‘Borisnomics’ could mitigate a Brexit bust

 

Since entering No 10, MP Boris Johnson’s political strategy on Brexit has been to take a hard line stance with the EU. Is there a risk that the UK could leave the EU without a withdrawal agreement?

  • The risk of a no deal Brexit has certainly increased under Boris Johnson over the previous administration under Theresa May
  • Boris has vowed to take the UK out of the EU by the end of October “do or die”
  • Boris has also made clear to the EU that the so-called backstop on the Irish border, an insurance device to keep Northern Ireland under the regulatory sphere of the EU in the event that the UK is unable to agree alternative arrangements for frictionless trade with the EU.

If the UK were to leave the EU without a withdrawal agreement, what would that mean for UK investors?

  • In short, we would see this as an opportunity for UK equity investors
  • That’s because we see Boris Johnson’s economic agenda as mitigating the investment risks from a no deal Brexit. This so-called “Borisnomics”, or “Boosterism” as Boris has called it, is likely to come in 4 areas.
  • First, at the heart of the Johnson administration’s Brexit toolkit will be a rolling back of austerity to lift economic growth over the medium term
  • Based on data from the Institute of Fiscal Studies and the PM’s announcements, we find that the government’s fiscal stimulus plans (e.g. income tax and national insurance contributions cuts and more expenditure on education, NHS and the police) could increase by over GBP30bn (1.4% of GDP) cumulatively by 2023/24.
  • taking into account this fiscal stimulus, the government is at risk of breaking the 2% structural (i.e. non-cyclical) budget deficit target rule established under the Charter for Budget Responsibility in 2010
  • the new Chancellor, Sajid Javid, could modify current fiscal rules to give the government more spending and tax cutting headroom
  • example, were the government to scrap its structural budget deficit target and change the fiscal charter simultaneously to keep public debt to GDP constant, we estimate it could free up around GBP233bn (9% of GDP) in cash over the next four years
  • Second, expect a loosening in monetary policy. While the BOE sets UK policy interest rates independently, the Johnson Administration will have a say on who will replace BOE governor Mark Carney when his term ends at the end of January 2020
  • Third, the government could adopt deregulation as part of its economic policy. In the past, Mr Johnson has talked about a divergence in UK rules from the EU in particular sectors to raise productivity and exploit new technologies
  • As a template, President Trump’s supply-side reforms of US deregulation (and tax cuts) to cut bureaucratic red tape from January 2017 led to surge in small business confidence and accelerating productivity growth.
  • Fourth, could be a boost to the housing sector from simplifying or reducing stamp duty, an issue that has been favoured by Mr Johnson during his Tory leadership campaign
  • We believe there is a good chance that “Borisnomics” could mitigate commonly perceived economic risks surrounding a no deal Brexit. Given undemanding valuations, UK equities are starting to look a little more attractive.

Won’t political risks rise from a no deal Brexit and undermine markets?

  • we see this risk as being reduced
  • UK equities have underperformed global markets, largely due to the risk of a potential left-wing Labour government under Jeremy Corbyn getting into number 10 and implementing policies that would undermine the market.
  • Labour have made clear that they would raise corporate tax rates, which would lower the amount of money that could be returned to shareholders through dividends and sharebacks
  • Jeremy Corbyn has made no secret of his desire to renationalise the water, energy, postal services and railway companies.
  • the bigger risk to the overall market is what a proposal be the shadow chancellor, John McDonnell, late last year to establish Inclusive Ownership Funds
  • The plan announced is to require companies with 250+ employees to allocate 10% of their stock (built up over 10 years) to funds which would award up to £500 dividends a year to employees with the rest going to the government
  • Arguably, Inclusive Ownership Funds amounts to a 10% expropriation and has been be viewed negatively be investors in UK equities through lower valuations.

Surely, a no deal Brexit is likely to lead to a weaker sterling. Wouldn’t the risk of a sharp fall in sterling scare investors off investing in the UK?

  • Our base case is to expect sterling is likely to depreciate further in the event of a no deal Brexit, this view is predicated on the uncertainty on what leaving the EU means for trade and importantly capital flows.
  • While trade disruption and trade balances with the EU could takes years to resolve, capital flows could happen much more quickly and have a larger impact on the sterling exchange rate.
  • in the event of a no deal Brexit, large sums of capital could very well leave the UK and drive down the currency
  • At some point, GBP will find a floor. It is not unclear what level that is. However, it is worth noting that sterling reached a post-ww2 floor of 1.05 in February 1985. That is approximately 13% from the current exchange rate.

Given ‘Borisnomics’ and concerns over a no deal Brexit, what should investors do right now?

  • Given the uncertainty over the direction of where Brexit is going, we would prefer to own those UK stocks, where much of their business operates outside of the UK
  • operations of these international companies are largely immune to domestic politics and where overeas’ earnings are denominated in foreign currency and can give a boost to sterling earnings under a weaker exchange rate
  • Such companies tend to do better when sterling depreciates over domestic plays, which are susceptible to domestic politics and are susceptible to current sluggish domestic demand
  • In the context of other equity markets, we will look for an opportunity to raise our exposure to UK stocks

Moving away from Brexit, global equity markets and the world economy have become sensitive to US trade protectionism and the downturn in international commerce. How should investors navigate the uncertainty that trade protectionism creates?

  • Undoubtedly, international commerce has suffered from President Trump’s trade protectionism agenda that began way back in early 2017 when the US launched an investigation into steel and aluminium imports as a national security concern. Global exports are still barely growing at all
  • Close trading partners, like Mexico and Canada have been forced into renegotiating NAFTA
  • Trump’s top trade protectionism target has been China, where the US has a visible trade deficit of over $400bn a year
  • It is unclear if Trump’s trade protectionism agenda actually brings back more jobs to the US than are lost from slower inevitably growth from global uncertainty
  • In August, the President Trump Administration announced another round of tariff increases on $300bn of Chinese exports to the US. Trump has backtracked somewhat since. The bulk of this latest round of tariff increases won’t be implemented until the middle of December in order to give time for the US and China to negotiate a trade deal.
  • the US has granted 90-day extension for certain U.S. businesses to work with Chinese telecommunications company Huawei
  • This matters, as China has made the Huawei licenses a condition for increased agricultural purchases from the United States after halting imports in August
  • If Beijing decides to resume the purchases, it would ease some trade tensions and raise the possibility of further tariff delays.

How do you quantify trade uncertainty into market valuations?

  • We constructed a Smith and Williamson world trade sentiment index to help gauge how trade uncertainty is priced in by the market. Our index uses a media database of words associated with various levels of trade protectionism, and follow methodology adopted by the Bank of England.
  • From our analysis, we find that trade sentiment alone does not move markets beyond the short term
  • we take into account improving fundamentals (proxied by earnings revisions) and the support from central bank (proxied by lower global bond yields). We find that the market has fully priced in the sentiment around trade.
  • The result of this is simple yet important: earnings improvement and the support from central bank have offset the worsening trade sentiment
  • This is likely the best framework for analysing trade tension. Although we can’t forecast what President Trump will say or do, we can count on the backing of central banks and monitor company earnings expectations.

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This episode was recorded on  28/08/2019

This S&W The Pulse podcast is of a general nature and is not a substitute for professional advice. No responsibility can be accepted for the consequences of any action taken or refrained from as a result of what is said. The views expressed are not necessarily those of the presenter or of Smith & Williamson or any of its affiliates. No reproduction of this podcast may be made in whole or in part for professional or recreational purposes. No action should be taken based on this podcast and we accept no liability if we change your views on any of the subjects mentioned.

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The Pulse from Smith & Williamson

Investment Show: ‘Borisnomics’ could mitigate a Brexit bust

Episode 1

Broadcast on at 09:00, 28th of SEPTEMBER 2019

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