What does Brexit mean for Indian Investors in the medium term: Part 1

On June 23^rd, 2016 the people of United Kingdom in a historic referendum voted to leave the European Union (EU). While this event risk, popularly known as Brexit, was known to the capital markets and financial community for some time, the results of the poll came as a shock to many, particularly since the opinion polls, though close, were giving a slight edge “remaining in the EU. When the poll results started trickling in capital markets around the world reacted with shock and almost all the major stock indices, including the Sensex and Nifty, fell sharply. The GBP (pound sterling) fell to 30 year lows. Bond yields in the UK and Europe fell to record lows as worries about UK and the European Union gripped financial markets.

However, after the initial shock, contrary to the doomsday scenarios painted by many market “experts” over the past few months, equity markets have showed some resilience, at least, till the end of last week. After falling by nearly 5% on the day when Brexit poll results were announced the Dow Jones has recovered almost all the losses and is back to near 18,000. In India, the Nifty fell 2% immediately after Brexit, but since then has recovered all the losses and closed last week at the year to date high.

However, since Brexit is a very recent event, readers should not draw any definitive conclusions about near term market direction, simply based on the market action in the last one week. There is a considerable amount of uncertainly over the slightly longer term implications of Brexit. Uncertainty causes volatility in capital markets and therefore, Indian investors should brace themselves for a period of volatility in the near term. However, retail investors should have faith in the intrinsic strength of our economy and its growth potential relative to other major economies.

We believe that, global economic risks posed by Brexit notwithstanding, there are considerable opportunities in the Indian equity market for investors to create long term wealth. In this blog post, we will discuss some of the risk factors in Indian equity market. In the second part of the post, we will discuss the opportunities for Indian investors, in the current economic and market scenario.

Why is Brexit a concern for global equity investors?

Readers, who have been following media coverage of Brexit over the last few months, are well aware of the concerns shared by the economists and capital markets; however, for the benefit of readers, who are less informed we will briefly discuss the backdrop of Brexit and the economic concerns thereof.

In the wake of post World War II reconstruction in Europe, the Treaty of Rome was signed in 1957 creating the European Economic Community (EEC, later known as the European Union), with a view to create a common market in Europe to facilitate trade and commerce between member countries. UK was not a signatory to the Treaty of Rome but subsequently made several applications to join the EEC. Finally in 1973 UK joined EEC; but from the early years of its membership in the EEC, there was political divide in the UK whether to “leave” or “remain” in the EEC, which resulted in referendum being held in 1975 over this question. Though the UK voted to “remain” in the EEC in the 1975 referendum, the political debate on this question lingered. Over the last few years, the political debate over “leave” or “remain” gathered steam and the culmination of this debate was the referendum held on June 23^rd 2016. The British Prime Minister, David Cameron, threw his weight behind the “remain” campaign and announced his resignation once the poll results were declared. The British Government has announced that, it will honour the will begin negotiations with the EU in Brussels over the coming months.

Let us now discuss the economic and political repercussions of Brexit from a global economic perspective. If you have been following Brexit on the media, the global capital market view is that, UK’s membership in the EU was beneficial for both UK and the EU. The UK market is a major source of demand for many EU countries; trade surplus with the UK is more than 1% of the GDP of 8 EU countries. On the other hand, the EU accounts for 50% of UK’s exports. Therefore, Brexit will worsen the overall economic situation both in EU and UK.

Let us now discuss the implications of this on the global economy outside EU and UK (while the global factors may also affect our country, we will discuss risks specific to India later). There are concerns that Brexit may spark off currency devaluations around the globe. The Chinese central bank has already cut the currency rate and other countries are following suit. Economic slowdown in EU and UK can affect economy of the countries for which the EU and the UK are major markets. London is seen by countries outside Europe, as the gateway to European market. With Brexit the mechanics of European market access may change.

Global economic uncertainty may cause risk aversion as far as asset allocation is concerned, which in turn will affect equity markets. The political ramifications of Brexit also pose serious concerns. After the results of Brexit referendum a number of political organizations in countries across Europe are questioning why their country should remain part of EU. Rise in nationalist tendencies leads political leadership towards protectionism, which is ultimately detrimental to global trade and commerce.

In Advisorkhoj we try to give our readers multiple viewpoints. The opposing view to the above is that, the Brexit fears are largely exaggerated. The people on this side of the argument point to the market’s resilience even after Brexit as support to their argument. They say that the World Trade Organization (WTO) tariffs, which its member countries like the US, UK and EU are bound to, are already low and therefore, they don’t expect the revised terms of trade between UK and EU member countries to be significantly worse than what it is now.

They also argue that, while the rating agencies have downgraded UK’s sovereign debt after Brexit, they do not expect significant currency devaluation because the UK borrows in its own currency (unlike say India). Further, many believe that the central banks around the world, including RBI, like in the past, will play a significant role in stabilizing the monetary situation in the short term. Finally, investors should remember that, once the dust from a global crisis settles down a bit, capital finds its way to its most efficient use. India is not only the brightest spot among the emerging economies basket, it is also the fastest growing major economy in the world.

Risk to Indian equities from Brexit

While some doomsday prophets have suggested that, a Lehman Brothers collapse like market scenario may play out in the wake of Brexit, the majority opinion among economists, including the RBI Governor, is that a 2008 like scenario is highly unlikely. Though the Nifty fell by more than 300 points when Brexit referendum results were announced, it recovered from the intraday lows by the close of the trading session on that day and closed above the psychological support level. Last week Nifty resumed its uptrend and closed the week at the year to date high. Please see below, the last 3 months price chart of the Nifty.

Source: Yahoo Finance

You can see that the Nifty has been on an uptrend for the last 3 months. In our technical analysis post on June 6, Nifty is now back above 8000: Is it time to be bullish or cautious, we had discussed why 8,000 is an important support level for the Nifty. In the same post we also said that, Brexit may cause market turmoil. Brexit caused Nifty to test the 8,000 support level and the rebound from 7,950 or thereabouts should reinforce our faith in 8,000 as a support level.

However, Brexit is a major event and its consequence on equity markets will be last longer than what we may be tempted to think. The most obvious risk to our market from Brexit is that, adverse global risk sentiments will affect foreign capital flows, especially FII flows to India. The chart below shows the FII gross purchase and sale activities in June (amounts in Rs crores).

Source: Moneycontrol

While FIIs have been net buyers in June causing share prices to rise, the Government bond yields in developed countries have fallen to multi-year lows. The 10 year US Treasury Bond yield has fallen to nearly its 10 year low on Thursday. The high demand for Government Bonds is a sign of risk aversion, which in turn could affect FII flows to emerging markets. However, as discussed earlier, the fundamental economic strength of India, relative to other emerging markets, makes it an attractive investment decision for long term investors. We should watch the FII data over the coming weeks and months.

The other risk factor will be the currency. The Indian Rupee after falling to below 68 to the US Dollar immediately after Brexit bounced back to 67. If Brexit, as discussed earlier, triggers off a full- fledged currency war, then the impact on Indian economy (in terms of fiscal deficit) and stock market will be negative. This may negatively impact FII funds flow. The RBI Governor has stated that, “the Indian economy has good fundamentals, low short term external debt, and sizeable foreign exchange reserve”. He has also assured that, the RBI will closely monitor the situation and provide liquidity support, if required. The role of the RBI will be important in ensuring stability in our financial markets in an environment of potential volatility in global markets.

What will be the impact of Brexit on India’s GDP? While European Union is an important trading partner of India, the EU India trade as a percentage of India’s total trade has been on a declining trend since the mid nineties. The chart below shows the top 10 trading partners of India in the fiscal year 2015 - 2016, accounting for, among themselves, nearly 50% of our total trade (amounts in $’ Billion).

Source: Ministry of Commerce, Government of India

You can see in the chart above that, Germany is the only EU nation among the top 10 trading partners of India. Please note that, Switzerland, though a European country is not a member of the European Union. Further, Germany is the strongest economic power in the EU and therefore, the impact of Brexit on Indo German trade is expected to be limited. What about Indo British trade? As per Ministry of Commerce data, in FY 2016 India’s exports to the UK totalled $9 Billion while imports totalled about $5 Billion. Unconstrained by EU regulations after Brexit is completed, UK and India can negotiate better terms of trade. Therefore, purely from a trade and commerce perspective, the impact of Brexit on India’s GDP is expected to be quite limited.

Brexit risk to specific sectors and companies

Brexit does pose risks to certain specific sectors which are dependent on the EU and UK for a considerable portion of their revenues. One sector, which has a large exposure to the EU and UK in terms of revenues, is the Information Technology sector. EU accounts for 25 – 30% of the revenues of some of the major IT companies. A large portion of their client’s technology spend is discretionary and this has usually been the worst impacted in economic downturns because it is one of the easiest to cut. Therefore, in the event of a downturn following Brexit, earnings of IT companies which have significant portion of their revenues coming from EU and the UK, will be impacted, at least in the short term. Travel and Tourism is another sector that may be affected adversely by Brexit. In an environment of economic uncertainty, the first thing that individuals, families and companies cut back on is leisure or discretionary travel.

Many companies which have substantial investments in EU or UK, or have a substantial portion of their revenues from the Eurozone may also be affected. Tata Motors and Tata Steel have substantial investments in the UK, and both the companies get a big percentage of their revenues from the EU. Auto Ancillaries manufacturer, Motherson Sumi is another example. These sectors and companies might be impacted by Brexit and therefore, investors should wait a bit to get a better understanding of the impact of Brexit on these companies, before making investment decisions.

Conclusion

In this post we have seen that, risks arising out of Brexit to specific sectors and companies notwithstanding, the medium term risks are limited, as far as Indian equities are concerned. In fact, the monsoon, GST Bill and the Q1 earnings season might be more important than Brexit. That said, the impact of an event of this magnitude should not be underestimated. In times of uncertainty and high market volatility, disciplined approach of investing is the best course of action. In the next part of this series, we will discuss the opportunities for Indian equity investors in the post Brexit economic and market scenario.

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