External forces (Archived)
UK plc looks set to remain vulnerable to external forces in 2016, with events in China the US and Europe all likely to be key. Here, Newton’s UK equity team looks at the impact of China’s commodity demand on UK ‘mega caps’; healthcare analyst Stephen Rowntree highlights the roadblocks posed by the US for UK pharma; while Newton’s strategist Peter Hensman outlines the potential trade impact of the forthcoming EU referendum.
UK mega caps have a mixed outlook in the year ahead but one thing they have in common is their vulnerability to outside forces. Multinational companies, by definition, have global influences. According to Newton’s UK equity team, of the top 20 stocks in the FTSE 100, four are sensitive to commodity prices, three are sensitive to interest rates, and two are sensitive to pricing trends and innovation in global healthcare markets. “If you were to generalise, you’d say their outlook is mixed. All are great companies in their own way but many of them have structural or regulatory headwinds that are unattractive.”
For Newton, the clearest challenge to the group is commodity pricing as it impacts the likes of BP, Shell, BG and Rio Tinto. “This is because managements of these businesses have no control over their output prices and have to budget and plan capital expenditure without any clarity about the price world they’ll be living in when projects are finally delivered, the team believes.
Overall, Newton sees a number of continued risks for the UK, including a potential housing bubble in China and much of the developed world. This is in addition to a possible contagion from a commodity-related debt crisis into the rest of the fixed-income world and a global consumer that is, Newton believes, made complacent by years of rising asset prices and low mortgage repayments.
For the group, mega caps with low commodity exposure and straightforward business models therefore offer the best opportunity in this environment.
Investors seeking nuanced mega-cap exposure could consider the UK healthcare sector but it too has external factors likely to affect returns over the coming year. One headwind, says Newton healthcare analyst Stephen Rowntree, is the US election and the prospect of more discussions on drug pricing by US politicians in the run up to the polls. This may make investors nervous about the growth outlook, he says.
Just as important to the performance of UK pharmaceutical mega caps in 2016 will be clear execution on their stated strategic business targets. Rowntree says for GlaxoSmithKline (GSK) this means the integration and the performance of recently acquired businesses, while for AstraZeneca (AZN) it means demonstrable progress in the R&D drug pipeline. “Both should be rewarded if they can deliver,” he says.
But given the global market volatility and uncertainty seen towards the end of 2015, is UK pharma set for a surge in popularity and, if so, what are the implications for valuations? According to Rowntree, valuations towards the end of 2015 did not look stretched and dividends appeared secure. “The performance of UK large cap pharma, and pharma in general, suffered a little from investor concerns about the potential for greater pricing pressure from the important US healthcare market,” he says. However, he believes improving fundamentals and sustainable growth make for an increasingly attractive opportunity set in a more volatile equity environment.
The ‘Brexit’ question
But what of the forthcoming EU referendum? How could this affect UK healthcare stocks? Rowntree notes mega-cap UK pharmas are not overly reliant on European sales, which constitute only about 27% of total sales
for GSK and 25% for AZN. This is not the case for domestic biotech which, he says, “may be more exposed to local European markets depending on who they are and what they do. However, most of the innovative biotech companies are still focused on R&D and do not yet have products to sell.”
Other sectors may not be so lucky with respect to their fortunes in Europe. After all, the continent is still the UK’s largest trading partner, despite the declines which were reported in the summer of 2015 amid the headlines of a possible ‘Brexit’ and the establishment of a referendum on the subject.
Newton global strategist Peter Hensman says it is difficult to make a firm judgement on the implications for the UK if it were to leave the EU, as there is no certainty as to what this departure would actually entail. In addition, he says, the available data and the arguments presented are obfuscated by politically motivated spin – and this makes such an assessment even more challenging.
According to Hensman, the medium to long-term impact of a Brexit could be smaller than both sides of the debate make out. A Newton-commissioned survey of companies likely to be impacted by a Brexit suggests few would consider relocating operations were the referendum to result in a vote to leave the EU. “Nonetheless, in the short-term, the decision to exit is likely to be a negative as the uncertain implications of this choice contributes to the postponement (and possible cancellation) of investment and trade decisions,” says Hensman.
Hensman says areas most likely to be affected by the UK departing the EU would be trade, inward investment and labour migration.
With respect to trade, Hensman says it seems unlikely flows will be significantly affected in the medium/long-term given the scale of markets available within the EU to UK businesses, and vice versa. However, the experiences of Norway and Switzerland suggest the difficulties in reaching separate bilateral agreements could contribute to significant disruption in the immediate aftermath of a vote to leave the EU. “Switzerland has 120 separate agreements with the EU covering trade and population migration for an economy that is much smaller, and less sectorally diverse, than the UK. Studies of the Norwegian and Swiss models also cite frequent additional costs and delays caused by slower implementation of EU rules and the lower level of familiarity with non-EU agreements which would inevitably occur were the UK to establish new agreements from outside of the union.”
The ability to attract external/foreign entities to invest in or purchase UK goods may also be adversely affected by a Brexit. That said, past warnings of the devastating impact on capital investment if the UK failed to enter the euro proved wide of the mark, he notes. “Capital flows into the UK from emerging economies, and more recently from Japan, demonstrate the attraction of investing in the UK. Language, legal structures and rights, low taxation and labour market flexibility all support the case in favour of the UK. These are unlikely to be altered by a Brexit.”
The companies surveyed by Newton said they do not anticipate any impact on talent migration in the event of the UK exiting the EU. Concludes Hensman: “All things being equal, the potential for labour markets to tighten more rapidly during an economic upswing are likely to contribute to faster wage increases and a squeeze on profit margins, especially for companies with larger workforces. In the medium-term, the incentive to improve productivity from this margin squeeze is likely to diminish this effect.”
What to watch:
- A UK EU referendum is expected to be held before the end of 2017, but there are reports it could be held as early as May 2016
- The November US presidential elections could affect markets
- The Bank of England and the timing and pace of a UK interest rate rise could spark volatility.
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