UK stocks are likely to continue to lag behind their global peers
Despite persistent uncertainty surrounding Brexit, UK equities have returned 34% (including dividends) since the UK electorate voted to leave the EU in the June 2016 referendum. This domestic performance looks respectable when compared against 10-year gilts, which returned 5% during the same time frame. However, UK stocks have lagged behind the 54% total return of world equities (ex-UK) in sterling terms since 23 June 2016.
Market uncertainty has increased following the publication of the government’s “soft-Brexit” white paper (the so-called Chequers agreement) in July that outlines its plan on what the UK seeks to achieve in negotiating its exit from, and new partnership with, the EU. The Chequers deal has come at the cost of the cabinet resignations of both Boris Johnson and David Davis, led to the alienation of many pro-leave Tory MPs and has hardened the split in the party. Potentially, PM May could face a leadership challenge that would use up valuable time required to negotiate the UK’s exit from the EU. Moreover, the EU may reject the Chequers agreement as it may be seen as “cherry picking” the four single-market freedoms of services, goods, capital and labour, which the EU regards as indivisible. The risk is the UK could leave the EU without a deal.
Tory party disharmony over Brexit is also beginning to wear thin with the public. Recent opinion polls show the Tories and Labour are tied in popular support. As we discussed in the June Investment Outlook, the threat of a market unfriendly, left-wing Jeremy Corbyn government getting into power is likely to weigh down on UK equities.
Aside from the politics, there are fundamental reasons behind the lagging performance of UK stocks. The uncertainty over the UK’s future relationship with the EU begets economic uncertainty, less business investment and lower growth. In the IMF’s updated economic projections, UK real GDP is expected to grow by 1.4% in 2018, versus 2.4% for all advanced economies. Even though UK firms are internationally focused (around two-thirds of FTSE 100 companies sales are derived overseas), sluggish domestic demand is evident in lower relative consensus earnings expectations when compared with the rest of the world. For example, UK Earnings Per Share (EPS) growth over the next year is forecast by the consensus to grow by 8.0%, which is less than the eurozone on 9.3%, emerging markets on 13.4% and the US on 14.1%. Unless British companies are able to deliver stronger EPS growth, it would be reasonable to expect UK equities to underperform global markets.
US deregulation provides a growth tailwind against trade protectionism fears
Throughout his presidential campaign and first year in office, President Trump has repeatedly stated that overregulation is hampering US output growth. Trump has made cutting back on red tape a key priority and signed an executive order in early 2017 that requires federal agencies to cut two existing regulations for every new regulation they implement. There is increasing tangible evidence to show that regulation cutbacks are happening. First, the number of pages in the Federal Register (a uniform system to track public regulations and legal notices issued by federal agencies) in 2017 fell 36% to 61,950. This marks the biggest percentage decline in regulations from data going back to 1947 and surpasses a 21% fall for President Reagan’s first year in office, the last president who made a significant drive to cut red tape.
Second, digging a bit deeper in a recent piece, the Brookings Institute (BI), a century-old US think tank, found that the regulation cuts under President Trump were surprisingly broad-based. In their analysis, the BI showed that deregulation was applied by both executive agencies (under greater control of the president), as well as independent agencies, which are generally more insulated from the White House. Both executive and independent agencies also cut major rules (>$100m in annual impact on the economy) and non-major rules (<$100m) evenly across the government. In short, the regulatory cuts are genuine and not designed to help the president make political gains.
The boost to the economy from deregulation (as well as tax cuts) has helped business optimism, and particularly for small firms, where confidence is at the high end of its historical range, after picking up sharply when President Trump was elected in November 2016. Given that America’s 28m small businesses create nearly twothirds of net new private-sector jobs, rising confidence increases the probability that the business cycle can be extended. On balance, we believe the combination of deregulation, tax cuts, steady economic growth and profit margin expansion from limited wage inflation, provides plenty of equity market support to offset the headwinds coming from trade protectionism concerns, allowing global stocks to rally further.