Judgement Day

Hello all, my name is Andrew Martin. I am a former classmate of Eddie McCann. I am an Economics major with a minor in Applied Data Analysis. My goal in writing this article is to encourage discourse. I will not utilize ‘hot takes’ in my writing to rile up readers. Instead, I will cite factual evidence, both empirical and conceptual, while asking questions along the way. I hope you enjoy.

Students at small liberal arts colleges are taught to think outside the box — using interdisciplinary thinking. The rationale behind this approach is if you are able to write a 12 page analytical essay on the Aeneid, while learning to code in R with no prior knowledge, you are able to answer critical questions drawing on multiple viewpoints. Brexit is the perfect application of this practice. I write this article from the heart of London where Boris Johnson was elected to replace Theresa May. It seems like ages ago that the infamous referendum to leave the European Union was passed. The pound, accordingly, has since been decimated. The U.S. dollar was valued at 1.48 per pound in the days leading up to Brexit. Since then, the dollar has significantly strengthened against the pound, trading around 1.21 per pound. The pound fell nearly 900 basis points the day following the Brexit referendum. I have included a five-year graph of the exchange rate to illustrate this decline. (see figure 1). The ten-year dollar to pound chart is below figure 1 for comparison (see figure 2).

Picture1
5-yr USD/GBP
Picture2
10-yr USD/GBP

 

What is particularly interesting to me is the lack of volatility in the five-year chart relative to the ten-year. There is no question the pound has significantly weakened, but it seems as if the more significant volatility occurred immediately following the referendum’s passing. Since 2016 there has been report after report of the deal or no deal that would occur. Johnson wishes to leave the E.U. as quickly as possible even without a deal, which will significantly hurt cross border trading for U.K. and some E.U. firms. To what extent has a no-deal Brexit been priced into markets? Have firms already paid the price for the 2016 referendum, or will October 31 be a black Thursday?

What puzzles me is whether Brexit will be the catalyst for a European recession. We know it’s coming. But when? Negative yields in Europe along with weak manufacturing data are developments that analysts use to forecast the future of the current business cycle. Mario Draghi, the European Central Bank (ECB) president, proposed a stimulus package that forecasts a rate cut. Negative rates and yields are uncharted territories for central banks. Fixed income logic says that borrowers should pay periodic coupons on their principal, not lenders. In order to increase the velocity of money, however, European banks desperately turned to negative rates: paying investors to borrow the bank’s money. Overnight European LIBOR is -0.468%. Negative rates have allowed companies to take on more debt in a slowing economy— increasing the magnitude of default risks for correlated businesses. This so-called temporary measure taken by the ECB in 2014 has persisted to today. Aside from rate cuts and stimulus packages, the ECB doesn’t have many monetary stimulus tools left to utilize. As former Citigroup CEO Chuck Prince said, “As long as the music is playing, you’ve got to get up and dance.” Economic conditions seem really bleak for Europe, and the music is slowly fading.

Tesco (TSCO traded on LSEG) is the top supermarket chain in the U.K., and has locations all across Europe. Tesco is the U.K’s equivalent to 7-Eleven with a variety of cost-competitive products. The company grossed the sixth most revenue for all U.K. firms in 2017. With Prime Minister Johnson’s planned exit in October, Tesco’s consumer goods producing status will inevitably be put under the microscope. A 2016 Morningstar article published shortly after the Brexit vote rated Tesco a buy as a result of increasing profit margins by driving down costs to compete with other supermarket chains. Morningstar was right. The stock has appreciated around 43% (dark blue curve) since the article. tescoThe FTSE 100, which Tesco is a member of, has appreciated 17.04% (light blue curve) since 2015.  Even with a strong performance since June 2016, Tesco CEO Dave Lewis warned of the consequences that a no deal Brexit could have on his firm. Lewis told shareholders in June “For us to be able to do what we did in March [increase inventory to protect against high future manufacturing costs] in October will be more difficult because we won’t have the space in our logistics system to be able to cope because we’ll be preparing for Christmas and the seasonal peaks that are there.” Tesco shares slid 3% upon news that Johnson was elected. Figure five illustrates the comparison of Tesco vs FTSE 100 over a five-year horizon. Tesco’s significantly larger volatility versus FTSE suggests there’s opportunity. Buying low between October through December seems like a smart strategy because Tesco will likely lose market value as Lewis stated. Holding Tesco long-term, however, is an optimal strategy because it has performed well in an environment with tremendous Brexit noise and a slowing Europe economic narrative, while leading an industry that will continue to evolve, but never die.

Tesco is emblematic of the well-managed U.K. companies that have already priced in a no-deal Brexit. These firms had over three years to prepare for any eventuality that Brexit could bring. With Brexit looking more like a no-deal, we will see if it’s just defensive stocks that survive and prosper.

 

 

References:

Header image

https://www.ft.com/content/3c72fc3a-aec6-11e9-8030-530adfa879c2

https://www.bloomberg.com/news/articles/2019-07-17/europe-dived-into-negative-rates-and-no w-it-can-t-find-a-way-out

http://www.morningstar.co.uk/uk/news/151021/is-now-the-time-to-buy-supermarket-stocks.aspx

https://finance.yahoo.com/quote/TSCO.L?p=TSCO.L

https://www.dailyfx.com/gbp-usd

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