My immediate answer is “riskier uncertainty”. Not knowing what happens on 29 March 2019 isn’t new. But although we now have a deal; the events of the last seven days seem to have increased probability of no deal. This is a new level of uncertainty with a rapidly approaching cliff-edge.
Which is why, rather than trying to second guess what comes next, I want to focus on the here and now. What can companies do to preserve, optimise, invest, and raise capital when no-one knows what comes next?
Where are we now?
UK and EU officials have agreed the text of a withdrawal agreement and political declaration; but parts of the text have hardened deep-seated battle lines – and not just in the UK. As I write, it there is a good chance that the EU will find an internal compromise, but unlikely that this deal will command a UK parliamentary majority in the ‘meaningful vote’ scheduled for mid-December.
A Conservative leadership contest, won’t change this fundamental maths. Meanwhile, the clock is ticking and the first UK vote isn’t the final milestone.
The most probable outcome remains a ratified withdrawal agreement – albeit possibly not in its current form or to the timetable above. Other options are unpalatable to a majority of MPs and/or they require several procedural stages, making them less likely. But, because the parliamentary maths is so difficult for the government, and the timetable so tight, a second referendum has increased in probability – as has the chance of ‘no deal’, which now has a probability of 25%, according to EY analysis.
It’s this increased risk that the UK will fail to sign a withdrawal agreement and leave the EU without a transition period that’s obviously focused attention.
How have markets reacted?
After Thursday’s drama, we’ve seen a period of relative calm, followed by a pick-up in sterling and UK-focused stocks on Thursday after the publication of the leak of the political declaration that promoted close ties. I expect this event-driven pattern to keep playing out, with bad news more readily acted upon than good until we reach a place of greater certainty. Reaction is also strongly differentiated, and dependent on investors’ views on UK market exposure, no-deal regulatory disruption and a possible General Election. The most significant pinch and potential rally points were there to see last Thursday.
Sterling swings: Investors’ hopes and fears have played out here for the last three years. The pound dropped 2% on Thursday 15th. It’s recovered since, but it is unlikely to push much higher whilst so much uncertainty persists.
Domestic peril: Less certain UK growth prospects, combined with the potential for weak sterling to spike inflation and hit consumers, knocked shares with a high domestic exposure. The flipside to this was a boost to the foreign-earnings focused FTSE 100. Outsourcers, utilities and house builders also reacted to election speculation.
No-deal disruption: Investors’ on-going structural airline and aerospace concern is compounded by post-Brexit regulatory fears.
Liquidity: No major equity issue failures to report yet, but there are clear signs of stress appearing in Sterling debt capital markets. Recent weeks have seen a number of Sterling bond offerings struggle, with some pulled completely as investor nervousness spills into European markets. There is also evidence of stronger UK outflows (see below) – and we know how quickly liquidity can dry up.
What does this mean for capital?
Meanwhile, through all of this, companies need to keep manufacturing, building, serving, selling and creating…. Which is why I really want to focus on what this all means on the ground for companies and their capital agendas.
In the normal course of business, companies assess the potential impact of changing market conditions on their operations and capital base – and react as necessary. But, what happens when the potential outcomes are so binary and uncertain – and their probability is changing almost by the hour? Companies can’t react to every event. They need to take action based on what they think are the most likely scenarios and their level of exposure and risk.
Unsurprisingly, in the last week, we’ve seen a number of companies increase their preparation for a ‘no deal’ scenario, by looking at the business-critical parts of their operation – including their supply chain – and detailing no-regrets responses and risk mitigations. More companies are starting to think about localising their supply chain (where possible) and stockpiling, with pressure building on warehouse space. For companies that rely on importing goods and raw materials, we suggest planning for import delays of up to two weeks. We expect the automotive, chemicals, aerospace, pharmaceuticals and food sectors to require some of the greatest planning in this regard.
Service companies might not need to worry directly about imports; but, they may have suppliers that do. Every sector will need to think about issues around employee travel, costs and availability in the event of ‘no deal’. There are signs that labour availability is already tightening some sectors due to Brexit uncertainty and a weaker pound.
It’s vital that companies plan and have supplier and labour conversations now. For want of one component or skill, companies may be unable to sell a completed product or service.
Some mitigating actions will strain corporate finances. Companies stockpiling imported goods, parts or raw material need to prepare for greater demands on their working capital – and think about the additional strain on their suppliers. in the same boat. Companies used to running just-on-time, low inventory models will be drawing much more heavily on cash. They’ll need to reforecast and model their projected cash flows – and monitor these closely. Cash and working capital problems are often the first sign of solvency issues.
The cost of importing in unhedged foreign currencies will also be more expensive as long as sterling remains weak – adding to working capital pressures. Even in the event of a ratified withdrawal agreement, some sterling weakness will continue until the UK begins to finalise its EU trade deal. The weak sterling-upside for exporters is only as good as their ability to transport and sell goods outside of the UK.
With demand also likely to be volatile, it will be harder to forecast sales and cash flow. It’s an especially tricky time for retailers, as we discussed last week. Amidst all this companies will also need to make assumptions around currency rates, interest rates, cost of capital and valuation. Companies need to keep their assumptions, budgets and forecasts under constant review.
Our recent Capital Confidence Barometer suggests that M&A has fallen down UK board’s agendas. Pipelines are still full, but they could thin as a result of greater caution. We see this more as a deal pause than a retreat. Change always opens up opportunity. We know that a high level of UK businesses are looking to divest assets because they don’t meet their portfolio needs or they don’t have the capital to invest – a trend that could be accelerated by a changing trading and economic landscape.
UK business investment growth is also on pause. But, there is a strong argument for additional spending in selected areas. A good proportion of the Brexit work we’ve done so far with business has involved establishing legal and physical entities to allow continued access to EU markets. Importers and exporters will need additional investment in cross-border compliance and supply chain mitigations, with change to rules and regulations coming under all but a ‘remain’ scenario. If labour becomes more expensive, there is a big incentive for businesses to invest to improve productivity – but will this happen in the UK?
A company’s ability to raise capital quickly and effectively is integral to its growth potential and financial well-being. The Bank of England has been quick to offer reassurance on the health of UK banks. But, capital is fickle. Our recent EY UK Attractiveness Survey showed that 30% of foreign investors expect to move money out of the UK after Brexit. Total net outflows from UK funds since the referendum vote hit £10.5 billion in September, according to the latest data from the Investment Association.
We can’t put all of this outflow at Brexit’s door. The EU and US have seen periodic strong outflows. But, with investors increasingly seeking havens in these more troubled times, there’s a danger that the UK misses out on any upside. Depending on the pace of events, we expect the next few months to be a tougher environment to raise capital – especially in the domestically exposed sectors named above. At the very least, Brexit is adding some additional clauses to bond documentation with extra consideration to jurisdiction.
Brexit may be dominating headlines at home, but we mustn’t forget the continuing travails of the Italian government and their EU budgetary negotiations. Leveraged Finance markets have also had the wind taken out of their sails, albeit perhaps as reaction to the proliferation of exceptionally borrower-friendly terms in recent times. Markets are still favourable by historic comparison, but the tide has definitely turned. Companies need to fully understand all of their different funding options available, choose their execution plans carefully, and have contingency plans in place as we sail into more turbulent waters.
Businesses cannot wait for certainty. Capital agenda decisions are being taken right now to ensure that businesses have no regrets come 29 March 2019. At what point could companies stand down from this preparation? Final legal ratification won’t come until March 2019. The strength or otherwise of UK and EU votes along the way could give us some clues, but not certainty. A second referendum vote or General Election could restore the status quo, or reaffirm the decision to leave and would likely require and extension to Article 50. Even in the event of a withdrawal agreement being signed, there will still be some uncertainty whilst new trade deals are put in place.
In the meantime, businesses still have to deal with the ‘here and now’ and planning and investing beyond Brexit. This is just one of many challenges – and not necessarily the biggest one for parts of UK plc. This week, we launched the EY Disruption Index ™, a tool that measures the level and speed of disruption across 13 sectors. It’s a reminder that there’s more than one challenge out there….
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