While the UK equity market appears attractively valued and has the potential for a rebound, I remain neutral on UK equities for now as I believe the uncertain political outlook provides a poor basis for active risk taking. In essence, the outcome of the Brexit negotiations is hard to judge, and a non-cooperative outcome could prove highly disruptive for the UK economy and equities. In my view, this risk is not priced into the market at present.
The UK has had a poor COVID crisis
The UK’s health and economic outcomes have been in line with the worst in Europe, and managing this twin crisis will remain problematic in the near term. At the same time, the UK faces longer-term challenges, such as changes in the migration framework, a sharp rise in minimum wages and the perennial issues of low productivity growth and a large current-account deficit. Together, these near-term and structural challenges create a poor outlook for growth over the medium term. In addition, the UK will have to deal with the fallout from exiting the European Union (EU).
Is a Brexit agreement in the making?
The UK has left the EU but is currently in a transition period lasting to the end of this year. By then, the two parties need to finalise an agreement on their future relationship. As expected, this is proving difficult and contentious. In the past few weeks, the UK government has taken aggressive steps that seemingly raise the prospect not only of failing to reach an agreement, but also of an acrimonious split with no cooperation.
I believe there is upside potential if a deal is reached
Although a deal is likely to be narrow and to prove costly in economic terms, it would provide an opportunity to move on. It would resolve a critical uncertainty, provide a positive basis for future negotiations and allow the UK government to focus on its economic agenda. Sterling would be likely to appreciate, and stocks of the (typically smaller) companies with domestic production or demand exposure could start closing some of their recent performance gap, along with UK banks. The FTSE 100 has little domestic exposure and so would be less likely to gain.
No deal presents corresponding downside risks
A failure to reach an agreement is not necessarily a big economic issue, as the difference between a deal and no deal is actually not that big. New tariffs and regulatory controls needn’t be that disruptive if implemented swiftly, effectively and in cooperation. For asset prices, the downside risk is limited as long as the split is relatively harmonious.
However, if a no-deal outcome results in an acrimonious split and non-cooperation, the impact would be unpredictable, potentially large and possibly even systemic, with important implications for global investors. I do not think this downside risk is priced in, partly because it is hard to understand.
The heightened political uncertainty makes me unwilling to increase exposure to UK equities at present, despite seemingly attractive valuations. The UK government appears to be deliberately obscuring its intentions with aggressive behaviour, possibly intended to secure more favourable terms in a deal. That is making it hard to assign probabilities to the risks. On balance, I think a deal is more likely than no deal (say 60:40), but neither the UK nor the EU have got an incentive to make the negotiations look easy. As a result, the risks could intensify in the coming period, and the timetable is unclear. I therefore expect further volatility in UK equities as the market engages with the idea of a non-cooperative outcome.