Can companies tells us about Brexit impacts?
There appears to be a striking difference between UK share prices and the public statements that company CEOs are making. Public statements are much closer to the worst-case economic predictions associated with the Treasury and Remain supporters seeking to influence the UK's negotiating stance, if not to reverse the Referendum vote. Since Brexit impacts are largely experienced as changes to the way we trade with the EU and trade is conducted by companies, we might expect internal company sensitivity analysis to have filtered through, via financial analysts, or as a result of analysts making their own assessments, to share prices.There should not be a public/private gap.
Anyone looking for possible confirmation of this gap might have seized on a survey referred to in the FT last week: "The most recent Boardroom Bellwether survey, conducted twice a year by ICSA, the governance body, in conjunction with the Financial Times, found that more than half - 55 per cent - of FTSE 350 company secretaries expected Brexit to have a negative effect on the economy, but this was sharply down on the proportion a year ago, when over two-thirds - 69 per cent - thought this would be the case. In addition, a majority of company secretaries - 58 per cent - said Brexit would have no impact on their business."
Though this survey may have been conducted before the post-Chequers shortening of the odds against 'no deal', those odds have surely been shortening, not lengthening, in the interval between this and the previous survey. So the change in attitudes appears significant.
Whatever your dog in this fight, or even having no dog (as a firm we should have no dog and our quantitative investment model certainly doesn't), this survey is not much help. The impact on a single business is more valuable knowledge than opinions about business impacts in general. Those opinions may simply reflect, and cannot resolve, the vast gulf between different economists' forecast of trade effects. Remember that the Treasury's forecasts over a 15-year period published before the Referendum were based on a so-called 'gravity model' that applies generic factors such as distance rather than analysing specific UK trade data. These growth effects have been dismissed as 'out' by a factor of four or five by other economists. Few economists dispute that there will be a trade off to be made between short-term costs to the economy likely to weaken growth and long-term possible benefits, not necessarily related directly to trade and possible explained better by what happens to the EU than to the UK. The EU is, after all, a political as well as economic construct and contains its own stresses and contradictions that create larger uncertainties than Brexit does for the UK and in the case of the Euro may even be existential. But the terms of the trade off ought not to be the subject of such extreme divergence of views. If this cannot be resolved by economists, we might hope for clarification to come from businesses themselves.
Specific company impacts are after all a function of idiosyncratic exposures and observed sensitivities rather than the general assumptions used as inputs to a gravity model or the 'backed-out' sensitivities derived from actual UK trade data. Expected general economic impacts are also probably different between the FTSE 250 and the FTSE 100, the former being more domestic and less sensitive to the reporting effects of currency movements. (As we observed at the time, the main impact of the Referendum itself on share prices was via the exchange rate - Brexit being essentially a trade shock - and that the immediate fall in sterling was a multiple of the tariff changes implied by trading on WTO terms.) But a response from a business to a simple question about Brexit impacts conceals the respondent's assumption about the nature of the agreement or, in the event of no agreement, the nature of the 'disagreement'. Survey responses conflate the expected impact of an event and the probability of the event. That could theoretically apply to some oif the 58% in this survey expecting 'no impact'.
The impacts depend not only on the chance of no deal but also the response of the EU to no deal. (Logically, of course, there is no such thing as no deal: there will be some contingency arrangements where these are vital to both sides' immediate interests.) The EU has the power to make a 'failed deal' outcome more or less difficult (WTO notwithstanding), although whatever it chooses must be symmetrical in impact on firms on both sides. But the form no deal takes might also be a function of non-business costs, notably how much the UK then believes it is obligated to contribute to the EU budget. The shape this failed outcome takes cannot be predicted by applying EU rules. It is never enough to say the EU is rules based and will always enforce the rules. It bends them whenever it thinks it suits it to do so - witness the responses to the credit crisis. I would be surprised to learn there are no instances where it also defies WTO rules.
If we want to see Brexit effects uncoloured by either the economic debate or individual probability estimates, it occurs to us that we can learn much more from companies' contingency planning. Maybe that is not even the right phrase to use. Given the importance of Brexit we might expect sensitivity calculations to have already formed part of good business planning, as possible sources of either planning uncertainty or (as we get closer) budget variance. This ought to contain company-specific impacts across a range of possible outcomes, rather than speculation about the most probable outcome.
This internal scenario analysis is likely to have fed through into the C-Suite survey responses published by the FT, to some extent. At least, you would not expect them to be diametrically opposed. In which case it might indicate that the worst fears of Remainers are based on expected trade impacts that are not borne out in fact. That dog can bite but isn't a killer.
Even if business planning risk assessment was not filtering through to seniors executive opinions such as these responses, you might well expect it to have had touched the work of financial analysts. They are highly motivated to seek an information advantage by making their own assessments of sensitivity so they will know how to react most profitably to events as they unfold. Ironically, MIFID II rules from Brussels have already shrunk the volume of analysis in mid-size and smaller companies but hopefully not to the extent of entirely cutting off companies' own business planning from the information flow in the public market. If we were to assume that the information flow is actually functioning, it is also striking that analysts do not seem to be supporting the very bearish version of bad outcomes. That dog looks more bark than bite.
Who is supporting the bearish view is the C-Suite itself. But any dichotomy between internal company risk assessment and the stated opinions of their CEOs or other executive directors may point to lobbying rather than planning. They are the people with most personal exposure to one particular attribute of Brexit: short/medium-term uncertainty. Any widening of the expected variance in business plans caused by the uncertainty about the effects of Brexit is tricky for executive remuneration. Existing incentives are threatened by the short/long-term trade off implicit in Brexit. And shareholders will be on the look-out for new incentives that exploit the variance by creating one-way options: if it turns out OK we win but we don't give up anything if we lose. The C-suite is barking loudest but it would, wouldn't it?
Anyone who knows Fowler Drew well will know we are not a 'bottom-up' manager. We know security analysis is a necessary function of public markets to ensure information efficiency but it does not need us (or most investors) to contribute to it. We manage goal-based portfolios using a quantitative model that works at the level of asset allocation and is then implemented using index trackers. So when we say there is gap between share price behaviour and the public statements made by business this is necessarily impressionistic. It is more of a challenge for the Brexit bears, and disinterested security analysts and stock pickers, to answer than a proof statement.