Brexit-led recession - revisited

With trade wars, the demise of the high street and falling consumer spending - and not to mention Brexit - is the risk of a recession increasing asks RM Capital's Pietro Nicholls?

In October 2017, I wrote about a potential Brexit-led recession and how the alarm bells including: stagnating house prices, rising consumer debt levels and sharp falls in high street consumer spending, had started to ring. Nearly 10 months later, where are we now?

The high street is failing: Almost every single week of 2018 has seen store closures, the restructuring or the collapse of retailers and causal fast dining companies. In addition to Byron Burger, Carluccio’s, Gaucho, Maplin, Poundworld, Toys R US and Mothercare in the UK, brands in the US tell a similar tale with Walgreens, Foot Locker, Best Buy and J Crew sharing the same industry-wide headache.

As I write this, House of Fraser’s £175m 2020 Floating Rate Bonds (not one we hold) have dropped another 20pts on news that the potential lifeline from C.Banner has been terminated. By the end of August, this may well be just another British retail institution to add to the list.

Now, one would argue that the collapse of most of these businesses is less an indicator of a recession and more likely driven by the failure of specific management teams, and Boards to adapt to the changing consumer habits and the structural changes affecting the wider retail landscape.  The “Amazon effect” and the rapid growth of online shopping can be seen directly in the increases in online vs store revenue mix, and indirectly through the growth of supporting digital infrastructure companies such as cloud or data centre providers – online stores require “space in cyber space”, after all. However, that is not the whole picture.

UK Consumer spending had been falling for the first half of 2018 despite increases in wage growth. The expected bounce recorded over the last month should not come as a surprise, the amazing British summer and England’s honourable performance in the World Cup provided a welcome boost. However, the ONS data released in the last week of July paints a darker picture of the health of the UK household balance sheet. UK Households have seen their net outgoings surpass their income for the first time in 30 years. In short, we are spending, and subsequently borrowing, more as individuals than we are saving and accumulating assets.

The BOE has risen rates twice since October, with the latest on 2nd August; we fear this latest rise could be one step too far, and  will ripple through the economy, increasing the pressure on consumers wallets.

I haven’t even touched upon the other alarm bell mentioned previously namely House Prices. Although the data has been mixed Nationwide House Price index results vs Foxtons’ (London centric) financial results,  properties are taking longer to sell, the latest BOE rate rise will further dampen demand, and let’s not talk about the implications of a hard Brexit on the property market.

Looking forward, where are we going?

The US declared war on trade, taking aim at, among others, China and Europe (no Brexit bashing on this today). Whilst the market knows these are opening moves to establish a firm negotiating position, there are only losers in a trade war, the impact of which will be felt by corporates with international reach, and ripple across the supply chains and consumers alike. A market leading indicator is the yield difference between the 10 and 2 year US treasuries, which is at its lowest level since the pre the global financial crisis, although the wider US data points do not yet support a US recession position.

Corporate debt and leverage levels are increasing, driven by cheap debt and the ever increasing hunt for yield. Yet, according to LCD, investor protections have deteriorated in the large cap space, where covenant-lite deals have rocketed from 4 per cent in 2008 to 72 per cent in 2018. In addition, Europe is starting to taper off Quantitive Easing,  albeit very, very slowly.

My view, as a portfolio manager, on the UK and the markets hasn’t changed in the last 10 months: the alarm bells are still ringing. We at RM Funds have positioned our funds accordingly.