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Britain's health check
Investors want to know what’s going to happen to the economy and the stock market now Prime Minister Theresa May has started the official process of taking the UK out of the EU.
While it is hard to know exactly how the markets will move, it is possible to make a few assumptions.
In a nutshell, the market is more likely to react to progress reports on trade negotiations and exit terms than the mere triggering of Article 50.
That means you should expect more stock market volatility later this year rather than in the immediate future.
Volatility could be exacerbated by any economic weakness, as there are already cracks showing in several key areas.
Britain has been stronger economically over the past nine months than many people expected at the time of the Brexit vote. But our analysis suggests its health is waning. We’ll get back to this point later in the article.
For now, let’s discuss key issues to monitor during the Brexit negotiations.
‘Few people thought Brexit would happen, hence why stock markets panicked on the vote result last summer,’ says Charles Newsome, a divisional director at Investec Wealth & Management, referencing the 7% decline in the FTSE 250 domestically-focused index over two trading days in June 2016.
‘We knew Theresa May would trigger Article 50 at the end of March this year, so that event won’t have been a surprise to the market. What we don’t know is how the Brexit deal will be structured or its costs – so it’s that kind of uncertainty which could be bad for the stock market.’
'The key question for the UK economic outlook is whether economics or populist politics dominate Brexit negotiations'
What are the potential trouble spots?
The UK Government wants to negotiate a free-trade agreement with the greatest possible access to goods and services markets.
It wants to be free to strike trade deals with non-EU countries and seek a ‘customs agreement’ with the EU. It also wants to stop paying large amounts of money to the EU budget and avoid having a prolonged transitional agreement.
It seems to want to reach an agreement within two years and then give businesses a limited time to plan and prepare.
‘The plan scored some points with markets and European politicians. It’s important to remember, however, that this is still a wish list and Europe has so far largely kept its cards close to its chest,’ says Hetal Mehta, European economist at Legal & General Investment Management.
‘The transition agreement is helpful as it makes a harmful cliff-edge exit less likely, albeit not impossible, as May rather strikingly insisted that “no deal would be better than a bad deal”. The risk of negotiations becoming bitter and acrimonious is there,’ she adds.
Some commentators believe Theresa May and her team will try to avoid regular progress reports, only commenting when something solid has been agreed. With that in mind, you might expect communication to be more biased towards EU officials.
Paul Derrien, investment director at Canaccord Genuity Wealth Management, warns investors to expect negative comment from EU politicians towards the UK as the negotiations take shape.
That could potentially trigger stock market volatility as investors look for any guidance on where the negotiations might be headed.
What is plan B?
‘In a thinly-veiled threat, May suggested the UK could slash taxes to attract companies and investors if the UK fails to agree a positive deal with EU,’ says Mehta at Legal & General.
‘We do not find this very credible for two reasons: the negotiating position of the UK remains relatively weak and corporation tax in the UK is already relatively low.’
A report by BofA Merrill Lynch Global Research says equity investors are not pricing in talks breaking down. The bank implies that amicable negotiations could see investors refocus on market fundamentals and the winners/losers from trade talks at a sector level.
Shares believes that scenario is more likely in 2018 rather than this year. Nearer term, we wouldn’t be surprised to see economic weakness become the dominant theme influencing the UK stock market.
‘The key question for our economic outlook is whether economics or populist politics dominate negotiations,’ says BofA Merrill Lynch. ‘The more the latter, the more trade could lose out. We see scenarios to the upside if a transitional trade deal is agreed; and downside if talks break down early.
‘Our base case remains that the UK exits the EU single market and customs union, and eventually a UK/EU free-trade deal is agreed. That would be economically costly, so we forecast weak UK growth in the coming years.’
If all those moving parts aren’t enough to give you a headache, we see other reasons why the UK and European stock markets could be in for a wild ride for the rest of the year and into 2018, all driven by political events.
France and Germany have elections this year and Italy follows in 2018. Scotland’s First Minister Nicola Sturgeon is pushing for another referendum. This has led people to suggest that Wales might want to hold its own independence debate, so too Northern Ireland.
The latter points could certainly stir up renewed volatility in sterling, according to Michael Wang, equity strategist at ETF Securities. He suggests investors may find better prospects in the European market on a medium term as that region’s economic recovery is starting to gather pace.
‘On a medium term we prefer European equities over the UK,’ comments Wang. ‘The outlook for the UK is weakening. Industrial manufacturing has been quite poor and real incomes for consumers are now being eroded by inflation. That suggests economic growth could be weak.’
Let’s now take a closer look at the key data points used to measure the UK’s health.
PMI UK manufacturing
After the Brexit vote, UK manufacturing contracted to 47.6 in Markit’s Purchasing Managers’ Index (PMI) in July 2016.
Fortunately, this didn’t continue as the manufacturing sector rebounded to a 10-month high in August 2016 as the weaker pound helped supported exports.
PMI UK construction
Initially the construction sector struggled following the Brexit vote. It faced the worst UK construction data for seven years in July 2016 as the PMI index dropped to 45.9, which hit housebuilders and commercial builders on the stock market.
From September, construction output grew with the index reaching 52.5 in February 2017 as an upturn in civil engineering outweighed weaker momentum in the housebuilding sector.
PMI UK services
The PMI index for the services sector dropped in July 2016 to 47.4. A figure below 50 is a negative situation.
In February 2017, the index recorded a healthier 53.3, although still below its long-run level of 55.1 as consumer spending came under pressure.
According to Markit’s chief business economist Chris Williamson, this implies household budgets are starting to crack under higher prices and weak wage growth.
House prices were not significantly impacted by the Brexit vote with average prices peaking in August and September 2016 around £206,000 before easing off to £205,846 in February 2017.
Surprisingly, this level is higher than May 2016 before the Brexit vote, although Nationwide chief economist Robert Gardner warns the economy is expected to slow through 2017 as heightened uncertainty weighs on business investment and hiring. That could hurt the property market.
After tailing off in the immediate aftermath of the Brexit vote the level of mortgage approvals began to recover and outpace expectations.
However in one of the first bits of economic data to come in significantly worse than expected since the Brexit vote, approvals for February 2017 came in at 42,600 against a forecast 44,900.
There were significant fears that voting to leave the European Union would result in significant job losses, although this nightmare scenario has failed to materialise.
In the three months to January 2017, the unemployment rate was 4.7%, down from 5.1% a year earlier – and has not been lower in more than 40 years.
UK gross domestic product (GDP)
Following the Brexit vote, the UK economy grew 0.6% in the third quarter of 2016, which was substantially better than the 0.3% pencilled in by economists. The economy also grew by 0.6% in the final three months of the year.
UK retail sales
Retail sales data has been mixed over the last nine months with an average monthly increase of 5%. October was the strongest month as sales enjoyed the highest rate of growth since April 2002 at 7.4%.
After a weak reading for January, there were positive signs in February 2017 with sales up 1.4% month-on-month and 3.7% higher year-on-year.
Inflation has been creeping higher since July
2016 thanks in part to the devaluation of sterling. The widely-followed CPI measure hit 1.8% in January 2017.
The Office for National Statistics now uses the new headline rate CPIH, which takes into account owner-occupiers’ housing costs and council tax.
Under this measure, the cost of living sharply climbed by 2.3% in February as a result of rising petrol and food prices.
WHERE NEXT FOR THE UK ECONOMY?
Leaving the EU represents a leap into the unknown but Berenberg senior UK economist Kallum Pickering says anyone ‘expecting something really dramatic over the next two years is going to be disappointed’.
Most of the action seems likely to be concentrated in the currency markets, where traders face the difficult task of pricing in so many intangible factors.
In economic terms Pickering sees Brexit as a ‘demand-side issue’ in the short term but a ‘supply-side issue’ in the long term.
Uncertainty as the UK extricates itself from the EU may impact on spending by both consumers and businesses. The lasting issues are likely to be around the supply of investment and immigrant labour.
He reckons the markets over-reacted to the Brexit vote because they neglected to focus on one of the most important elements of the UK economy – household spending.
‘Around half of households voted for Brexit so they would have taken a positive view on 24 June, the idea that consumer spending would dry up overnight seemed overdone.’
Sure enough consumer spending has been a key plank behind the better than expected growth seen in the UK since the referendum result, buoyed by low unemployment, resilient house prices and rock-bottom interest rates.
Pickering says the availability of cheap credit means the impact of inflation on household purchases may not be as severe as feared. ‘Consumers are already spending using debt so the impact on real earnings from rising prices might not make as much difference as people think’.
PwC chief economist John Hawksworth agrees up to a point: ‘Increased borrowing may help fill the gap in the short term, but there are limits to how far UK consumers can continue to live beyond their means with spending rising faster than disposable incomes.’
Is sterling undervalued?
Martin Walker, UK equities fund manager at Invesco Perpetual, makes the case for sterling being undervalued, particularly relative to the dollar based on an ‘academic construct’ called purchasing power parity or PPP for short.
According to PPP, two currencies reach parity when a market basket of goods (taking into account the exchange rate) is priced the same in both countries.
According to Walker exchange rates tend to revert to the PPP over time and it is currently implying a ‘fair value’ for the sterling-dollar rate of around $1.60, against the actual level around $1.25.
Set against this argument, the complexity of an event like Brexit makes it extremely difficult for foreign exchange traders to price in.
Rate rise risks
Pickering also sees the UK economy becoming more export driven. That would be a result of economies in the US and Europe performing better and weaker sterling makes UK exports more competitive in relative terms. More negatively, currency movements are also leading to higher input costs for manufacturers.
Pickering’s base case is an interest rate rise in the second quarter of 2018 but he sees a 30% chance of a rate hike in 2017.
‘A key risk is the Bank of England allows the economy to overheat and is forced to take more aggressive action’. This could create a significant economic shock given the high levels of indebtedness in the UK. (DC/TS/LMJ)