Notwithstanding the (as yet) unknown impact of the coronavirus crisis on the economy, we see the UK as a standout opportunity, and particularly for domestically focused stocks. Our optimism is predicated on stronger UK economic growth that gives uplift to company earnings at home. We see three channels driving the economy from here.
The first channel is through increased business and consumer confidence following an election that delivered a large majority for the Tory party, removing the political risk of a left-wing Labour government for the next five years. Consumers now feel sufficiently confident to release pent-up demand through greater expenditure. Increased confidence is manifesting itself in the residential market. According to the Royal Institution of Chartered Surveyors, estate agents reported another strong consecutive monthly reading in January over the outlook for house prices. Given the fairly tight relationship between house prices and retail sales, this is a constructive omen for private consumption.
The second channel is through deregulation, as part of the UK’s economic policy in a post-EU world. In the past, PM Johnson has talked about a divergence in UK rules from the EU, a point that was made clear in his Greenwich speech in early February. Essentially, the government wants the flexibility to adjust regulation in order exploit new technologies to raise productivity and growth. As a template, President Trump’s supply side reforms of US deregulation to cut bureaucratic red tape, as well as tax cuts, led to a pick-up in small business confidence and accelerating productivity growth over the last few years.
The third channel is through an end to austerity via public spending. In the September spending review for the next fiscal year, then Chancellor Javid announced the biggest day-to-day government current expenditure increase for 15 years. The rise in public spending was broad-based with no government department seeing a cut, the first time that has happened since 2002.
Rishi Sunak’s replacement of Sajid Javid as the new Chancellor paves the way for a fiscally loose budget that is more aligned with the political demands of Number 10. Essentially, the Boris Johnson Administration is embracing a close relationship between Downing Street and the Treasury, akin to how the David Cameron and George Osborne regime operated.
Looking forward, research house Capital Economics believes that the government can raise spending (focused largely on public investment) by another 0.5% of GDP from here at the upcoming Budget without exceeding existing fiscal rules. Capital Economics expects total fiscal spending amounting to a sizeable 1% of GDP boost to the economy in the fiscal year 2020/21, which should provide a favourable demand-driven environment.
One implication of the coronavirus outbreak is that it may force the Chancellor to delay the government’s tax raising and expenditure plans until the autumn spending review. Should UK economic growth disappoint in the first half of 2020, it may mean there is less money available to be injected into the economy. Though it is possible that current fiscal rules are adjusted under the new Chancellor to borrow more and raise government spending in order to honour Tory manifesto commitments at the last election.
In terms of the investors’ concerns, we expect these three channels of “Borisnomics” to mitigate economic risks should the government fail to secure a trade deal with the EU when the UK leaves it transition period at the end of 2020. Our base case scenario is that we believe the risk of a “no deal” Brexit is probably contained, as it is in the interest of both the EU and UK negotiators to work out a basic economically beneficial Free Trade Agreement in goods at least.
Another issue is that the government is loosening fiscal policy at a time of tightening labour markets. The unemployment rate is currently at its lowest level since the 1970s and there is a risk that wage costs could rise to crimp profit margins. However, provided that increased government investment spending is accompanied by deregulation that raises productivity and lowers unit labour costs, there is a decent chance that inflation can be contained sufficiently not to worry equity investors.
To conclude, we see the combination of improving confidence, deregulation and greater fiscal spending to drive demand provides a business-friendly environment for companies to operate. Over time, we expect current cheap UK equity valuations (and particularly domestically focused stocks) to mean revert and drive up stock prices in the process.
All values and charts as at 29 February 2020. Total returns in sterling.
Returns are shown on a total return (TR) basis i.e. including dividends reinvested (unless otherwise stated).
Net return (NR) is total return including dividends reinvested after the deduction of withholding tax.
Source: Refinitiv Datastream and Bloomberg
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