So another quiet week then! Ostensibly nothing has changed; but, by triggering Article 50 the UK has begun a new chapter. There’s a risk of greater volatility as negotiations begin and investors try to second guess the ending. No spoilers here, but this week, I’ll talk about the importance of narrative, the changing story and the themes we expect to see in the markets.
Choose your own adventure
Apparently Netflix is working on a way to allow viewers to take control of storylines and choose from multiple endings. Sounds interesting! But, what happens when the person you’re watching with has a different idea about how the story should play out, let alone end?
As BREXIT begins in earnest, it’s clear that this storyline could go in several directions, but both sides effectively want the same ending. So we’re hoping that they don’t spend too much time arguing over the remote control. That said, even if discussions progress relatively smoothly, there will undoubtedly be periods of uncertainty – arguably higher now than any period since BREXIT, since any differences will finally be out in the open.
The narrative arc
This could create significant volatility if investors are continually reassessing their expectations for the final deal alongside the 24 hour news cycle. It seems that we have an instinctive need to fill in the gaps in the story and this alone can have a significant and impact on behaviour. Nobel Laureate Robert Shiller gave an address early this year on narrative economics. He argues that popular narratives shaped the path of both the last financial crisis and the depression.
The human brain has always been highly tuned towards narratives, whether factual or not, to justify on-going actions, even such basic actions as spending and investing. Stories motivate and connect activities to deeply felt values and needs. Narratives “go viral” and spread far, even worldwide, with economic impact.
Arguably, the leave campaign in the UK Referendum and the Trump campaign in the US told more compelling stories that more people could relate to. The unexpected consumer spending boom of last year in the UK isn’t all that surprising in the context of 52% of voters approving of the outcome.
Mood vs data
We’ve seen the power of narrative in the US since the election, with hopes for Trumponomics spurring the US market on. Or was it the hard data, the positive figures for growth and employment? The wobble in the markets following concerns about future legislation – suggests that there is some sentiment in there, we just don’t know how much. As the Wall Street Journal puts it:
The next three months will be crucial in achieving some denouement to these quandaries. In particular, a key question will be resolved: is there actually fundamental economic growth underpinning the US economy, or is what the equity markets see as a pick-up in economic activity really just positive sentiment that could peter out? In effect, either we will see a convergence between sentiment and survey data and real economic activity data — or we won’t
In the case of BREXIT, the deal will obviously effect the long-term outcome, but in the meantime there will be a symbiotic relationship between hopes and sentiment and what happens on the ground. As, Mark Gregory, our Chief Economist for UK & Ireland points out, we are starting to see a BREXIT pause in the economy. Business investment fell by 1% in the final quarter. And, as mentioned here last week, retail is already having a much tougher time – a fact underlined by a number of retailers going into administration in recent weeks.
The UK economy is remarkably adaptable and the global economy, whilst not reaching warp speed, is finding some momentum – this will help. But it is hard to turn this into a positive picture. I await the EY ITEM Club’s latest thoughts on this – released on 10 April – with interest.
What does this mean for companies? There isn’t one story for all of UK plc and, as discussed, there will be branching narratives and many possible endings. But we can pick some market themes.
As our analysis recently showed, investors are strongly differentiating stocks – primarily it seems on exposure to sterling. Retail, Travel & Leisure and Personal & Household Good sectors show the biggest fall in EV/EBITDA multiple in the last year and the biggest negative differential against their European peers. Although, there is also significant divergence within sectors, as some companies show greater structural or operational resilience.
Assuming we continue to see a weak pound driving up inflation, this differential should continue. But there are other scenarios to consider. Once talks begin, trade should come more to the fore. If sterling rallies, it will dent the FX boosted forecasts of many exporters. But whatever happens, we think there will be greater divergence given the greater number of factors for investors to discriminate on.
Deals are primarily initiated for strategic reasons and these still need to add up. But the numbers on UK companies are adding up differently for foreign buyers. Bidders may see this as an opportunity – a bet worth taking, especially if BREXIT talks seem to be progressing well in areas pertinent to their operations – trade, labour, regulations etc.
Although, it should also be said that much of the recent M&A action has been domestic. UK companies looking to consolidate or buy adjacent assets. No surprise when costs are rising. UK public companies need to think about bid defence – the best defence being a good offence, i.e. a share price that reflects value & good investor relations.
At the moment, debt markets are open to UK companies and, for strong credits, there is little discernible difference to the pre-BREXIT world – as we noted a few weeks back. We can’t say that won’t change given the likely increases in US interest rates and the potential for a BREXIT settlement that adversely effects vulnerable sectors; but whilst there is so much liquidity out there and so little there is still confidence in the long term prospects of UK businesses.
Meanwhile, however the U.K. IPO market remained subdued. IPO investors generally like certainty about the direction of travel – for a sector and market valuation – and it’s hard to do either of these, especially when the pound is acting as BREXIT-o-meter.
EY EU Referendum Page contains further insight and information.