Delay, delay: Groundhog Day

The fog of uncertainty won’t disperse anytime soon. But the FTSE is an international market, defensive and quite possibly one of the better places to be as global growth slows.

The European Union (EU) and the UK have agreed to delay Brexit until 31 October if a solution cannot be found sooner. This plays into our ‘never-ending story’ scenario, which we have thought the most probable path since we launched our Brexit decision tree last July. Sterling barely moved on the news, showing investors still believe that ‘no deal’ remains a significant risk. The fog of uncertainty remains and we do not expect international fund managers to return to UK markets with confidence. This same fog will also continue to weigh on economic growth.

Political deadlock

The long delay is the result of political deadlock, a manifestation of the stark reality that no pathway for leaving the EU commands both a majority of Conservative MPs and a majority of all MPs in Parliament. Such an impasse is usually resolved with a general election, but there appears to be no appetite to call one. (Under the Fixed-term Parliaments Act 2011, two-thirds of the House must vote to call one, or the government must lose two no-confidence votes within a fortnight.)

Purchasing Labour leader Jeremy Corbyn’s alliance with a post-Brexit customs union would also cleave the Conservatives, perhaps irrevocably. So it may be that the only politically expedient way forward may be a second referendum, despite strong protest from both leavers and remainers inside Westminster and among the electorate. Prime Minister Theresa May has spoken of Parliament ‘reaching the limits’ of any attempt to find agreement, while Chancellor Philip Hammond has been quite open about his support for the notion if limits have indeed been reached.

We do not know what the outcome of a second referendum may be. There are lots of polls, with questions phrased in lots of different ways. Together, the results are inconclusive. One of the very, very few polls to predict that Britain would vote to leave the EU in 2016 was the Eurobarometer survey, which asks whether people view the EU positively or negatively. The last update was November – and the sample size was a little on the small side – but the results were very, very different to 2016. Back then a little over 30% of UK respondents viewed the EU positively, compared to 35% negatively. Today, 43% view the EU positively, with just 22% seeing it negatively. We have also viewed survey evidence that suggests public opinion has stopped seeing freedom to control immigration as more important than access to free trade, perhaps due to abatement of Europe’s migrant crisis. But these are just interesting observations: positioning for a certain outcome of a second referendum would be gambling, not investment management.

‘No deal’ is still on the table

The House of Commons and the Lords passed the Cooper-Letwin Bill to force the government to extend Article 50 rather than take the UK out of the EU without a deal. But that does not mean that a ‘no-deal’ Brexit is off the table. For Parliament has already voted for the potential of a ‘no-deal’ Brexit by invoking Article 50 in the first place. The EU does not have to accept the UK’s timetable.

Our view is that the risk of ‘no deal’ may have diminished at the margins, but it remains a significant risk.

To be clear, our aversion to a ‘no-deal’ Brexit is in no way a judgement on whether Brexit is right or wrong for the British polity, in all of its many social, economic and juridical facets. It is simply a narrow expression of the empirically grounded difficulty of substituting trade with countries further away for trade with one’s nearest neighbours, with or without new trade pacts. It is also based on the behaviour of firms and households since the referendum. In the long run, if lots of non-EU trade deals are struck and the EU fails to capitalise on further integration, the UK economy may be better off. But for the next few years at least, the likely impact of “no deal” would be grave.

How has the UK fared since the referendum?

The consensus among economists was that UK economic output would be a cumulative 2% lower than it would have otherwise been between the referendum and the end of March 2019, should the UK vote to leave. And that’s the way it appears to have panned out.

The economy grew at just 0.2% in the fourth quarter of 2018. The newly introduced monthly GDP data showed a bounce in January and February, but this data series is too noisy to look at month-by-month, and the three-month moving average is still 0.3%. Furthermore, recent strength is concentrated in the manufacturing industry, with the services sector still sluggish (0.1% growth in February). This may suggest stockpiling ahead of Brexit.

It’s not all doom and gloom, however: job creation was strong in the fourth quarter of 2018 and the annual growth of regular pay in the private sector has reached 3.5%, a post-crisis high although still someway short of the average growth pre-2008.

The economy has taken a different route than the one most economists expected, however. Household spending has been rather stronger, while business investment rather weaker than anticipated.

When households are uncertain about the future, they usually save a little more and spend a little less. This didn’t happen after the referendum. The household saving rate fell to an all-time low, while consumer credit grew at a pace so rapid that the Bank of England worried about its effect on financial stability (it has since become more sanguine). Perhaps that’s not too surprising since most people, both ‘leavers’ and ‘remainers’, were pretty certain that some sort of deal would be reached. Even if sentiment remains resilient, we question how much further savings rates could possibly fall.

Business investment has been exceptionally weak since the referendum, while business investment elsewhere in the world has been growing strongly. A recent study by the Centre for Economic Performance at the London School of Economics estimated a total increase in UK investment in the EU of £8.3 billion over the period between the referendum and the end of September 2018. To the extent that this investment would otherwise have taken place domestically, this represents lost investment for the UK, and is difficult to explain by anything other than a Brexit effect. Higher outward investment has been accompanied by lower investment into the UK from the EU. The study found that new EU investments in the UK fell by 11%, amounting to £3.5 billion of lost investment.

Mass divestment unlikely

There is a risk that this trend continues or even accelerates, and this would be concerning. Inward foreign investment is extremely important. Modern economic growth is about ‘technological transfer’ – in English, that means learning from others and improving on it. We can see that at work in businesses: the productivity of UK firms with no inward foreign investment is almost half that of firms with foreign investment.

We believe the idea that foreign investment will fly out and trade will collapse to a destabilising degree is rather far-fetched. As we highlighted in our 2016 report, If you leave me now, there are plenty of reasons why companies choose – and will continue to choose – to invest in the UK that have nothing to do with access to the EU. Accounting firm EY reports that a significant amount of planned business investment will be in research and development (R&D) which is geographically agnostic. And there are reasons for optimism: while overall business investment has been weak since the referendum, R&D investment has been holding its own.

Customs union: worst of all worlds?

Leaving the EU but remaining a part of the customs unions, without any other favourable terms of trade, would help manufacturers and farmers. But the UK’s dominant services sector would remain out in the cold. ‘Passporting’ arrangements, on which international activity of many UK financial service firms depend, would come to an end.

Since before the referendum, we have highlighted the vulnerability of the financial services industry, which plays a big role in UK trade and inbound investment, both directly and through the agglomeration of other business services it supports.

UK financial services would have to seek ‘third-country equivalence’ under a number of separate pieces of EU legislation, which allows for firms from a country outside of the European Economic Area (EEA) to operate in EEA member states on similar terms to those granted by the financial passport as long as the third country’s regulatory and supervisory arrangements are judged equivalent to the EU’s. Market access is based on continuously demonstrating regulatory equivalence between the third country and the EU. At present third-part equivalence regimes are pretty much untested, but legal experts concur that they would entail a potentially laborious and certainly costly compliance process. There’s a good chance of these regimes being used as political leverage by the EU too, and potentially removed at short notice.

Furthermore, not all financial services activities that can be passported under the current system are even eligible for third-party equivalence. In other words there may be a complete loss of access to the EU market for some businesses. There is no third-party equivalence regime for banking services such as lending and deposit-taking under the Capital Requirements Directive (CRD IV). Or retail asset management, under UCITS. Or direct insurance under Solvency II (reinsurance is covered).

Remaining within the customs union would ameliorate much of the both permanent and temporary losses of productivity from increased non-tariff barriers to trade and supply chain disruption. But it also obliterates the possibility of doing significant trade deals with other, faster-growing economies, which is one of the few reasons why Brexit, in the long run, could make the UK better off. Sure, the UK may still be free to negotiate trade deals for services – i.e. sectors not covered by a customs union. But trade deals are usually about give and take, and Britain has such a dominant position in global services, that it’s difficult to see what another country would get in return for allowing services trade access if goods access wasn’t on the table.

Tarnished sterling

As we consistently highlighted in our Brexit decision tree updates, we believe that the foreign exchange market had priced in a very high probability of a hard Brexit. We anticipate sterling appreciating over the next three to five years, regardless of the nature of the deal that is eventually struck. On a long-run basis – the only timeframe over which we believe currency forecasts can be made with any certitude – sterling is very undervalued (you could use purchasing power parity or we like to use own ‘Behavioural Equilibrium Exchange Rate’ framework, which looks at relative prices, relative productivity and relative savings). This currency weakness holds even when we hypothesise an adverse Brexit scenario. Indeed against the euro, it is undervalued by almost as much as it has ever been in the last 35 years (although the euro hasn’t existed for that long we can calculate a theoretical exchange rate based on the fixing rate at which the old national currencies joined the euro). But as we have discussed, ‘no deal’ is not off the table, and we fully expected the pound to stay volatile and under pressure.

What about interest rates?

With significant downgrades to expectations for GDP growth and inflation in 2019, February’s

Inflation Report pushed the Bank of England’s stance in a decidedly dovish direction. In other words, continued uncertainty has led to an even stronger case for rates to stay on hold. The disinflationary effects of greater spare capacity in the economy – shops being empty, factories running at reduced pace, etc. – and the slower pace of interest rate rises this implies, has been made more explicit in recent speeches by UK monetary policymakers Gertjan

Vlieghe and Silvana Tenreyro. Even Michael Saunders, who has been one of the most hawkish members and most optimistic on the UK economic outlook, has advocated a wait-and-see approach for now.

Interest rate futures aren’t pricing in another rate rise until 2023. We believe that rates will stay low for a long time, but no rate rise for four years is unlikely so long as Brexit proceeds in an orderly manner. Remember that Brexit depresses both supply and demand, so GDP growth around 1.5% will likely be consistent with 2% inflation. GDP expansion higher than that will necessitate tighter monetary policy. We don’t envisage that until next year.

UK equities: let’s get defensive

A stronger pound would present a headwind for the large multinational companies in the FTSE 100 that derive most of their earnings overseas in non-sterling markets. There is a good case for a softer Brexit resulting in both a stronger pound and a stronger FTSE, a typically unusual occurrence because those foreign earnings are worth less in sterling when the pound rises. Why could it be different this time? Because the FTSE is so under-owned by global investors. The latest Bank of America Merrill Lynch Fund Manager Survey showed us that investors around the world were more or less the most underweight UK-listed equities than at any time in the poll’s history. The national accounts tell us that net outflows from UK equities were larger after the referendum than at any time since 2007.

But until the Brexit uncertainty is resolved, we do not expect international flows to return with meaningful effect.

There are, however, compelling cyclical reasons for favouring the FTSE 100 at the moment. As global leading economic indicators slow, more defensive markets tend to outperform. Similarly, after the US yield curve inverts – when the return on short-maturity bonds rise above those of longer-dated bonds – defensive markets around the world tend to outperform. The earnings underlying the FTSE 100 are, in aggregate, among the least sensitive to global economic growth of any major index. That makes the UK one of the world’s great defensive markets.

UK investors are global

The most important thing to remember is that the typical UK investor is a global investor. Even if you only held companies listed on the UK’s FTSE 100 index, 70-80% of the underlying revenues originate overseas. And Brexit is not a globally systemic event, like the financial crisis of 2007-08 or the European debt crisis of 2011-12.

Though the UK is the fifth-largest country in the world in terms of GDP, it’s not large enough to influence global prices, interest rates or income unilaterally. In 2018, the UK represented just 2% of global economic output, compared to the US’s 15% share or the EU ex-UK’s 17% share. Although Europe will also feel a pinch, the bulk of the adjustment will fall squarely on the shoulders of the UK economy, with very little impact on global growth and therefore the outlook for earnings growth of non-UK companies.

Brexit has become a national obsession, albeit a reluctant one for most. Remember the good old days when it was only the miserable weather that dominated our conversations? Unfortunately, Brexit is going nowhere anytime soon. It will continue to affect the UK economy even when nothing seems to be happening –as shown by the substantial falls in business investment. But well-diversified UK investors shouldn’t fret too much. When your home market is defensive, undervalued and global, it should help make your assets that much safer.

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