Brexit extension will ease uncertainty looming on UK assets

How do you see the UK medium-term economic outlook?

Even if a no-deal Brexit is avoided, there could be risks to growth at the end of the transition period, as mentioned above. Even in the case of a smooth transition into a new permanent trade regime with the EU, the loss of access to large segments of the EU Single Market – especially services – combined with potential restrictions on immigration -- will be detrimental to potential growth, unless the UK ultimately opts for a formula where it remains closely aligned with the Single Market. At this point, it is difficult to say whether the UK economy will underperform that of the EU over the long term, as this depends on economic policies conducted on both sides of the Channel. Whether the City of London can retain most of its high value-added functions and its status of global financial hub will be an important factor. In any case, just as Britons have been divided over Brexit, they are likely to be divided also over economic policies to pursue after Brexit.

What are your expectations regarding UK monetary policy, and which developments do you foresee regarding UK government bond yields?

Following recent developments regarding Brexit negotiations – also partly driven by a broader global trend in bond markets ‒ UK nominal rates have increased over the past weeks, from around 0.40% in early October up to 0.75% following the announcement of the deal and the significant reduction in the likelihood of a no-deal outcome. Market-implied probabilities of an easier stance by Bank of England (BoE) rapidly changed as a consequence, with markets moving closer to a more neutral attitude on the part of the central bank compared with over 25 bps of cuts discounted at the peak of uncertainty.

The agreed extension and the likelihood of ratification of a deal should allow the BoE to stay on hold for a long time unless the global picture deteriorates further. There are two factors supporting an on hold stance: domestically, some uncertainty will remain due to the Brexit cliff at the end of the transition period; the second factor relates to the global trend towards easier monetary policy by major central banks over the past few months. For such reasons, we expect UK 10-year government yields to have limited upside.

What are your main investment convictions on UK fixed income and the forex market?

On a tactical basis, with the no-deal risk greatly reduced, growth could pick up slightly, pressuring Gilt prices lower, with yields rising accordingly.

Offsetting such an impact, sterling has rallied recently, pushing import prices lower and reducing the need for the BoE to raise rates to keep inflation at target. This should help keep short-dated bond prices supported. We would therefore expect a steepening of the Gilts curve. In view of the progress towards a deal, further GBP strengthening versus both the dollar and the euro is likely, and we are no longer negative on sterling. The likelihood of the Conservative party winning a majority in December would encourage inflows and keep Gilt prices well bid, with yields lower than they would be otherwise.

From a strategic standpoint, any relief for Gilts and support for the currency is likely to be short-lived. Given that the United Kingdom is an open economy and that it is loosening its ties with its biggest trading partner, Brexit will have a long-term corrosive effect on the economy, with consequently structurally lower rates.

Over the past couple of years, there has been a large gap between the two indicators, with UK equity valuations under pressure because of Brexit-related uncertainty. The gap between the UK and the Eurozone indexes corresponds to rerating potential of 17% in favour of UK equities. This means that if the value of the underlying indicators that contribute to the CVI is increased by 17%, the UK would then have the same score as the Eurozone for such indicator. However, such an outcome may not materialise. Even if a no-deal Brexit is avoided, the path to a new policy framework – especially regarding trade agreements – is uncertain.

A few factors could prevent potential upside in UK equities:

• First, as the UK market is export-oriented (73% of the MSCI UK index sales are overseas), the exchange rate has a strong impact on corporate profits. If a deal is approved, the pound should rebound, weighing on UK earnings and the equity market.
• Second, since the UK market enjoys high dividend yields (currently 4.8% compared to 3.5% for the MSCI Euro index), the UK market will also be affected by rising bond yields. In conclusion, the UK markets trade at a valuation gap compared with European equities, but such a gap may not close quickly once Brexit uncertainty disappears.

For the time being, we see opportunities in UK domestic stocks that are less export-oriented than the FTSE100 companies. A likely rebound in consumer confidence may benefit house builders, UK consumer discretionary stocks (eg, low-cost airlines), and banks.

Once Brexit is behind us and geopolitical uncertainty lessens, do you expect investor appetite to return regarding European equities?

A reduction of uncertainty should help drive investors back to European equities, as this market is highly sensitive to economic surprises, which were a drag on sentiment over the summer months, with EPS expectations for 2019 revised lower.

While attractive relative to other geographies, the European equity market is not cheap in absolute terms. The trigger for a return of investor appetite could come from supportive fiscal policy. There is growing consensus among governments that greater fiscal expansion ‒ on top of the accommodative monetary policy by the ECB ‒ in terms of infrastructure and ‘green’ expenditure is necessary to cause an acceleration of the economy. While this will not happen immediately, prospects are for a heightened willingness to invest. In addition, European corporates benefit from sound financial positions in terms of balance sheet sustainability and cash generation that should be supportive over the medium term. Finally, Europe is currently out of favour with global investors with relentless outflows. Better valuations should help drive capital flows back to Europe.