Luke Newman, portfolio manager on the UK Absolute Return Strategy, gives his thoughts on some of the risks and opportunities he sees – on both the long and short side – in the months ahead, as trade talks begin between the UK and EU.

  Key Takeaways

• Clarity over the direction of Brexit has made the UK equity market investable for the first
  time since 2016.
• The upcoming UK Budget is likely to see a significant increase in government spending, in
  line with the promises made in the Conservative Party manifesto, with a focus on infrastructure development.
• In an uncertain environment with heightened geopolitical risk, we believe that a flexible, cautious approach to investing is a sensible option. 

 

Underlying sentiment towards UK equities have improved since the UK election, which gave the incumbent Conservative Party an unexpectedly strong majority, ending several years of wrangling and uncertainty. The rejection of a perceived ‘hard left’ government by voters fed through to a relief rally in those sectors considered to be in the crosshairs of the opposition Labour Party, such as housebuilders, utilities and financials. More domestically focused sectors were early beneficiaries, while a modest reaction in sterling also ensured that those UK-listed companies that derive a significant proportion of their earnings from overseas were not adversely impacted. A ‘no deal’ Brexit remains on the negotiating table – as such, we have thus far avoided any material currency strengthening, which would have acted as a headwind to repatriated profits.

Political clarity, at last

We have been quite vocal about the challenges facing UK markets over the past few years. Uncertainty over the UK’s membership of the EU has weighed heavily on sentiment towards UK assets, and built indecision into the investment strategy for many businesses. But the election of the first majority government in some time, brought in line via a mandatory commitment to Brexit, gives us some hints of what direction we will take from here – at least over the next few months. This has created a big change in our home market; it has made the UK equity market investable again, for the first time since 2016.

From a political perspective, the Conservative Party is in an opportunistic position to progress its Brexit strategy and wider domestic agenda, potentially turning the UK into a test case for higher government spending. A year ago, this would have seemed impossible. The biggest question then was whether a divided Conservative Party could garner enough support (including confidence-and-supply partners in the DUP) for Theresa May’s planned withdrawal agreement, while mechanisms to prevent a no-deal scenario were being strengthened by votes in Parliament. Much like the paradox of Austrian physicist Erwin Schrödinger’s thought experiment in the 1930s, it was impossible to know whether Brexit was dead or alive, until we knew for certain.

Looking ahead to the upcoming Budget, planned for 11 March, we expect to see newly installed UK Chancellor Rishi Sunak (who replaced Sajid Javid following his recent resignation) announce more expansionist policies in line with some of the spending promises made in the Conservative manifesto. The budget provides a window of opportunity to look at the possible impact on UK-listed businesses that might be expected to benefit from higher government spending, with potentially higher levels of spending aimed at infrastructure development.

Globally, deteriorating economic data combined with limited monetary firepower has resulted in governments and central banks considering more expansive fiscal policies, with likely inflationary outcomes. Comparatively, long-term depressed valuations combined with increased government spending makes the UK market, in our view, a source of potentially attractive value. But risks remain – not least concerns around the spread of the coronavirus from China, and its impact on economic growth.

Where now for UK equities?

Returning to the ever-present topic of Brexit, it is difficult to give any clarity over what the UK’s departure could mean for UK assets over the long term. Political theatre aside, sentiment towards UK businesses is likely to be closely tied to how the government is perceived to be handling negotiations over any future trade deal between the UK and EU in 2020. Investors remain very sensitive to news flow. We saw that in December, when fears of a ‘cliff edge’ no-deal Brexit were reignited by UK Prime Minister Johnson’s announcement that he will not request an extension to the transition period, whatever the state of negotiations. Both sterling and UK stock prices fell on news of the unexpected burden of additional time pressure on negotiations.

At this point, the government’s negotiating tactics on leaving the EU remains opaque, while geopolitical risk remains elevated, including recent events in the Middle East or the ongoing trade war between the US and China. As we move further into the new year, stock pickers will be looking at opportunities on both the long and short side, reflecting the favourable levels of stock dispersion we can see within sectors. Over the long term, there will be both winners and losers. In this environment, we believe that a flexible, cautious approach is a sensible option for investors.