Thoughts on managing money in these interesting times. July 4th What we have learned since the referendum

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1 Thoughts on managing money in these interesting times July 4th 2016 What we have learned since the referendum One thing we can be sure of, if we didn t know it already, is that we can t predict what s going to happen. The perfect example of this truth is the way in which Boris Johnson went from being front-runner to become the next Prime Minister on Monday, to dropping out of the contest on Friday. It also turns out that the Chancellor, George Osborne, far from being forced into a tax-raising emergency budget, is not going to have a budget at all, and is proposing to cut corporation tax to 15%, the lowest rate in Europe, in order to attract new investment to the UK, while persuading wavering companies to stay. Mr. Osborne is working together with Mark Carney, Governor of the Bank of England, to calm the financial markets and help the UK economy through what is likely to be a difficult few months. We have also had a piece of very good news. Our impending negotiations with the EU may be difficult, but already eleven of the world s largest economies have indicated that they would like to negotiate trade deals with us, sooner rather than later. These countries include the US, China, Brazil, Australia, South Korea, New Zealand and India. Apparently New Zealand has offered to lend us its top trade negotiators to help in our dealings with the EU. India could be a stand-out opportunity. With close linguistic and cultural ties to the UK, and a rapidly growing population and economy, the trading potential is substantial. In making trade agreements, the EU is hampered by the fact that all 28 (now 27) member states must ratify them individually. Apparently the deal between the EU and Canada, begun around ten years ago and still not concluded, was held up for several years owing to a dispute with Greece over naming rights for feta cheese (1). Paul Marshall of the Marshall Wace group predicted in an article in the FT on June 28th that news bulletins over the next two or three years will be punctuated by the exciting agreements that Britain forges as it becomes the beacon of free trade. We sincerely hope that this early promise reaches fulfilment. Will Brexit actually happen? Over the last week, we have heard a number of different views. One is that, because the British people have spoken Brexit will inevitably happen. Others say that it must, arguing that whoever leads the country forward must be from the Leave camp (ie. not Theresa May). 1

2 However, there are precedents where countries have rejected EU proposals in referendums, as the Irish rejected the Maastricht Treaty in 1992, and the Danes voted against the Nice Treaty in 2001, and the Lisbon Treaty in 2008, only to be offered concessions, which allowed a second referendum to be won. It is worth looking at the coming negotiations from the point of view of the EU s negotiators. They need to achieve two apparently contradictory outcomes. On the one hand, they need to appear to be acting tough on the UK, so as to discourage other countries from applying to leave. On the other hand, the UK is an important market for EU exporters, and the EU is unlikely to want to offer trade terms so onerous that the UK is forced to source its imports from elsewhere. Negotiators will also be mindful of the three million EU citizens who live in the UK. It has been suggested that the EU could offer an emergency brake on immigration, and that had it done so before the referendum, Remain would probably have won (2). The brake could be offered to all countries across the EU, and not just to the UK. The circumstances of the last few years have been unusual David Cameron s claim that during his first five years as Prime Minister, the UK created more jobs than the rest of the EU combined, is more or less true (between the first quarter of 2010 and a similar period in 2015, the UK created slightly more than two million jobs, while the EU area created 1.8m, though in a lopsided way, with Germany creating 2.4 million jobs, while employment in Spain and Italy fell). The UK may not always be the job-creation powerhouse of Europe, and the tensions arising from high levels of immigration may be felt elsewhere. In other words, an emergency brake could be useful for other countries, too. The emergency brake would only be applied in exceptional circumstances, but it could make the difference in another referendum or a General Election. While we don t know what s ahead, the possibility of improved terms and another referendum cannot be ruled out. The outcome will also depend on who is doing the negotiating on the UK side. Who will be the UK s next Prime Minister? Of course, we don t know, but it is an important question. It is said that in Tory leadership contests, two people never win, the front runner and the person who put the knife in, in this case Boris Johnson and Michael Gove. Mr Gove, though talented, tends to be controversial, and is unlikely to be seen as the best person to unify his party and the country. Of the others, Liam Fox may be too old, too right wing, and possibly not charismatic enough, while Stephen Crabb is probably too inexperienced to be a credible choice for Prime Minister at this stage. Current front runner Theresa May, though very experienced and a safe pair of 2

3 hands could be hampered by the fact that she campaigned for Remain, though in a very-low key way. The fifth candidate, Andrea Leadsom, has a strong CV, and, unlike any top politician in recent history, has worked for most of her career at the top level of financial services, most recently for ten years as Head of Corporate Governance and Senior Investment Officer at Invesco Perpetual, before becoming an MP in She is clearly a person of great ability, but has no experience either as party leader or at the highest level of government. However, in a year when the expected never happens, she could emerge as the surprise winner. Will inflation rise? Probably, and for two reasons. One is Brexit-related. The falling pound will raise the cost of imported goods. The other isn t the commodity downturn appears to have ended, so the deflationary effect of lower commodity prices has waned. Will interest rates rise? Almost certainly not. The Bank of England is too concerned about the health of the UK economy to risk raising interest rates in the near future. There is a precedent. A few years ago inflation rose to 5%, but interest rates stayed at 0.5% as the cause of the inflation was judged by the then Governor of the Bank of England, Mervyn King, to be external, and not caused by an over-heating domestic economy. How the markets have reacted Many people have expressed surprise that the UK stock market ended the month of June higher than the day before the referendum. On reflection, this fact is really not so surprising. The currency markets reacted to the referendum result by marking the pound down by around 10% against the US dollar and the Euro, a sharp fall, but far less severe than might have been expected. A weaker currency means that exporters, who earn their revenues in overseas currency, are immediately better off, while importers, including most of us as consumers, are worse off. We are already paying 10p a litre more for our petrol that we paid on June 20th. The domestic economy will suffer a double blow. Not only will we have less money in our pockets after paying more for our imported goods, but a lot of projects and transactions will be delayed during this period of heightened uncertainty. In the aggregate, the UK s largest hundred companies make over 70% of their sales overseas. In sterling terms, their sales have just risen by 10%, with no added costs attached. As a 3

4 result, they will be substantially more profitable than before, for as long as the pound remains at these levels. After an initial period of two days in which all shares fell, investors became more discriminating, and bought the large, exporting companies in the FTSE-100 index, while selling the domestic-focussed companies, which tend to be found in the mid and small-cap indices. Interestingly, the markets which fell furthest were those of Greece, Spain and Italy. The election result is seen as increasing the chances of an EU break-up, a fact which may not be lost on the EU s negotiators. TB Wise Income In TB Wise Income, we have responded to the situation by raising our cash from a low level to around 6% of the fund, and would raise it further should the stock market rally continue. We see two opportunities, one in the short term, and the other a bit further off. TB Wise Income s portfolio contains a number of smaller companies. Some of these are purely domestic, like the construction company Henry Boot. Others such as Tarsus (international trade exhibitions) Quarto (publishing) and XP Power (transmission systems) make a large proportion of their sales overseas, and will benefit in the same way as the largest exporters but have been sold off because they are smaller companies. There is an opportunity to add to these holdings selectively on weakness. The next few months are likely to be difficult for UK investors. We will not know the next Prime Minister until September 7th, and meanwhile we are likely to see a slew of economic forecasts being revised lower, and companies issuing profits warnings. The Bank of England will do what it can to ease the situation, but as Mr. Carney said, it can only do so much. We can expect prices to remain volatile, and there will no doubt be some bad days. In the medium term, the case for austerity has weakened. The policy was adopted in 2009 because of real concerns that if the UK government wasn t seen to be making inroads into its 180bn deficit, the financial markets would only offer new loans at high rates of interest. Today, there is a need to stimulate the economy as it makes the transition away from EU membership (if that is what happens). The government can borrow an almost unlimited amount of money, at extremely low rates of interest, over periods of up to 50 years. There is therefore a strong case for a period of Keynesian stimulation, concentrating on our roads, railways, sewers, airports and power generation capacity. Such a programme would address 4

5 a need, which has become urgent in the case of airport capacity and power generation, and stimulate economic growth, while making the UK more attractive as a place to invest and do business. A decision to make this investment would have to be made by our next Prime Minister. If adopted, it would be hugely beneficial for the UK s construction companies. TB Wise Income owns one or two of these companies, including Kier and Henry Boot. They are already very cheap. It is too soon to add to these holdings, but the potential for re-rating in the event of an infrastructure programme would be very substantial. In the short term, we can do more than watch the share prices falling further, while conducting more research into the sector. In the longer term, the effect of market movements following the vote has been to increase the existing distortions in the market further. Since the crisis of , investors have been faced with an increasingly stark choice between safe assets, such as UK gilts, investmentgrade corporate bonds, and the shares of companies whose dividends exhibit bond-like qualities, and the risk assets, which are increasingly shunned. Following the vote, the return on UK gilts has fallen below 1.0% for the first time ever. The dividend yield on a risky share such as the insurer Legal & General has risen above 7.0%. We would happily hold safe assets in our funds, but their prices have risen to levels where the safest aspect of them is the certainty of losing money. Our process continues to lead us towards looking for quality and value in the risky sectors of the market. We continue to believe that the best way to future-proof our portfolios is not to attempt to guess what challenges our assets might have to cope with in future, but to choose assets which we believe to be sufficiently well-managed to thrive in a large number of different conditions. Summary The UK s economic situation post-referendum may turn out not to be as dire as has been forecast. The EU s negotiators will want a settlement which gives the most benefits to the Euro bloc. Such a solution may have benefits for the UK as well. Meanwhile the early indications are that non-eu countries are keen to negotiate trade terms sooner rather than later. After the initial shock, the markets reaction to the referendum result looks rational. The pound s fall has achieved what central banks in the Eurozone and Japan have been trying to engineer for years. We expect volatility to continue over the summer, and have raised a suitable level of cash to take advantage of the bargains which we expect to appear. 5

6 Tony Yarrow July 4th 2016 Please note this blog contains the opinions of Tony Yarrow, and is not intended as financial or investment advice I am happy to respond to your questions or comments References British Business has broken free from Little Europe Paul Marshall (1) I do not believe that Brexit will happen Gideon Rachman (2) Both the above articles from the FT, June 28th 6