Brexit bother as Boris’s Mexican stand-off misfires
Having spent most of 2020 hoping things can get back to normal, Britain’s political news over the last couple of weeks has left us thinking ‘be careful what you wish for’. Stalling Brexit talks, political disarray and the potential for a full-blown constitutional crisis all created that familiar feeling of prepandemic times. Indeed, as if there was not enough déjà vu, parliamentary action even saw Ed Miliband standing in as leader of the opposition.
Jokes aside, the emphatic return of Brexit risks to Britain’s economy and capital markets is clearly bad news. Those sympathetic to the government insist that the provisions laid out in the Internal Market Bill – allowing the government to unilaterally break international law – are just a negotiating tactic to establish a credible threat of ‘no deal’. But reaction from the continent, and within Johnson’s party itself, suggests this particular negotiating ploy is unlikely to pay off.
Even if it does, in the short-term it will cause great uncertainty over Britain’s relations with its largest trading partner – not to mention the constitutional chaos it might bring (if passed in its current form, the bill would almost certainly be challenged in the Supreme Court). As we have seen over the last four years, uncertainty is highly detrimental to businesses and consumer expectations.
Accordingly, capital markets reacted swiftly to the news. After a strong run in recent months, sterling fell dramatically last week, sinking to €1.07 against the euro and $1.27 against the dollar – its deepest weekly fall since March. At the time, head of Lombard Odier’s currency strategy Vasileios Gkionakis told the Financial Times that “The market is simply going through a rude awakening,” readjusting for Brexit risks that seemed to clear over the summer.
However, the sell-off was short lived. Throughout this week, sterling has regained much of its losses against its global peers and, at the time of writing, sits around €1.10 and $1.29 against the euro and dollar respectively. UK equities made marginal gains last week – partly down to the weakness of sterling itself – and this week have edged slightly higher overall. Interestingly, Brexit turbulence gave investors a fright, but only briefly. For nearly five years, Britain’s long and drawnout divorce from Europe has been one of the main drivers of UK asset prices (and in the case of sterling, practically the driver). Now that we are again facing down a precarious Brexit deadline, why the nonchalance from global capital markets?
Put simply, we suspect it is the pandemic. With the world edging out of lockdown in recent months, the key question on the mind of most investors has been when the cyclical rally – backed by a recovering economy – will begin. Historically, UK equities (especially the FTSE 100) are extremely sensitive to cyclical forces – growing when global growth is strong and lagging when it is not. If growth – in its conventional ‘analogue’ rather than ‘digital’ shape – is indeed returning, it therefore bodes well for UK assets.
From this perspective, UK stocks look cheap. Even before Brexit, the UK was unloved by global investors. With political risks piled on, British assets have been consistently underbought relative to other major markets, resulting in UK stocks making up a much smaller portion of global investment portfolios than a decade ago. In valuation terms, UK stocks are currently trading at around 16.5x their expected future earnings on average, compared to around 19x for European stocks and well over 20x for US equities. It is even slightly below the global (excluding US) average at around 18x.
That relative undervaluation is – to an extent – justified.
The prospect of a hard Brexit as the UK is still reeling from a total economic shutdown is a significant economic risk. But for the past few years, anxious investors at home and abroad have been selling UK assets. As such, even in the worst-case scenario of a chaotic ‘no deal’ Brexit, the immediate downside is limited.
There are just not as many investors left to sell. This can be seen from the performance of the FTSE 100, which has traded mostly sideways for months. When you combine the prospect of a global cyclical recovery, UK assets look like a bargain. Indeed, even if global investors remain pessimistic on UK equities, a rebound in global activity – and subsequent increase in company earnings – would mean that equity prices could rise without much of a change in valuations.
However, two things need to happen for this positive scenario. First, the cyclical rally has to materialise. While there are some emerging signs, it is simply too early to tell. Second, some kind of resolution to the Brexit drama needs to be found. For now, the dark cloud of a hard Brexit looms large over UK markets, making many investors uninterested even at cheap valuation levels. Threats to unilaterally break components of an already-agreed treaty do little to help them.
There are reasons for positivity, though. Reports this week suggest Britain is willing to deal with the thorny issue of fisheries more pragmatically in its negotiations with the EU. And, while much was made on the issue of full sovereignty in deciding state aid in the latest Brexit spat, the recently agreed free trade agreement with Japan already commits Britain to stricter state aid restrictions than the ones that have caused the latest furore. Given a negotiation success towards the EU on the freedom to subsidise issue would therefore not actually result in any more leeway for the UK, this suggests the government may be willing to reconsider its position – leading to a swifter resolution.
For now, the barriers to an agreement seem to be mostly superficial. But as the last four years have shown, things can quickly take a turn for the worse. If an agreement can be reached – and if the cyclical rally does indeed begin – UK assets will be in a good position. Until then, we will all have to wait and see.
Lothar Mentel, Chief Investment Officer, Tatton Investment Management
Rule of Six
With the number of coronavirus cases rising across the UK, the Prime Minister was back on the Downing Street podium last Wednesday to announce new measures. As we enter the autumn, with the country at a critical moment and the average rate of new infection four times higher than in mid-July, the government announced the introduction of the rule of six. From Monday (14 September) social gatherings of more than six people (of all ages) are banned in England. This limit applies to indoor and outside settings and is enforceable by police, who will issue fines or make arrests.
A support bubble or single household larger than six, will still be able to gather and COVID-secure venues such as gyms, restaurants and places of worship, can still hold more than six in total. The rules do not affect education and work settings.
Boris Johnson said, “we must act” to avoid another lockdown, adding, “Let me be clear – these measures are not a second national lockdown – the whole point of them is to avoid a second national lockdown… I wish that we did not have to take this step, but, as your Prime Minister, I must do what is necessary to stop the spread of the virus and to save lives… it is so important that we take these tough measures now.” Matt Hancock said the new rules will not be kept in place “any longer than we have to.”
During the briefing, the Prime Minister also outlined ‘Operation Moonshot’, an expansion of testing to ten million a day by early 2021. Frequent testing of the population would allow people without the virus to conduct their lives as normal, allowing the economy and society to remain open despite the virus being in circulation. Boris Johnson said the government was “working hard” to increase testing capacity to 500,000 tests a day by the end of October.
Quarantine list additions: Last week, in a change of policy for the government, England introduced island-specific quarantine, rather than restrictions applying to an entire country. Travellers arriving in England from seven Greek islands needed to self-isolate from 4am last Wednesday. Mainland Portugal was placed back on the quarantine list last week, effective from Saturday (12 September) morning. Meanwhile, Sweden has been added to England, Scotland and Wales’ safe lists.
Economic growth and trade talk wrangling’s: According to official figures from the Office for National Statistics, the UK economy grew by 6.6% in July, the third month in a row of economic expansion. Despite this, output remains below prepandemic levels and the ONS outlined the UK ‘has still only recovered just over half of the lost output caused by the coronavirus.’ The UK’s economy is 11.7% smaller than it was in February.
Despite subdued trading, the FTSE 100 ended higher last week. Trade deal negotiations between the UK’s Brexit negotiator Lord Frost and his EU counterpart Michel Barnier continued last week. The UK has published a bill to rewrite parts of the withdrawal agreement it signed in January, but the EU is demanding the UK drops plans to alter it. Lord Frost said, “Challenging areas remain and the divergences on some are still significant”, but UK negotiators “remain committed” to reaching a deal by the middle of October.
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Covid 19 update
As Storm Francis lashed the UK last week, another storm was brewing as the government took a late U-turn regarding the use of face coverings in schools in England. From the beginning of September, secondary pupils and adults in local lockdown areas of England and in areas facing extra government restrictions, will be required to wear face coverings when moving around the school, in corridors and communal areas.
Any secondary school in England will have discretion to introduce the use of face coverings in communal areas, where social distancing is not possible, a move which has prompted criticism from some teachers, with the announcement last Tuesday being made just hours before schools reopened in Leicestershire. The guidance does not include the use of face coverings in the classroom during lessons, where the government says they could ‘inhibit learning.’ The guidance extends to further education colleges but not to primary schools. Education Secretary Gavin Williamson said the new policy follows updated advice from the World Health Organisation, “Our priority is to get children back to school safely. At each stage we have listened to the latest medical and scientific advice… I hope these steps will provide parents, pupils and teachers with further reassurance.”
Eat Out success prompts extension – Some restaurants are keen to continue offering discounted meals in September, following the success of the Eat Out to Help Out initiative in August. The scheme ended on 31 August, but nationwide chains including Prezzo, Harvester, Toby Carvery, Bill’s and Pizza Hut are amongst those due to take part, although the eateries will have to cover the costs themselves.
Support for those self-isolating on low incomes – From Tuesday (1 September), workers on low incomes living in parts of England where there are high coronavirus rates will be able to claim up to £182 if they have to self-isolate. Strict eligibility criteria mean people claiming Universal Credit or Working Tax Credit, who are unable to work from home, will qualify for the £13 per day payment. The benefit is initially being trialled in parts of North West England. Eligible individuals who test positive and are employed or self-employed, need to isolate for 10 days and will receive £130. Eligible members of the household, who would have to self-isolate for 14 days, will be entitled to a maximum of £182. In addition, anyone who is told to self-isolate by NHS contact tracers and meets the eligibility criteria will be entitled to £13 a day for the duration of self-isolation.
Renewed optimism US stocks hit record highs last week after Federal Reserve Chairman Jerome Powell outlined the central bank’s strategy for avoiding future crises and inflation control measures. During the week, stocks rose amid renewed optimism about US China trade tensions, with both Chinese Vice Premier Liu He and US Treasury Secretary Steven Mnuchin renewing their commitment to a trade deal.
Quarantine list additions – Due to a rise in infection rates, quarantine rules were implemented on Saturday morning for travellers returning to the UK from Jamaica, Switzerland and the Czech Republic. Cuba has been added to the list of countries now exempt from quarantine.
In other news The government is preparing to launch a campaign this week aimed at encouraging employees back to their workplaces. Lockdown restrictions in parts of Greater Manchester, Lancashire and West Yorkshire will be lifted on 2 September due to ‘positive progress’, the government has announced.
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