Brexit: Trick or Treat?

That's a view shared not just by politicians and voters but by businesses too. For many, their only wish now is to finally move to the next phase so they can secure clarity over what the future holds. And for investors in UK plc, the big question now is how will companies fare in a post-Brexit world? Will Brexit prove to be the treat that keeps on giving, or a terrible trick that will cost us all dear?

The trick case

Chancellor of the Exchequer Sajid Javid has refused to conduct an economic assessment of the effect of the UK leaving the EU, on the grounds that doing so is “self-evidently in our economic interest”. Most economists, though, think there is nothing at all self-evident about this.

There are two different ways in which Brexit impacts the economy.

The short-term one operates through uncertainty. Uncertainty encourages companies to delay capital spending until they have more clarity about the environment in which they will be operating. Stanford University’s Nick Bloom and colleagues have estimated that this uncertainty has reduced growth in investment by around six percentage points, relative to what we would have seen had we voted to remain in 2016.

From this perspective, finally achieving Brexit might boost the economy, as companies unfreeze the capital spending plans they have put on ice – especially if we leave with some kind of deal.

Such a boost, however, might be weak and short-lived. The question: 'on what terms will we leave?' will be replaced by: 'what sort of trade deal will we get with the EU, and might we end up leaving with no deal once the transitional period ends in late 2020?' Uncertainty, then, will continue.

The longer-term impact is that that Brexit will reduce growth in trade. Even if we have a free trade deal with the EU, there will still need to be customs checks – for example, to ensure that goods satisfy rules of origin standards. This slightly raises the cost of trading with the EU and so deters such trade. Most economists think these costs will not be offset by the UK striking free trade deals elsewhere. This is partly because we trade much less with most non-EU countries than we do with the EU; because the UK has no recent experience in negotiating such deals; and because they often leave non-tariff barriers in place and so do little to promote trade.

The think tank, The UK in a Changing Europe, estimate that these effects will eventually reduce UK GDP per person by around 2.5 per cent, relative to what it would have been were we to stay in the EU. Less trade, however, is likely to mean lower productivity growth – because it means companies face less foreign competition and have less incentive to up their game to meet foreign demand. The UK in a Changing Europe estimates that this might eventually cut GDP per person by a further 4 per cent.

https://voxeu.org/article/rising-brexit-uncertainty-has-reduced-investment-and-employment

https://ukandeu.ac.uk/wp-content/uploads/2019/10/The-economic-impact-of-Boris-Johnsons-Brexit-proposals.pdf

What leading indicators are telling us

Besides the possible impact of Brexit, we can turn to lead indicators to point to where equities are heading. A few factors have predicted equity returns (to some extent) in the past and might continue to do so in future. Sadly, however, at least three of these indicators now point to equities doing badly.

One is the ratio of the global money stock (as measured by the OECD) to the MSCI world index. This is now unusually low relative to its long-run trend. On the three previous occasions when it hit such lows, the All-share index fell in the following 12 months: in 2000-01, 2007-08 and in 2015-16. Since January 1998 the correlation between this ratio and subsequent annual changes in the All-share index has been 0.52. If this relationship continues to hold, there’s a two-thirds chance of the index falling over the next 12 months.

There’s a simple reason why this measure works. The money-price ratio is an indicator of the proportions of cash and equities in global investors’ portfolios. When the ratio is low, as it is now, it’s a sign that investors are overweight in equities and underweight in cash. This suggests they are pricing in more good news than bad, so there is more risk of a nasty surprise than of a good one. It also means that – other things equal - investors are more likely to rebalance their portfolios away from equities than towards them. On both counts, there’s a risk of share prices falling.

This, however, is not the only sign that global investors might be over-optimistic. Another is that non-US investors have begun buying US equities again after months of selling. Figures from the US Treasury show that they bought $36.6bn of them in the three months to July, the biggest buying since 2017-18.

This matters because investors usually only buy lots of foreign equities – even US ones – when they are unusually confidence. And high confidence is often a sign that shares are at a peak. Previous high-points for foreign buying of US stocks came in 2000, 2007 and early 2018. On all three occasions global markets subsequently fell sharply.

Granted, foreign buying isn’t yet so high as to justify comparisons with those periods: it has only recently turned positive. Nevertheless, if the post-1998 correlation between such buying over a three month period and subsequent annual changes in the All-share index continues to hold, it points to almost a 50-50 chance of the market falling in the next 12 months. This is an above-average risk

A third worrying sign is that the gilt yield curve is now inverted; ten-year gilts yield less than three-month money. This too points to low equity returns and a heightened chance of prices falling. Since 1985 the All-share index has on average risen by 10.1 per cent in the three years after a month in which the yield curve was inverted. But it has risen by an average of 27.8 per cent in the three years after the curve has been upward-sloping.

It's not just in the UK that the curve is inverted. It is in the US as well. And this fact is sending an even more powerful sell signal. Since 1987 an inverted curve (defined as ten-year yields being below three-month Treasury bill rates) has led to the S&P 500 index falling by an average of 22.8 per cent in the following three years. And if US shares fall, it is very likely that they'll drag down UK ones. 

This shouldn’t be surprising when you remember what an inverted yield curve means. Just ask: why would anybody want to hold a long-dated gilt which yields less than cash? It’s because they expect interest rates to fall, so they’ll make less on the cash when it is reinvested but a capital gain on the gilt. And why would they expect rates to fall? Because they expect a weak economy – something which often drags down share prices.

We have, therefore, three reasons to be bearish.

To this you might object that on the other hand there is a great bullish signal. At 4.3 per cent as I write, the dividend yield is well above its 30-year average (of 3.5 per cent). This matters because the yield has historically been a fantastic predictor of returns, especially over longer periods.

But, but, but. Two things suggest the yield might not be so good a predictor now.       

One is that developed economies generally have entered an age of what former US Treasury Secretary Larry Summers calls secular stagnation. If this continues then a high yield is a sign not that the market is under-priced, but is simply compensation for lower future dividend growth.

It’s not just low growth that warrants a high yield, though. So too does something else – political uncertainty. US economists have complied an index of this going back to 1997. During this time, this index has been strongly correlated with the dividend yield on the All-share index: the correlation coefficient has been 0.57. This tells us that the yield will stay high – and hence that share prices won’t rise much – if political uncertainty stays high.

Which it could. Next year will bring a US presidential election, and perhaps a UK general election as well as ongoing negotiations about the precise form that Brexit will take. 

Halloween is a time when we traditionally tell each other scary stories. But we don’t need stories to be concerned about the fate of the UK market. Many statistics are telling us to be cautious too. 

The treat case

Economic calamity awaits Britain if it leaves the European Union without a deal. At best, if a deal can be done it would soften the impact of departure. But as with any divorce there is an inevitable net loss on both sides. At least, that’s what the doomsters and gloomsters would have you believe.

However, there is in fact every reason to be confident that UK plc – and by extension, with all the usual caveats, UK equities – will do well whatever the outcome from the country’s departure from the EU. If anything is to be feared, it’s the prospect of a Corbyn-led government, not a no-deal Brexit.

One reason stands out above all else in the bullish view of UK equities – value. UK equities are abnormally cheap compared with peers, largely since global investors turned drastically underweight on UK-listed stocks in the wake of the EU referendum in 2016. For three years they have remained shy of going more heavily into the UK – three years after the Brexit referendum the FTSE 100 was 25 per cent cheaper than pre-referendum levels based on forward earnings multiples.

Analysts at Credit Suisse argue that UK equities look ‘unusually cheap’, with valuations at the lowest level since 1999. According to their models, UK equities are 15 per cent undervalued. On a relative basis both forward price-to-earnings multiples and dividend yields suggest an abnormally cheap market.

This is not entirely due to Brexit uncertainty. Over the last decade growth has won against value and the composition of the UK market is underweight growth. This is a global phenomenon: in the US, growth has been trading at a record premium to value and reflects the post-crisis market dynamics. However, historic data suggests that value ultimately wins over growth and there are signs of the market already reverting to the mean.

So, where do you put your money? Global investors should be looking at the UK because a) domestic equities are very cheap relative to international peers, and b) the UK has a strong value composition of stocks with low PE multiples, high dividend yields and a propensity to return cash to investors that ought to benefit from a global rotation that is happening unrelated to Brexit.

There is significant universe of around 30 or so UK blue chips offering yields in excess of 5 per cent that is well beyond the historic norms. Even if you allow for uncovered dividends, the number of UK companies offering healthy returns is compelling.

The FTSE 100 is trading on a forward earnings multiple of about x13, versus about x15 for France and Germany. US equities as measured by the S&P 500 are at x18, while the high-growth Nasdaq trades on more than x21 forward earnings. The current PE multiples highlight the same discrepancy, with the UK (FTSE 100) trading at x17.5 earnings versus about x20 for German, French and US equities. 

The FTSE 100 is well positioned from a dividend perspective versus peers. Currently it’s yielding in excess of 5 per cent, against 3 per cent for German and French equities and around 2 per cent for S&P 500 companies.

The market has already started to rotate – the shift in the US out of growth and into value only really started in September but is only just beginning. Even Bill Gross, the bond king, suggests dividend stocks are a better bet than a good deal of government paper. “High-yielding, secure-dividend stocks are what an astute investor should begin to own,” the retired Pimco founder said in his first market outlook since retiring. 

Now with the spectre of Brexit to fade, there is a good reason why global fund managers will be drawn to UK high-yield value stocks.

The other reason to be confident is because of the relative clarity that Brexit will bring to the economy. As the cloud of uncertainty over the UK lifts along with the Brexit pall, there is good reason to be more upbeat about the UK economy as business investment and trade pick up, giving unloved pro-cyclical sectors more upside. Even if you take a dimmer view of the global economy, the generally defensive make-up of the UK market has a draw for investors. 

Expecting a weaker pound?

We can make one or two economic observations about Brexit which will impact equities in a range of ways. 

Certainly, the value of sterling ought to be lower after leaving the EU because we would have less favourable terms of trade and higher non-tariff barriers with our biggest trading partner. 

Although how much is already ‘priced in’ to the value of sterling is up for debate, and depends on the future relationship both with the EU and other trading partners, a weaker average exchange rate against the US dollar and euro compared with the last 15-20 years seems certain. A weaker pound boosts the blue-chip dollar earners like Shell, Imperial Brands and GSK, but it’s less positive for the bulk of domestic-oriented stocks. 

One of the problems facing UK equities since the referendum has been the uncertain outlook for businesses. This has hit investment, which accounts for about 10 per cent of GDP. 

According to the National Bureau of Economic Research, uncertainty over Brexit has seen business investment cut by 11 per cent over the last three years. 

It seems facile to say that the market hates uncertainty, but it’s true. An exit on whatever terms produces an outcome, and this means greater certainty for businesses. Bank of America Merril Lynch says buying UK mid-caps as the Brexit denouement brings an end to ‘multi-year pessimism’ on this area of the market is one of its ‘2019 policy panic trade’ ideas. In other words, with the uncertainty lifted, money should flow back into the UK.

No deal, no problem?

Even a no deal exit would be less of a problem than many fear, albeit there would be a high degree of short-term turmoil until the market effectively forced the two sides to reach a deal. Companies would benefit from a predominantly zero-tariff regime. Under the government’s planned temporary tariff rule, 88 per cent of total imports to the UK by value would be eligible for tariff free access. So far from going down the protectionist route, the UK seems to be adopting a policy of unilateral liberalisation. 

Of course, this can open up some businesses to greater competition. But on the whole the, albeit temporary, regime would protect consumers from higher prices. This will have an important bearing on consumer confidence and spending, the cornerstone of the UK economy. Therefore, we cannot necessarily expect consumers to rein in spending as much as feared. Companies importing goods from abroad may also benefit from lower tariffs – the EU’s protectionist agenda would be swept aside. 

The jobs market remains strong, wages are firming and there are signs that the economy will pick up, boosting pro-cyclical sectors. PMIs show softening in the economy, but nothing beyond what we see in other developed economies. Export growth has declined to zero, but is showing signs of turning higher again. Real and nominal wage growth are rising steadily. 

More importantly, the government is opening the spending taps and the fiscal boost should not be underestimated. Indeed, the nascent rotation into value stocks, which tend to do better when interest rates are rising, corresponds with a newly-energised debate around the merits of fiscal stimulus versus monetary policy. There appears, in many quarters, growing acceptance that central banks are out of ammo and that the support for world economies needs to come from more government spending, not from more interest rate cuts. The era of central banks is over, and we’re now entering a phase of higher borrowing and spending to juice flagging western economies.

What to buy?

Credit Suisse argues buying UK international earners that are cheap versus their peer group and the examples they cite include Johnson Matthey, Elementis, Rentokil, Relx and BAT. They also suggest Imperial Brands, which has been on the receiving end of vaping blow up in the US, as being among those most under-valued. A 10 per cent dividend yield points to this stock being severely under-appreciated by investors.

There are plenty more dividend giants – Rio Tinto and BHP among them – which are offering chunky 6-7 per cent yields and which are insulated from Brexit in the sense that they earn their crust abroad and benefit from a weaker exchange rate. 

Airlines may also be a bargain. Bank of America Merril Lynch analysts recently upgraded their sector view and gave a buy rating to both IAG and Wizz Air.

And CS agrees, suggesting that EasyJet and IAG are looking very cheap relative to the wider European market. They say that the triple headwinds of a weak economy, a weak currency and excessive capacity growth “are now to some extent behind us”, adding that the shortage of slots further supports the sector.

They also like utilities including United Utilities and SSE. Utilities, which have been discounted due to a changing regulatory backdrop and the risk of nationalisation implied by a Corbyn-led government “have become unusually cheap versus their European peers”, the bank notes, adding that they’re still behind the rally in index linked bonds. Meanwhile nationalisation risk has sharply diminished with Labour’s decline in the polls. 

Indeed, generally we can see defensive stocks are coming to the fore. As CS notes: “The UK market is traditionally defensive in its sector composition, being significantly underweight of cyclicality and thus UK equities tend to outperform when PMI new orders fall as they have done over the past year.”

UK equities have seen extreme outflows and risk appetite has fallen to the lowest level across all regions.  In other words, to borrow a phrase from 1997, things can only get better.