The fog of Brexit

Focus on the longer term and stay invested, albeit with a bias to lower risk companies.

Rather than add to the uncertainty by trying to predict what will happen next with Brexit, we thought it might be more helpful to remind you of how the UK economy has fared since the referendum, as well as our position on a “no-deal” Brexit.

On the eve of 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 new monthly GDP data showed a bounce in January, but this data series is too noisy to look at month by month, and the three-month moving average is still 0.2%. It’s not all doom and gloom: lots of jobs were created in the fourth quarter and annual growth of regular pay in the private sector has reached 3.5%, a post-crisis high. Sadly for anyone with a day job, that’s still someway short of the average growth observed before 2008.

The economy has taken a different route than the one most economists expected, however. Household spending has been rather stronger, while business investment has been 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 expressed concern about its effect on financial stability (it has since become more relaxed). Perhaps that’s not too surprising since most people, “leavers” and “remainers”, were pretty certain that some sort of deal would be reached. Even if sentiment remains calm, we question how much further savings rates could possibly fall.

Business investment has been exceptionally weak since the referendum, while it has been growing strongly elsewhere in the world. A recent study by the Centre for Economic Performance at the London School of Economics estimated an extra £8.3 billion of UK-based investment poured into the EU between the referendum and the end of September 2018. To the extent that this investment would otherwise have taken place domestically, this represents a legion of lost opportunities 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.

There is a risk that this trend continues under a protracted period of uncertainty or accelerates in the event of “no-deal”. This would be concerning, for inward foreign investment is extremely important. Modern economic growth is about “technological transfer” – in English, learning from others and improving on it. We can see that at work inside firms: the productivity of UK firms with no inward foreign investment is almost half that of firms with foreign investment.

That said, we believe the idea that foreign investment will fly out and trade will collapse to a destabilising degree in the event of a “no-deal” 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.

A no-deal Brexit is likely to hurt the economy over the short to medium-term, however. We agree with the consensus reached by a range of forecasters: growth will likely fall to between -1% and 1% in 2019 depending on the level of disorder characterising the “no-deal” environment.

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 so far. 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. 

The good news for investors is that Brexit is not a globally systemic event, like the financial crisis of 2007-08 or the European debt crisis of 2011-12. Only 3% of the revenues earned by US companies originate in the UK; just 6% for non-UK European companies. Although Europe will also feel a pinch from a “no-deal” Brexit, 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. Moreover, the typical UK investor is a global investor. Even if a portfolio held only the companies listed on the UK’s FTSE 100 index, 70-80% of the underlying revenues originate overseas. 

Furthermore, any weakening in the pound will boost returns from those overseas revenue streams, when translated back into sterling. The pound is likely to fall on news of “no-deal”, but it has already fallen so far that even in this scenario it is significantly undervalued versus other major currencies and further downside should be limited. On a long-run basis – the only timeframe over which we believe currency forecasts can be made with any certitude – sterling is very undervalued.  And once the dust settles, the longer-term outlook for the pound is one of appreciation, even in the case of “no-deal”.

So as much as you can, try to block out the daily dangers dreamt up for the 24-hour news cycle. Focus on the longer term and stay invested, albeit with a bias to lower risk companies.

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