Yesterday I listened once again to the excellent Karen Ward, a Chief Market Strategist at JP Morgan Asset Management. Prior to this role she was Chair of the Council of Economic Advisers for the Chancellor of the Exchequer advising the Chancellor on macroeconomic issues including fiscal strategy and Brexit. Previously she worked for a decade at HSBC’s investment bank in a number of roles, including Senior Global Economist. Suffice it to say she knows her stuff and moreover communicates her understanding very well.
The webinar yesterday was on Brexit notably on the economic impact of a no deal. She naturally set this out in the context of the politics – the complex multi-outcome game of chess, which appears to be entering its end game. I don’t intend to detail her political comments here but try to summarise the economics and the potential impact for investors.
Ward explained with a no deal we would fall under World Trade Organisation (WTO) rules where tariffs would apply on each product. However under the rules tariffs have to be applied uniformly across all applicable countries which would prevent the EU, should they be so minded, to arbitrarily set punishing tariffs on the UK’s exports. She stated that the weighted average of these tariffs would be 3.2%, a figure which surprised me as being low. Customs and regulatory checks would apply to goods and the UK financial services sector would lose its passporting rights into the EU. The UK would have to replace the 40 free trade agreements the EU has negotiated on our behalf, although 13 continuity deals encompassing 38 countries have been agreed. Please see https://www.bbc.co.uk/news/uk-47213842 on this point.
Ward then considered the Bank of England’s modelling of a no deal Brexit and explained the impact of disruptive and disorderly scenarios. The former would lead to an 3% contraction in the economy as measured by GDP (Gross Domestic Product), the latter an 8% fall. My impression was she thought the former outcome was more likely. Under the less damaging scenario the unemployment rate would rise to 5.75% (currently 3.9%), house prices would fall by 14%, commercial property prices would decline by 27%, inflation would rise to 4.25% and the Sterling dollar exchange rate would fall to 1.10 at the trough. That said Ward noted the UK economy has held up remarkably well since the 2016 referendum. Although there has been a marked downturn in investment, consumer spending has been very supportive and the labour market resilient with very high levels of employment and wage growth. Ward also declared that Tory austerity was over – the implication being government spending would help boost the economy and that the Bank of England would cut interest rates in a no deal scenario.
On the downside Ward expressed concerns about falling export orders as EU companies source alternative suppliers, a weak PMI (Purchasing Managers Index)* and a low house-hold savings ratio which has fallen significantly since 2010. The latter is important as a buffer against rising costs.
Ward thought the outlook for Sterling was binary with the pound moving to either $1.10 or $1.40, depending on how favourable the outcome was perceived by investors. That said in the near-term downside risk is predominant. A weak pound is bad as we import inflation but there is an inverse relationship between the pound and UK stocks. As previously noted around 70% of the earnings from FTSE 100 companies comes from overseas and is derived in dollars, Euros and Yen etc. When Sterling is weak and the earnings are repatriated they get a currency boost. Apparently after the referendum Sterling fell by 13% but the FTSE 100 rose 3%. In contrast the more domestically focused FTSE 250 index declined by 8%.
In summary I liked Ward’s analysis and conclusion. It seemed fair and balanced. She thought the UK was a dynamic and adaptable economy and whilst there would be short term pain she did not consider it would be a catastrophe. The clear implication is in the longer term there would be a recovery. How long it would take is an interesting question.
So what is my conclusion? I broadly think equities remain the best long term investment although the ride might be volatile. UK equities are very unloved, quite right you may say but have they been over-sold? They trade at a very large discount to other developed markets although in the near term the discount could widen. Global equities and UK smaller companies offer investors protection from damage to UK/EU trade. My conclusion is investors must think long term just as they had to through recessions in the past, the global financial crisis and the more recent Eurozone crises. That said I am aware that some of my clients are deeply concerned about a bad Brexit outcome and I have been recommending selected profit-taking cautious risk investment.
*The Purchasing Managers’ Index is a highly important monthly survey of business confidence in the private sector, covering both manufacturing and services. It is a good indicator of the direction of the economy.
The content of this blog is based on my own understanding of the UK economy as explained by Karen Ward and is intended as general investment information only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.