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