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Volkswagen Could Soon Get Clobbered On Brexit

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About: Volkswagen AG ADR (VWAGY)
by: Atlas Grinned
Summary

Cars are the biggest German export.

The UK is the largest export market for German cars outside of the US.

A no-deal Brexit will see tariffs of 10.8% raised against German cars.

A no-deal Brexit continues to look more and more likely, whether this month or January, pro-Brexit parties are on the cusp of a full-out majority in the latest polls.

Volkswagen (OTCPK:VWAGY) could be about to get smashed in a way it hasn't experienced since the 2015 emissions scandal. A no-deal Brexit could devastate the company and push share prices to new lows, below the depths of the 2015 debacle, at least over the short term. First, I will discuss the Brexit possibilities as I see them, and then how each of these possibilities may affect Volkswagen investors.

Brexit Crunch Time

So, we are now in Brexit crunch time, with news from many directions indicating that British Prime Minister Boris Johnson will do everything he can to get out of the European Union by October 31, in just over 3 weeks' time. Negotiations over a deal appear to be falling apart with neither side willing to budge. If no-deal is reached by October 19, Johnson will be forced to request an extension to January 31 from the EU as dictated by the Benn Act passed just before parliament was prorogued, though Johnson is doing everything he can to try to wriggle out of it.

Even if Johnson doesn't succeed at escaping the Benn Act and a no-deal Brexit is delayed for another three months, Johnson and his Conservative Tory party plus Brexit party allies (at least on the Brexit issue) are so far ahead in the polls that it looks extremely unlikely that Brexit would be delayed yet again past January 31. Three months for a stock like Volkswagen is relatively insignificant, so even if we see a delay to January 31, it won't matter much in the scheme of things assuming Johnson wins the next election, which seems almost certain.

The latest polls indicate that pro-Brexit parties including the Tories and Nigel Farage's Brexit Party are on the verge of an outright majority in the event of new elections. Opinium Research, in a poll taken from October 3-4, indicated that Johnson's Conservatives have 38% and the Brexit Party 12%, together 50%. Labour, which is still not a fully committed Remainer party and may have a handful of MPs who are nevertheless pro Brexit, is at 23%. Pro Remain Tories have already been purged from the party, so it is unlikely there will be any this round. The party that has fallen the most has been the Liberal Democrats, which came out recently explicitly for revoking Article 50, the Brexit Clause. They have fallen to 15% from 20% in Opinium's previous poll. All signs indicate that the Brexiters are on the upswing and will have a strong majority to overcome Parliamentary opposition if they can't overcome it this time, and so another delay will only be a stay of execution.

Can Johnson overcome a delay? He insists he can, though it's not so clear. A flurry of news over the past few days shows he is trying every angle to get out of an extension. First, Tory Brexiters are planning to challenge the Benn Act in court. One Tory MP is contemplating looking for loopholes to get out of it legally. Assuming that fails, the Daily Mail, linked above, says the following:

A senior Number 10 source told the BBC the government remained of the view that a Brexit delay could be avoided even if Mr Johnson is forced to ask for one. For example, the government could ask for a delay to comply with the law while also making clear in public and private that it will not negotiate any further with the EU.

This strategy would make a delay pointless because it would not lead to any further negotiations, especially if part of the official letter requesting an extension explicitly states that the UK will not negotiate any further. Would that be enough to get one of the EU27 to veto an extension? All the UK needs is one country to do so and there will be no extension.

The best candidate for that is Hungary, which has a Eurosceptic Prime Minister Viktor Orbán. Plus, Hungary has only weak economic ties to the UK. The UK is the destination for 3.4% of Hungarian exports as of 2017, and only 2% of its imports come from there. If needed, the UK market can be replaced or at least buttressed by alternatives for Hungary. The country wouldn't be heavily directly affected by a no-deal Brexit. So, if Hungary feels that it is inevitable, then it might veto an extension request.

Supporting this possibility is the fact that the Hungarian Foreign Minister and Ambassador were seen leaving Johnson's cabinet building around the same time he called an emergency cabinet meeting. A plan may be being cooked up for a veto.

How Volkswagen Is Affected

Unlike Hungary, the trade ties between Germany and the United Kingdom are strong. Not only in a general sense, but particularly in the very goods that Volkswagen sells - cars of course. Cars are the biggest component of German exports generally, and Volkswagen is Germany's (and Europe's) biggest car company. The UK is also the single largest export market for German cars outside of the United States, which is ahead of the UK by only $1.4B as of 2017. The infographic below shows how German passenger car exports are apportioned by country. The US is the largest destination at 14%, and the UK 13%. Total car exports to the UK account for about half a percent of total German GDP.

What about Volkswagen specifically? According to Volkswagen's latest annual report, deliveries to the UK totaled 493,768 in 2018, more than any other country outside Germany, once again except for the US. Deliveries to the UK accounted for just below 5% of total deliveries worldwide. According to the Telegraph, Volkswagen's hometown of Wolfsburg is especially dreading a no-deal Brexit:

The German carmakers finally broke their silence on Brexit last month. In a rare joint statement with car industry lobby groups from across Europe, they warned that a No Deal Brexit would have "seismic" and "devastating" consequences for the sector. A German study released earlier this year predicted that No Deal could put as many as 100,000 jobs at risk in Germany - and that Wolfsburg would be among the worst hit cities. Already reeling from the Dieselgate scandal, No Deal is the last thing VW needs.

One could theoretically argue that a no-deal Brexit wouldn't have much of an impact on car exports to the UK because according to The Guardian back in March, Britain is planning to slash tariffs down to zero on most imports if it happens. The problem is, tariffs would still be applied to car imports. Here's The Guardian:

Among the consumer goods that will be hit are imports of beef, prices of which will go up by almost 7%, cheddar cheese, up by about £20 per 100kg, and imported "fully finished" cars, which would attract a 10.8% levy, or about £1,500 for an average new car.

How to Trade It, And the Risks

Anyone shorting Volkswagen in anticipation of a no-deal Brexit should keep in mind that the decline once it hits could be quickly reversed if and when the UK and EU agree on a deal post facto, which, in my opinion, is very likely especially if we start to see a systemic banking crisis within the EU. I have made my opinion clear on that front in past articles, namely that a banking crisis could start in Deutsche Bank (DB) specifically if a hard Brexit is triggered. Also, those short Volkswagen should be aware that if we get a delay to January 31, the stock could jump temporarily. If it does, Johnson is still most likely to win the next election by a wide majority, so there probably will not be any further delays. In the event of a 3-month delay then, traders may want to consider adding to short positions to a target of around $11.50, though more conservative traders may want to stick to a $12 or $12.50 handle or higher.

The bigger risk is for Volkswagen shorters is that a deal could be reached at the last minute, either this deadline or next if it comes to that. With politics anything is possible. In that case, Volkswagen is likely to rally, perhaps significantly, and in that event, traders would probably have to cover to avoid further losses.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.