Whilst COVID-19 related articles dominated our investment blog this quarter. Head of Equity, James Penn covered three other topics: UK Government Debt, Raising Capital and Brexit progress.

UK Debt Exceeds GDP

Published: 23rd June 2020

Three months on from the outbreak of the COVID-19 crisis, and the bills are finally starting to arrive.

The figures for UK government borrowing in May are truly shocking. The deficit hit £55bn in one month, nine times bigger than in May the previous year.

Debt as a proportion of GDP has reached 100% - in other words the amount of debt is the same size as the entire economy, something that hasn’t been experienced since 1963 when the country was still paying off debts accumulated during the Second World War.

The debt, of course, is still rising – we are far from the peak, and the UK debt to GDP ratio will likely hit at least 120% in the next two years.

As for the markets, where they go from here is anyone’s guess. We had two contrasting views from US investment banks last week.

On the one hand, Citigroup argued that European stocks will be trading at the same level in 12 months’ time. Earnings will drop -50% in 2020, but rebound only 30% in 2021, leaving the market’s valuation at 22x forward earnings (and so expensive), rather than the 15x PE ratio it appears to be trading at on current analysts’ forecasts.

On the other hand, Morgan Stanley argued that the cycle is ‘more normal than appreciated’, and that the world will experience a sharp recovery.

They think the global economy will roar back to pre-pandemic levels by the fourth quarter and fuel a strong stock-market bounce into 2021. ‘We have greater confidence in our call for a V-shaped recovery, given recent upside surprises in growth data and policy action.’

At this point one can’t say much other than that – either of them could be right.

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Raising Capital in a Crisis: What is Pre-emption? 

Published: 8th June 2020

Pre-emption allows existing shareholders first dibs at buying new shares, and thus preserving the relative value of their shareholding, and compensating them for dilution with nil paid rights.

Previously, under UK Company law, the maximum amount of equity that could be raised in a placing was 10% - specifically to avoid dilution. The rules have now been relaxed so that pre-emption only kicks in at 20%, allowing many companies to raise the money they needed without going to all the hassle and cost of a rights issue.

As a result, most of the equity raised this year has been through share placings, where the company is permitted to approach new shareholders, usually institutional ones, very quickly and at low cost.

Thus, hospitality business Compass raised £2bn in mid-May through a placing – the biggest one yet seen this year. Informa, the media group, had raised £1bn a few weeks earlier. Many other companies have taken advantage of the 20% facility, including Restaurant Group, Gym Group, Foxtons, DFS, Hiscox, and National Express.

Other companies, food group SSP and online retailer ASOS, have issued 19% new equity, while Hays, WH Smith, JD Wetherspoon, and Polypipe have raised 13-15%. None of these capital raises would have been permissible under the old regulations.

Some companies have gone down the traditional route. In June, Whitbread concluded its rights issue to raise £1bn, with the existing shareholder base benefiting from pre-emption.

The verdict on the attractiveness of the opportunities presented thus far? Not obviously great, with only ASOS standing out as a compelling buying opportunity – perhaps due to its online characteristics. Some of the others may take longer to bear fruit.

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What happened to Brexit?

Published: 26th May 2020

To recap, the UK’s Withdrawal Agreement passed through Parliament in January with barely a whimper. The UK was then in the ‘transition period’, which would permit discussion about the future trading relationship between the UK and the EU.

Both sides seem to be so far apart now that no hope of an acceptable agreement seems possible. Whether this is due to the difficulties of negotiating in virtual meetings, or an underlying impassable gulf in the two sides’ ambitions, is difficult to say.

In mid-May, the UK government published its proposed tariffs (or exemptions on tariffs) in a post-EU world; it seems the UK is now planning aggressively for a no deal scenario. Tariffs will be retained on autos and agricultural goods to protect UK producers, but otherwise largely abolished.

From a UK perspective, the stumbling block is the ‘level playing field’ that the EU is insisting on, under which the EU would continue to have oversight, and effective control, over UK customs and other regulations. The government’s view is that this is completely unacceptable for a sovereign nation. The EU also wants access to UK fishing waters on the same terms as before. Meanwhile, the UK wants access to the EU for services companies, particularly financial services.

Earlier in the year, with Boris firmly in control, an overspill of the ‘transition period’ into next year would have seemed plausible.

COVID-19, however, has arguably made the situation so bad that leaving on WTO terms won’t make things appreciably worse. We are already in the worst recession since the 1930s. Movements between the UK and the EU have already come to a standstill while trade between countries is significantly reduced.

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