Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn


Brexit: worst-case scenario hits British bank and supermarket stocks

Alex Morozov, CFA  |  12 Dec 2018Text size  Decrease  Increase  |  
Email to Friend

Betting on the outcomes of political debates isn't our forte, and the upcoming UK House of Commons vote that could determine the direction of the world's fifth largest economy for the foreseeable future is no exception.

As bottom-up, fundamental, long-term-focused analysts, however, we do want to ensure our industry analysis and models adequately account for the macroeconomic and political risks. In this research, we use a worst-case scenario of a disorderly no-deal Brexit to stress test models for our companies with the greatest exposure to the UK economy and Brexit.

While we identify a number of firms that could face long-term adverse developments following a no-deal Brexit, namely in the automotive space, we also see most disruptions as short term in nature and thus unlikely to materially alter our long-term views. We believe we adequately account for the heightened risk via our uncertainty ratings and see a number of investment opportunities with the market getting jittery as we get closer to the Brexit Day.

Brexit timeline

While a severe and prolonged downturn in the UK economy will have material implications for the UK-centric firms – firms with significant revenue tied to the UK market, we should at the very least be cognizant of a potential contagion effect of a global recession, even if most forecasts we have seen do not consider that to be a meaningful risk. For now, we are assuming in the disorderly worst-case scenario, the economic downturn will be primarily confined within the UK but have a modest effect on the remainder of the EU.

Smaller caps will feel brunt of Brexit downturn

Morningstar's global equity research coverage tends to skew toward larger-cap stocks, which also tend to be multinational companies. With the exception of a few UK-focused industries, food retail and telecoms for example, companies in our coverage have global operations, mitigating whatever impact would be felt from an isolated-to-the-UK economic downturn.

Bank of England U.K. GDP Forecast Under Varying Brexit Scenarios

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

Brexit Scenarios

Source: Bank of England

Not surprisingly, smaller UK-centric firms that compose much of the FTSE 250 are likely to feel the brunt of the downturn, which has depressed their performance relative to their larger FTSE 100 peers, particularly since the news of an impending vote rejection of Prime Minister May's proposal started circulating. Housing, construction, and retail companies in particular are more likely to be affected in the recessionary environment.

Autos integrated with the EU

The UK automotive industry is highly integrated with the EU, including vehicle production and parts manufacturing. Auto industry trade ties are especially strong between the UK and Germany. Germany is the top destination for UK vehicle and parts exports. Just slightly behind the US, the UK is the number two destination for German vehicle and parts exports. UK automotive trade with France, Italy, and Spain is also very substantial.

If a trade rule tariff were just on the imported vehicles, UK consumers could switch to competing products not subject to EU tariffs. However, EU tariffs on vehicle parts presents a problem, potentially causing price increases for UK-built vehicles, too. BMW, Jaguar Land Rover, Vauxhall and Nissan all carry risk.

The risk is there for UK banks

Banks are particularly sensitive to unexpected shocks – like the UK tumbling out of the EU without any trade deals in place – which can often spark a loss of confidence and be the catalyst for a full-blown crisis.

Five banks in our coverage universe have significant retail and commercial banking operations in the UK. Our preferred exposure would be the narrow-moat, global giants HSBC (HSBA) and Santander where we believe the market often discounts too great an impact from any potential Brexit-inspired crisis, given its relatively modest exposure.

Narrow-moat Lloyds (LLOY) would be our preferred pure-play UK banking name, as we believe its market-leading current account franchise provides it with a steady and cheap funding base that will benefit from higher interest rates.

Our conviction is the lowest on Barclays (BARC), where its relatively greater exposure to volatile, capital hungry investment banking remains problematic. We believe that Royal Bank of Scotland's (RBS) government ownership and troubled history have led to certain decisions that favour public opinion over profitability and shareholder interests.

Aerospace vulnerable

Within our aerospace coverage we believe Airbus, Rolls-Royce (RR.), Safran, Leonardo, and Meggitt remain the most exposed to Brexit risks. The direct impact of Brexit is already being felt at many of these companies with management teams moving to increase inventory levels in the event of delays at the UK-EU border. This will hit cashflows but not necessarily revenues since we believe these buffer stocks should enable product deliveries to continue unabated.

Consumer companies best positioned

In the event of this risk of economic shock and stagflation coming to fruition, there are two reasons why large cap consumer product manufacturers are likely to be more defensive investments than retailers. First, many manufacturers possess wide economic moats. In most cases, the moat sources lie in supply chain competitive advantages, but some manufacturers still possess pricing power.

The second reason we expect the multinational manufacturers to be relatively defensive in this sector is that they are much more geographically diversified than the retailers. For global players such as Unilever (ULVR), Nestle, and Danone, the UK represents 5% or less of total revenue, so the impact to valuation of an outcome of UK stagflation is not material. Perhaps the greatest exception to that rule is Reckitt Benckiser (RB.), for which the UK represents almost 15% of its top line.

But supermarkets will struggle

Overall, we think food grocers under our list will have a hard time passing on food cost pressures to consumers while there would be an inevitable down-trading, which will benefit hard discounters both in the food and non-food markets.

Specifically, we think Associated British Foods (ABF) is well positioned due to Primark as the lowest cost clothing retailer in the UK, while all three grocers under our list; Morrison (MRW), Sainsbury (SBRY), Tesco (TSCO), will face headwinds including tariff and currency induced food cost inflation, fierce competition from hard discounters, to the benefit of "no-frills" discounters.

Alex Morozov is the director of the health-care team at Morningstar.

© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend