Developments in the UK have led us to renew our focus on the region in recent weeks, amidst the start of Brexit negotiations and the general election. We have not made any changes to our neutral position on UK equities and UK rates, or our negative view on sterling.
We suspected that a hung parliament would likely result in an investor shift away from domestically-focused risk assets amid heightened uncertainty raised by a return to coalition politics. Ahead of the election our managed funds, fixed income and global equity desks were broadly neutral on the UK, and within the region we had been allocating to large caps and more internationally-focused growth companies.
But trying to predict which way markets would move felt even more problematic than it might have ahead of previous UK elections – as with last year’s referendum on European Union membership, several polls were within the margin of error. In the event, the market response fell along predictable lines, with a weaker sterling, strong equity performance led by overseas earners, and sustained weakness in shares exposed to the domestic economy.
With respect to Brexit, our base case is that a fairly hard Brexit, where we lose single market access, would result in a weaker sterling and a more vulnerable gilt market. The failure of the Conservative Party to gain a majority in the election has thrown additional light on the Article 50 negotiations with much discussion on whether a coalition government (containing a chastened Conservative party) would lead to a softer Brexit. Indeed, the mechanics of Brexit itself are central to forecasting economic outcomes. While on the one hand it is possible that the UK might be able to withdraw its Article 50 application before two years lapse, it is also conceivable that the nuts and bolts of Brexit are not agreed over this period and a chaotic, cliff edge Brexit ensues.
Under a softer Brexit or a no Brexit, any risks to growth are judged to be on the upside, with a less inflation-tolerant Bank of England. A cliff edge Brexit presents meaningful macro risks, threatening an already weak consumer, with a likely move higher in gilt yields, led by outflows from overseas investors. Our base case is for a fairly hard Brexit in which immigration remains a key issue and access to the Single Market is lost or severely constrained.
So how has all of the above impacted our forecasts for the UK?
We are turning more cautious on domestivally-exposed UK equities, as existing headwinds have been brought into sharper focus following the election result. These companies must contend with further softening in consumer spending, as uncertainty rises and inflation erodes real incomes; moreover, the savings rate has collapsed, pushing the household financial balance into deficit for the first time since 2008. Large global companies may also be vulnerable to weakness in the US economy, especially those that are richly-valued. Meanwhile, the one off boost to international earners from weaker currency may have run its course.
Despite these headwinds, we anticipate growth in corporate earnings per share of 20% this year, falling to 7% in 2018. These forecasts are supported by the fact that investor underweights to UK equities are close to pre-Brexit lows, opportunistic M&A activity is picking up, and at 15 times 2017 earnings, valuations – particularly compared to the US – appear attractive. Finally, UK equities continue to offer a good dividend yield of 4.1% (falling to 3.7% excluding commodities). In short, corporate profits are somewhat underpriced at present.
Elsewhere, developments across the European high yield corporate fundamental landscape have been positive and appear likely to remain positive for a number of reasons. For example, there are only frictional or idionsyncratic defaults on the horizon, and meaningful outflows across public funds (combined with a supply glut across March and April) failed to derail strength in the market earlier this year. From a valuation perspective the market looks rich relative to its history, but the market was rich in the years before the credit crunch (2005-2007), illustrating that the lack of a negative catalyst can continue to attract investors as long as spreads over-compensate them for embedded credit risk – this appears to be the case today.
Maya Bhandari, Multi-Asset portfolio manager, Columbia Threadneedle Investment