Brexit: Worst-Case Scenario Hits Bank and Supermarket Stocks

While a severe and prolonged downturn in the UK economy will have material implications for the UK-centric firms – firms with significant revenue tied to the UK market, we should at the very least be cognizant of a potential contagion effect of a global recession, even if most forecasts we have seen do not consider that to be a meaningful risk. For now, we are assuming in the disorderly worst-case scenario, the economic downturn will be primarily confined within the UK but have a modest effect on the remainder of the EU.

Smaller Caps Will Feel Brunt of Brexit Downturn

Morningstar's global equity research coverage tends to skew toward larger-cap stocks, which also tend to be multinational companies. With the exception of a few UK-focused industries, food retail and telecoms for example, companies in our coverage have global operations, mitigating whatever impact would be felt from an isolated-to-the-UK economic downturn.

Not surprisingly, smaller UK-centric firms that compose much of the FTSE 250 are likely to feel the brunt of the downturn, which has depressed their performance relative to their larger FTSE 100 peers, particularly since the news of an impending vote rejection of Prime Minister May's proposal started circulating. Housing, construction, and retail companies in particular are more likely to be affected in the recessionary environment.

Autos Integrated with the EU

The UK automotive industry is highly integrated with the EU, including vehicle production and parts manufacturing. Auto industry trade ties are especially strong between the UK and Germany. Germany is the top destination for UK vehicle and parts exports. Just slightly behind the US, the UK is the number two destination for German vehicle and parts exports. UK automotive trade with France, Italy, and Spain is also very substantial.

If a trade rule tariff were just on the imported vehicles, UK consumers could switch to competing products not subject to EU tariffs. However, EU tariffs on vehicle parts presents a problem, potentially causing price increases for UK-built vehicles, too. BMW, Jaguar Land Rover, Vauxhall and Nissan all carry risk.

The Risk is There for UK Banks

Banks are particularly sensitive to unexpected shocks – like the UK tumbling out of the EU without any trade deals in place – which can often spark a loss of confidence and be the catalyst for a full-blown crisis.

Banks are particularly sensitive to unexpected shocks – like the UK tumbling out of the EU without any trade deals in place – which can often spark a loss of confidence and be the catalyst for a full-blown crisis.

Five banks in our coverage universe have significant retail and commercial banking operations in the UK. Our preferred exposure would be the narrow-moat, global giants HSBC (HSBA) and Santander where we believe the market often discounts too great an impact from any potential Brexit-inspired crisis, given its relatively modest exposure.

Narrow-moat Lloyds (LLOY) would be our preferred pure-play UK banking name, as we believe its market-leading current account franchise provides it with a steady and cheap funding base that will benefit from higher interest rates.

Our conviction is the lowest on Barclays (BARC), where its relatively greater exposure to volatile, capital hungry investment banking remains problematic. We believe that Royal Bank of Scotland's (RBS) government ownership and troubled history have led to certain decisions that favour public opinion over profitability and shareholder interests.

Aerospace Vulnerable

Within our aerospace coverage we believe Airbus, Rolls-Royce (RR. ), Safran, Leonardo, and Meggitt remain the most exposed to Brexit risks. The direct impact of Brexit is already being felt at many of these companies with management teams moving to increase inventory levels in the event of delays at the UK-EU border. This will hit cashflows but not necessarily revenues since we believe these buffer stocks should enable product deliveries to continue unabated.

Consumer Companies Best Positioned

In the event of this risk of economic shock and stagflation coming to fruition, there are two reasons why large cap consumer product manufacturers are likely to be more defensive investments than retailers. First, many manufacturers possess wide economic moats. In most cases, the moat sources lie in supply chain competitive advantages, but some manufacturers still possess pricing power.

The second reason we expect the multinational manufacturers to be relatively defensive in this sector is that they are much more geographically diversified than the retailers. For global players such as Unilever (ULVR), Nestle, and Danone, the UK represents 5% or less of total revenue, so the impact to valuation of an outcome of UK stagflation is not material. Perhaps the greatest exception to that rule is Reckitt Benckiser (RB.), for which the UK represents almost 15% of its top line.

But Supermarkets Will Struggle

Overall, we think food grocers under our list will have a hard time passing on food cost pressures to consumers while there would be an inevitable down-trading, which will benefit hard discounters both in the food and non-food markets.

Specifically, we think Associated British Foods (ABF) is well positioned due to Primark as the lowest cost clothing retailer in the UK, while all three grocers under our list; Morrison (MRW), Sainsbury (SBRY), Tesco (TSCO), will face headwinds including tariff and currency induced food cost inflation, fierce competition from hard discounters, to the benefit of "no-frills" discounters.