The Weekly - Another week, another deal

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04/02/2019
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We avoided Brexit last week and delivered our views on ESG investing (Environmental, Social and Governance).  Unfortunately, we couldn’t make that stretch for another week and we have to now return to the latest chapter in Brexit: the Prequel, episode 34!  The deal of the day now appears to be the Malthouse Compromise which is named after the housing minister, Kit Malthouse, who has encouraged talks between different groups of MPs, albeit all Conservative, but a collection of Leavers and Remainers. 

In a nutshell, they are suggesting an alternative to the backstop, which does seem a non-starter given the lack of appetite from the EU to re-negotiate.  I suppose it all depends on how desperate both sides are to avoid a ‘no deal’ Brexit, which was one of the key reasons for not taking it off the table.  Taking a ‘no deal’ off the table was always a strange suggestion when this is the default if nothing is agreed. But then again, it could be argued that the only route to avoidance in the event of no agreement would then be to delay Brexit and resurrect another referendum, attractive to the Labour party who are generally against Brexit.
 
Anyway, the markets and sterling are telling us that a ‘no deal’ is now seen as unlikely.  It is avoidable by simply extending Brexit and neither side would want to be responsible for allowing that to happen by accident by strictly adhering to a procedural timetable.  There is a point where political grandstanding has to make way for the real world of voters’ lives and livelihoods.  Up to now, the UK government has been lambasted in the European media for creating all the confusion and uncertainty.  Brussels is acutely aware of the need to show competence and sympathy whilst also trying to deal with the problem child that has always tended to occupy the naughty step.  It is the British way to stand up and be counted with freedom of expression exercised to the full and we should be proud of that, no matter how much our EU partners frown upon us.  It is always difficult for other cultures to fully understand what makes a nation tick.  Perhaps this lies at the heart of the whole debate – a bloody-minded refusal to accept rules from somebody else.  It may be a mess but at least it’s our mess!
 
It is very easy for an investor to get spooked by the Brexit shenanigans, decide that perhaps their risk appetite isn’t what they thought it was, panic, and run for the security of cash.  No matter how much the financial advice industry advises clients to take a long term view and ignore the short-term noise, this is very difficult when the media are having a field day and catastrophising constantly.  Do you believe or ignore the theory behind Project Fear?  This could equally apply to the election of a Corbyn government.  Would it really be as bad as many believe?  At the end of the day, the UK is still projected to grow GDP at 1.5% in 2019 from 1.4% in 2018 – hardly supportive of the intensity of the forecasts of our impending doom.  At least the respective leaders of the House of Commons are now speaking to one another, albeit from entirely different perspectives.
 
Theresa May’s deal was rejected by Parliament on 14th January 2019, but this looked inevitable when the government lost several unrelated votes in early December as some key supporters fired warning shots, causing her to delay until the New Year.  Investor sentiment was not helped by the US equity market having its own crisis of confidence during the government shutdown and Trump’s refusal to back down over his wall funding.  In fact, from the beginning of December to Christmas Eve, the S&P 500 fell -14.8% in US Dollar terms only slightly worse than the Nikkei 225 which fell by -14.3% (1).  This was a remarkable fall over three weeks and does suggest an overwhelming sense of bearishness and perhaps capitulation panic.  From this low point, the S&P 500 has rallied by 15.3% and the Nikkei 225 by 9.0% along with other global indices more generally.  This has been helped by the cessation of the US government shutdown, the softening of the Federal Reserve Bank’s stance on interest rates and an increasing sense that Donald Trump needs some good news which may present itself in the most amazing Chinese Tariff Deal of all time.
 
Peering through the London fog, it is useful to look at the differing performances of the respective sectors of the UK equity market.  Most UK investors will have a substantial portion of their equity exposure in the UK and therefore their risk budget within their portfolios.  The Brexit debate is causing conflicting effects, whilst sterling gyrates around the political developments.  When the uncertainty intensifies, and sterling weakens, the FTSE -100 with its foreign earnings holds up.  However, when there is a development like the chances of a ‘no-deal’ reducing, sterling strengthens and the domestic sectors sensitive to Brexit, such as property, respond accordingly whilst the FTSE -100 flags. 
 
Let us consider a well-run company such as Persimmon, currently yielding a 9.8% prospective dividend based on its 2018 year-end forecasts.  This is covered 1.2 times by its forecast earnings.  It is not alone in the sector with Crest Nicholson yielding 9.7% and Barratt Developments 8.2%, again both being covered by their earnings (2).  So, as a prospective investor, the market is pricing in a lot of pain in these companies with dividends of this magnitude normally suggesting that there is a considerable chance that the dividend will be cut and that earnings will collapse.  Of course, the longer Brexit rumbles on, the more likely house purchasers are to delay exposing themselves to interest rate risk, especially if a ‘no-deal’ Brexit leads to inflationary pressures.
 
If you believe Mark Carney’s predictions on a ‘no-deal’ scenario that GDP could fall by 8% and house prices by almost a third, then that would certainly make sense when looking at these company valuation fundamentals.  The construction & materials sector fell by 20% from the end of September to Christmas Eve but has since recovered half of that loss (2).  Global investors continue to steer a wide berth around the UK equity market considering it to be a no-go area.  However, housebuilders and commercial property exposure is a small part of the overall quoted market.  In addition, many global investors obtain their UK exposure on a pan-European basis, taking a view that we are part of the European trading bloc.  Of course, after Brexit, we may no longer be considered as such and perhaps there will be a structural shift in the way investors gain access to what is, after all, the world’s fifth largest economy and fifth largest equity market, currently yielding over 4% as an entire entity.
 
The political will in Brussels and Westminster to break the impasse and deliver a Brexit deal that satisfies all parties is undoubtedly there.  Nobody wants to be responsible for unleashing potential economic chaos on both sides of the channel.  At the very least, it is preventable by delaying the implementation date.  If the principle of the backstop can be preserved and an acceptable phase two agreed after the transition period and any extension thereof, then we can collectively sigh with relief.  However, the returning talk of technology solutions will have to transfer into reality because that can be the only way of having an open border when there are potentially different tariffs on either side.  Even if we can agree a mechanism of free trade preservation with the EU, what happens if and when either the UK or the EU brokers a different trade deal with a third country, resulting in different prices for the same imported goods either side of the Irish border?
 
Technological development has to be given a chance but if it fails, then there cannot be an arbitrage opportunity for smuggling across the border, either way, thereby destroying the integrity of the single market.  This is why the backstop keeps Northern Ireland within the single market and prevents the UK from striking new trade deals.  It all reverts back to not having our cake and eating it.  It is going to be interesting, when all this is behind us, just how third-party countries approach us regarding trade deals relative to the EU.  Most members of the EU consider it to be a significant advantage being part of a large consumer bloc when negotiating terms with foreign exporters.  However, Brexiteers dispute this and fall back on our commonwealth, colonial and empire links citing an appetite for enhanced trade access from the US, Australia, India and Canada, to name but a few.  Of course, this assumes that trade was the only basis for supporting Brexit which is not the case for many.
 
From a stock market perspective, business and trade is the only fundamentally important variable.  If our car manufacturing, aerospace industries or property markets are affected negatively, then the UK equity market will continue to price this in and apparently attractive dividend yields will be illusory.  However, if there is a way through to an amicable solution, by whatever means, then perhaps we can move on to more settled and prosperous times, both economically and as investors.
 
Source: FE Analytics 2019 (1) – Accessed 04/02/19
Source: Hemscott (2) – Accessed 04/02/19

 

US Jobs Data Impresses Once Again

Hiring in the US smashed expectations last month with 304,000 new jobs created, almost double market forecasts. Annualised wage growth of +3.2% was just below the decade high set last time with the labour participation also ticking up once again. The only negative within January’s labour market report was the 10 basis points (bps) increase in unemployment (to 4.0%) although that was largely the result of the temporary government shutdown. Whilst the Federal Reserve has adopted a more dovish stance in recent weeks, data like this does suggest that US economy remains in rude health which should give policymakers at the Fed something to ponder over the coming months.

The employment data arrived too late in the week (Friday) to fully reverse the drop in Treasury yields over the previous few days. The US 10-year closed Friday 6bps lower for the week at 2.69%, albeit up from the month low set back on Thursday with the equivalent UK Gilt yield rising by the same amount to 1.25%.

Domestic equity markets maintained their positive start to 2019, the FTSE100 rising by +3.1% with the mid-cap focussed 250 adding +0.9%. US stocks also ticked higher despite some mixed earnings data. 117 S&P500 businesses reported results over the week with notable positive releases including the likes of Facebook and Apple. European markets were mixed with French equities rising modestly whilst German and Italian bourses fell, the latter coming after data revealed that the Italian economy has slipped into recession. Japanese equities were largely flat.

Gold continued with its recent positive momentum, the precious metal rising by +1.5% to $1,318 an ounce. It is has now risen by more than +7.0% over the course of the last 3 months. Oil has also rallied during 2019 so far, reversing the rapid descent seen during Q4 of last year. Brent Crude rose by +1.8% to $62.75 barrel last week and is now +15.0% above the recent low point set just before Christmas.

Sources: Forex Factory & DataStream

 

The Week Ahead

The Bank of England is due to hold its latest monetary policy meeting on Thursday. Given the weakening of global economic data as well as continued Brexit uncertainty, no change to UK interest rates is forecast this time or indeed for the rest of the year. The central bank is also scheduled to release an updated inflation report to assess the current state of the economy.

Domestically, inflation numbers are scheduled on Wednesday morning, following Tuesday’s updated Purchasing Managers Index (PMI) data for the dominant Services sector within the UK economy to measure business activity levels. Meanwhile, the Institute for Supply Management will release equivalent data in the US, also on Tuesday.  European countries are also set to publish a raft of PMI data in addition to Retail Sales figures, gauging the strength of consumer spending across the Eurozone.

In Asian markets, a preliminary estimate of Japanese fourth quarter gross domestic product is due along with Chinese inflation data, both scheduled for release the early hours of Friday morning.