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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.
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