The overall economic impact of Brexit won’t be as significant as many investors fear it will be, although currency movements should still be watched closely, according to Old Mutual’s Luke Kerr (pictured). 
The FE Alpha Manager, who heads up the four crown-rated Old Mutual UK Dynamic Equity fund, says there is cause for optimism despite fears that the triggering of Article 50 by the UK government could have negative repercussions for markets.
That said, he believes investors still need to tread carefully when buying into UK equities and warns that certain sectors – such as cyclical consumer goods – are best avoided over the medium term.
“For the UK, the outlook is clearly clouded by Brexit. We feel that the chief impact of Brexit is clearly the fall in sterling, but we don’t think the economic impact is going to be that pronounced, certainly in 2017,” Kerr reasoned.
“I don’t think it’s going to cause much change to the economic outlook. The leading economic indicators – the PMI surveys – all look quite positive at the moment. It looks like Q1 GDP growth will be 0.6 per cent.”
“Clearly if we kept that up all year we’d get 2.4 per cent. Now we’re not quite that optimistic, but I certainly think a result towards 2 per cent is imminently achievable for the UK compared to the doom and gloom that was around immediately post the Brexit vote. That’s quite a change.”
However, the manager admits Brexit won’t necessarily be positive and says the potential major headwind caused by the UK’s break away from the EU would be the continued fall in sterling.
Performance of sterling vs US dollar since 2016
Source: FE Analytics
This would therefore mean steering clear of sectors reliant on importing materials and instead buying into stocks that are global-facing or have strong, weather-proof fundamentals.
“Don’t get me wrong, Brexit isn’t necessarily positive. If you look at it from a company point of view, I think the outlook is a bit different because of the huge move in sterling, which clearly boosts profits for the exporters but creates quite a big margin squeeze for the importers,” Kerr said.
“A lot of the consumer sectors are net importers, if you think about importing food, clothing - even a lot of the alcohol we drink all gets imported so it’s quite tricky for the retailers generally and for the leisure sector.”
“It’s not only the inflation bought in from their imports, it’s also the National Living wage being cranked up a gear, there’s a big increase in business rates. There are cost pressures just building.”
The manager also warns that the outlook for consumer spending is not as positive as it has been over the last couple of years.
Again, he says this isn’t a reason to be pessimistic, but points out that inflation is likely to peak at between 2.5 and 3 per cent in 2017, which is broadly equal to the predicted earnings growth.
He warns that real wage growth is therefore likely to remain flat in 2017 whereas, over the last two years, people have benefitted from stronger pay rises versus inflation and have therefore had greater spending power.
“It’s not negative, it’s just not as positive as it was which makes it much harder for the consumer-facing sectors to pass on all that cost inflation,” Kerr continued.
“So in terms of our positioning, through the course of the whole of 2016 we shifted from being quite overweight consumer cyclicals to being quite underweight now.”
“It’s not because we think Brexit is going to kill the economy, it’s because sterling has moved and therefore consumers are going to have less money in their pockets. It would be hard for consumers to increase their spending year-on-year. So domestic sectors will have a bit of a margin squeeze because I think they will struggle to pass on the cost of inflation.”
Old Mutual UK Dynamic Equity is able to across the cap spectrum, although it predominantly invests in stocks outside of the FTSE 100 index and is benchmarked against the FTSE 250 (ex IT) index.
Yet, the fund also holds some constituents of the blue-chip index – such as Ashstead – which was introduced to the fund when it was far smaller and remains part of the portfolio as Kerr thinks it still has further to run.
Another differentiator versus its peers is that it can hold up to 30 per cent in short positions and up to 30 per cent in cash. This means that, during a period when the manager is particularly cautious, a minimum of 40 per cent of the fund can be held in long equity positions.
Kerr is also able to adopt growth, value, defensive or cyclical investing styles at any one time depending on his top-down view of the economy.
Currently, the manager has positioned the fund in predominantly global-facing holdings further down the cap spectrum, despite common belief that a vast majority of small- and mid-cap stocks are domestic-facing. He also holds just four short positions and has a net market exposure of 98.7 per cent.
“I think broad-brushed, about 75 per cent of FTSE 100 earnings come from overseas and it’s about 50 per cent for mid-cap, so it’s by no means a domestic index, it’s half and half,” he said.
“But when you look at small and mid-cap there are so many more stocks – when you take out investment trusts there are around 450 stocks. If you include AIM in that it goes up from there. If we wanted to, we could construct a portfolio that has no domestic exposure whatsoever.”
“If you talk about generic small- and mid-cap and you go and buy a tracker fund, you will get more domestic exposure and, as I’ve described, I think companies with domestic exposure in certain sectors are going to struggle this year.”
He added: “Actually, the ability for a small- or mid-cap manager to shift their fund to give them appropriate exposure for the prevailing conditions means there’s no reason why small- and mid-cap managers should underperform in 2017 if they’re in the right place.”
Since Kerr launched the fund in 2009, Old Mutual UK Dynamic Equity has returned 302.47 per cent compared to its sector average and index’s respective returns of 135.49 and 214.52 per cent.
Performance of fund vs sector and benchmark
Source: FE Analytics
It has also achieved top-quartile returns each year since 2010, apart from in 2011 when it outperformed its average peer by 1 percentage point and last year when it performed broadly in line with its peers. That said, it comfortably outperformed its benchmark during both of these years.
Old Mutual UK Dynamic Equity has a clean ongoing charges figure of 1.1 per cent.
In an article next week, we will look at the Brexit-proof stocks Kerr is holding from across the UK market cap spectrum.