So Brexit happened. What now?

As Brexit can be considered a once in a decade major events, this article tries to answer everything from some background to the potential implications to the world and Malaysia as well as the strategy moving forward.  You are welcomed to read the full article but if you think it’s too long, you can skip to the relevant parts by referring to the index below.

1. Unexpected twist

2. What is the big huh-hah and why does UK want to leave Euro?

3. Lessons learned

4. Is Brexit really so bad?

5. Political noises incoming

6. What about economic effects?

7. How will it affect Malaysian economy?

8. So what will happen to the financial markets?

9. Implications on other countries’ policy

10. Strategy moving forward for Malaysian investors

11. Names to consider

12. Other names to consider

13. Alternative investments

1. Unexpected twist

Just when everyone though Brexit camp was leading, a politician’s death reverse the trend. And just as everyone thought UK is set to remain in Eurozone up until Thursday night, it turns the other way round and cause havoc in all financial markets.

2. What is the big huh-hah and why does UK want to leave Euro?

Mainly due to two issues, namely subsidies to other weaker Euro countries and immigrants.

To explain the origin and nature of Brexit in layman’s terms, think about it like your own family (UK), living within a Taman (Europe). Then other families propose why don’t we form a big family (Eurozone) and everyone can live in everyone’s house, enjoy each other’s food and stuffs. At the same time, everyone agrees to a set of house rules and will observe it when setting their respective family rules.

Everyone is happy at first since everyone thought it’s such a great concept where everyone benefits and sharing is caring. Over time, then you see some families (Greece, or PIIGS) who spend their money recklessly and are now suffering. You no longer want to go over to their houses but as part of the bigger Taman, you and other families have a responsibility to put together some money to help them (subsidy). And since it is a big Taman, some families are clearly poorer than others. Their children now come over your house and do household chores (jobs) usually done by your siblings and you (UK citizens) and get pocket money (wages) from your parents.

Over time, pissed off, some of your siblings decide to pressure your parents (leaders) to leave this Taman concept and lock your family doors again, or they will disown your parents (not electing them as leaders in next election). Feeling pressured, your parents held an open vote and more than half of your siblings vote to leave this Taman (Brexit).

3. Lessons learned

Angry crowd knows no bounds and are often more emotional than rational. So discount his chances all you like, but never dismiss chances of clowns like Donald Trump could get elected as US president.

Another lesson we can learn is individual benefits outweigh the collective benefits. Yes this is against what you learned in school but the school of life just show you the evidence. The Bremain campaign mainly focused on the negative impact on economy while Brexit campaign focused on immigrants and job issues, which clearly reasonates more with voters.

These lessons learned unfortunately lead to only one thing. That there will be more populist than sensible policies and more loud-mouthed, combative officials ride these waves into office.

One person one vote, the greatest attribute of democracy is also its greatest flaw as it also means a sensible person gets one vote just like any other irrational people. Appeal yourself enough to the irrational voters and the officials could legitimize any actions through majority support.

Not a direct comparison, but this is the exact method how Adolf Hitler got into power and how Japan went into war.

4. Is Brexit really so bad

There are many arguments on the potential long term benefits and implications of whether UK remain or leave UK so I will leave it there. Those interested can google the arguments of the Bremain and Brexit camps.

Personally I am against the Brexit. Like most people, I don’t know what exactly will be the long term implications but what I do know that short term it’s going to cause some damage to both UK and world economy. Yes Euro may be a failed concept and yes it may be potentially good in the long term for UK to leave the Euro but as world economy is struggling so badly, Brexit is like pouring oil onto fire. So regardless if Brexit is good or bad, at least in terms of timing it couldn’t come at a worse time.

5. Political noises incoming

Right after Brexit is confirmed, one of the first implications is the resignation of UK prime minister. Then there are talks of another Scottish referendum for independence and a possible disintegration of UK into England, Scotland, Wales and Northern Ireland. Brexit also gives imagination to all right wing politicians in Europe countries who have long talked about a potential exit.

So what is the significance if all these countries go and hold their own referendum to decide the places in Eurozone? First things first, the time and effort which could be used for more productive use would now be devoted to all these political talks. Politicians would be more interested in pulling votes instead of setting public policies to revive their economy. UK for example, will now see their politicians squabbling who will be the next prime minister and whoever takes office next, we can expect more populist policies designated to please the crowd and defend his/her position instead of focusing on doing the right things.

6. What about economic effects?

The main economic effects would be on free trade, capital flows as well as jobs. Free trade is not entirely off between UK and Eurozone, but at least it won’t be as close like old times. There may be some concessions made so trade relations don’t drop drastically but until a new FTA is in effect, it is not politically right for Eurozone leaders to minimize the effects on free trade as this will make other Eurozone countries doubt what’s the benefit then by staying in the Eurozone.

So economy of UK and Euro countries will definitely take a temporary blip. There are even talks of a potential technical recession for UK. I may not be a economist but I do see benefits of free trade. Some may argue that free trades are taking away jobs of locals and to certain extent, I do agree with them. But what we cannot dispute is that what may be bad for an individual has so far been good for the countries involved. In that kind of environment, it is up to the individuals to stay competitive. However, like I said earlier, an angry crowd is often not the most rational one and when they achieve critical mass, they are dangerous.

And London did not achieve its financial center status by shutting its door to other countries. UK, like most developed countries, run a trade deficit, and does rely on capital inflows from other countries to finance its growth. With this Brexit issue hanging, potential investors would be worried to invest in UK as nobody knows how bad it could be since UK is the first country to set the precedent. If you are a conglomerate who has footprints in multiple countries and looking to invest in an advanced economy, yeah maybe you can afford to take the risk. But for other enterprises which are considering which economy they should set foot in, UK may be too risky for your appetite, at least for now.

Companies who want to tap into the larger Eurozone will not consider UK anymore since it does not enjoy privilege status when dealing with other Eurozone countries. And those who are already in UK will want to move as well because of the same reason. You may think it’s premature to assume that since Brexit won’t actually happen overnight but relocation of business operations also doesn’t just happen overnight. It is a reasonable guess that many companies are now planning to either relocate or at least scale down their UK operations to focus elsewhere, especially those who have close business ties with the Eurozone.

With free trades drying up, capital flows pausing, jobs opportunities reduced, these are exactly why a Brexit is bad for UK and Eurozone in the short term.

7. How will it affect Malaysian economy?

I expect by now, there are already flurry of reports out there trying to calm investors’ nerve that Brexit has little impact on Malaysian economy. In fact, I am sure you already seen quite a bit these two days (which is precisely why I don’t want to write these until end of the weekend). The main argument would be that UK is not a major trading partner with us, accounting for only +/-1% of our exports.  But please don’t forget if we include Europe as a whole, it’s more like 10% of our exports. And even if UK is not our major trading partner, what about UK or the EU countries’ trading partners? If UK and EU suffers, won’t their economy and their trading partners' economy suffer and in turn won’t our economy suffer as well?

Rising tide lifts all boats. Same applies when it is the other way round. So the economist, politicians or brokerage houses can downplay the effect all they like, but I am more bearish on the potential effect, again at least in the short term.

8. So what will happen to the financial markets?

I get these question a lot over these two days. I would summarise my answer in one phrase, “Fear will subside but volatility is set to stay”.

If unfortunately the negative effect of Brexit does hit the world and Malaysian economy, then financial markets won’t react well. But will it be a bear market? At least now it doesn’t look like it. Of course this is only taking into account Brexit, which will happen in the course of at least next two years. But it is the unknown that could blindside us. Should there be more bad news coming in, then it may or may not be the trigger for the next financial crisis. But to predict that is simply speculative at this juncture.

My view is that markets may experience temporary blip for the next few days but after that, as people get to digest the Brexit aftermath, they will calm down and recognize Brexit as what it is, a bad news for free trade, bad news particularly for UK and Euro, but it’s not like the collapse of Lehmann Brothers or collapse of a major economy. The market may still trend down but it won’t free fall and if the market was oversold for the next few days, there could be a slight rebound.

However with directions unclear, markets may be choppy as investors simply have a hard time gauging all the news/noises incoming and wonder how they will affect the market. Funds with cash may also choose to stay on the sidelines, leading to reduced volume. All these would most likely results in increased volatility as market could simply fluctuate up and/or down.

9. Implications on other countries’ policy

One of the most important implications would be that it is almost certain now that US Fed won’t hike the interest rate by July, as some predicted earlier. For me, September is off the cards as well and they might only consider a December rate hike just to salvage some credibility on their previous guidance and show that they are still on the right path of nomalising interest rate. While I always think that ultra low interest rate is simply like feeding steroid to a wounded man, nobody wants to take the risk if the man aches a little bit more here and there. With rate hike delay, this should boost the stocks markets worldwide and hold it high up at least a little bit longer.

For Malaysia, since June is almost up, Brexit won’t have any effect on our 2^nd quarter GDP numbers. But if Brexit negative sentiment continues and does hit our economy in the 3^rd quarter, Bank Negara may be forced to reduce the overnight policy rate in tandem with government fiscal investments to hold our economy steady.

As for ASEAN, I believe the ASEAN vision is now over in substance. Economic integration between countries in a region would be a taboo now and ASEAN would end up be nothing but a glorified multi-country FTA concept.

10. Strategy moving forward for Malaysian investors

Unfortunately, I am now more bearish on Malaysian markets than ever. With upside limited and negatives looming, the risk reward is simply not proportionate. One saving grace is that our national funds, like EPF, Amanahraya etc. are extremely strong in terms of their fund size and liquidity relative to our equity markets so barring a financial crisis, our market will still be relatively well supported. So traders who want to trade KLCI put warrants really need to time their entry and exit well.

For the latest quarterly results released, majority companies delivered disappointed earnings. If I remember correctly, it’s 7 or 8 consecutive quarters of earnings decline for market as a whole. For 2016 second half,I will just summarise my views for the major sectors for your reference.

Banking

Asset quality may deteriorate if economies remain weak, credit cost could hit earnings. However, if net interest margin compression reduces, operating expenses come down (mainly due to VSS/MSS), this could provide support for earnings.

Telcos

Price war is really killing them and doesn’t seem like it is stopping any soon. Spectrum reallocation could also affect certain telcos more than others

Utilities

Defensive, more of a dividend yield play, price upside doesn’t look exciting but may see more interest now with more funds seeking safe haven

Plantation

CPO price seems to hit a snag since Dorab Mistry predicted it will hit RM3,000 mt (sorry for the dig but I think this is not the first time he always make big predictions when trend’s about to reverse, hidden agenda maybe?). Production volume greatly affected due to El Nino and even if volume recovers in second half, earnings may not increase too much and most major plantation companies are still expensive in terms of PE

Construction

A very crowded sector now but at least will still be supported by continued newsflow of contracts awarded. Earnings however won’t kick in soon as companies just start their works. Better to choose bigger caps (ability to ride through tought times and any liquidity squeeze) with good exposure and chances to win MRT phase 2, LRT3 or Pan Borneo highway contracts.

Oil and gas

As a sector it’s doomed for the next one to two years. Downstream companies may benefit a little in terms of margin but it is more of a timing issue and won’t last indefinitely. Upstream will still be dependent on oil prices. With the lowest so far for Brent around $27 per barrel, I expect $54 would be a significant resistance (100% profit resistance) so price should fluctuate between $40-$55 in my opinion for the next 6-12 months. Service companies would suffer even worse as their rates won’t be revised upwards until oil price rise and sustain for a reasonable period. So even if oil price recover, their earnings will only recover much later than that.

Properties

Continue to limp along. Buyers are not rushing in and banks are generally cautious in lending with loan approvals rate dropping. Earnings should still suffer for a few quarters but valuations have dropped so low that any narrowing of valuation gap could give them a boost in price.

REITs

Office REITs will continue to struggle if economy struggles. Retail will see pressure if consumer starts to cut spending (not yet for now).  Both office and retail also expect more floor space coming up. However, Grade A offices and premier retail malls at strategic locations should still do well. For the past few months, REITs have done relatively well so upside may be limited for the short term. Fed rate increase is negative on yield vehicles like REITs, however slow the rate increase may be, but may be offset by the rates cut seen in other countries. If BNM indeed cut OPR, then it’s positive for REITs.

Consumer

Consumer discretionary would see pressure while consumer staples should do hold steady. Many consumer staples also pay decent dividends but generally already trade at high valuations. If earnings don’t grow too much, price upside may be capped as well.

Technology

Prices of big tech companies like Globetronics and Inari were hit. Judging by the brokers recommendation and market reaction, earnings seem to be expected to remain weak for a while.

Healthcare

People still need to spend on healthcare like it or not. But healthcare stocks valuations are not cheap so buy at your own risk.

Gaming

Nothing exciting. Valuations are not particularly attractive and also a victim of weaker consumer sentiment.

Aviation

Shot up a lot, riding on low oil price. As I think oil price will remain range bound for some time and most of their fuel cost has been hedged till next year, coming few quarters will be positive for them. Airasia might still go up a bit if confidence return and market give it a higher PE. Airasia X is more exposed to overseas and with Brexit contagion may not be affected fundamentally.

Transport

Even Tan Chong make losses now, that should give you an idea on how transport sector is doing. Buyers thinking twice of buying or upgrading, price competition and banks shying away from auto loans, things do not look good for this sector. No potential turning point seen yet.

Export counters

On hindsight, the export theme was overplayed. Now that Fed rate hike is expected to slow down, US dollar may not strengthen much more against Ringgit. Only go for companies that still make good profit regardless of forex fluctuations.

11. Names to consider

If you read my previous articles, I spoke about SPACs and a company called Triplc. SPACs had done well for the past 18 months but the past was the past. In fact, I have liquidated most of my positions since there is not much upside left. Reach Energy maybe, but I still expect the QA to fail, meaning the return still has to be adjusted for about 15 months time horizon. Triplc has done well (went up about 25%) since I last wrote about it. I still have a strong feeling that its business can be sold for around RM150-RM180m or RM2.20-2.70 per share. Together with land disposal, this could boost the company net cash value to above RM3.00 per share. Then again it’s just my calculated guess. Details you could refer to my previous article on it.

12. Other names to consider

CIMB (if earnings recover, valuation gap may close), Suncon (strong orderbooks, potential of contract wins, potential catalyst if they get back their Syariah status), Gadang (possibility of MRT contract, lucrative JV profit), SAM (strong orderbook, riding on aviation industry growth, strong shareholder and ambitious management).

There are sectors above that may still be positive in this current environment. I may not highlight any names from those sectors as I may not have studied those companies or no obvious names comes into mind. Small caps, as always, will have gems waiting to be uncovered. If the small cap can survive through this tough time, then it is really a fundamentally strong company.

Bottom line, try to angle your investment within a shorter timeframe, say 6 months, hit and run. If any of your investment makes decent profit, it may be better to sell and lock in your profit. With uncertainty looming, no one knows what will happen next and what you thought is cheap could become cheaper over time.

13. Alternative investments

Fixed deposit will always be your safe haven especially when Malaysia’s deposit rate is still relatively decent. For forex, futures and options, this is the best time to make money but also the best time to lose your whole fortune. Unless you have been trading them for some time and make consistent profit through a reasonable and still valid strategy, please do not jump on the bandwagon.

For options, traders can consider selling instead of buying options now since implied volatility is so high. For forex, I think it’s still technically illegal to trade forex in Malaysia so I’ll stop here and advise you to do it at your own risk. Gold may enter a bullish phase now, especially as I expect Fed to hold back rate hike. I am referring to gold futures but if you want to invest through some gold deposit or physical gold, the bid-ask spread is much wider and will eat into any potential profit.

As for MLM schemes, please scrutinize them as usual. MLM as a concept is ok but sadly often abused by crooks. Just make sure the main profits earned are through real business and not through adding new downlines and is something you can sell without going against your conscience. Remember the old, boring saying, “what is too good to be true, often is”

Invest safely. Cheers.