Edison Investment Research

Brexit: EU can do it if you really want….

Prospects of an orderly exit receding but no-deal remains less likely than extension

Alastair George, Chief Investment Strategist

The obstacle in the way of the amended Withdrawal Agreement (“the deal”), a document supported by both the EU and PM May, remains the UK Parliament. However, in our view, those accusing the UK Parliament of irresponsibility may as well level that charge at the institution of parliamentary democracy, described famously as the worst form of government except for all the others. While the currently chaotic scenes may be unnerving, there appears little appetite for compromising long-standing UK democratic principles, arcane or not. A week is a long time in UK politics and the prospects of an orderly exit on schedule are now clearly receding, compared to our earlier thoughts. Even so, an extension to Article 50 remains more likely than no-deal or Article 50 revocation and a way out of the impasse is also within the EU’s power.

Brexit: PM May’s deal may finally be in sight.

UK Parliament has motioned itself into a corner

This post has been updated to reflect the events of Thursday March 14.

Alastair George, Chief Investment Strategist

This week the UK Parliament has voted to avoid no-deal under any circumstances and at any time. In addition, Parliament comprehensively rejected the government’s Withdrawal Agreement, as modified by the additional instrument and declaration negotiated with the EU at the weekend. Following the votes on Thursday March 14, the choice for next week will be between supporting a short extension to Article 50 – and by implication supporting the modified Withdrawal Agreement - and a much longer extension. Under the second option of a prolonged extension, all possibilities (except perhaps no-deal) are on the table, including a new government, general election and second referendum. It is high stakes but we still cannot rule out the UK Parliament will do the “right” thing, for investors at least, by approving the Withdrawal Agreement - after trying everything else.

Brexit: The big guns go silent.

PM May has quietened her opposition for now – but will it be enough?

Overnight, the UK and EU have agreed an additional instrument which provides further assurances that the Northern Ireland backstop will be temporary. In particular, should either the UK or EU act in a manner which seeks to apply the backstop indefinitely, as decided by an arbitration panel of judges, then the other party would be entitled to a suspension of its obligations under the Withdrawal Agreement. It is not a time-limit on the backstop, nor a change to the Withdrawal Agreement. It also does not give the UK a unilateral right to terminate its obligations under the Withdrawal Agreement, but merely appeal to arbitration in the event of suspected foul play. Nevertheless, the mechanism for unilateral suspension is a significant concession in our view which may be sufficient to win over enough MPs in the UK’s Parliament. Key to any success will be the legal opinion expected later today of UK attorney general Geoffrey Cox.

ECB: Buy the rumour, sell the news.

Markets had run ahead of ECB’s policymaking; valuations suggest near-term rally complete

Despite the ECB’s policy action yesterday, which pushed out the date of the first interest rate increase and confirmed a substantial package of targeted bank financing intended to ease credit conditions for the corporate sector, the market reaction was largely negative. Yet a key part of our bullish call in January was that equity valuations had retreated to levels which were close to long-term averages, a relatively unusual occurrence in this economic cycle. Since then, equity valuations have rebounded sharply as markets have risen while 2019 consensus profits estimates have fallen. This was largely in anticipation of easier monetary policy in our view. We now expect markets to trade only sideways in the absence of a near-term catalyst, while awaiting evidence of a turn in the economy during Q2/Q3. In respect of a US/China trade deal, the apparent cancellation of the Xi/Trump summit due in late March is however unhelpful for sentiment.

Brexit: Prepare for a confrontation.

No-deal preparations on both sides represent a predictable escalation in tensions

UK PM Theresa May has survived the confidence vote triggered by her own party. A further proposed House of Commons confidence vote is also destined to be defeated. However, PM May’s continued premiership does not mean there will be no change in Brexit tactics. She faces the same unresolved conflicts as before. In order to deliver her deal, she may shift towards a more confrontational position with the EU in order to obtain increased leverage. Investors should not confuse this with actively seeking a no-deal Brexit. However, the road to amending the Withdrawal Agreement and winning UK Parliamentary approval now seems paved with market volatility. While UK markets are now trading at valuation levels which discount a significant degree of Brexit disruption, declining earnings forecasts in both the eurozone and UK suggest that it is too early to materially increase equity exposure to these markets.

Brexit on pause as UK PM challenged.

ECJ Article 50 decision means UK Parliament is in control of its destiny

After letters from at least 48 MPs, the UK Conservative party will now hold a confidence vote in its leader later today. If the incumbent UK PM May fails to secure a majority of Tory MPs, a leadership contest will be triggered. The postponement of the Parliamentary vote on May’s Withdrawal Agreement and subsequent day of flying around Europe meeting heads of state, yet appearing to achieve little but photo opportunities has forced the matter to a head. Regardless of the outcome of the confidence vote, the Brexit process is at stalemate with the UK Parliament unable to ratify the only agreement the EU is prepared to offer to date.

Economic survey data on a weakening trend outside US.

The fly in the ointment for investors trying to look through political developments

Following a difficult autumn, investors are likely to be weighing whether 2018’s risks are almost in the rear-view mirror. Brexit could conceivably be settled by January, with minor changes to the Withdrawal Agreement; the Italian budget stand-off could be resolved by a telephone call. In terms of financial conditions, the Fed may raise rates in December but could guide to a pause, reflecting economic or market turbulence. Similarly, the ECB could acknowledge that the weakening trend in eurozone data warrants a continuation of QE, or at least some very doveish forward guidance.  Finally, following the mid-term elections, rebel Trump’s politically motivated trade war on China is now without a cause, at least in the short-term. Speculation of a US/China trade “deal” at the upcoming G20 meeting in Argentina is rising, which could perhaps at least represent a cease-fire in hostilities. Such a shift in sentiment may seem far-fetched, but should at least be considered alongside more bearish scenarios.

Brexit: A decisive step into the fog.

Limited support for UK PM May’s Brexit deal creates further uncertainty

UK PM May’s Brexit deal has achieved the unlikely honour of uniting both pro-EU and Brexiteers in rejecting it. Despite a difficult House of Commons session yesterday, she only reiterated later her role is to finalise the text and bring it back to Parliament for a vote in December. At this point it is difficult to see how she will succeed. A key rival is in the process of securing the 48 letters required for a vote of no-confidence and she has failed to secure a new Brexit minister. Without an election, any new PM would have the difficult task of renegotiating the current deal - and would have to create a credible deterrent of no-deal to succeed. An election risks a Labour government less accommodating to the corporate sector. Both these scenarios are likely to be unwelcome for financial markets. The probability of sufficient change to the draft agreement to pass the UK Parliament appears slim but would in contrast be welcomed by investors. 

2019 Earnings forecasts softening.

October market declines coincide with falls in non-US 2019 profits outlook

In recent consensus earnings revisions, we see a modest acceleration of downgrades to 2019 UK and continental European profits forecasts which have been drifting lower since August. In contrast, US forecasts have been revised only fractionally lower. The real action is in emerging markets, where 2019 forecast profits growth has fallen from 15% as recently as August to only 11% today. Finally we note that the typical upward trends in analysts’ target prices has stalled during 2018. This in our view confirms our top-down perspective that higher interest rates have been feeding through to company valuations, even as profits continue to grow.

Brexit: UK Risk premium likely to remain in place.

Investors face continued UK uncertainty and polarising outcomes post-Salzburg

The unproductive summit of European leaders in Salzburg this week has highlighted the lack of substantive progress on finding any solution to an exit agreement for the UK which will satisfy the EU, Ireland, Northern Ireland,  UK government and UK parliament. Most importantly the declaration by EU Council President Tusk that the UK’s “Chequers” plan will undermine the single market highlights an objection in principle to the UK’s initiative for a free trade area in goods during any Brexit transition period. This principles-based roadblock suggests that tinkering at the edges – such as customs checks in the Irish Sea are irrelevant details. We see elevated political risk in the UK, potentially polarising the outcome between a hard Brexit and no Brexit. Investors will also need to consider the increased risk of a populist UK government.

2018 Earnings forecasts stable over the summer.

Only marginal declines in EMs suggest that fears of an imminent crisis are overblown

There is a relatively strong correlation between the direction of earnings forecasts and the short-term relative performance of equity markets. Over the last 12m, US markets have outperformed peers as Trump’s corporate tax reductions and fiscal stimulus have provided a tailwind for US earnings. In the UK, although weighted earnings forecasts have risen, UK stocks have trailed behind, impacted in our view by the negative domestic sentiment in terms of Brexit. Similarly in continental Europe, market sentiment has been impacted by international and domestic political events. Intriguingly, the median emerging market forecast has only fallen by 2% since the Q1 peak, similar to the UK and Europe, suggesting fears of an imminent crisis are not at present feeding through to the corporate sector.

You can’t be given a bloody nose twice.

The vote ‘no’ to Italian constitutional reform in this Sunday’s referendum has cost the Italian prime minister Renzi his job and perhaps thrown the Italian government into turmoil. Markets are however not in turmoil. The euro is close to unchanged, having fallen modestly after the referendum result. European equity markets are sharply higher this morning. While Italian 10y government bond yields have breached 2%, this increase in yields is notably less sharp than at the time of Trump’s election. Investors who panic sold after Trump and Brexit have been reconditioned (correctly in our view) to not immediately re-price risk on the back of specific political events.

Earnings revisions: Gap widens between U.S. equities and earnings forecasts.

Though the bullishness is palpable, U.S. equity markets are not being driven higher by 2017 earnings forecasts, which have declined during November. In the absence of upgrades, we would now question how far the slogan of “Make America Great Again” can push U.S. equities. In the UK, market indices appear better supported as earnings forecasts are still increasing, even as the stock market has lagged. In Europe, in euro terms both the market and estimates have remained stable over the last quarter.

Trump’s double surprise.

It is quite clear that in the days leading up to the U.S. Presidential election, both markets and surveys got it wrong. Traditional polling once again failed to spot the depth of support for radical political change. This was after all the U.S., which has delivered the strongest post-crisis economic performance of any developed nation. 

BOE leadership: Carney’s conundrum.

Mark Carney’s testimony to the UK’s House of Lords economic affairs committee was notable both in regard to his personal intentions and the future interaction between fiscal and monetary policy. In respect of the former, his emphasis on personal circumstances in terms of whether he wished to serve a full 8 year term at times felt uncomfortably close to sounding as if he wished to spend more time with his family. Even if this may have been unintentional it has contributed to the speculation over his future.

Sterling: Lower for longer as the EU strikes back.

The UK’s new Prime Minister Theresa May’s honeymoon period is clearly over. Days after emphasising the importance of national sovereignty and appearing to lean towards a ‘hard’ Brexit, a dawn raid on sterling and subsequent weakness has given opponents ammunition to attack the UK’s plan to leave the EU. Furthermore, tough talk from the UK government has been reciprocated from EU leaders and European heads of state. President of the European Council Donald Tusk may even have given the game away by linking the concept of a ‘hard’ Brexit to ‘no Brexit’. For sterling, we believe investors should look through the politics and focus on the economics.

UK economy and corporate profits: Refusing to follow forecasts.

Since July, there have been over 250 UK corporate earnings reports or trading statements, which we have been tracking for any sign of Brexit-related weakness. Within these corporate filings we can find little evidence, in either outlook statements or in managements’ referendum commentary, to suggest a slowdown in trading is underway.

On the contrary, over 80% of company earnings reports indicate that trading is in-line with earlier expectations. Furthermore, 16% of companies report that trading is ahead of expectations against only 3% reporting that trading has fallen below expectations. In addition, recent data on house prices and manufacturing surveys seem to confirm that fears of a Brexit-induced slowdown in the UK have proved overblown, over the summer at least.

Brexit webinar - One month on.

A month after the UK’s vote to quit the EU, markets are moving on. Despite the UK’s new Prime Minister committing to implement Brexit, global markets remain calm, even if sterling is still well below pre-referendum levels. Within the EU, aggressive Brexit rhetoric has given way to the realisation that a mutually beneficial relationship will need to be found between the UK, the EU and its member states. Early indications suggest a slowdown in the UK in some regards, but earnings estimates have only fallen modestly so far – and only in the most exposed sectors.

Brexit, Fed: a short squeeze.

If in the short-run the market is a voting machine, as attributed to value investor Benjamin Graham, yesterday’s 3% rise in European markets represents a vote of confidence in the Remain campaign winning the UK’s referendum on Thursday and a consistently more dovish US Fed for the remainder of the summer.

Brexit: Ultimately unlikely.

Edison has not taken any formal position on the desirability or otherwise of the UK leaving the EU. We are however pleased to provide the following summary of the key issues.

First, we believe any discussion on Brexit should be placed in the proper context. Based on current polling data it is significantly more likely than not that the UK will remain in the EU in the two years following the referendum on June 23rd. Online polls may indicate a nation split nearly 50:50 on the issue, but online polls also proved significantly less accurate than telephone surveys in the UK’s most recent election.

M&A in the UK - is Brexit opening a (relative) value opportunity?.

Whether down to the potential for Brexit or a widening current account deficit the decline in sterling over the last 6m has been substantial. On a quarter-on-quarter basis the trade-weighted value of sterling has fallen by 7%, representing a move of more than 2 standard deviations away from the mean.