Political risks are likely to remain a drag on relative UK equity performance
Last month Prime Minister Theresa May agreed with European leaders for a second delay in the UK’s date of departure from the EU to the 31 October 2019, but with an option to leave earlier if Parliament agrees a divorce deal. This so-called “flextension” is not necessarily a solution to resolving Brexit and comes with plenty of political risk. That’s because the flextension means that the UK has to participate in European Parliamentary elections on the 23-26 May. Given recent opinion polls show that the Tories lag behind Labour, and are losing votes to Pro-Leave parties, such as UKIP and Nigel Farage’s newly formed Brexit party, the government is set to perform poorly. Moreover, in order to look for a solution to overcome the Brexit impasse in Parliament, PM May has opened talks with the opposition Labour leader, Jeremy Corbyn, to get cross-party support for her Withdrawal Agreement, a move that has not gone down well with Tory backbenchers and the party’s membership. Yet it is far from certain that the Tories and Labour can agree a way forward on Brexit.
Party rules show that Theresa May can’t be forced out until a new Tory leadership ballot is triggered in December. However, should the Tories suffer disappointing results in the European elections, and the PM continues to work with Labour on securing a Brexit deal through Parliament, it would raise pressure on Theresa May to resign. Should that happen, a transition to a more Pro-Leave PM, like former Foreign Secretary, Boris Johnson, could split the Party. Alternatively, a new PM may gamble on seeking a fresh mandate from the electorate through a snap general election to break the Brexit deadlock. That would come with huge political risk, as current opinion polls show that Labour would likely be the largest party in Parliament after an election and could possibly form a government with the SNP.
To understand what a Corbyn-government would mean for markets, it is worth looking at the last (2017) Labour party manifesto and pledges from the party conference last year. Some market sensitive policies include Labour’s intension to raise corporate income tax to 26% (from 19% currently) and increase income tax for high earners. Labour also wants to increase public sector borrowing, has flirted with the idea of central bank money printing to finance government investment, as well as nationalising water, energy, postal services and the railways. More recently, a leaked letter in the Sunday Times, from Shadow Chancellor, John McDonnell, to a senior Treasury official warned that he will present an emergency budget within 10 weeks of taking power. The letter calls for civil servants to be re-schooled in economic theories and for Treasury officials to consult members of the public and trade unions in “listening exercises” around the country. For investors, the uncertainty of such left-wing policies is likely to remain a drag on UK equity relative performance to its global peers. We continue to look overseas for more favourable risk-adjusted returns.
Reasons to be cheerful over US company earnings and equities
So far, US S&P companies have reported sluggish Earnings Per Share (EPS) growth of around 2% in the first quarter of 2019. Looking forward, the consensus expects EPS growth to accelerate to 9% by the fourth quarter of this year. If equities are to rally into the rest of 2019, then company earnings need to at least match market expectations. We believe the chance of companies meeting those expectations is fairly high.
First, there have been some transitory factors that negatively affected earnings in the first quarter that should dissipate as the year progresses. These include the Federal government shutdown (which is now over) and extreme cold weather. Second, the consensus estimate for 2020 earnings before tax, depreciation and amortization, an underlying measure of company profits, has accelerated to an annual rate of 8.7% from a low of 6.5% in the summer of 2018. Third, there are signs that the EPS downgrade cycle is ending. After falling sharply in the early part of 2019, the 1-month change in EPS forecasts, a more timely measure of annual EPS, is now nearly flat. And fourth, faster US economic growth provides upside to EPS growth. For instance, first quarter US annual real GDP growth came in at 3.2%, a full percentage point higher than consensus expectations.
Aside from the expected recovery in US EPS growth, the Fed also continues to give a dovish message to the market. The Fed has formally announced the intention to end balance sheet normalisation (quantitative tightening or QT) at the end of the third quarter 2019. Given that the US inflation outlook is benign, the Fed is unlikely to raise short-term interest rates this year. That has led to a decline in US government bond yields and mortgage rates. In turn this has given a boost to the important real estate sector to support overall growth and company earnings. On balance, this market and economic backdrop should enable stocks to rally further.