Macro vs. markets: The Brexit effect
Brexit uncertainty and the political fallout from last year’s shock referendum vote present challenges for the UK economy. However, there has historically been little or no correlation between the UK’s economic performance and stock market returns. In fact, from a market perspective, there may be reasons to be optimistic.
Brexit means Brexit but what does Brexit mean?
The Brexit referendum continues to cast a shadow of uncertainty over the outlook for UK growth. Over a year after the referendum, the Conservative party has not been able to agree amongst themselves what their Brexit strategy is, let alone articulate a coherent vision to the EU, businesses or the people, making the decision to trigger Article 50 in March of this year all the more flabbergasting. We are still some way from knowing what our trade terms with the EU will be and what Brexit actually means for the economy.
Negotiations on the terms of the UK’s withdrawal from the EU are proving difficult and slow, while the Conservatives poorly executed June general election campaign has left them with a weak and divided government battling a rejuvenated and increasingly popular left-wing Labour opposition. All of which create fragility and uncertainty, which reduce investment.
A challenging economic outlook
Whether you supported Brexit or wanted to remain in the EU, one thing that we can all agree on is that the current uncertainty over what Brexit will look like is not helpful for the UK economy. After all, the EU is by far the UK’s biggest trading partner so businesses urgently need clarity on the UK’s future access to European markets.
Trade with the EU won’t just suddenly dry up overnight (as some doomsayers would have us believe), but it doesn’t look likely that trade agreements with the rest of the world will, in the short term, be able to make up for any loss of trade with the EU due to Brexit. Furthermore, UK industries with strong links to European markets are coming under pressure—for example, Frankfurt, Dublin and Paris are all looking to grab some of London’s financial services business.
On the positive side, exports have received a boost from the sharp drop in the value of sterling since the referendum. But the drop in sterling has led to inflation, which has eaten into real wage growth and is now starting to threaten consumer demand. In this environment, it’s unclear where the next leg up in UK growth will come from.
Reasons to be cheerful
Fortunately, an uncertain economic outlook does not necessarily translate into an uncertain stock market. There are also good fundamental reasons why we should perhaps be more positive on the outlook for UK equities. The UK market is dominated by multinational companies with large overseas businesses, which means UK investors will have good exposure to the strong pickup in global growth supporting robust earnings growth. International revenues account for around 70% of total FTSE All-Share revenues—including more than 20% of revenues from North America and nearly a quarter of revenues from emerging markets (as of 31 July 2017).
At the same time, sterling’s weakness is a key support for the UK market. Not only does it make exports more competitive for UK companies, but the value of any overseas earnings is enhanced when they are converted back into sterling. Currency weakness has also boosted merger activity as corporate buyers look to buy world class UK-listed companies at a discount.
The UK equity market remains attractively valued on a 14.7x forward price earnings ratio, supported by a dividend yield of 3.9% (Source: Bloomberg).
The crucial thing to remember is that the UK stock market and the UK economy are not the same thing. Investors should focus on the fundamentals in the current uncertain macro environment: there will be ups and downs along the way, but sterling weakness and an ongoing cyclical pickup in global growth continue to provide a supportive backdrop for UK equities—whatever the outcome for Brexit.
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