Brexit: Put to the test

By Frédérique Carrier


There’s no break in the clouds as a delicate economy and a weak government keep the UK equity story mired in uncertainty.

union jack umbrella on wet pier

The stress of divorce

For an open economy, where exports represent a hefty 31% of GDP and which enjoys full employment, the UK underwhelmed in 2017, particularly given the synchronised global recovery backdrop. This is likely to continue as the uncertainty related to Brexit seeps in.

After expanding by just 1.5% (RBC Capital Markets estimate) in 2017, RBC Capital Markets forecasts the UK economy to grow a meagre 1.4% for 2018, among the weakest growth rates in the G7. Despite disappointing growth, the Bank of England (BoE) has begun tightening monetary policy so as to tame the now 3%+ inflation induced by the post-referendum slide in the pound. Its first hike in a decade boosted the bank rate to 0.5%. 

Inflation should subside from now on thanks to base effects, but the BoE’s recent messaging suggests it will increase rates by another 0.5% over the next three years. RBC Capital Markets believes this will largely be back-ended and looks for no increase in 2018 as Brexit uncertainty weighs on economic activity.

High inflation and subdued wage growth have eroded household disposable income. Consumers have stepped back somewhat. The household savings ratio, recently at an 18-year low, is likely to move higher with house price inflation now deteriorating, providing little reason to be optimistic about consumer outlays ahead.

UK household savings ratio is very low

UK household savings ratio

Source - RBC Wealth Management, RBC Capital Markets, Haver Analytics; data through Q2 2017

Investment is not offsetting weak consumption. Business spending has suffered over the past 18 months, and whether it picks up will depend on how Brexit negotiations proceed. It is generally believed that unless there is more clarity by the end of Q1 2018 around the future trade relationship between the UK and the EU, businesses will restrict domestic investment projects.

Meanwhile, the government has scaled back austerity plans, postponing its deficit targets, though RBC Capital Markets does not expect government spending to add much to economic growth in 2018. 

The pound gained 10% against the USD in 2017, propped up by monetary tightening expectations and the possibility Brexit negotiations would move on from settling “divorce issues” to discussing the future trade relationship. 

Views are polarised about sterling’s prospects for 2018—the currency has the widest range of forecasts of any G7 country. On the one hand, a tighter monetary policy to control inflation might prop up the currency. On the other, the pound could be pressured by a weaker economy, or by inflation subsiding and removing the need for monetary tightening, or by challenging Brexit negotiations. RBC Capital Markets is in the latter camp, expecting renewed currency weakness in 2018.

Between a rock and a hard place?  

Brexit-related risks are well flagged, though the risk of early elections is underestimated, in our view. A Labour government that would likely focus on an aggressive public spending agenda, including nationalising certain industries, could be voted in.

Brexit is going ahead despite apparent economic costs in the short term. Polls suggest little regret concerning the referendum result. Having spent nine months settling the issues related to the separation of the UK from the EU, the UK has been given the go-ahead to start negotiations regarding a transition agreement and the terms of the new relationship.

This upcoming phase will likely prove even more challenging. The stakes are very high for the UK for whom the EU is a much more important trade partner than the UK is to the EU.

Exports as a percentage of GDP greatly differ

UK exports to EU

Source - RBC Wealth Management 

Complicating matters further, UK politicians are not in agreement as to what they are trying to negotiate and what, if anything, would replace the EU single market and customs union memberships. The clock is ticking. Negotiations need to be completed within nine months to leave enough time for any new agreement to be ratified by parliaments in the UK and EU before the UK leaves the EU on March 29, 2019.

Brexit timeline

Brexit timeline

Source - RBC Wealth Management, RBC Capital Markets  

Given the stakes, there is a non-negligible probability of a breakdown in talks and of the economically damaging “hard Brexit” scenario materialising. Under such an outcome, the UK would lose tariff-free access to its largest export market and have to fall back on WTO rules. This would entail not only tariffs, but also having to meet the burdensome cost of abiding by complex “rules of origin” regulation. A hard Brexit scenario would be negative for the pound and would probably result in higher Gilt yields.

Our base case is that the UK will aim for a two-year transition period after the set March 2019 exit date to extend the status quo, and defer the settling of the details of the future relationship to a later date. 

The second risk, with arguably a wider range of consequences, is the spectre of early elections. Prime Minister Theresa May’s government is weak with a razor-thin working majority of only 13. With Brexit negotiations dividing the government, there is a material probability of a general election before the end of 2019, or some two years before elections are due. A Labour Party win is a real possibility, in our view, given Labour’s surge in the polls since mid-2017.

The Labour Party has shed its centre-left stance and now backs a programme of nationalisations and has suggested an additional £500B in spending to be financed by higher Gilt issuance, which is likely to increase both inflation and Gilt yields. The party is deeply divided on Brexit, and so far has had an ambiguous stance on the matter, though it has not opposed the government’s position. 

A wide array of outcomes is possible for financial markets. On the one hand, should Labour win a sweeping majority and push for a hard Brexit, UK financial markets would almost certainly come under pressure. This scenario is not very likely, but UK politics have proven to be unpredictable of late.

In a more benign scenario, Labour would emerge victorious but without a majority of seats, making it more difficult to pass extreme measures. Should it also shift its stance on Brexit and opt for a Norway-style agreement where access to the single market is retained, it is conceivable the pound and economy could both strengthen. There are many other potential permutations to be considered.

UK equities: Fog of uncertainty

In our view, UK equities present a less attractive proposition than those of other regions despite more appealing valuations. UK equities lagged in 2017 and we think this is set to continue in 2018, given the unappetising stew of severe political risk and a comparatively weak economy.

UK equities look especially cheap compared to other markets, particularly on a price-to-book value basis, partly due to the structural derating of banks and commodities. On a forward price-to-earnings basis, excluding commodities, the UK trades at a 10% discount to global markets, a level it hasn’t seen in nearly 10 years.

Emerging markets and commodities exposure is high

emerging markets and commodities

Source - RBC Wealth Management, National research correspondent

Such cheapness is warranted, in our view, given the risks enumerated above. The consensus earnings growth expectation of less than 6% for 2018 is comparatively uncompelling. With the number of profit warnings at a six-year high in Q3 2017, earnings expectations may well be reined in further.

Moreover, as a high dividend-paying market, yielding 4% overall, the UK has tended to underperform when monetary policy is tightened. UK equities are also still largely exposed to commodities and emerging markets, which are both highly sensitive to the U.S. dollar. Should the dollar rally, as RBC Capital Markets expects, it could also contribute to restraining UK equity performance.

Some argue that, should the pound weaken markedly due to a breakdown in negotiations, UK equities could rally, much like they did after the referendum results. We concede that a cheap pound could eventually attract buyers, but worry a breakdown in talks could also be interpreted as the worst scenario materialising, in which case, the inverse relationship of the pound falling but equities gaining may well dissipate. The outlook is finely balanced.

We remain selective, preferring high-quality businesses with sound balance sheets, robust cash flow generation, and a track record of compounding returns to shareholders. We maintain our bias towards international exposure, focusing on companies exposed to either a strongly growing Europe or to U.S. tax reform, or both. We would steer clear of companies in the potential crosshairs of nationalisation (utilities, transport) and believe that despite their underperformance, it is still too early to step back into domestic stocks. 

With the UK outlook mired in uncertainty, we expect volatility to increase and for better entry points for equity, fixed income, and foreign exchange investors to materialise in the months ahead.

Required disclosures
Research resources

Non-U.S. Analyst Disclosure: Frédérique Carrier, an employee of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (UK) Limited, contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since she is not an associated person of RBC Wealth Management, she may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.

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Frédérique Carrier

Managing Director, Head of Investment Strategy

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