The last decade in British politics has been nothing short of astounding in its capacity to confound the pundits and to challenge the orthodoxy. It is fitting, therefore, that last week’s General Election should provide us with further seismic shifts in the political tectonic plates. Perhaps the biggest change over the last week has been that we should have some short-term clarity over what happens next. Or, then again, maybe not.
The initial reaction to last week’s election result was predictably bullish. The received wisdom was that a thumping majority for the Conservatives would lead to the certain approval of Mr Johnson’s Withdrawal Agreement, and with him no longer beholden to the ERG faction of the party could effect a softer version of Brexit than might otherwise have been the case with a majority where every blue vote in parliament would be required to get any piece of legislation through. Sterling and domestic earners surged in the aftermath of the vote, foretelling a British economy that would be released from its present torpor as business investment is re-ignited and the government loosens the fiscal shackles to meet its manifesto promises. The fear of a future “cliff-edge” collapse in trading relations was also assumed to have been diminished. It is generally accepted by those with experience in these matters that a comprehensive trade deal between the UK and EU will take much longer to iron out than the year remaining until the end of the transition period on 31st December 2020. With an unbreakable majority, it was expected that Boris Johnson will have enough political capital to extend the transition period out to a more sensible time frame.
All of this was perfectly plausible one week ago. However, since then some of this thinking has started to unravel. There have been Tory briefings that the new government would “outlaw” any extension to the transition period. This is nothing other than political posturing; the last year has educated us all in the minutiae of political procedure, and any law passed today can relatively easily be repealed in future. An extension cannot be outlawed. Yet, it has showed the mindset; and that mindset is to “get Brexit done” by the end of January, and end the transition period before 2021 arrives. This raises the spectre of “cliff edges” and “no deal being back on the table”, potentially undermining the certainty and clarity offered by the election result. As a consequence, as this is being written, Sterling is back to levels seen in the early days of December.
Equity values, however, are not. The UK market jumped in the aftermath of the election, and have nudged further ahead since. So, which gives us a greater steer on what to expect in the near- and medium-term? The equities or currencies? At this stage, we would take our reading from the equity market, but caution that benefits of the new political climate may take longer to feed through to numbers than some might expect. And that in the intervening period, things could get a bit shaky on the delivery of numbers.
Let’s deal with the political situation in the UK first off. Boris Johnson has made his priority the speed of Brexit, not the type of Brexit. There is a natural conflict between doing Brexit quickly, and achieving an agreed Brexit with only a very loose set of rules for the ongoing trading relationship. Convincing the EU to give the UK easy access to its markets without any of the obligations on standards will take years of horse-trading. These are years that Mr Johnson is unwilling to spend. By insisting that Brexit is “done” by the end of next year necessitates a very close relationship between the two parties. Those who fear a “WTO Brexit” next December might consider two salient points. Boris Johnson is not an ideological Brexiteer. He is an opportunistic Brexiteer. We would wager that his vison for Brexit is based on political expediency rather than purity of outcome. Where he does have a clear vision, is surrounding his own place in the pantheon of UK Prime Ministers. The election just past has offered him a golden opportunity to sit at the top of British politics for the next ten years. A chaotic, cliff edge Brexit that destroys the country’s short-term economic performance would present a massive threat to his political longevity. A threat that is in his power to avoid.
As an aside, and from a Scottish perspective, there is another reason for the Conservatives to get the process over as quickly as possible. The pressure for a second Scottish independence referendum is intensifying. The key plank of the argument for another referendum is that Scotland is being dragged out of the EU against its wishes. Yet, if Scotland is already out of the EU by the time the next plebiscite is arranged – and has no easy route back in – the chances of Scots selecting the “double out” option (out of the EU and out of the UK) is remote. Shattering the Union is another pitfall Mr Johnson will be keen to avoid if it is within his power.
One other major change to the economic outlook over the last week has been the temporary cessation of hostilities between the United States and China over trade and related matters. Phase 1 agreement of a new trade deal has been reached, which will see $160bn of Chinese goods avoid further tariffs for the quid pro quo of a doubling of Chinese purchases of US food and agricultural goods. This Phase 1 deal has signalled that mutual self interest will potentially be the dominant driver in future rounds of these negotiations. However, with the US President facing the ignominy of an impeachment trial, there is no telling what diversionary tactics he might use to deflect attention elsewhere.
The global economic backdrop is less threatening to equity investors than it was a few months ago; largely because of the factors already mentioned. Yet, it still contains enough threats that we wish to be cautiously optimistic, rather than full-on “fill yer boots”. The prospects for domestic economic growth and global trade are brighter than they were. On the domestic front we see ample scope for upside driven by business investment, growth in real disposable incomes and a more confident property market in the South East of England. Internationally, declines in the automotive and aerospace sectors are moderating, potentially looking to provide a bottom to industrial output. However, in neither area is activity likely to turn on a sixpence. Trading conditions for many businesses will remain challenging for a while yet, so there is a very real risk that profit expectations for 2020 need to be rebased early next year. Equity valuations globally don’t have a lot capacity to absorb bad news at this stage.
We all know that equity markets are forward looking; the substantial rise in valuations has little to do with what happened this year. The positive returns made have been a gradual incorporation of better news on future trading. What happens from here depends on whether that picture brightens further still. In the UK, we see a strong argument for that assertion being correct. The three year period since the EU referendum has stalled the maturity of the natural economic cycle. There is ample scope for growth to pick up due to the factors already mentioned. Elsewhere in the world, the picture is less clear cut. Recent data coming out of the US has been better than expected, but 2020 is going to bring a Presidential election campaign in the twilight years of this economic expansion. With few policy response options to any further slowing of growth, the risks of negative shocks coming out of the US are higher than they have been for many years. In China, the authorities have kept the plates spinning so far, but the complexity of maintaining super-normal growth without asset and debt bubbles bursting will eventually become unmanageable. By contrast, continental Europe may find the political will to loosen the fiscal purse strings to stimulate growth.
As we close out this year, we are pleased to have delivered attractive returns of more than 30% on the starting price on January 1st. If we were politicians, we might promise you the same again next year. That would be foolhardy. For the UK, 2020 is likely to be better than 2019. But that is already reflected in valuations. The outcome for 2020 will depend on how the landscape for 2021 evolves. It is unlikely to be plain sailing; but compared to other asset classes and other territories there is still a compelling valuation advantage to buying UK companies. With the prospects of a more settled political environment for the foreseeable future, both domestic and international investors are likely to reverse the persistent net selling of UK assets seen for most of the last decade.
This augurs well for attractive medium term returns to be generated for investors.
As usual, we thank all our clients and investors for their support over the year. Based on current valuations, funds under management in Revera have increased by almost 60% since the start of the year. Performance has been good, which has allowed us to buck the overall market trend and deliver substantial inflows into UK equity products over the year. We will continue to work hard to justify that confidence placed in us. To those who are thinking think about becoming clients and investors, we still have plenty of room for you.
To everyone, can we please wish you all a very Merry Christmas, and hope you enjoy the whole of the festive period. We hope everyone comes back in the new year rested and invigorated to face whatever challenges 2020 throws at us. We might not know what they are, but they will definitely exist.