United Kingdom

30 Oct 2019

The mood in the UK can best be described as febrile and that is a label that can be applied equally to both politicians and investors.  Boris Johnson won the leadership contest for the Conservative Party in late July and duly became Prime Minister.

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His term of office did not start propitiously however, losing all six of his first Parliamentary motions as he endeavoured to muster support for an early General Election.  Subsequently his Government triggered a prorogation of Parliament, though a legal challenge led to the Supreme Court ruling such a suspension to be unlawful.  The Prime Minister’s approach to delivering Brexit has been characterised as “do or die”, exemplified by his own comment that he “would rather be dead in a ditch than ask for a delay”.  Rising tensions led 21 Tory MPs to vote with the Opposition and they were summarily ejected from the Party.
The Prime Minister’s approach to delivering Brexit has been characterised as “do or die”
The atmosphere in the House of Commons has become highly charged with many of the debates featuring extremely unseemly behaviour as we approach the existing deadline of October 31st with no sign of an agreement either within Parliament or between the UK and the European Union on revised exit terms.  Although the likelihood of a no-deal Brexit has probably reduced following the passing of the Benn Act, which requires the PM to seek a three month extension to the Brexit deadline in the event that Parliament does not ratify an exit deal by October 19th, sterling continues to be buffeted by every piece of political newsflow.
After the robust performance of the economy during the first quarter of the year, the inevitable correction occurred and GDP was reported as negative for Q2 as stockbuilding was reversed and industrial confidence subsided further while awaiting certainty on the Brexit outcome.  With export volumes failing to benefit from a more competitive sterling exchange rate, it was left to consumer spending to shore up economic activity; higher real wages, as annual increases overtook inflation for the first time in several years, and the ongoing payouts from mis-sold Payment Protection Insurance claims, limited the decline in the economy.  
Furthermore the number of people in employment continued to rise as more than 350,000 individuals joined the workforce during the latest twelve months.  About a third of this addition registered themselves as self-employed but the majority of the increase reflected businesses preferring to add to headcount than to sanction capital spending plans ahead of any Brexit decision.  
UK Blue Chips – under-recognised play on a weak pound

UK Blue Chips – under-recognised play on a weak pound

Source: DataStream, Citi Research

With the economy likely becalmed until Brexit is resolved and the Bank of England in no position to act on interest rates, most investors’ attention has fallen on sterling.  It is well understood that more than two-thirds of the revenue earned by the companies making up the UK stock market stem from overseas economies through both exports by domestic businesses and from overseas operations of UK companies.
Most economists use the Bank of England’s trade-weighted calculation to measure the strength or weakness of the pound; this reflects that more than twice as much trade is done by the UK with Europe than with the US
This has made the UK stock market an inverse barometer of Brexit expectations, so that an increased possibility of a no-deal outcome would weaken sterling but the lower exchange rate would add to UK corporate profits calculated in pounds, thereby supporting share prices.  One aspect of this relationship which is not well appreciated however is that most economists use the Bank of England’s trade-weighted calculation to measure the strength or weakness of the pound; this reflects that more than twice as much trade is done by the UK with Europe than with the US.
The strategy team at Citigroup have modified this calculation to base it on the currency mix of revenues for the constituents of the FTSE index, which have a much greater preponderance of dollar trade.  The chart above illustrates that the prevailing level of the UK stock market fails to reflect all the weakness in the pound when recalculated on this basis (due to the dollar being much stronger than the euro) and may reflect investors choosing to avoid the UK market irrespective of valuation until the Brexit clouds clear.
Some corporate investors have alighted on this anomaly as reflecting an opportunity for acquisitions and during the past quarter bids were launched from overseas for the defence contractor Cobham, the leisure company Greene King and the London Stock Exchange itself.  Overall returns from UK shares during the three months were just above 1%, though share prices of smaller companies in aggregate fell due to their greater reliance on the domestic economy.  
At a sector level, the highlights were shares in healthcare and telecoms, whilst the weakest performers were found in the most cyclical areas such as oils, mining and chemicals.  Profit estimates for the UK market, whilst lower than made back in the spring, still reflect a modicum of growth and this should permit a modest increase in dividend payments, sufficient to offset inflation for investors.

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