BACKGROUND TO BREXIT

After the summer 2018 recess, Brexit negotiations with the European Union are gathering pace again. Although still slim, the chances of a so-called “No Deal Brexit” appear to have increased in recent months after EU negotiators again rejected Prime Minister Theresa May’s latest proposals for a new trade agreement. In August, Dominic Raab MP, Secretary of State for Exiting the European Union, issued 25 “technical notices” looking at various consequences of a No Deal Brexit and EU officials have also been preparing for this eventuality. So how should we as custodians and investors of client assets respond to this possibility, especially since, after two years of slow progress, the timetable is now relatively tight?

 

Context

Britain joined what was then called the Common Market in January 1973 during the Conservative administration of Edward Heath. Over the last five decades, many voters, politicians, investors and business people have come to value the benefits of operating within the European Union, such as;

  • A barrier-free trade relationship with a large and important partner

  • A strong and clear regulatory framework

  • A migration system which allows businesses to access the skills and labour they need to deliver growth

  • EU funding for industry, science and research

However, ever since we joined, our membership of the Common Market/EEC/European Community/European Union has been a contentious issue, with politicians of the left and right as well as plenty of voters uncomfortable with being part of what many viewed as European super-state run by unaccountable technocrats.

Forty years after joining and reflective of this national debate, David Cameron, then British Prime Minister, gave his “Bloomberg Speech” on 23rd January 2013 in which he pledged an “in or out” referendum on Britain’s membership of the European Union by 2017 if he was not able to win some concessions from the EU. Mr Cameron said he wanted Britain to stay at the heart of the EU, but he wanted to re-negotiate what he described as “restrictive EU rules” for this country. Mr Cameron suggested that “Britain’s national interest is best served in a flexible, adaptable and open European Union and that such a European Union is best with Britain in it.”

Three years later, on February 20th, 2016, Mr Cameron finalised his “deal” with the 27 other European leaders and presented it to Parliament and the country; the Referendum in June 2016 was a vote on the deal that Mr Cameron struck.

 

Brexit Milestones

23rd June 2016 – UK Referendum on Membership of the European Union

The electorate voted to leave the European Union – the figures were;

Remain - 16,141,241 Votes, 48.1% of total votes.

Leave - 17,410,742 Votes, 51.9% of total votes.

Turnout was 72.2%. (Source: BBC)

29th March 2017 - Article 50 triggered. The UK gave notice of its intention to exit the EU in line with the wishes of the electorate and the guidance set out in Article 50 of the Lisbon Treaty, thereby starting the clock on a formal two-year notice period. Article 50 also obliges the EU to try to negotiate a ‘withdrawal agreement’ with the departing state. Theoretically, there is nothing to stop the government unilaterally withdrawing from the EU by simply repealing the 1972 European Communities Act (the “No Deal” scenario), Article 50 compels only the EU to seek a negotiation, not the withdrawing member state.

18-19th October 2018 – the next Quarterly EU summit. This is chief EU negotiator Michel Barnier’s target date to agree a withdrawal treaty, tying off legal loose ends for departure, such as the rights of citizens, mutual financial commitments and the Irish border. The mooted agreement is also expected to contain details of a transition deal and be accompanied by a separate “political declaration” outlining the broad terms of a free trade accord and other relationships to follow that.

January 2019 - The EU and British parliaments must ratify the withdrawal treaty before Brexit. To avoid eleventh hour nervousness, getting that done at least two months ahead of scheduled exit. Having said that, the EU’s preferred style seems to be thrashing out a deal at 4.00 a.m. after a good dinner with a deadline looming.

29th March 2019 – Brexit Day. Britain is scheduled to exit the European Union at 11p.m.

It is still unclear what precisely will happen on Brexit Day, what kind of deal, if any, we will leave with and the outcome of the negotiations. Some of the biggest questions could come to a resolution before this summer is out.

 

Deal or No Deal?

It is important to note that, technically, there is no such thing as “A No Deal Brexit”. If there is no agreement on a trade deal prior to 29th March 2019, then our default position would be trading with the EU (and the countries with which the EU has a Free Trade Agreement) under international law as administered by the World Trade Organisation (WTO) although there is unlikely to be any “transition period”, under these circumstances. The UK already conducts much of its trade with non-EU members such as the US and China under unmodified WTO rules.

The present focus of negotiations between Britain and the EU is on the framework for a future trade deal but any such agreement does not guarantee a post-Brexit free trade agreement (FTA). It is worth noting that such an agreement must be negotiated after 29th March 2019 when the UK is a third country and that these negotiations may fail.

Recently, the odds of no agreement appear to be shortening. Mark Carney, the Remain-supporting Governor of the Bank of England, recently warned that the possibility of Britain exiting the EU without an agreement in place is “uncomfortably high.” Even the Brexit-supporting Trade Minster, Dr Liam Fox, has put the chances at 60-40 in favour of No Deal, an opinion for which he was criticised by the Prime Minister.

There is still a good chance that the UK and the EU will agree on a framework relationship and there are several options for a framework trade deal:

  • On the basis on the Chequers’ Agreement, though we note Mr Barnier’s latest rejection of part of it and its general lack of popularity

  • A simpler Canada-style free trade agreement (FTA) though, arguably, this is politically unlikely given the concessions the UK has already made that cannot be “unmade”. In other words, it could be too late politically to switch from the Chequers’ model to a simpler model before Brexit. The chances of a Canada-style deal are regarded as probably low.

  • There is even the possibility a deal will be agreed that includes the Single Market (in the EEA) and/or the Customs Union, though the probability of such an outcome must be very low.

We assess the probability of various exit scenarios at the end of this report.

 

Possible Consequences of a “Messy” Brexit

The Brexit vote led to an increase in uncertainty about the economic prospects of the UK and of the EU and created unwanted volatility in investment markets. As we know, the UK is a leading global financial centre and the financial heart of Europe. One immediate consequence of the Brexit vote in June 2016 was the drop in the value of Sterling versus the Euro from around €1.30 to £1 to below €1.20.

Research by University College, Dublin indicates that the impact of the depreciation of Sterling on the Euro area economy should be limited. Of greater concern are the longer-run economic and political implications of the UK leaving the EU.

The political threats to the continued existence of the EU appear to be higher now than ever before. The migrant crisis means that the Schengen Agreement on free movement is being ignored by some member countries and the German Chancellor Angela Merkel, a big influence on the EU, only remains in power at home thanks to a relatively fragile coalition. The Brexit vote served as a reminder that the EU is less popular than its leaders might think, while blaming the EU for a wide range of economic problems is an effective tactic for various political groups in places like Italy and Hungary. The last thing the EU needs just now is somebody leaving so they seem determined to make it as difficult as possible for Britain to leave pour encourager les autres.

We are long-term investors and our strategy is to hold the great majority of our investments for at least five years to generate the best return for clients and we position our portfolios accordingly. We should remember that The City overwhelmingly thought Brexit would be voted down in the referendum, so we had to take that as the prevailing view and act ahead of the event accordingly. At the time, our portfolios were “UK PLC” focused and therefore lost out in the rally of the top 100 overseas earners in the aftermath of the vote. We asked our fund managers what tactics they have implemented in their funds to deal with Brexit and, more recently, the threat of a potential “No Deal” Brexit.


Mark Elliott

Manager of the Castlefield B.E.S.T UK Opportunities Fund

The terms of our future relationship with our main trading partner feel as elusive now as when negotiations commenced. In such a vacuum of policy, or indeed clear rhetoric, investors must consider an unusually broad range of potential outcomes. As stewards of our clients’ assets, we are continually assessing the potential impact on portfolios and what possible opportunities or threats might be presented by this major event.

Therefore, we must ask ourselves how we might best anticipate market developments based on an eventual outcome that is yet to be articulated by policymakers. We might consider the reaction of investors immediately after the referendum result was delivered as a reasonable guide to this exercise. Investor reaction at that time reflected shock, as “Leave” was not the central expectation of a perhaps overtly metropolitan and financially liberal investment community. However, the initial slump in markets was quickly followed by a more measured consideration of what the impact might be for various industrial sectors and companies.

As briefly mentioned above, the most extreme impact was seen within currency markets as Sterling fell against other major currencies. That reaction persisted after the initial reaction to the referendum result subsided and its consequences began to filter through into stock market performance of different sectors.

 

 

Although the Pound has recovered from the worst of its losses, it is still below June 2016 levels against the three major currencies and the investment performance of various UK market sectors through the second half of 2016 was heavily influenced by these exchange rate moves. Exporters and those companies with a high proportion of their assets in other currencies, especially the US Dollar, fared particularly well. Resource stocks such as the mining groups and Oil & Gas majors substantially outperformed the wider market. Conversely, those sectors that performed least well were those with a strong bias to the domestic economy such as the utility companies.

 

 

How do we view the current environment?

The lack of policy guidance and the ensuing currency weakness are a feature of the investment landscape today, but we also note some related trends that make the world very different to mid-2016. These factors together mean that we can’t simply rely on a “re-run” of market developments to play out again when we do leave the EU next year.

Inflation has increased since 2016 as a direct consequence of “imported inflation” resulting from the weaker Pound. Interest rates are still near record lows but have recently been increased in part to try and contain inflation which passed through 3% earlier this year. While this only reverses the “emergency” 0.25% cut implemented shortly after the referendum result, the likely trend from here is for furthernormalisation of interest rates over the next few years.

This change has had a detrimental impact on those stocks and sectors that might be viewed to be “bond proxies” i.e. those which have much more stable earnings and dividends. Such sectors might include the tobacco stocks, big pharmaceuticals companies and “consumer staple” stocks. The performance of these sectors can often be more defensive in nature, which might be a positive attribute in current circumstances; however, they also tend to be negatively affected by rising interest rates.

 

What are companies doing to deal with this?

Investors are increasingly asking what actions companies are taking to mitigate the effects of a chaotic Brexit. As the possibility of an abrupt and disorderly exit from the EU increases, this question is also being posed to the various trade bodies or other industry organisations which can collectively informthe behaviour of companies in the UK or lobbyon their behalf.

The regular contact that we have with the directors of companies in which we invest as well as those that might be of interest makes us well positioned to observe emerging trends. There has been a distinct shift in the narrative from these meetings of late and we are increasingly seeing companies and trade bodies lobbying the government to remind them of their duty to the industries that they claim to have stood for. Initially, UK and international companies with operations in Britain were rather coy about their plans post-Brexit for fear of upsetting any political sensitivities. That time has now gone and companies are increasingly making public their plans to set up offices or change their staffing to comply with future regulatory demands about where they might need a physical presence.

Mergers & Acquisitions - We have spoken with many of the larger financial institutions including banks and insurance groups whose shares we hold and most are already well served with the necessary licences to operate in the UK as a separate entity to the EU. Some firms are still making acquisitions as a quick way to fill gaps in their organisational or regulatory structure.

 

How are we positioning portfolios to deal with this?

We have positioned our portfolios to be less exposed to the negative trends outlined above but have been careful not to anticipate a facsimile of the conditions that prevailed in mid-2016. We are less exposed to the most “UK-centric” businesses, such as utilities. Instead our financial sector exposure (shown below) includes holdings such as global life insurance group Prudential, a major presence in the US and Asian financial markets and other specialist financial groups such as spread betting group IG which also has the majority of its business outside the UK.

 

(Source: Castlefield funds & LSE)

Mindful of further yield increases, we do not hold many “bond proxy” stocks with no tobacco companies, for example and our Consumer exposure is made up of more growth-oriented discretionary stocks. This is preferable to holding the lower growth consumer-staples stocks that have become very expensive. Dollar strength is likely to benefit the Oil & Gas and Resources groups although these industries come with their own pitfalls. We are instead offsetting a small exposure to these sectors with more investment in global chemicals groups or industrial stocks that provide engineering services to other groups in Dollar-dominated industries but do not have the same asset-based risk as the oil majors.

With some selective investment choices set out above, we hope to mitigate the worst of any negative market reaction to Brexit. One important final caveat is that whatever form Brexit takes in March 2019, it will only be a first step, with a “transitional phase” agreed to by all sides. How extended that period becomes will depend on the level of disagreement prevailing, although the longer it does persist, the greater the amount of time companies and investors will have to adjust to the new investment reality.

 

David Elton

Co-Manager of the Castlefield B.E.S.T Sustainable UK Smaller Companies Fund

For those old enough to remember, there’s a touch of the Millennium Bug about fears that planes will be grounded and we won’t have any food after Brexit Day. If we “crash out without a deal” to use the alarmist parlance, UK equity markets and probably a few across Europe will probably take a temporary hit but nothing should come as a surprise given that the timetable for departure has been clear since Article 50 was invoked in March last year. That said, uncertainty remains, whether for domestic businesses heavily geared to the UK economy or those with a more international footprint.

UK smaller companies are typically more domestically-focused than their larger peers. True to this, over one third of holdings in the Castlefield B.E.S.T Sustainable UK Smaller Companies Fund are primarily UK-centric businesses with little or no exposure to foreign currency. Such companies are more reliant on the UK economy and arguably a Brexit-induced consumer confidence shock or economic wobble could have an impact. However, we believe that many of our companies are unique in that their products and services and have dominant market shares as well as high barriers to entry, keeping them somewhat insulated. Take these examples:

  • Augean is the sector leader in hazardous waste management providing sustainable, compliance-led waste management solutions for Britain’s more difficult to handle wastes. Ostensibly cyclical in nature, Augean operates in a very specialist niche and hazardous waste will still need to be dealt with whether we are in or out of the EU. We therefore do not perceive Brexit to be a major issue for Augean.

  • The Gym Group operates low-cost gyms around the UK which are both growing the market and taking share from more expensive incumbents. Should there be any form of economic downturn in the UK because of Brexit, The Gym Group would arguably benefit due to its price point.

  • Lakehouse serves customers in the social housing, public buildings and education markets, along with a broad mix of customers in energy services. Arguably, regardless of the Brexit vote, government initiatives to improve on the apparent shortage of decent, affordable homes puts Lakehouse in a good position.

Balancing out those with a domestic bias, we have approximately two thirds of the Fund invested in companies which do have exposure to foreign currency. These tend to be companies which have ambitions to be, or are at present, significant global players in their respective markets and have operations all over the world. Anpario, VP Group and Keyword Studios are prime examples of this. The companies with exposure to foreign currency, however, tend to be more exposed to the US Dollar than to the Euro. Those which we have identified as having the greatest exposure to Euro revenues and profits and therefore may face a greater Brexit challenge, are:

  • Anpario is an international producer and distributor of high performance natural feed additives for animal health, hygiene and nutrition and therefore has exposure to several currencies including Euro and USD. EU revenues are estimated at <15% of revenues (Source: company CEO’s comments on UK/Ireland revenues). The company sees Asia Pacific, Latin America and the US as markets which offer the best growth potential. It In its recent results announcement, the company highlighted Brexit as a risk but commented that ‘Anpario has been proactively engaged in understanding the potential scenarios and drawing up plans to mitigate any future risks to the business’. Brexit therefore does not appear to be a major issue for Anpario.

  • Autins Group is a manufacturer of noise and heat management products principally for the automotive industry. There are fears that UK automotive parts suppliers may suffer from the requirement that European OEMs must typically have at least 55% of a product's parts originating from the EU to qualify for EU free trade deals. However, this should not be a major concern for Autins as it has manufacturing sites within other EU countries. In addition, the value of Autin’s products within each vehicle is a tiny percentage of the total value of the vehicle. Indeed, the company has recently announced that it has secured technical approval for its Neptune materials across all its targeted European OEMs, suggesting that Brexit is not going to be a major issue for Autins.

  • Headlam Group is Europe’s largest distributor of floorcoverings, providing the distribution channel between suppliers and its customers. It operates 63 individual businesses across the UK and Continental Europe (France, Switzerland and the Netherlands), with each business operating under its own unique trade brand with their own individual sales teams. Approximately 14% of revenues by geography are derived from Continental Europe (source: company accounts), clearly indicating exposure to Brexit. However, the company has a market-leading position and extensive distribution network, built through organic growth, acquisition and considerable investment. This is not easily replicable and creates significant barriers to entry. We are confident that Headlam’s strong market position can help it weather Brexit.

  • Porvair is a specialist filtration and environmental technology group with three operating divisions – Aerospace & Industrial, Laboratory and Metal Melt Quality. It has operations in the UK, US, Germany, the Netherlands and China. Most of its revenues are generated outside the UK, with c.13% from Continental Europe (by destination, in 2017 (source: company)). Despite this exposure, Porvair is a company that should ride out Brexit uncertainty, given its products are so well placed in attractive niches and embedded with customers. Notwithstanding any further currency volatility in the short or medium term, its products are arguably mission critical and therefore Brexit should not be a major issue.

  • Strix is the global leader in the design, manufacture and supply of kettle safety controls and other components and devices involving water heating and temperature control, steam management and water filtration (source: company presentation). Its parts are used an estimated 1bn times a day by c.15% of the world’s population (ibid), so exposure is very broad from both an end-user and currency sense. Strix does much of its manufacturing in China, which will aid its global sales in a post-Brexit world. Whilst not immune from the trade implications of Brexit, particularly given its legacy Isle of Man HQ, it is very well rooted in its markets.

Irrespective of the uncertainty Brexit brings, our approach is very much focussed on a long-term view and centres around picking quality companies that will outlive Brexit, as well as the next “big issue” and the one after that. We believe the companies we hold bear suchcharacteristics of resilience, have a proven track record, and/or earlier stage where we are taking a very long-term view and are willing to be patient.

We also place a lot of emphasis on the quality of management at the companies we invest in. Many management teams of companies within the Fund have been in place for a long time and have experience of dealing with destabilising events. So, despite there being historic scenarios and setbacks beyond their control, they have survived. An example of this is Alumasc, the supplier of premium building products, systems and solutions. Alumasc is a global player and the current management team have been in place for well over a decade, so they have piloted the business through previous crises such as the credit crunch, which had a major negative impact on the construction sector. This kind of experience gives us confidence our capital is in safe hands.

 

Simon Holman

Manager of the Castlefield B.E.S.T Sustainable Income Fund

This Fund has a bias towards UK domestic exposure and away from the more (and often larger) multinational companies. In large part this is due to its filtering criteria, with the likes of tobacco, oil & gas producers and mining companies all excluded from consideration, each of which has a significant proportion of revenues and profits denominated outside of sterling. This gives them a potential double benefit that the Fund misses out on, in that any UK economic weakness is diluted for them, while the greater exposure to other currencies mean they benefit from the translation adjustment should sterling weaken sharply. Domestic companies don’t enjoy either of these factors to the same extent.

The immediate experience after the referendum vote bore out the above in performance terms, with the Fund struggling, as indeed many UK ethical equity funds did. Domestic sectors such as retail, construction and real estate all fell sharply and then recovered relatively more slowly than the multinational sectors mentioned above. As a result, it would be an obvious parallel for the Fund to experience a similar profile in the event of a ‘No Deal’ Brexit.

Alternatively, investors may view the UK market as vulnerable to an economic shock and be less discriminating in selling off. If wholesale market selling takes place, this might hurt large and mega caps too and particularly if trackers bear the brunt of the selling. This might mean relative performance holds up better than in the scenario above. In addition, the Fund's holdings in infrastructure, particularly renewable energy infrastructure funds, might well provide downside protection for a significant element of the portfolio, again helping relative performance.

Finally, what might be a positive scenario? I can quite easily foresee the market being weak between now and the exit point, as investors sell the rumour but who may then buy the fact. That might see people believe domestic companies have been overly punished and that the reality is not going to be as bad as share prices imply. That could see a positive backdrop for retailers, for example, albeit there may be some more pain for them before then.

Essentially, I think that the status quo is unlikely - markets and sterling are likely to be meaningfully higher or lower than they are presently, but not anchored around current levels. A sterling crash and currency-led market bounce most likely hurts the fund, whereas a sterling recovery would likely see the opposite. Similarly, the fund will likely perform in the opposite manner to the fate of the mega-cap multinationals.

 

Rory Hammerson

Manager of the Castlefield B.E.S.T Sustainable European Fund

“Trade negotiations traditionally are not normally concluded until ‘one second before midnight’, and the exit negotiations with the rest of the EU are unlikely to be much different.”

(Ian McCafferty, external MPC member of the BoE - December 2016)

Before I delve into the portfolio, a comment on the question of currency prediction. I’d sooner not go on a fool’s errand, best to leave to the ‘experts’. That said I have a view: continued exchange rate volatility. The impact of this will be lower business investment, postponed decisions and, at the margin, allocation of resource diverted from the UK. All these factors, added to a debt-laden UK consumer, don’t make me feel bullish for Sterling.

 

Sectors

In terms of how sectors will be affected, as the portfolio is constructed from a concentrated selection of companies irrespective of sector and country, I’d sooner stick with talking about companies. However, we can look at how the markets reacted post 16th June 2016. I generally use data from a week before a major event because, immediately before such an event, there always seems to be an increased amount of trading or “noise”. (All percentages below are calculated by Factset.)

In the three months plus to the end of September, the proxy for the Europe ex-UK index rose 17.4% in Sterling and 7.5% in Euros (see the table below for a breakdown). The impact was of course most severe in the immediate aftermath of the referendum. Looking at Q3 (July to September 2016) the Europe ex-UK index rose 9.1% in £ and 4.8% in Euros. My conclusion is that roughly 50% of the return for a Sterling investor in Europe was from currency. This trend continues if we look at returns for Europe for a year after the referendum. In local terms the market rose 28% in Euros, driven by re-rating and flows. In Sterling terms, the market rose 41.3%, so currency was still a major contributor but its impact had diminished.

 

Source:Factset

 


Stocks

My top ten investments make up 37.5% of the fund, so what we call stock-specific risk is my highest factor risk, while sector risk is secondary or indeed tertiary where country allocation is a large factor risk in multi-country funds.

 

Source: Castlefield

I highlight below three stocks which have direct exposure to the UK; Kingspan, Kerry and Santander. Several the stocks in the portfolio have exposure to the British economy but this is often masked under the heading of Europe sales and profits; Kingspan, Kerry and Santander have clear UK franchises.

 

Kingspan

Kingspan is an extremely well-known brand in the UK although it is an Irish company. Its specialises in insulation panels and boards, access floors and other environmental building products. A favourite in many ESG portfolios, management is very strong and renowned for its cautious approach and consistent growth. Within the context of Brexit, Kingspan is one of the few companies in the fund which would be directly affected by a failure to arrive at a deal with the EU. Roughly a quarter of sales are derived in the UK (source: Castlefield), which translates to around 30-35% of EBITDA (source: Castlefield). Given the wide geographic diversity of revenues, we see that a 10% fall in sterling would result in a 4% drop in earnings (source: Castlefield). So, even if Sterling were to fall 20% on the back of a disorderly Brexit, it would represent an 8% drop in earnings per share (source: Castlefield). This does not impact our investment case nor conviction in the potential for the stock, which is a long-term compounder. Clearly the demand for panels and boards would fall if investment spend falls, but the market is already pricing in a weaker UK environment.

 

Kerry Group (and by default Ireland)

You may not have heard of Kerry Group, but you’ll know their products. The company manufactures and delivers “technology-based taste and nutrition solutions” for the food, beverages and pharmaceutical markets. The company operates through two segments: Taste and Nutrition; and Consumer Foods. The T&N division produces ingredients and flavours and Consumer Food products include frozen meals, hot and cold pies, processed meats and dairy spreads, selling to 80 of the top 100 food manufacturers (source: company). It distributes under the following well-known brands: Cheestrings, Dairygold, KerryGold, Richmond, Wall's, and Mattesons.

Ireland has very close geographic and economic ties to the UK, with Irish exports to the UK representing 35% (https://rctom.hbs.org/submission/the-impact-of-brexit-on-kerry-group/) of all its exports. As such, Brexit was always going to have significant impact on the Irish economy and the food sector, which accounts for 10.7% of total Irish exports (Source: https://rctom.hbs.org/submission/the-impact-of-brexit-on-kerry-group/). Kerry is Ireland’s largest exporter, with €5.2bn sold outside of Ireland last year (source:https://rctom.hbs.org/submission/the-impact-of-brexit-on-kerry-group/). Nearly 30% (Source: https://rctom.hbs.org/submission/the-impact-of-brexit-on-kerry-group/) of these sales were to Britain. Kerry’s annual report and accounts cites three potential effects of Brexit which could impact their business,

  1. Exchange rates

  2. Labour costs and availability

  3. Tariffs in relation to movements of goods and services

Logistics and supply chains would also be impacted. From a supply chain perspective, over 70% (ibid) of Irish exports are shipped through the UK. The process involves docking at a ‘UK landbridge’ for onward transport to the rest of the UK, Europe or beyond. In a post-Brexit world, the complexity associated with this could increase dramatically if customs regulations are imposed, increasing costs and delays. Irish exports abroad could become far less competitive. Kerry, with perishable dairy products, would be impacted by this as any risk of variability in timing of supply could create additional costs and customer issues relating to uncertain timelines.

Secondly, there is the issue of cross border trade between the Republic of Ireland and Northern Ireland. More than €5bn of products (ibid)were traded across this border last year, with 30% of the milk produced in Northern Ireland subsequently processed in the Republic (ibid). The level of border controls imposed in a post-Brexit world is one of many issues subject to intense debate. A ‘hard border’ between the UK and Ireland would add significant complexity to the supply chain for exports.

The Irish Maritime Development Office currently estimates an 18-hour advantage of the UK land-bridge over direct shipping to Europe. Erosion risk would ensue if customs and other checks at UK ports become overly ‘onerous’. New shipping and air links directly to Europe and the rest of the world would need to be established to ensure Irish food products maintain a competitive position, particularly for perishable exports such as those of Kerry Group. In some cases, this is already underway, for example the distribution company Maersk introduced a new route to ship directly from Ireland to Spain rather than via the UK. This route is nearly 10 days faster than existing routes, with further improvements potentially available post-Brexit. Obviously significant investment would be required in Irish ports, with upgrades needed to establish and operate these routes. Higher costs will eventually find their way to the consumer through price rises.

Kerry need to work with their logistics operators to establish plans for the various Brexit scenarios to ensure shipping routes suitable for their perishable products are established. In the medium term, Kerry Group are mitigating their exposure through their well-established manufacturing footprint in the UK and in mainland Europe which means they are well positioned to meet customer requirements in the individual country markets. They are also diversifying and restructuring their portfolio to enable greater focus on high growth emerging markets to reduce their dependence on the UK.

After a meeting with William Lynch from Kerry in May, Castlefield noted “In Consumer Foods, the currency exposure to Sterling has had a material negative impact on the business. With Irish manufacturing and sales in Sterling, the impact has been 3-4% on a group level. The plan is to lower this exposure risk to 2% by shifting some of the manufacturing to the UK”.

 

Banco Santander (2.6% of the portfolio)

Banco Santander has 780 branches in the UK and has a 10% share of the UK mortgage market (source: Company). The UK accounts for 18% of the banks customers, and 14% of profits (source: Company). The loan book in the UK is £205bn and customer deposits total £179bn (ibid). Santander describes the UK economy as relatively stable; however, uncertainty remains. Here’s what they say about the outlook for the UK mortgage market:

Source: Santander

The risk of Santander in the portfolio is mainly translational. 14% of profits come from the UK, so if the currency falls by 10%, profits will decline by around 1.4% (source: Castlefield). There will be other associated costs particularly if the group decide to shift investment banking operations from London.What I found noteworthy was that there was only one mention of Brexit in Santander’s recent quarterly report:

“In a highly competitive environment with some remaining uncertainties (nice understatement) surrounding Brexit, attributable profit was 14% lower year on year at EUR692m. this was due to pressure on spreads and investments in regulatory and strategic projects. Cost of credit was only 10bps. The second quarter attributable profit was 16% higher quarter on quarter. The pressure on mortgage spreads was offset by higher fee income, increased gains on financial transactions and lower costs and provisions”.

We are very comfortable with our positioning for any Brexit scenario, although we would clearly hope for an orderly transition to avoid volatility. This portfolio was launched in November 2017, so the stocks chosen were already embedding some of the impact of political risk. Most of our investments are global by nature, and some are focussed entirely in European countries. We see the impact on the portfolio mainly coming from the increased volatility which will ensue in the event of a No Deal. We have been increasing cash at the margin with around 2.5% to take advantage of any weakness in our high conviction investments caused by market volatility or a more global concern over trade. We remain very sanguine about the outcome and feel confident that a No Deal is very unlikely, though of course, not impossible.

 

Four Brexit Scenarios

Having heard from the people who manage your money, we conclude by offering four potential options for any future trade relationship. These are scenarios for the final deal whose broad parameters should be understood (at least in principle) by this October. Market uncertainty could endure longer than that but that the key elements of the future trade relationship can only be agreed on during the transition period.

  1. A quasi-EEA relationship (“Soft Brexit”). Access to the single market (but with a few exceptions, including some in financial services) and only minor restrictions on movement of people. 25% probability. This scenario would be the most positive for the UK economy, but could meet opposition from Brexiteers arguing that it has given the UK almost no additional flexibility in comparison to EU membership (except the right to sign trade deals with third parties, if Britain UK exits the EU Customs Union), basically forcing the UK to keep or adopt single market norms and standards while depriving us of a voice in decision-making bodies (the Norway situation). It could also be difficult for the EU to accept extensive free trade with the UK in financial services if there is any restriction in free movement of people – “no cherry picking”.
  2. An intermediate relationship. Free trade in goods and a number of sector agreements for passporting services (with less access to the EU market of financial services than enjoyed by Switzerland). 50% probability. This limited access is the price the UK would pay for imposing major restrictions on movement of people and paying only limited contributions to the EU budget (possibly on a cash-for-access basis, as recently suggested). This scenario, seen by some as not in the UK’s short- and medium-term economic interest, would satisfy Brexiteers while not generating a “moral hazard”’ (incentive for other countries to leave) on the EU side, something the EU is naturally keen to avoid. It is, however, likely to meet opposition from both the mostly Remainer Parliament as well as business lobbies.
  3. NO DEAL: A hard Brexit (trading on WTO terms with very little or no passporting of financial services). 15% probability. Caused by a failure to find any agreement, this scenario would trigger a serious shock to the UK economy and would also, to a much lesser extent, negatively impact the Eurozone economy. The probability of this eventuality has increased in recent months.
  4. No Brexit. 10% probability. Difficult to imagine. A precondition for this to happen would be early elections in the UK and a Labour victory or a coalition led by Labour (possibly including the SNP), followed by another referendum (currently ruled out by Labour) before May 2019 (after which the UK will have left the EU). There is also a very remote prospect that the UK could request to postpone its exit (a possibility under Article 50, provided all EU members agree) or even to withdraw its invocation of Article 50 (although that possibility to do so is legally unclear), which could make room for a Brexit reversal.

 

 

Disclaimer

The views expressed are the fund managers alone. You should not rely on these views to make an investment or other decision but should obtain independent advice of your own. You should not consider the fund managers’ views to constitute investment, legal, tax or other advice.

The value of any investment may go down as well as up and an investor may not get back the full amount invested.

Castlefield Investment Partners LLP (CIP) is authorised and regulated by the Financial Conduct Authority and is a member of the London Stock Exchange. CIP is registered in England & Wales No. OC302833

Whilst the views of the fund managers are given in good faith at the time of writing, their accuracy or completeness cannot be verified by CIP. The views of the fund managers should not be considered a personal recommendation, nor to represent the views or opinions of CIP, its partners, members, employees or agents.

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