contained in this article is produced by K2 Asset Management Ltd ("K2") AFSL: 244393 in good faith and is intended as general information only and is not complete or definitive. K2 does not accept any responsibility, and disclaims any liability whatsoever for loss caused to any party by reliance on the information in this article. Any advice in this article is general in nature and does not consider your individual objectives, needs or financial situation. You should consider your individual circumstances before making a decision about any of the financial products discussed in this article. K2 is the issuer of a number of managed investment schemes. A product disclosure statement for the managed investment schemes referred to in this article can be obtained at http://www.k2am.com.au or by contacting K2. You should consider the product disclosure statement before making a decision to acquire or continue to hold an interest in the managed investment schemes.