Recognising when sentiment and fundamentals diverge is the basis of good investment. At a time some commentators are expressing concerns about market levels in general, it is incumbent on the investor to seek value relative to prospects. By most metrics, the UK is the cheapest market in the developed world. The very simple reason is Brexit and the near-hysteria of some about the consequences of a possible no-deal exit.
Investors need to assess the fundamentals to determine whether this is justified. Certainly the extent of inward investment and foreign takeovers would suggest those outside these shores have more confidence. But could our domestic doomsayers be right? The answer to this important question will help investors determine whether the UK market remains unloved or represents the buy of the decade – and the clock is ticking.
Fundamental analysis
Evidence of negative sentiment abounds. Latest valuations suggest the UK’s cyclically adjusted price/earnings ratio (CAPE) of 16.5 is better value than virtually every other developed market. Other research claims the market has only been cheaper twice during the last 100 years, while the dividend yield metric points to equities being at 20 year lows.
Yet the UK is seeing record low unemployment, record manufacturing output and record inward investment – attracting more investment last year than Germany and France combined. The corporate sector is in good heart and investing. Meanwhile, Greene King joins Just Eat, Dairy Crest and Merlin Entertainments in having been bid for this year. Such decisions have been made in the full knowledge that ‘no deal is better than a bad deal’.
Those opposed to a no-deal Brexit are concerned about the economic implications of the UK leaving the EU on World Trade Organisation (WTO) terms by 31 October. Terminology such as ‘crashing out’ or ‘cliff edge’ in describing this possibility has entered the mainstream and is perpetrated by certain sections of the media and Parliament.
And yet there has been a lack of fundamental analysis as to the economic effect of leaving the EU on WTO terms. Such analysis is detailed and does not make for the sound-bites so beloved of journalists and politicians – especially those who regret the result of the EU referendum. And yet there is no substitute.
The circumstantial evidence certainly points to the UK trading very successfully with the rest of the world outside the EU essentially on WTO terms. Indeed, six of the EU’s top 10 trading partners trade under WTO rules, and this reflects the EU’s poor track record at striking trade deals. The WTO offers a rules-based system which provides the basic framework for countries to trade with each other.
A central case of the no-deal critics is that no country trades on just WTO terms because there are many little known side-deals which the EU has with its trading partners. Yet there has been very little scrutiny about the detail of these micro-agreements. Examination is revealing.
The majority tend not to be about trade. Of those that do relate to trade, most are usually not essential whilst over half typically relate to international agreements to which the UK may already be party to, or be able to accede to, in its own right. By way of example, examination of the trade between the EU (and therefore, presently, the UK) and the US under WTO terms is illustrative – there being no trade deal.
There are 147 micro-agreements or side-deals. Of these, 85 are multi-lateral agreements including the Air Transport Agreement and Paris Climate Agreement – both of which the UK is a party. Of the 62 bilateral agreements, half do not relate to trade. The half that do include agreements relating to the coordination of energy-efficient labelling programmes for office equipment, customs cooperation and matters related to trade in wine.
Given the UK’s massive trade deficit with the EU, it is unlikely the EU will not wish to replicate such agreements where relevant, given it disproportionately benefits from the trade. Should there be any doubt the EU presently has 97 side-deals with Russia – a country against which it operates sanctions.
Perhaps more importantly, the WTO imposes obligations on countries to agree Mutual Recognition Agreements (MRAs) for trade where it can be objectively justified. Refusal by either the EU or UK would be treated under WTO rules as both arbitrary and discriminatory, since each would be offering MRAs to other countries for the same products and services.
As for some of the more ludicrous scare stories about food, water and medical shortages, planes not flying or ports getting clogged, space does not allow an explanation as to why they are … well … ludicrous. Suffice to say, all have been discredited by the relevant authorities or appropriate sources – even though the media have given these assurances little prominence.
Investors need to be wary of forecasts from vested interests including big business which benefits from EU regulation. Many forecast a DIY recession and dire job losses by Christmas 2016 if the UK voted to leave. In March 2016, media prominence was given to a CBI forecast that a Leave vote would cost 950,000 jobs within a couple of years. The Bank of England, Treasury, IMF and Government pamphlet all incorrectly added to the forecasts of gloom.
The no-deal sceptics ignore the fact that investment is about comparative advantage. The competitiveness of our tax rates, the flexibility of our labour markets, our financial expertise, skilled workforce, record on innovation and top universities are, in aggregate, more important than WTO tariffs averaging 3-5 per cent. The near-£39bn saved courtesy of no-deal would help any industries to adjust – as with similar assistance in previous economic cycles.
In all reality, the Government’s new approach under Boris Johnson is more likely to yield concessions from the EU and an agreement, provided his room for manoeuvre is not restricted by Parliament – whereupon the market will rise. But it will still perform well should the UK leave with no deal once the scare stories prove unfounded. Investors should be positioned accordingly regardless of any general election.
We certainly continue where appropriate to pivot the nine real investment trust portfolios run in real time on the website www.johnbaronportfolios.co.uk towards the UK. While we tend to avoid currency predictions, a further factor in the UK market’s favour, relative to others, could be a bounce in the £ on any favourable news – with smaller companies looking best placed of all.
Portfolio changes
During August, the Growth portfolio added to its holding in Edinburgh Worldwide (EWI), and replaced Aberdeen Standard Equity Income (ASEI) with The Mercantile Trust (MRC). Prices achieved were £1.84, £3.66 and £1.99 respectively. There were no changes to the Income portfolio.
