UK investors ask about Brexit more often than any other topic. Many even share concerns about investing in light of the uncertainty surrounding the outcome. Equally, the only question my international colleagues ask about the UK is 'what will happen on the 31st October 2019?'. As we near yet another deadline and negotiations run in parallel with a blame game, we simply do not know how the differences between the UK and the EU can be resolved. Boris Johnson says that we will leave come what may on the 31st of October, meanwhile Parliament are insisting on requesting an extension if a deal is not agreed. There are numerous possible paths forward, all of which require a degree of compromise. Whilst initial responses to the latest proposal from the UK Prime Minister were negative, Thursday's meeting between Boris Johnson and the Irish Taoiseach, Leo Varadkar, indicated that there may, after all, be a "pathway" to a deal on the key Irish border issue. At present, we are reluctant to suggest that any outcome is more likely than another. Uncertainty makes it difficult for investors to make commitments, resulting in many wondering if they are safer sitting on cash.
There is a cost to sitting on your hands; the base rate, set by the Bank of England at 0.75%, is currently returning less than inflation. The Retail Price Index (RPI) was up 2.6% last year. So, in real terms, cash has fallen in value. Ten-year gilts only yield 0.53% so are no better. Ten-year inflation linked gilts provide a return of RPI less 2.93%. So, low risk investment all lock-in negative returns after inflation. Unfortunately, there is no such thing as a free lunch, and therefore investors are forced to accept higher risk in order to see potential positive returns. The pound is generally expected to decline in the event of a no deal Brexit and this, together with trade tariffs, is likely to increase consumer prices. To add to the situation, it is also unlikely to be matched by a rise in interest rates.
If the pound falls on a no deal outcome, it will boost the overseas earnings of FTSE 100 companies, potentially lifting the index. If Boris Johnson manages to get a last minute deal with the EU that also receives the approval from Parliament, then we would expect the pound to be stronger, which would have the reverse effect. However, in this scenario, there may be renewed interest in UK equities as overseas investors finally receive some political clarity. Since the vote for Brexit, international investors have reduced their exposure to the UK. In this time we have also seen the FTSE 100 Index return 31%, the MSCI Europe ex UK Index up 51% and the S&P 500 Index up 79%, all in sterling terms. The dividend yield on the FTSE 100 of just over 5%, is nearly ten times that of the gilt index and double the inflation rate. Even in the 2008/9 financial crisis, FTSE 100 dividends were cut by less than 30% overall. Therefore, even in this scenario the yield would be more than gilts or inflation. For now, investors continue to be deterred by Brexit and will need to see some clarity in order to return. However, we continue to see value in the UK equity market today, and upon a resolution, the readjustment may be abrupt.
Elsewhere, with low or even negative interest rates, many markets look cheap relative to government bonds. Trump's ongoing trade war overrides Brexit as the global markets primary concern, and the manufacturing sector, in particular, is suffering as a result. This week, US-China trade talks have resumed and we may see some progress on this. If Trump wants to get re-elected, a strong economy will be the key to success and a resolution of the trade dispute with China may be the key to a return to global growth.
Uncertainty is everywhere, and volatility is likely to remain high, but risky markets offer opportunities for investors. A US-China trade agreement and a Brexit deal would remove some of the uncertainty. Those who can take a longer-term view, who are sitting on excess cash, should reflect on the negative real return they are getting and the potential opportunities present in equity markets.
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