Trade Wise: Brexit: Gauging the contagion effect of Brexit

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This article first appeared in Corporate, The Edge Malaysia Weekly, on June 27 - July 3, 2016.

WHILE most analysts agree that Malaysia’s fundamentals will not be significantly affected by Britain’s withdrawal from the European Union (Brexit), many fear the spillover effects and inevitable uncertainties could weigh on the local economy and financial markets.

Nomura Securities warned clients not to underestimate the “depth and reach of financial market contagion to Asia”. In its note last Friday, it says that taking the view that the financial and economic impact would only be limited to the UK due to its economic size is too simplistic for two reasons.

“First, we expect non-trivial spillover to the Euro area’s economy and financial markets. While the value of merchandise exports from the rest of the EU to the UK is only 3% of the rest of the EU’s GDP, the UK’s position as a global financial hub — the UK financial sector’s assets account for more than eight times its GDP — leaves the rest of the EU much more exposed to the UK in terms of financial and investment linkages, in part reflecting the UK’s relatively liberalised domestic market and its strong legal framework and institutions,” Nomura says.

Secondly, it fears that Brexit could further inflame anti-EU sentiment in other member states, increasing fears that they would also leave the union.

Asian equities and currencies tumbled last Friday after 51.9% of the UK electorate voted to leave the EU the day before. The FBM KLCI declined 1.7% to 1,611 before recovering to 1,634. Save for the South Korean won, the ringgit was the hardest-hit among the major Asian currencies, sliding 2.1% against the US dollar to 4.09.

“We believe that the overall implications of the vote to leave are negative for emerging currencies, particularly the central and eastern European currencies. In addition to this, currencies with large foreign portfolio exposure and wide external imbalances will also face large downside pressure. These currencies are also the most ‘risk off’ currencies and include the Indonesian rupiah, Malaysian ringgit, Turkish lira and Brazilian real,” writes HSBC Global Research in a recent report.

Nonetheless, the biggest victims of Brexit appear to be the British pound and the UK and European markets. The pound took a pounding, depreciating 8% against the greenback while the Euro Stoxx and FTSE lost 8.4% and 3.5% of their market value respectively in the first few hours of trading last Friday. In contrast, US Treasuries, the yen, the Swiss franc and gold rose as investors flocked to safe-haven assets amid heightened market volatility.

Local brokers generally think that Brexit will have a minimal impact on Malaysia. Hong Leong Investment Bank in a June 24 report points out that Malaysia’s trade with the UK amounted to only 1% of total exports while foreign direct investment from the UK in the 2008 to 2015 period averaged just 4% annually.

Hence, risk to Malaysia emanates mainly from financial contagion. Credit Suisse in a recent note says only a handful of Malaysian companies have significant exposure to the UK.

Indeed, only five companies in the FBM KLCI lost more than 2% of their market capitalisation last Friday. Out of the five, Genting Bhd, Genting Malaysia Bhd and YTL Corp Bhd saw their shares decline 2.4% to 3.8%. The other two large caps are SapuraKencana Petroleum Bhd and Astro Malaysia Holdings Bhd, which lost 4.3% and 3.8% of their market value respectively last Friday.

“The increased market volatility we see today is due to the risk off sentiment, which dominates market sentiment following the Brexit vote. As investors reverse their positions in risky assets and emerging markets, local bonds and equities and the ringgit will certainly be under selling pressure. Meanwhile, we also saw the US and European stock index futures drop a few percentages, indicating that US and European shares are likely to fall when the markets open later,” says Areca Capital CEO Danny Wong.

“That said, the selldown is just a knee-jerk reaction and is short term in nature. Brexit would still require parliamentary approval and it could take up to two years to complete the process. Positively, the odds of having two rate hikes this year are very low as the US Fed turns more cautious on the outlook of the global economies. This is good news for emerging market equities,” he adds.

“After the dust settles, investors will reassess the market situation and probably come back the Asia — the only bright spot that offers decent growth in a low interest rate environment. The alternatives don’t look attractive enough: US interest rates are too low while investors have largely turned more cautious towards European assets. Therefore, the next couple of days could be a good time to capitalise on the Brexit-induced share price weakness and accumulate blue-chip stocks such as Tenaga Nasional Bhd or Malayan Banking Bhd,” Wong concludes.

“The market turmoil is a natural flight to safety but it’s still too early to gauge the full impact. I think we have to wait and see how the US markets respond to Brexit and how the Asian markets respond to US shares on Monday. So far, our local stock market has held up relatively well against its Asian peers with the FBM KLCI still staying above 1,600. For instance, Tokyo Stock Price Index lost 8% and Hang Seng dropped 3% while FBM KLCI fell marginally by 0.4%. Malaysian Government Securities saw yields rise but the amount was small,” says Etiqa Insurance & Takaful head of research Chris Eng.

“Strategy-wise, watch the FBM KLCI on Monday — after the US markets absorb the Brexit news — on whether it can remain resilient and stay above 1,600. As the initial system shock from Brexit subsides, and as the markets expect just one Fed rate hike in 2016, I believe that the local stock market could gradually recover towards 4Q. As such, if the index trades close to 1,600, it’s a pretty good entry point to accumulate stocks. However, if the index falls below 1,600, this will also set off another leg for a further fall,” he adds.

“Nonetheless, Brexit is still a negative development for the global trade and economy. Looking ahead, the further disintegration in the EU and the rise of populist politics are risks that investors need to watch out for. People shrugged off the possibility of Rodrigo Duterte becoming the president of the Philippines, but it happened. Then people thought that Brexit was unlikely to materialise, but it happened. This November, we have the US presidential election and people dismiss the idea that populist candidate Donald Trump could be elected into office. If Trump really becomes president of the US, this could have an adverse impact on global trades, economies and markets,” Eng concludes.


Impact on sectors

Analysts do not expect Brexit to directly impact Malaysian banks as their exposure to the UK is very small.

The UK-related loans of the largest bank, Malayan Banking Bhd, amounted to RM1.27 billion as at end-March, or just 0.3% of total loans. CIMB Group Holdings Bhd, the second largest bank, had UK-related loans amounting to RM948 million, also just 0.3% of total loans.

“Loans to the UK is really small, so I don’t think there’ll be a direct impact. But there could be secondary effects, in that the banks may have exposure to companies that have high exposure to the UK,” says a banking analyst with a local research brokerage.

In a June 21 report, Credit Suisse notes a stronger British pound means higher ringgit revenue and profits (or vice versa), translated from the UK business units.

YTL Power International Bhd leads the pack as some 24% of its revenue is derived from UK-based Wessex Water. The water and sewerage subsidiary in the UK contributes ~82% of YTL Power’s pre-tax earnings. This business will likely remain resilient after Brexit.

With over 40 casinos, Genting Malaysia is one of the largest casino operators in the UK. Credit Suisse estimates that Genting Malaysia’s UK operations will only contribute 2.5% of earnings before interest, taxes, depreciation and amortisation in 2016E. Genting is exposed to UK via its 49.3% stake in Genting Malaysia.

The Battersea Power Station project in the UK is owned by Sime Darby Bhd and S P Setia Bhd (40% each), with the Employees Provident Fund owning the remainder. A weaker economy will adversely affect the take-up in future property launches in the country.

Sime Darby’s property division will see associate profit contribution from Battersea in the UK in FY2017. “We estimate that Battersea will make up about 11% of Sime’s net profit. If the UK economy weakens, the worry is that future launches in Battersea will be adversely impacted. The Malaysian property market remains lacklustre,” says Credit Suisse.

The first phase is expected to be handed over progressively over a six-month period from December 2016 and the expected contribution to S P Setia’s bottom line is about RM280 million, or 36% of consensus’ FY2017 estimates, it says.

Eco World Development Group Bhd and Eastern & Oriental Bhd have meaningful exposure to the UK as well.

Eco World International (EWI), in which the listed Eco World will eventually hold a 30% stake upon its listing, has a huge exposure in the UK. As at January, EWI recorded £712 million in property sales.

E&O ventured to the UK in 2012 when it acquired Princes House in Central London. The project with an estimated gross development value of £60 million is slated for completion this year, in which revenue and profit will then be recognised. E&O recently aborted its proposal to list its UK-based property unit, E&O Plc, on the London Stock Exchange.

Although the local bourse’s decline last Friday was the smallest among the region’s markets, the uncertainty over the global effects of Brexit is likely to dampen investor sentiment in the coming weeks, until the dust settles and clarity emerges.