Strategy November 26, 2018 / 04:42 pm UTC

Cheap UK Equities Still Unattractive Due to Rising Risks

By Mike Gallagher, Andrew Wroblewski
  • With the EU summit having approved the UK withdrawal deal, focus now turns to the meaningful vote in the UK parliament expected on December 12. Investors are asking whether the time could arrive to go overweight UK equities. 
  • Bottom line: We still believe that the UK parliament will not approve the withdrawal deal, and this will accentuate already-high and economically-damaging uncertainty. The most likely prospect remains for a delay in the Brexit date and a continued political limbo in 2019. Indeed, while the weekend EU agreement means that some risks have been overcome, there are plenty more risks ahead.
  • Market implications: Uncertainty over Brexit remains too high to go overweight UK equities. GBP will be hurt by a government defeat (EURGBP could move to 0.92), but a collapse is unlikely. Since Brexit, overseas inflows into UK debt have supported GBP based on a sluggish UK economy and slow Bank of England (BoE) tightening. A no-deal Brexit on March 29 remains a low probability.

Figure 1: UK Equities Undervalued Versus U.S./DM Equities (equity/bond relative measure)

Source: Continuum Economics. Note: Our equity/bond relative measure takes the cyclically-adjusted price-to-earnings ratio in yield terms versus 10y real bond yields (in %).

The Meaningful Vote and UK Equities 

Markets’ focus is now turning toward the vote on the withdrawal bill in the UK parliament, expected on December 12. After two years of Brexit uncertainty, global investors are starting to ask whether this is the time to switch from underweight UK equities to overweight in their 2019 portfolios. 

The UK is one of the cheapest DM equity markets according to our key measure of equity-bond yields (Figure 1). This is both due to an undervalued UK equity market (based on a low cyclically-adjusted price-to-earnings ratio) and low UK real bond yields. Indeed, if uncertainty over Brexit starts to lift, then an upward rerating of UK equities would be likely.

The problem is that with a vote expected on December 12, the Government seems unlikely to have even close to enough parliamentary support to pass the current version of the withdrawal bill—up to 90 (of 319) Conservative MPs and all of the 10 Democratic Unionist Party members are said to be opposed. With the Labour Party trying to trigger a general election, support from pro-EU Labour MPs is likely to be modest. Our expectation remains for the government to be defeated at the first vote and for a new, if not more marked, phase of Brexit uncertainty to occur. In this case, GBP would experience downward pressure.

These are six alternative scenarios that exist:

  • The second vote passes in January: one line of thought in political circles is that a financial market crisis could then occur, which would persuade some change by the EU. Theresa May could then force a second parliamentary vote to pass in January 2019 to allow the transition period to kick in on March 29. 

We see three problems with this scenario. The first is that the EU could fine-tune its non-legally-binding political declaration but still be reluctant to change the withdrawal deal. The second is that it could trigger a Conservative leadership contest in which May could be more vulnerable after having lost the first parliamentary vote—she could even resign. The third is that financial markets will react negatively but will not collapse on a government defeat, both as UK equities will partially benefit from a lower GBP and as portfolio flows into UK debt will likely occur. 

UK balance-of-payment data shows that since Brexit, there have been a cumulative £217 billion of foreign portfolio inflows into UK debt and £16 billion of foreign outflows from UK equities. Debt flows are a function of Brexit, with slow growth and ultra-slow BoE tightening attracting inflows into UK debt. Debt is more important than equity for UK current account financing and GBP. This is likely to remain the case, as we believe the BoE will delay its 2019 tightening if the withdrawal deal is defeated.

Figure 2: Quarterly Debt and Equity Flows Into the UK 

Source: Continuum Economics, Macrobond 

  • A new general election: a second (low-probability) option is that defeat for the withdrawal bill could trigger a general election, but this remains unlikely because the Conservatives would probably lose a snap general election on current opinion poll standings and are thus unlikely to allow May to lose the necessary parliamentary confidence vote. If a new election did occur it could mean a softer Brexit, but UK debt markets would be worried about a Labour government’s large-scale spending plans and the risk of a UK government rating downgrade. This would likely cause its own large-scale uncertainty.
  • European Economic Area (EEA) membership: a third (low-probability) option is that the “remainers” in the cabinet and parliament are amenable to the alternative of a softer Brexit, which could come in the form of EEA membership like Norway has. This is unlikely because it would probably split the Conservative Party (and thus prompt a general election) and because it would require the free movement of people, which would be a likely red line for Labour as well. 
  • A no-deal Brexit: a fourth (low-probability) option is the UK crashing out of the EU on March 29 without a deal and or a Transition period, thus immediately reverting to WTO terms and bringing about a chaotic period in Q2 2019 for the UK economy. This is low-probability because the UK wants to avoid this situation all costs and the EU also wants some kind of deal with the UK, not least as it would suffer some economic fallout. 
  • A new referendum: a fifth (slightly higher, but still modest-probability) option is that the deadlock in the UK parliament could cause politicians to decide to hold a new referendum. On current opinion poll standings, the UK electorate just now favors staying in the EU. However, we assign only a modest probability to this scenario, as May is reluctant to go back to the people and the Labour party is on the fence regarding the idea of a new referendum. In addition, the form of referendum would be hotly debated, making it all the more difficult for parliament to reach agreement.
  • Brexit delay and limbo: A sixth (more likely) option is that the UK and EU-27 agree to delay Brexit and extend negotiations into 2019. While this limbo is unattractive, it appears more likely than the previous four options—the EU may appear unwilling to countenance this at the current juncture, but may do so as the March date approaches. Indeed, as we discussed previously, the EU would be aware that the economic fall-out from a no deal would be damaging to the EU itself. But perhaps more notably, the EU would also be aware that any such request from the UK would, in itself, be the clearest acknowledgement that leaving the EU is not only economically damaging for the UK but also politically impracticable.

A UK government defeat for the withdrawal deal—our baseline scenario—would heighten uncertainty, likely pushing EURGBP to 0.92. However, the FX market will continue to see a no-deal Brexit on March 29 as a low-probability outcome. UK equities will be volatile in the face of renewed Brexit uncertainty, although partially counterbalanced by a weaker GBP. On balance, now is not the time to go overweight UK equities against the MSCI World equity benchmark.

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I, Mike Gallagher, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.