Investment Strategist - Europe, the Middle East and Africa
October 25, 2016
To best view Citi Private Bank's site and for a better overall experience, please update your browser to a newer version using the links below.
UK assets may struggle to achieve sustained rallies amidst Brexit uncertainties.
Between now and the planned triggering of Article 50 in March 2017, which starts the UK’s two-year withdrawal process from the European Union (EU), there will be a high level of uncertainty. Prime Minister (PM) May will try and seek support for her negotiating stance, against a likely backdrop of weakening economic growth and rising inflation. During this period, we believe rallies will be difficult to sustain in equities, bonds, and Sterling.
At the recent Conservative Party Conference, PM May indicated that her negotiating priorities would be control over the UK’s borders and restoring sovereignty. Statements from various EU leaders stressed that these priorities would be incompatible with maintaining the UK’s current level of access to the EU’s single market, the world’s largest free-trade zone. While both sides could soften their stances over certain things in the coming months, it is fair to say that at this stage PM May is leaning towards a “harder” Brexit that first and foremost meets the main demands of Brexit-supporting voters.
Three topics will command particularly high attention in the coming months. The first of these concerns is the extent to which certain sectors’ access to the single market can be largely maintained within PM May’s harder Brexit approach, and which might they be. The UK’s financial services sector and car-making are among the critical sectors which are likely to lobby for protection.
The second topic is whether or not parliament will be debating or voting on the negotiating stance. Thirdly, there is expected to be pressure for another Scottish independence referendum, with Scotland’s First Minister Nicola Sturgeon likely to publish a draft second independence referendum bill shortly.
The UK economy therefore faces great politically-induced uncertainty, especially with regard to inflation and growth. The surprisingly resilient streak of post-Brexit data is likely to eventually fade, and reflects snap judgments about immediate economic impact that is likely to be more gradual. Indeed, anecdotal information from the corporate sector is already indicating growing cautiousness; and this could be reflected in the macroeconomic data with a lag.
The consumer price inflation already showed an uptick to 1.0% year-on-year, the highest since November 2014. While this is well below the Bank of England’s target of 2%, it represents a rapid increase from the low earlier this year, which could subsequently lead to a rise to nearer 3%. Increased inflation would probably hit consumer spending through falling real wages and through rising costs from retailers who pass on their higher import costs. Businesses not able to pass on higher costs will face profit margin pressures, which in turn could constrain hiring intentions.
In assessing the likely investment slowdown, the EY Item Club – the only nongovernmental forecasting group to use the Her Majesty’s Treasury’s model of the UK economy – is expecting investment to fall 1.5% this year and 2.3% next year. The latest British Chamber of Commerce quarterly survey showed an eight-point drop in manufacturing investment intentions, and a 12-point drop in service sector firms’ training.
What matters is not just the stock of new investment but the flow, so decisions to delay expansions could be just as important as headline-grabbing closures. With these probable pressures on both consumption and investment, GDP growth could halve to around 1% by the second quarter of 2017 and be very reliant on export growth of around 4.5%.
In assessing precisely where the economy resettles in the medium-term, two factors are going to be especially important. Firstly, it is going to be vital that foreign direct investment is sustained, given its importance in helping the UK fund its twin deficits. Secondly, there have been recent signs of policy disagreement between the PM and Governor of the Bank of England (BoE), particularly over the appropriateness of the BoE’s on-going quantitative easing program and whether fiscal easing should begin to take up more of the slack. This uncertainty will hopefully be clarified in Chancellor Philip Hammond’s November 23rd autumn statement, which is expected to include a firm signal that further fiscal loosening is coming.
Against this backdrop, we think the UK’s FTSE 100 Index faces volatility in the months ahead. At best, we think a trading range is likely between now and March 2017, with the domestically-orientated FTSE 250 Index struggling to hold its recent gains. Notably, dividend yields for larger, global firms listed in the FTSE 100 provide solid valuation support. Meanwhile, Sterling – down 18% against the US dollar since the Brexit vote – looks technically overstretched, so we may see a recovery bounce in the short term. However, given the risk of rising inflation and a worsening fiscal deficit, a sustained Sterling rebound is unlikely.