15 May 2018
Earlier this month Antony Manchester, BlackRock UK Public Policy and Roland Arnold, BlackRock Small and Mid Cap UK Equity Portfolios, sat down and discussed Brexit and the UK equity market in a recent webinar.
There is a dual negotiation between the EU and UK. The Article 50 discussion deals with the‘divorce’ issues. At the same time, there is a separate discussion on the future relationship. This isn’t part of the article 50 discussions, but a separate political declaration will be made at sametime. Each side is trying to sequence these discussions differently and there are some issues, such as the Northern Ireland border where the two interact.
An outline legal text on withdrawal emerged in March covering financial obligations, the rights of citizens, the practical divorce issues (such as EU agencies) and the transition period. The transition means that the relationship will remain static into 2020 and all legal obligations will still apply.
Nothing is agreed until everything is agreed. There are a few outstanding issues such as the Northern Ireland border. These are unlikely to be resolved until the October or December meetings. Afterwards, the whole deal has to be ratified by the EU and UK parliaments. As such, there is unlikely to be legal certainty on the withdrawal agreement until January 2019.
Northern Ireland border
This is the key issue. It is a political and totemic issue, as the border was closely associated with the Northern Ireland troubles and having a ‘soft border’ is important. A customs union, orcustoms relationship would solve the problem, but this would pre-determine the UK’s futurerelationship with the EU, which is meant to be negotiated after the UK has left.
The EU wants UK to remain within customs union. A number of other options are being discussed, such as a virtual border; pre-customs approval; or a customs partnership that would see the UK police EU customs borders and collect tariffs. There are a lot of complex and detailed things that need to be agreed and markets will be watching these pressure points.
How likely is no deal?
‘No deal’ assumes that the two sides can’t reach an agreement and can’t find a compromise, or that the agreement can’t be ratified by one or other parliament. It is unlikely the EU will sign up to an agreement that can’t be ratified, so the risk is on the UK side. However, those in parliament who might seek to frustrate a deal wouldn’t want to see a hard cliff-edge Brexit. As such, thesolution will probably be to extend the clock and keep talking. We believe that a ‘no deal’ situationis quite unlikely.
Is the impact on Europe being properly considered?
It is looking increasingly like an acrimonious divorce to external observers. From a global perspective, it makes the whole of Europe look less attractive as a place to do business. On theEuropean side, the economic impact hasn’t been widely considered. For example, there may be derivatives contracts that UK firms can’t provide. This could impact car insurance, it is an offencein some member states to provide a service if there is no authorisation. These issues need to belooked at. The same is true for clearing. Trade is weighted in the EU’s favour, with the majority of trade in goods coming from Europe into the UK. That’s what’s driving the EU to want UK to stay in the customs union, but is there a plan B?
Is currency volatility creating difficulties?
We aim to ensure that our portfolios aren’t influenced by exogenous factors, such as FX,economic growth or oil prices. We work hard with the risk team to understand those exposures.Specifically, we don’t try and predict FX rates. Our process tends to lead us to internationalcompanies, but it has been hard for some domestic companies, such as retailers, who are importing inflation. The last few weeks have seen sterling strengthen against the Dollar, but, to our mind, it is not enough to start looking at consumer sector again because there are other factors at work.
Is the weakness in UK domestic stocks just Brexit, or are there other factors?
Certainly, productivity growth has been weak in the UK. Some of this is Brexit-related: companies have been recruiting temporary employment, rather than putting hard capital to work. They have seemed disinclined to make the investments into capital equipment that would grow productivity.
However, the UK’s economic situation is not entirely related to Brexit. The UK was growingstrongly, when EU growth was lacklustre and there is a degree of catch-up. That said, Brexit has an impact on real wage growth and consumer confidence.
What are companies saying?
We see a wide range of companies and there are a wide range of views. Some pared back on investment after the Brexit vote and regretted it, because the UK growth outlook remained stronger for longer. For UK-exposed companies, we find a general lack of conviction on what to be doing. As a result, they are deferring large-scale investment projects.
Does Brexit impact your ability to drive returns?
Global fund manager sentiment towards the UK has been very poor.1 When you are that underweight, we believe, there is only one way for sentiment to go. Good, market-leading, well-capitalised businesses haven’t seen their valuations fall very much. Within domestic companies, they don’t act as one unit. Some have reported strong growth. We believe that as long ascompanies are taking market share and are well-capitalised, they can still do well.
Are there areas you are specifically avoiding because of Brexit?
We are underweight the UK consumer, but that is for a variety of reasons. We recognise that UK financial services would struggle in a hard Brexit scenario because of passporting rights. But we believe UK financial companies still have good opportunities in front of them. There is no sector that is uninvestable because of Brexit.
What is your biggest side risk?
Even if the government has simply postponed the cliff-edge, companies and the public sector will have had longer to prepare and it is a lot less risky than if the UK were to crash out next year. To our mind, the biggest risk is that the government falls. There are also a number of global risks.
1 Are Investors Right to Ignore UK Equities?, Morningstar, March 2018
The opinions expressed are as of May 2018 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.
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