As we know, the forerunner of the current European Union (EU) was set up after the Second World War to help foster greater economic cooperation among European countries. The idea was that countries bound together closely in trade agreements are much less likely to go to war against each other.
Over time the European project has progressed and enlarged to include 28 countries, merging legislative and administrative bodies, while also creating a single market to allow free movement of goods, services and people across a trading bloc consisting of over 500 million consumers stretching from the Atlantic to the Black Sea. Nineteen countries have also joined a monetary union, with a single currency and a single central bank.
How did we get here?
On 23 June 2016, the UK electorate voted in a historic referendum to leave the EU, by a margin of 51.9% to 48.1%. The unexpected leave vote cast the UK into a period of high political and economic uncertainty, triggering significant reactions in political, economic and financial markets. And yet, while everyone grappled to try to understand the implications, the UK economy has shown remarkable resilience—and in many cases has surprised positively.
In truth, much remains unchanged since before the vote. What we’ve been waiting for is Article 50 of the Lisbon Treaty to be invoked (the mechanism by which a country can withdraw from the EU).
The pound did slump in the days after the referendum and remains around 15% lower against the dollar and 10% down against the euro. But the predictions of immediate doom have not proved accurate with the UK economy estimated to have grown 1.9% in 2016.
The UK’s Prime Minister, Theresa May, has now announced that the UK government has triggered Article 50, setting in motion a two-year period of negotiations to take the UK out of the EU.
What is article 50?
Article 50 of the Lisbon Treaty is the mechanism that member countries can use if they want to withdraw from the EU. By invoking Article 50, the UK has kicked off a process that gives the two sides two years to agree terms of the split. At the same time the UK government will enact its Great Repeal Bill.
Extraordinarily, Article 50 is something of a new thing. Up until 2009 there was no formal mechanism for a country to leave the EU and it has never been used before. No-one really knows how long it will take or exactly how the process will work.
The two-year negotiation period is a guideline. Any terms of Britain’s exit will have to be submitted to 27 national parliaments, requiring approval from at least 20 countries in order to be ratified by the European Parliament. This process could take time, and should no agreement be made before the time limit is up then in order for negotiations to be extended it will require all 27 countries to agree.
The only previous nation to leave the EU was Greenland. The autonomous Danish territory took six years to fully exit after the original decision to leave in 1979. This could give an indication of the magnitude and complexity of the task at hand.
What we know
At this early stage in the process details are limited and it would be wrong to jump to conclusions. The only thing that we can say with absolute certainty is that there will be uncertainty over the next two years as the UK negotiates with the EU on the terms of the future partnership.
But uncertainty isn’t necessarily a bad thing. If I went into the loft at home to dig out my economic textbooks and flicked through the pages I would see many times the words "with increased risk lies potential for increased reward". Among all the market turmoil on 24 June 2016, as the referendum result was announced, there were opportunities. For example, stocks with limited UK revenue exposure sold off heavily simply because they were listed in the UK. But more on that later.
Theresa May followed her initiation of the Brexit process this week by setting out how she plans to bring thousands of EU regulations under UK control. The Great Repeal Bill, despite its grand name, isn’t designed to repeal but to convert EU law into British law, with the aim of ensuring continuity in the months after Britain leaves the EU sometime in early 2019. A contentious part of the bill may be the wide powers for ministers to change the rules as they’re converted to UK statutes. The government argues this is essential to remove references to European institutions.
While the constitutional detail may sound obscure, if May fails to get the powers she needs from parliament she could struggle to deliver favourable Brexit conditions. A blockage over the expanded powers could give her the excuse she currently lacks to call an early general election, something she has so far rejected, despite her Conservative Party’s healthy poll lead over the Labour opposition.
What did the letter include?
While the referendum result takes the EU into uncharted territory, little is known of how negotiations will proceed. The letter submitted to the European Parliament gave some indication of what the UK was looking for, but not a high degree of detail. Nothing will change until 30 March 2019, two years after the triggering of Article 50. It will therefore be a while yet before we are able to fully understand the implications of the action taken by UK voters on 23 June 2016. The letter did, however, suggest a strong desire and determination to complete the negotiations in the two-year period to ensure that both sides can remove uncertainty as soon as possible.
The letter to the EU itself was generally conciliatory in tone with several mentions of a desire for a "deep and special partnership". It was made clear that the UK would not be seeking membership of the single market and fully understood that "cherry picking" would not be accepted. This did not mean, however, that the UK government would not be seeking some kind of trade partnership. Without an agreement on trade, the UK would have to operate under World Trade Organisation rules, which could mean customs checks and tariffs. There were, however, some comments suggesting that if a trade deal could not be reached, there would be negative implications and this is where a slightly more defiant tone started to appear. As an example, the Prime Minister cited "a failure to reach agreement would mean our cooperation in the fight against crime and terrorism would be weakened".
The letter also mentioned that the UK government would be seeking trade talks to run in parallel with exit negotiations with comments that it "believes it is necessary to agree the terms of our future partnership alongside those of our withdrawal from the EU", calling for "greater scope and ambition than any such agreement before it so that it covers sectors crucial to our linked economies such as financial services and network industries". This could be the first potential stumbling block as the EU has the view that the withdrawal agreement needs to be finalised before any discussions over future partnerships can be agreed.
There is also the issue over whether the UK remains as "the UK". The letter triggering Article 50 clearly stated that the negotiation will be taken as one. Scotland, Northern Ireland and now Wales, however, are all experiencing increased rhetoric regarding their places in Europe. In Scotland, polls appear to suggest that the majority actually want to remain as part of the UK but the Scottish National Party continues to rally support against doing so Northern Ireland is in a similar situation that, despite the political rhetoric, the majority of the population also appears to wish to remain as part of the UK. The importance of the situation in Northern Ireland was specifically mentioned in the letter.
Despite a slightly bumpier road than expected, the UK has delivered on its plan to trigger Article 50 before the end of March, the ball is firmly in the court of our European counterparts and the market will be watching.
For now, negotiations on behalf of the UK will be left to the three Brexiteers: David Davis, Secretary of State for exiting the European Union; Liam Fox, International Trade Secretary; and Boris Johnson, Foreign Secretary. Theresa May will of course have significant involvement and will have to work hard to keep the UK united and in union.
Impact on the UK equity market
The truth is no one really knows exactly what the end outcome will be of this negotiation process but what I want to stress are some key facts to demonstrate that UK equities are not the basket-case that some might fear.
As investors have been reminded since the Brexit vote, UK equities are not purely a UK investment but a view on global growth, with 70% of revenues from UK-listed companies sourced overseas. With global leading indicators showing expansion and growth forecasts showing signs of improvement, UK companies stand to benefit. Sterling weakness, as a result of the referendum vote, has boosted UK earnings and improved the terms of trade for many UK companies supplying goods and services around the world. This is reflected in unexpectedly strong manufacturing data.
One consequence of a weaker sterling exchange rate has been increased inbound merger and acquisition activity as global companies look to pick up their UK counterparts at a cheap price. Another consequence is that a UK workforce is now relatively cheaper than it was prior to the referendum.
UK equities have shown significant resilience so far. The most recent reporting season for UK companies was strong. Estimates were beaten on both earnings and, more importantly, on sales with the quality of this success enhanced by the fact that earnings estimates had been revised upwards heading into results.
UK equities have delivered strong performance for investors in recent months. But valuations do not look stretched. In fact, the cyclically-adjusted price-to-earnings ratio for the FTSE All-Share is still approximately 15% below its long-term average. Valuations also look attractive relative to bonds, with the UK equity market offering a 4% yield—little changed from back in 1990, when Gilts were yielding 10%-12%.
Earnings estimate revisions are strong around the globe and this is mirrored in the Citi Economic Surprise Indicators which show that global economies, including the UK, are exceeding expectations. As economic growth picks up, so too are inflation expectations and equities remain the best way to protect against inflation.
From an asset allocation perspective, Bank of America’s Merrill Lynch’s Fund Manager Survey from March 2017 still suggests that investors are underweight UK equities. This suggests an out of favour asset class with a potential upside opportunity to current positioning.
Clearly there are some sectors that will suffer from structural headwinds, particularly those that import goods as they will be exposed to rising input costs. Running an unconstrained fund can work to our advantage as we tilt the portfolio to where we see the best opportunities with the strongest fundamentals, whilst not being forced to own stocks which we do not feel are attractive opportunities at that point in time.
It cannot be denied that Brexit has created a great deal of emotion both at an individual level and within the financial markets. Our behavioural finance team at J.P. Morgan Asset Management use an approach that focuses on company fundamentals and aims to reduce emotion in the decision making process. Should we see a similar reaction to Article 50 to the one we saw in the aftermath of the referendum, we are confident that we have a process that will allow us to uncover and capture those longer term opportunities.
The emotion and uncertainty that Brexit presents should benefit active managers and, in particular, our behavioural finance approach. Each deal negotiated along the path to a UK outside of the EU will either be positive or negative for individual companies and this will be a constantly changing landscape. The government will also, no doubt, do all it can to support British businesses. Company fundamentals are going to be the drivers for share price returns but, for investors, being rational, selective and agile will be key.
Blake Crawford is a fund manager on the JPM UK Dynamic Fund. Read more about the Fund: UK Advisers
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