26 April 2016
Luca Sarri
How should investors treat this potentially volatile period in the run-up to the June 23rd EU referendum?
Recent comments from the Washington-based International Monetary Fund, “we have clearly elevated so-called ‘Brexit’ as more of a serious downside risk to our forecast for global growth” (Managing Director Christine Lagarde), suggests the vote will be a serious matter for global markets, not just UK/EU markets.
Personally, I am pleased the IMF has added its commentary as an impartial, informed opinion.
President Obama in London
President Obama’s London visit has reminded the UK audience that concluding trade agreements, with an independent UK, would take considerable time. His “back of the queue” comment rather stuck in a jaw, but this was its purpose.
There is considerable uncertainty over the US/ UK trade position, post an exit vote.
The suggestion was, post an exit the UK would not immediately have reciprocal access to U.S.-based consumers or businesses.
A great deal will depend on the campaigns in the run-up to the vote. Whilst we have mayoral elections to get out of the way first, other than a mail shot the “Remain” campaign has not really got going and seems to be rather lazy. The same can be said for the “Leave” campaign.
The EU referendum is “binary” in nature, there are two outcomes only.
According to the www.whatukthinks.org/eu on April 25th, the pollsters are saying the vote is 54% Remain/ 46% Leave. The previous read on 18th April showed both sides on 50%. This is, therefore, a variable “swing-o-meter” indicating a high degree of poll movement and potentially a close result.
A vote to leave will have immediate implications, for sterling, gilts, equities and politics. It will mean a slowdown in UK GDP growth.
What would follow is a period of uncertainty whilst the UK negotiates its EU exit. Would the PM survive? This is debatable. Would we get Boris Johnson in no.10? Ok, so I am extrapolating a bit here!
Looking beyond a Brexit… what about a Frexit?
Beyond the UK, the fact of a large EU country leaving the EU is bound to have profound implications for EU members. Not only would it set a precedent, it would amount to a useful case study. What is to prevent other EU countries making demands on the EU bloc using the threat of an in/out referendum?
We have looked at beneficiaries from increased capital markets volatility as the first order outcome. We have also included an investment trust that would benefit from weaker sterling and finally a UK utility.
ICAP is the world’s leading interdealer broker (an IDB is a financial intermediary between financial institutions who wish to maintain anonymity and not reveal trading position sizes). The business is broadly split into:
i) electronic markets via BrokerTec (fixed income) and EBS (currencies) ii) PostTrade Risk and Information and iii) Global Broking (this business is being sold to Tullett Prebon). ICAP is a direct beneficiary of high market volatility which increases trading in US treasury bonds and other government bonds.
ii) PostTrade Risk and Information
iii) Global Broking (this business is being sold to Tullett Prebon). ICAP is a direct beneficiary of high market volatility which increases trading in US treasury bonds and other government bonds.
ICAP is a direct beneficiary of high market volatility which increases trading in US treasury bonds and other government bonds.
| Company | ICAP |
| Share Price | 478 |
| Target Price | 520 |
| 52 Wk. Hi/Low | 566/401 |
| Shares O/s | 651.5m |
| Market Cap. | £3.11bn |
| Avg. Daily Volume | 580k |
| Dividend Yield | 4.7% |
Source: Fidessa Ltd.
ICAP’s deal with Tullett Prebon will soon merge both companies’ “voice broking” businesses. ICAP shareholders will receive 36.1% of Tullett with ICAP retaining 19.9%. The deal when complete will result in £60m of cost savings from back office synergies. We expect the deal to complete in H2 2016.
ICAP is a beneficiary of increased volatility in the run up to the 23rd June EU referendum and post-referendum if the outcome is “Leave”.
i) ICAP future profit is sensitive to volume growth which has been weaker recently.
ii) The ICAP business is reliant on key personnel whose departure would be detrimental.
iii) ICAP/ Tullett Prebon deal is subject to competition, regulatory clearance, and shareholder & bondholder vote. Should the deal fail, ICAP shares would decline due to the loss of anticipated merger benefits.
( Formerly Fleming Japanese Investment Trust) the JPM Japanese Investment Trust is a well-run, low expense specialist in large and mid-cap Japanese equities. The trust achieved a return of 14.7% in sterling to end 30 September compared to a 6% jump in its Tokyo Stock Exchange (TOPIX) benchmark. The trust is an active manager and backs competitive export companies.
The trust has a low gearing of 9.2% hence the board has employed borrowings in a modest way against capital. The JPM Japanese Investment Trust reported net assets per share of 345.45p per share (18 April 2016) hence is trading at a 14.6% discount to net assets, somewhat larger than normal discount.
| Company | JPM Japanese I.T. |
| Share Price | 298 |
| Target Price | 330 |
| 52 Wk. Hi/Low | 303/243 |
| Shares O/s | 161.25m |
| Market Cap. | £480.05m |
| Avg. Daily Volume | 42k |
| Dividend Yield | 0.95% |
Source: Fidessa Ltd.
The trust has a 30.9% exposure to ten blue chip Japanese investments; primarily companies that should benefit from “Abenomics” (which involves asset purchases by the Bank of Japan/ higher inflation and budget deficit reduction).
One major benefit of recent government policies, a weaker Yen will boost export companies and benefit the trust.
But government policies have yet to lift inflation or significantly cut the budget deficit.
JP Morgan Japanese pays 2.8p p.a. equating to 0.95% dividend yield.
1. Exchange rate changes may cause the value of underlying overseas investments to go down as well as up.
2. Investments in smaller companies may involve a higher degree of risk as these are usually more sensitive to price movements.
3. The investment objective of a trust may allow some flexibility in terms of portfolio composition
4. External factors may cause an entire asset class to decline in value. Prices and values of all shares or all bonds could decline at the same time.
SSE (formerly Scottish & Southern Energy) is a leading UK/ Eire gas/ electric distributor with three major divisions, Wholesale, Networks, and Retail. SSE is building its Networks regulated asset base, it expects its Network assets to reach £10bn by 2020 from £7.6bn now.
SSE will, therefore, be able to earn more profit as its regulated asset base increases. SSE has an impressive track record delivering dividend growth, annual dividends per share were 88.4p in 2015, and the policy is to lift the dividend by at least the Retail Prices Index.
The SSE board indicated on 24th March, it would interpret RPI for dividend purposes as “at least” equal to 1%.
| Company | SSE Insurance |
| Share Price | 1482 |
| Target Price | 1700 |
| 52 Wk. Hi/Low | 1696/1321 |
| Shares O/s | 1.01bn |
| Market Cap. | £15bn |
| Avg. Daily Volume | 1.48m |
| Dividend Yield | 5.93% |
Source: Fidessa Ltd.
Ahead of finals on 18th May 2016, the consensus profit forecast for EPS is 116.2p with a dividend of 89.57p. At the interims, the board confirmed EPS target of 115p after reporting 32% operating profit gains due to stronger power generating profits. The board pointed out it was comfortable adjusting the dividend cover range from 1.2x-1.4x in the three years to March 2018.
SSE is a regulated utility company hence pricing structures are determined by Ofgem.
Key Risks to Price Target
i) SSE market share is under threat from smaller gas and electricity suppliers who are growing market share by poaching customers. There are 24 smaller UK competitors many of whom have reported double-digit UK customer growth.
ii) SSE recently warned profits for the 2016 financial year face “significant uncertainties”.
iii) In recent years SSE’s dividend cover, i.e. SSE’s ability to pay dividends from profits has reduced. There would be a risk to the dividend being cut, should this trend continue.
The pre-vote period is idiosyncratic in that a vote for “Remain” is unlikely to elicit much upside as it delivers nothing new. The “reforms” obtained from the EU by the PM do not amount to meaningful change – but a vote to “Leave” will result in significant uncertainty over exit terms and the perception of the UK abroad. Previous votes on EEC membership and the Scottish referendum is not much guidance.
In this context, we view ICAP as benefiting from Tullett merger synergies and a period of high global volatility. JP Morgan Japanese IT is sufficiently “remote” from the UK to have very little impact, whilst SSE adds to the mix as a high yield favorite, with limited exposure to EU issues.