Are UK industries resilient in dealing with uncertainty? The case of Brexit.

• Author: Bouoiyour, Jamal
• Position: Report

1. Introduction

   The 2016 was a bad year for traders and investors. First, the recession scare in January following the great Chinese currency deterioration, the market decrease of oil price attaining $25 a barrel coupled with sharp credit markets tumbling. Second, the nk of Japan pursued the European experiment with negative interest rates, which arises a vexing question about the appropriateness of global central banks to help avoiding an untoward event of a real economic downturn. Add to this the geopolitical development; On Friday, 24 June 2016, it was officially announced that the United Kingdom (UK) voted to withdraw from the European Union (EU), resulting in what is commonly known as "Brexit". This result was surprising by the vast majority of capital market participants and even on the day of the referendum, bookmakers' odds supposed a 90 percent chance that the withdrawal of the UK from the EU would fail (Bloomberg 2016). In fact, the historic decision by British voters to pursue Brexit was very shocking for investors and regulators. The traders' panicky knee-jerk response highlights their belief that the decision to leave the Europe would harm the home-grown businesses. Soon after the Brexit results, many experts have predicted that UK stocks will crash markedly given the uncertainty over the potential timing and terms of a managed UK exit from the European Union. David Reid -Portfolio Manager at Black Rock- has gone a step further, forecasting which stock-market sectors will get hit hardest in the onset of Brexit. Some sectors are expected to lose less than others.

   To mitigate harmful consequences, UK industries (especially the largest losers from the announcement of Brexit) have to make important economic choices based on the resulting policy environment (Brogaard and Detzel 2015; Schiereck et al. 2016). In fact, the referendum on the UK's EU membership can be viewed as a sharp change in UK government policy. Normally, policy changes lead to a drop of stock prices, especially when the anxiety over such change is greater. Accordingly, Tielmann and Schiereck (2017) provided evidence that Brexit had strong detrimental impacts on UK financials and logistics companies owing to the wider uncertainty with respect to the future UK-EU relationship. Several financial institutions placed their EU headquarter in the UK to gain from the developed UK financial market (in particular, the financial technology also known as "Fintech") and the European passporting rules to undertake investments in other EU members. Nevertheless, the Brexit vote exacerbated fears regarding the prospects of the operations of international financial and banking institutions and the regulatory environment, since it is unclear whether the institutions located in the UK will remain enjoy a full access to EU financial markets.

   Prior research on the impact of sudden events and changes in government policy documented an adverse influence on share markets. For example, Kolaric and Schiereck (2016) investigated the reactions of airline stock prices over the terrorist attacks in Paris and Brussels. By examining 27 of the biggest U.S., Canadian, and European airlines firms, they deduced that the adjustment of stock prices is in line with the assumption of efficient capital markets. The reaction to the attack events seems significant for all the companies studied, due to the unprecedented damages caused by this sudden event and the particular attention these events receive from the media and social networking. Potentially, they showed that the largest companies are more threatened by the attacks than the smaller industries, and thus the effect of a sudden event on the performance of companies depend on their sizes. They also suggested that stocks do not depend to the net income in the year prior to the event. So far, the empirical research on Brexit remains rather limited, with some analyses focusing on the overall impact of Brexit for different countries (Balis 2016; Bouoiyour and Selmi 2016; Ham 2016), while others concentrate on specific sectors, whose core business is directly affected by the UK's withdrawal from EU such as logistics (Tielmann and Schiereck 2017) and airlines (Kolaric and Schiereck 2016). Bouoiyour and Selmi (2016) tried to test whether the way in which Brexit was disseminated by media causes disquiet among investors in UK and Europe. Using quantile regression model and frequency domain causality test, they showed that the reactions of UK and EU equities to Brexit are heterogeneous. Indeed, the stock market of Germany suffered more than that of UK and France. In addition, Oehler et al. (2017) carried out an event study analysis to investigate the abnormal stock returns following the Brexit referendum. They documented that stocks of firms with larger proportions of domestic sales realized more negative abnormal returns than stocks of firms with more sales abroad. In other words, they deduced that the international diversification help to mitigate the detrimental influences of Brexit on stock abnormal returns. Besides, Bouoiyour and Selmi (2017) tested whether the way in which Brexit was communicated in social media affect the performance of UK defense and aerospace stocks. They showed that the uncertainty surrounding the Brexit event puts at risk defense and aerospace companies (negative and significant influence on defense and aerospace stock returns) that benefit from EU membership with access to integrated European supply chains, Research and Development funding and collaborative procurement programmes. Moreover, Ramiaha et al. (2017) assessed the effect the EU referendum results on various sectors of the British economy. They found that Brexit has a mixed influence on the abnormal returns with sharp sector-by-sector differences. They indicated also that the banking and travel and leisure sectors were typically more responsive to the Brexit outcome.The present study explores, at sectoral level, the British stock market behavior around the announcement of the Brexit result and addresses the following questions. Do markets anticipate the Brexit outcome? Are British stock markets efficient? Are stock markets resilient in dealing with the uncertainty arising from this event? Is there homogeneity in stock market behavior around the Brexit result between the different sectors? What would be the investing implications of Brexit? We explore these questions using a standard event study methodology that examines the abnormal returns behaviors for several sectors of the British equity market (Financials, Oil and Gas, Real estate, Defense and Airlines, Pharmaceuticals and Biotechnology, Consumer goods and Technology) around the announcement date. This study complements and contributes to the existing literature by testing the Uncertain Information Hypothesis (UIH) of Brown et al. (1988). This hypothesis assumes that markets absorb news and political trends into asset prices in anticipation of the event (in this case, the Brexit result). Policy changes may lead generally to falling stock prices, particularly if the uncertainty is greater (Pastor and Veronesi 2012). Much of the uncertainty surrounding the Brexit outcome may be resolved after the announcement date, i.e., once the uncertainty over Brexit is mitigated, stock prices would rise again (Pantzalis et al. 2000).

   The remainder of the paper is organized as follows. In Section 2, we present our formal hypothesis and describe the methodology and the data sources. Section 3 reports and discusses the empirical findings. Section 4 concludes and provides some policy implications for UK companies in upheaval.

2. Hypotheses, methodology and data

   Since Efficient Market Hypothesis has arisen in the 1960s (Fama 1965), it has been subject to a huge number of researches. In efficient capital markets, we anticipate that equity prices will adjust at once without any overreaction and that the necessary adjustments become smaller if a certain kind of event occurs repeatedly. Nonetheless, as Lo (2004) argued, there is no consensus among finance academics as to whether stock market is efficient. Most of them believe the market is weak-form efficient (Doran et al. 2010); Grossman and Stiglitz (1980) even claimed that a perfectly efficient market is impossible. This contradiction has yielded to the emergence of new hypotheses in behavioral finance including the Uncertain Information Hypothesis of Brown et al (1988). The Uncertain Information Hypothesis assumes that anxiety will rise in financial markets following the occurrence of unexpected event. So that investors cannot appropriately respond to unanticipated new information and thus they could in the early stages set security prices below their fundamental values. Moreover, this hypothesis asserts that the stock return is stronger than the average return over periods when no event-induced uncertainty happens. The first hypothesis to be tested consists, therefore, of two parts:

   H[1.sub.a] : [CAR.sub.-5;0] > 0 (1)

   H[1.sub.b] : [CAR.sub.0;+1] > 0 (2)

   When the event-induced uncertainty is reduced, positive abnormal returns are expected in the time period following the occurrence of the event. In this study, we assess the five-day period after the announcement date to test our second hypothesis:

   H2: [CAR.sub.+1;+5] > 0 (3)

   This research is interested on the UK referendum and evaluates, at sectoral level, the impact of the UK's decision to leave the EU on UK stock market prices. The referendum outcome was...