A deal in January can give the UK a Brexit bounce
- Wednesday, December 4, 2019
There has been very little ‘united’ about the United Kingdom in recent months. The political temperature certainly increased as we got closer to the second Brexit deadline of October 31st with so much at stake and with so little compromise. The passing of the Benn Act, compelling the government to seek a further postponement to Brexit, brought to a head the inevitable necessity for a general election. When the extension to January 31st was granted by the EU, opposition parties could no longer refuse to back a poll on December 12th and to bring in a new parliament with a new mandate.
The threat of a no-deal Brexit has declined since the passing of the Benn Act and the success of Boris Johnson’s renegotiated Withdrawal Agreement which received a majority in the House of Commons. As a result, sterling has risen from US$1.22 to US$1.29 over a period of 10 days from October 9th.
The election result, at the time of writing, looks to be going in Boris Johnson favour. The Conservatives are ahead in the polls and the Brexit Party is only standing against sitting Labour and Liberal Democrat MP’s. The Leave Alliance seems to have realised the consequences. The Labour Party, still split on their preferred outcome for Brexit refused to join a Remain Alliance with the Liberal Democrats, the Greens and Plaid Cymru. If Boris Johnson is returned to Downing St with a working majority, then the passage of his Withdrawal Agreement will take place and Britain will leave the EU on January 31st 2020, if not earlier. However, if there is a hung parliament the passage of the Withdrawal Agreement will be harder and uncertainty will remain.
Against the back drop of Brexit uncertainty, it is not surprising that the UK economy remains in a low gear. According to the Office of National Statistics (ONS), the UK grew by 0.3% in Q3 equating to a year- on-year growth of just 1%, which is its slowest annual rate of growth for 10 years. The decline was put down to manufacturing and construction sectors contracting.
However, since the Referendum, the UK has grown in 13 of the 14 quarters with total accumulated growth of 4.9%. This compares well to Germany at 4.7%, Italy at 3.2%, but behind France at 5.8% who has comparatively outperformed. The ONS confirmed that UK employment stood at 32.74 million people in October, a fall of 58,000 due to the closure of several high street retailers. Interestingly, unemployment fell by 23,000 to 1.31 million as wages grew by 3.6%. UK inflation stood at 1.8% meaning that wages are again rising ahead of inflation.
The City of London Corporation views the Brexit extension to January as only a ‘sticking plaster rather than a sustainable long-term solution’. The Corporation stated ‘Continued uncertainty has left business without the clarity needed to make everyday decisions on investment, expansion and recruitment. The three-and-a-half-year impasse needs to find a positive solution that enables business to get the certainty required in order to strive’.
Car production within the UK has fallen due to Brexit uncertainty and weaker overseas demand. Car imports for the year to the end of October fell 15.6%, making 2019 the weakest year for the car industry since 2011.
The Society of Motor Manufacturers and Traders (SMMT) cite the threat of a no-deal Brexit has caused international investment to stall and cost UK operators £500million on no-deal contingency planning. The SMMT welcome the general election with the hope that it will bring clarity and conclusion to a frustrating period for car manufacturers. The SMMT hope that the new government will agree and implement an ambitious relationship with the EU that safeguards free and frictionless trade.
There are many different scenarios and economic consequences depending upon the outcome of the general election. We have taken a view to plan for what is progressively emerging as the most likely outcome.
For the economy, a smooth Brexit with a transition period in which to negotiate our longterm future with the EU removes a great deal of downside risk to the UK and the EU. It would be expected that business investment would recover on the basis that business will know what it will be planning for. Overall household spending and the housing market should have a lift and bring about a gradual improvement in confidence and GDP growth.
However, if the UK were to leave without a deal for any reason, then it would do so without a transition period and all current EU trade deals would end. Custom checks would be installed at borders which would have a major impact on delivery times. In this scenario, it is thought that sterling could fall to around US$1.10. Inflation would rise due to the additional cost of imported goods which may hit consumer spending. As UK household spending is the biggest driver of GDP growth, we could see GDP fall further and remain low for some period of time.
Business investment is likely to fall in some areas but rise in others; while government spending is expected to increase to limit the impact of a hard Brexit in the more effected parts of the economy. Interest rates are likely to be reduced from 0.75% to 0.25% with some additional QE implemented to encourage bank lending. These outcomes are likely to be equally replicated in the Republic of Ireland but to a lesser extent in the Eurozone.
If the UK were to leave with a deal, then we could see sterling rise to around US$1.32 given there is a trade deal still to negotiate by December 2020. Inflation may dip and then rise as households enjoy a boost to real income and start spending. British investment that has been held up for some time would return and be supported by the government spending that was announced in the last budget. The economy should see a marked pickup in growth compared to the recent lacklustre performance. There will still be some uncertainty over the future relationship with the EU which would still need to be negotiated but the near-term risk of disruption could be is avoided. Sterling is currently valued at US$1.289 meaning that much of the rise in sterling due to a Brexit deal is already priced in.
If the UK were to revoke Article 50 and remain full members of the EU, which is the Liberal Democrats policy, we could see sterling rise above US$1.43, its level prior to the referendum. This would be the most positive scenario for immediate economic benefit.
The two barometers for Brexit uncertainty are foreign exchange rates and domestic investment. In areas such as employment levels, consumer spending and inflation the economy is doing well. If a deal is agreed in January then one expected benefit is an improvement in investment and capital expenditure from business at home and abroad.
Sterling has fallen in value from US$1.43, prior to the Referendum in June 2016, to a low of US$1.22 in October 2016, only to recover back to US$1.43 in April 2018 and now stands at US$1.28. The pound has fluctuated on the likelihood of UK securing a deal to leave the EU. The expectation of a Brexit deal has allowed sterling to strengthen recently. The long-term value of sterling against the dollar is US$1.45 so at US$1.28 it is 12% undervalued. If sterling regained this position, there would be a negative impact on the value of unhedged overseas assets when revalued back into sterling. We think this unlikely in the near term.
Most analysts consider that the UK stock market as undervalued compared to other developed markets. This undervaluation has been present since the June 2016 EU Referendum despite a relatively strong showing from the UK economy over that period. The FTSE 100 is heavy in commodity stock, but light in technology stock which is a particularly high value sector. International investors have been put off by Brexit uncertainty, while the potential threat of widespread nationalisation has put off utility sector investors, which makes up a significant proportion of the FTSE index.
Many commentators believe that getting a Brexit deal through parliament in January will give the UK a Brexit bounce. UK equity markets will be a beneficiary of this, particularly the UK focused FTSE 250 index of companies. The UK is seen as undervalued and with Brexit uncertainty lifted, foreign investors will be attracted to the UK. The strength of the UK economy, its flexibility and competitiveness should enable it to survive and prosper after the transition to a new relationship with the EU.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.