The performance of UK shares has generally confounded most strategists. Since the vote to leave the EU in June, UK savers have enjoyed returns of close to 15 per cent. While the weakness of sterling has eaten most of those returns for overseas investors, we are in a much better place than many were predicting in the aftermath of what was an unexpected outcome.
Before we come to consider the extent to which the performance of UK shares will be more difficult from here on, it is worth considering the main reasons why the markets appear to be shrugging off Brexit.
Shrugging it off
First, markets tend to get far less roiled by events that are anticipated, assessed and analysed in advance.
Second, with a weakening (but not a collapse) in sterling, this acts to boost the reported sales and profits of UK-listed companies which conduct the majority of their activities overseas.
Third, there has been much better than expected performance by the underlying economy. My view was always that the economy may be more resilient after Brexit than many expected. Given that investment by the private sector was substantially constrained ahead of the referendum, and a fall in the value of the currency was likely (it had already declined substantially in the year running into the vote), sectors such as manufacturing and tourism would be well supported. And so it has proven.
Finally, it could be argued that the response of the Bank of England has had a role in the better-than-expected outcome, although whether its actions have bolstered or diminished underlying consumer confidence is a matter for debate.
Given the Prime Minister’s hardening language around the Brexit process, most are of the view that a recession in the UK has been delayed rather than avoided, and that the currency will remain under sustained pressure.
There is even a sense among the enthusiastic Leavers in the Conservative party that the euphoria which characterised the post-referendum period is now slipping away. With a strong showing for markets since June and a deteriorating outlook, surely the time has come to sell the Brexit rally?
This perspective may again prove too pessimistic. The recent weakness of sterling could be much shorter lived than many predict. While the political process of Brexit will remain a source of uncertainty over the coming years, the fall in the value of the pound may not only continue to act as a support to the economy, but will start to reframe the attraction for international companies of retaining and even increasing their investment in the UK.
There will also continue to be a reassessment of the outlook for inflation over the coming year.
Already when we look at the Bank of England’s inflation expectations for the next three years, the level of overshoot could be significant.
A combination of a reducing drag from oil and food prices, limited capacity in the labour market and imported inflation could mean that the near-term outlook for both short and long rates could begin to rise. Last week, we saw Tesco’s spat with Unilever over higher prices. There is the potential that all this leads to a recovery in sterling over the next six months.
And what of the markets? While the upside in the very short term will clearly be more limited, there are a number of reasons to think that the market will continue to be well supported.
First, the benefits of a weaker sterling will feed through gradually to the reported earnings of the listed sector, as many companies will have hedged their near-term currency exposure.
Second, as the purchasing power of international companies grows, it is likely that UK assets will look attractive from a corporate activity perspective. This appetite may be further increased if there is a growing sense that the currency has found a floor, and even more so if the consensus position of further medium-term weakness shifts.
Finally, however complex the management of the Brexit process, we know that markets prefer almost anything over uncertainty. Almost counter-intuitively, even if the terms of the economic arrangements with the EU are less favourable than some would hope, the clarity itself may provide some relief.