"Brexit: The (attractive) risk reward of UK assets"

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Brexit: The (attractive) risk reward of UK assets

“Make no mistake; there will be no Brexit negotiation”

Yanis Varoufakis, former Greek finance minister

6^th May 2017

Shortly after the 2016 referendum, there seemed to be several possible avenues that Brexit could take. Possible options ranged from a Norway style deal, a ‘Canada+++’ deal, to a bespoke UK/EU deal (considered ‘good’ by all).

In the past 2.5 years, though, the UK’s options have (increasingly) proven to be limited. That was well predicted by Varoufakis (and probably others who attempted to negotiate with the EU during the EZ crisis). This Wednesday, the EU narrowed the UK’s options again to: (i) no deal; or (ii) Theresa May’s deal*. 

Judging which choice Parliament will make is arguably challenging. Our central view, though, is that there’s more appetite in Parliament for Theresa May’s deal (however unappealing), than a hard, ‘no deal’ Brexit. That view has, of course, increasingly been shared by markets (and illustrated by recent strength in sterling, which is the best performing DM currency YTD, vs. the USD).

Having said that, significant fear is still priced into sterling (and, as such, a large GBP rally is likely if a deal is agreed). Furthermore, a sterling rally would bring about a few quarters of cyclically stronger economic growth in the UK; and, of interest in that respect, the UK equity market is (extremely) cheap on certain key valuation measures. For those three reasons (which we explore below), UK assets currently have an attractive risk reward profile. As such, and while cyclical challenges in the UK economy remain, we therefore increased our weightings in UK assets in strategic portfolios earlier this week (as well as making a number of other key changes – see below for a full summary). 

*If Theresa May’s deal is rejected next week, there will be a short extension (to 12^th April), at which point the UK will need to set out its ‘next steps’ or leave without a deal.

The UK Beyond Brexit (in a ‘deal’ scenario)

Clearly, accidents happen and we wouldn’t rule out a hard Brexit in early April. Having said that, the market is net SHORT sterling (FIG 1) with investors and traders, broadly speaking, braced for what is (probably) a tail risk event. As such, and in the event of a deal, there’s plenty of fuel for a sterling rally (as certainty is restored and SHORTs are squeezed).

FIG 1: GBP speculative positioning vs. GBP/USD

…That’s also the message of GBP sentiment indicators. This one below has just started moving higher – from multi-year low/bearish levels….

FIG 2: GBP sterling sentiment (CONSENSUS Inc.**) vs. GBP/USD

**CONSENSUS Sentiment Index created by CONSENSUS, Inc. and is based on market opinion published by brokerage house analysts and independent advisory services. consensus-inc.com Tel: 816-373-3700.

If our central view is correct, and sterling rallies, a phase of stronger economic growth is likely. That would occur through (at least) three key channels:

1. A sharp fall in inflation and stronger real income growth.

FIG 3: Trade weighted sterling (Y-o-Y %, scale INVERTED) vs. goods import prices (Y-o-Y %)

…that then fed into a bout of ‘all goods’ deflation (FIG 4) and a fall in headline CPI rates (to around ZERO for much of 2015). A similar ‘currency & inflation’ scenario, we expect, is likely in the event of a Brexit deal.

FIG 4: UK ‘all goods’ inflation vs. headline CPI inflation (Y-o-Y %)

That would, as it did in 2015, boost real income growth (and consumption – e.g. see the pick-up in real retail sales growth, FIG 5).

FIG 5: UK retail sales (real, Y-o-Y %)

2. A deflationary impulse would ease pressure on the BoE to tighten (thereby further easing financial conditions and, with that, probably lowering mortgage rates/lifting house prices).

In a scenario of weaker goods inflation, headline inflation would therefore weaken (as noted above, and in FIG 4). Given that service sector inflation is low/stable (and below its range of the past 25 years, see FIG 6), the BoE would likely leave rates unchanged (or even ease, depending on the evolution of global monetary policy)...

FIG 6: UK ‘all services’ inflation (Y-o-Y %) shown with UK recession bands

…That would, no doubt, ease UK financial conditions (which have already started to improve in recent weeks, see FIG 7)…

FIG 7: UK financial conditions (Bloomberg index)

…and potentially stimulate risk appetite amongst commercial banks (and feed into lower mortgage rates). Of note, the change in mortgage rates has, unsurprisingly, been a key leading indicator of UK house price growth (see FIG 8 below). As we have shown in recent research, “Where Housing Goes, So Goes the Economy” (see HERE for detail).

FIG 8: Change in mortgage rates (Y-o-Y, pp.) scale INVERTED vs. house prices (Y-o-Y %)

3. Pent up demand for business investment would likely be released.

FIG 9: UK investment spending: Private business vs. total (GBP, billion)

Given that backdrop, it’s interesting that UK equities are (extremely) cheap. Most strikingly, the UK’s equity market valuation, relative to global equities, is particularly cheap using a price to forward cashflow ratio (see FIG 10). That, and other valuation metrics, as well as the rationale laid out above, supports the case for increasing OW positions in UK assets at this time.

We would note, though, that a ‘Brexit deal’ bounce (in UK growth & UK assets), sits in the broader context of a weakening economy, which has been under pressure on many fronts (see HERE for detail).

See below for a full update on our strategic asset allocation views…..

FIG 10: Relative forward price-to-cashflow ratio: UK vs. world

Latest Update on the Strategic Outlook (i.e. quarterly asset allocation)

This week, we published the final section of our global quarterly asset allocation (i.e. the front section). This is our strategic 6 month to 2 year asset allocation recommendations. The analysis is carried out during the final month of each quarter (i.e. in March, June, September and December). The full list of related publications with links is below. An extract from the front section is also published below.

Full document is published in 5 key sections as follows:

• Sections 1 – 5 (overview, conclusions and recommendations), 20^th March 2019: " (continue to) Position for ‘Global Reflation’ in Strategic Portfolios" – see HERE for full piece
• Section 6 (Eurozone), 14^th March 2019: "Eurozone: The new Japan” – see HERE
• Section 7 (US), 15^th March 2019: "US Growth Soft Patch Ongoing in 2019" – see HERE
• Section 8 (China), 13^th March 2019: "Chinese Growth: Set to Re-accelerate" – see HERE
• Section 9 (valuation chartbook), 19^th March 2019: "Valuations Now Compelling (in certain markets)” – see HERE

Extract from front section:

“…..On balance, though, there’s not enough evidence to conclude that a US recession is likely for (at least) the next 12 months. Recessions begin when companies are (i) overstretched (i.e. running a large cashflow deficit); and when (ii) there’s a shock which then forces them to retrench. Usually that shock is the ‘overtightening’ of Fed policy (often aided and abetted by other shocks, e.g. an oil price spike). Those preconditions are not currently in place. The corporate sector, for example, is cashflow rich (for detail see 15^th March LV on Friday “The Structural State of the US Economy”). In addition, Fed policy is not overly tight: Money supply growth, for example, is still positive (fig 4); credit conditions are relatively loose; and the yield curve has not inverted (at the 2s10s part of the curve). On top of that, rather than an oil price spike, the oil price has fallen sharply.

FIG A: ISM new orders vs. Fed policy (Fed funds & ‘Shadow’ Fed funds, %)

Instead of a recession, the evidence supports our “Eat, Sleep, Rinse Repeat” theme. That is: the US and global economy has entered a growth ‘soft patch’ (probably similar to the experience of 2011 and 2015). In the US, that soft patch should persist over coming months (and possibly quarters) and drive Fed policy onto a loosening bias. The evolving outlook for Fed policy is, in our view, one of the most important drivers of price direction across global asset classes. That backdrop, coupled with evidence that China’s credit cycle is turning, is therefore key in shaping our strategic asset allocation recommendations (laid out in detail in Section 1). In particular, it’s a backdrop which, if our recession risk assessment is correct, supports the case for (continuing to) tilt strategic portfolios towards reflationary assets (see below for detail).

In our view, the ongoing shift in Fed policy will be driven by further weakness in two key (interest rate sensitive) parts of the US economy (i.e. manufacturing and housing) and probably result in a rate cut in 2H 2019. Other factors add to the case for Fed easing, and are examined in detail in Section 7 (published as a separate Extract – see March 15^th 2019: “US Growth Soft Patch Ongoing in 2019”). The rationale for expecting weakness in those two key sectors is as follows:

• Manufacturing inventories have risen to multi-decade highs. Companies are now beginning to destock (by reducing production and new orders, e.g. see FIG A). In recent history, almost all phases of destocking have been followed by (and have triggered) an easing of Fed policy (for detailed analysis see Feb 19 Longview Letter No 121: “The Rhythm of ‘mini-cycles’ a.k.a. Bond Yields, Inventories & Orders”).

FIG B: US housing supply (months), shown with Fed funds interest rates (%)

• Housing has a similar message: Transaction volumes are shrinking, house price growth is slowing and housing ‘supply’ has risen to high levels. Historically, whenever housing inventory reaches ‘7 months of supply’, the Fed has eased policy (see FIG B above).

That backdrop sets the stage for a number of key (top level) asset allocation themes in 2019 (and into 2020). In particular, in phases of Fed pausing/easing, global liquidity has eased, and the seeds for ‘global reflation’ have been sown. Historically the easing of global liquidity has been illustrated/proxied by a sharp fall in real interest rates (e.g. in 2016, as the Fed backed away from its plans to tighten policy, see FIG C). That usually creates a positive environment for emerging market equities (as well as other classic reflationary assets).

The macro and liquidity backdrop laid out above suggests that further falls in real yields are likely. In particular, it (continues to) support the case for adding risk in strategic portfolios, and tilting exposure towards classic reflationary assets (most notably EM assets, as well as European).

FIG C: US 10 year TIPS yield (%, scale INVERTED) vs. EM equities relative to DM

Of note, and in addition to weaker US economic data, it’s possible that another bout of weakness in risk assets is also necessary to bring about a (more meaningful) Fed policy response (i.e. to keep recession risks contained and complete the ‘set up’ for a phase of ‘global reflation’). As such, and while we favour moving modestly OW risk, the changes to our strategic asset allocation recommendations are relatively modest at this juncture (and we anticipate increasing risk in portfolios as/when weakness is forthcoming).

For detailed strategic asset allocation recommendations please see HERE….”

Have a great weekend.

Kind regards,

Longview

Longview Research Recently Published

This week:

Extract from Quarterly Asset Allocation No. 37, 20^th Mar ’19:

“(continue to) Position for ‘Global Reflation’ in Strategic Portfolios” – see HERE

Extract from Quarterly Asset Allocation No. 37, 19^th Mar ’19:

“Global Valuation Chartbook: Valuations Now Compelling (in certain markets)” – see HERE

Weekly Market Positioning Update, 18^th Mar 2019:

"Shifting message from the bond & rates market"

Last week:

LV on Friday, 15^th Mar 2019:

"The Structural State of the US Economy" – see HERE

Extract from Quarterly Asset Allocation No. 37, 15^th Mar ’19:

"US Growth Soft Patch Ongoing in 2019" – see HERE

Extract from Quarterly Asset Allocation No. 37, 14^th Mar ’19:

"Eurozone: The new Japan" – see HERE

Extract from Quarterly Asset Allocation No. 37, 13^th Mar ’19:

"Chinese Growth: Set to Re-accelerate" – see HERE

Weekly Market Positioning Update, 11^th Mar 2019:

"How much are portfolios positioned for rate cuts?"