If the Brexit negotiations last year seemed tense, they are likely to pale in comparison to the upcoming discussions regarding the terms of the new trading relationship between the UK and Europe.
UK politicians are not in agreement about what they are trying to negotiate and what, if anything, would replace the EU Single Market and Customs Union memberships.
Negotiations need to be completed within nine months to leave enough time for any new agreement to be ratified by parliaments before the UK leaves the EU on 29 March next year.
Given the stakes, there is a highprobability of a breakdown in talks and of the economically damaging “hard Brexit” materialising.
In such a scenario, the UK would lose tariff-free access to its largest export market and have to fall back on World Trade Organisation rules. This would entail the imposition of mid-single digit tariffs on UK exports to the EU.
More importantly, exports would also have to abide by complex “rules of origin” regulation – a heavy burden that would be both time consuming and costly, particularly for SMEs. A hard Brexit would likely lead the pound to retest its post-referendum lows. Higher inflation would likely push gilt yields up.
Another risk, with arguably a wider range of consequences, is the spectre of early elections. With Brexit negotiations dividing the government, there is a material probability of a general election before the end of 2019, particularly as Theresa May has a razor-thin working majority of only 13.
A Labour Party win cannot be dismissed, given its surge in the polls since mid-2017.
A wide array of outcomes would then be possible for financial markets. On the one hand, should Labour win a sweeping majority and push for a hard Brexit, UK financial markets would almost certainly come under pressure due to nationalisation and £500bn fiscal spending programme.
In a more benign scenario, Labour would emerge victorious, but without a majority of seats, making it more difficult to pass extreme policy measures. Should it also shift its stance on Brexit and opt for a Norway-style agreement where access to the Single Market is retained, it is conceivable the pound and economy could both strengthen.
In our view, UK equities present a less attractive proposition than those of other regions, despite having more appealing valuations.
UK equities lagged in 2017 and we think this is set to continue in 2018, given the unappetising stew of severe political risk and a comparatively weak economy. UK equities look especially cheap compared to other markets, particularly on a price-to-book value basis. This is partly due to the structural derating of banks and commodities.
On a forward price-to-earnings basis, excluding commodities, the UK trades at a 10 per cent discount to global markets – a level it hasn’t seen in nearly a decade. In our view, such cheapness is warranted, given the risks enumerated above. The earnings growth expectation of less than six per cent for 2018 is comparatively uncompelling. With the number of profit warnings at a six-year high in the third quarter of 2017, earnings expectations may well be reined in further.
As a high dividend-paying market, yielding four per cent overall, the UK has tended to underperform when monetary policy is tightened. UK equities are also still largely exposed to commodities and emerging markets, which are both highly sensitive to the US dollar. Should the dollar rally, as we expect, it could also contribute to restraining UK equity performance.
Should the pound weaken due to a breakdown in negotiations, some argue that UK equities could rally, much like they did after the referendum results. But we think this could be interpreted as the worst scenario, in which case, equities may well dissipate. The outlook is finely balanced.
We remain selective, preferring high-quality businesses with sound balance sheets, robust cash flow generation, and a track record of compounding returns to shareholders. We maintain our bias towards international exposure, focusing on companies exposed to the robust European economy, or US tax reform.
We struggle to be enthusiastic about domestic stocks. Domestically focused FTSE 350 stocks have underperformed their peers with international exposure by more than 15 per cent over the past three years.
With the barrage of pressures unlikely to fade in the short term, we believe it is too early to step back into domestic stocks. The UK outlook is mired in uncertainty, and we expect volatility to increase. This could mean better entry points for equity, fixed income, and foreign exchange investors in the months ahead.