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October 20, 2016

Buying Opportunities from Brexit

By Joseph Hogue, Street Authority

Geopolitical issues have dominated the markets this year, and polls have been useless in lending any kind of certainty to asset prices.

OPEC has successfully managed expectations for a production freeze, even if an eventual deal is still unlikely, which has driven oil prices to nearly double since their February lows. Few would have predicted in January the momentum of the Trump campaign and the potential uncertainty on global trade.

As important as these events have been, however, 2016 will likely be remembered for one event in particular.

A referendum that most polls predicted would fail has forced a massive selloff in one of the world's top currencies, and has put in doubt the future of one of its largest economies.

As is always the case, investors have rushed to the exits in this environment of economic uncertainty. When the dust settles, though, it may turn out to be one of the year's best trades.

Investors Fearfully Look To The Future Of The UK

The British pound is now the worst performing currency of the year, down nearly 16% this year and to its lowest level in 31 years against the U.S. dollar. A flash crash of 6% in early Asian trading on October 7 spooked investors further, though the currency has recovered 5% from its low.

In a speech at her Tory party conference earlier this month, Prime Minister Theresa May promised to carry through with Article 50 by March of next year, starting the process of the UK's exit from the European Union.

The speech surprised many that were still hoping for some kind of reconciliation, or at least a slower exit from the monetary group.

The announcement has also heightened fears that the UK may not have time to work out trade deals with the EU or the United States before the exit removes valuable trade preferences.

Additionally, Chancellor Merkel has also taken a hard-line against giving the UK trade benefits without also maintaining EU immigration rights. President Obama has said that Britain will have to wait in line to negotiate any trade deal with the United States.

It's likely much of the rhetoric is just politicking. The EU and the United States both need the UK as an important trade and political partner. The EU in particular can little afford to see already sluggish growth stagnate further.

The Republican-controlled Congress has been supportive of the Brexit vote, and a bill is already before the senate to push for faster trade negotiations. For her part, May's speech was primarily meant for her party's consumption at the convention, in contrast to her prior remarks which indicate a more collaborative exit.

In fact, May conceded that Parliament should be allowed to vote on Britain's exit strategy later in the week, previewing a more negotiated settlement than earlier comments. While half the voters favored Brexit, most lawmakers in parliament opposed the exit, and they are likely to push for closer ties in any negotiations.

Keep Calm And Carry On With UK Investments

Not all is as bad as it seems with the UK economy or the pound. A lower pound will be a boon to exporters. The International Monetary Fund recently upgraded its estimate for GDP growth in the UK this year to 1.8%, the highest among G7 economies.

Britain has been of the economic standouts since the 2008 crisis, bouncing back relatively quickly with 2.9% GDP growth in 2014 that was higher than 2.4% U.S. growth and more than three times the rate of euro-area growth. Manufacturing has recovered since showing signals of weakness in July, and September data on consumer confidence reached its highest point since 2014.

While the IMF lowered its 2017 forecast for the UK to 1.1%, another group of economists is projecting faster growth of 2.6% on effects of a weaker currency.

The iShares MSCI United Kingdom ETF (NYSE: EWU) holds shares of 112 companies based in the country and trades for a price-to-book value of 1.86 times, a 35% discount to the 2.85 book multiple on stocks in the S&P 500. The falling exchange rate may hit the dividend in dollar terms, but higher payouts as exporters thrive could help maintain the 4.6% yield.

Few are calling for a quick turnaround in the pound, but it could mean big dividend payouts when it does. When the GBP strengthened 31% against the greenback over the five years leading up to November 2007, the annual dividend nearly tripled from $0.28 to $0.84 per share.

While financials represent the second highest weight at 18.7%, the fund is also heavily exposed to consumer goods (30.0%), energy (14.3%) and health care (11.3%) which should all continue to do well in the strong consumer environment even as Brexit moves forward.

Risks To Consider: While the underlying UK economy remains strong, the country fund will remain at risk to investor sentiment until fundamentals prevail.

Action To Take: Take advantage of fear around the Brexit and the plunging British pound to take a position in UK companies that will benefit on stronger exports and a rebound in value.

P.S. The UK isn't the only country where politics give investors a reason to worry. Virtually every new President to take office has had a devastating effect on economic growth. It happened with Obama, it happened with Bush and Clinton... in fact, it's happened to every president for 183 years. Will these 3 simple plays make you rich while the rest of the nation bleeds?

Courtesy of Joseph Hogue, Street Authority (More from Street Authority here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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