Brexit, the pound and investment opportunities
29 March 2017
So far 2017 has been a topsy-turvy year for the British pound and it continues to be the focus of attention for many investors concerned about the UK economy’s fortunes post Brexit.
While we cannot comment directly on the politics of Brexit, we can draw conclusions about the financial and economic impact that the political machinations will have.
Investors were well-prepared for the submission of Article 50 but were eagerly anticipating the tone of the Prime Minister’s accompanying statement to parliament. While the pound has suffered since the referendum last June, the more conciliatory tone in Theresa May’s statement gave some comfort. The pound rallied to an intra-day high against the euro and the dollar as she emphasised that the UK was not turning its back on Europe or rejecting its values. However, in her letter to Donald Tusk, President of the EU, May said that “the United Kingdom does not seek membership of the single market: we understand and respect your position that the four freedoms of the single market are indivisible and there can be no “cherry picking”.
While investors have been conditioned to expect this outcome (with the potential that tariffs will be imposed on UK exports to the single market and the UK financial services industry penalised for being outside the EU), it could be worth holding back a little on negative speculation: good negotiating practice demands that the UK government and its European trading partners strike an uncompromising early tone. This is not necessarily reflective of the end position that either side expects to reach.
Sterling will no doubt continue to be impacted by the unfolding drama of the negotiations, which itself drives a number of equity sectors.
In our view the degree of negativity surrounding the UK pound has been excessive. Better economic performance, or a more constructive resolution of the negotiations, would enable it to recover. A stronger pound can weigh on returns as it means that the high volume of foreign revenues UK companies earn are worth less in sterling. Even so, parts of the market will benefit (such as retailers and real estate) and overall it makes it easier for UK equities to outperform their overseas peers. It would help smaller businesses, which tend to be domestically focused, to outperform larger companies that have benefitted from the fall in the pound inflating their overseas sales.
The FTSE 100 today dipped a little during May’s statement although this could easily be a reaction to the slight rise in the value of the pound.
But markets have a lot to digest apart from today’s official start to the process of leaving the EU. Markets are also ruminating on the prospect of a second independence referendum in Scotland and political risks across Europe. However, more mundane issues are also crucial, such as the UK’s economic performance.
The UK has performed better than expected following the decision to leave the European Union but financial markets, which represent the collective view of investors, remain downbeat on the UK’s economic prospects.
That said, there is a misconception that, compared to the UK, the Europeans do not have as much to lose from failing Brexit negotiations. This approach assumes there are winners and losers from trade (depending whether you are the seller or the buyer), however the reality is that trade only ever takes place if it is in both parties interests.
There is a reasonable chance that both parties would see this is the case, and work towards a deal. It is possible that a protectionist approach would be taken for political reasons but doing so would be mutually harmful.
Despite this, if the worst were to happen, the situation could be dire for the UK. The UK spends more than it earns in international terms, and must attract foreign capital every year to maintain the current level of economic activity. Failure to offer investment opportunities would mean a further decline in the pound, and a decrease in both output and private spending.
We think this is unlikely. Developed economies like the UK are unlikely to suffer from a rapid collapse in confidence. It might look set to be a rough ride at times, but investors don’t need to jump ship.
Over the coming months, the markets will have to make judgements. Part of their cue will come directly from economic data and part of it will come from policymakers’ pronouncements.
We have recently seen good employment growth numbers and, despite the UK having one of the highest employment rates (the share of the population with jobs) in the developed world (far higher than the US for example), wages have remained subdued. We expect to see consumer spending slow as a result of higher inflation over the coming months.
We also learnt that one member of the Bank of England’s Monetary Policy Committee voted for higher interest rates in March’s rate meeting, showing an increased appetite for raising rates which should see sterling strengthen.
It would be a fair result. Sterling looks cheap despite the circumstances and we think, even with low confidence, the currency has scope to improve if the worst fears of investors are allayed once negotiations begin.
However, it is difficult to argue with the strong consensus of the MPC that rates will stay low for the time being. Even so, from the ultra-loose stance of monetary policy at the moment we judge there to be a much higher chance of policy being incrementally tightened (maybe through a reduction in quantitative easing) than further loosened, which would be likely to lead the pound to appreciate. A rising pound would normally make it hard for overseas holdings to outperform domestic equities. It would tend to suggest smaller companies will outperform large international companies. We have therefore been tilting our portfolios more in that direction while maintaining broad diversification.
Guy Foster, Head of Research
Guy leads Brewin Dolphin’s Research team ensuring that a rigorous and exhaustive investment process is employed. He also provides recommendations on tactical investment strategy to Brewin Dolphin’s investment managers and strategic recommendations to the group’s Asset Allocation Committee. Before joining Brewin Dolphin in 2006, Guy was an Investment Director at Hill Martin (Asset Management). Guy has a Masters in Finance from London Business School. He is also a CFA charterholder, holds the CISI Diploma, and is a member of the Society of Business Economists. Guy frequently discusses financial issues with the written and televised media as well as presenting to the staff and clients of Brewin Dolphin.
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