Brexit, Britain's exit from the European Union is more of a sure thing now than it was just a few short weeks ago, after voters in that country's general election overwhelmingly put their support behind the U.K.'s new Prime Minister, Boris Johnson.
It was a volatile week that followed Johnson's victory: The Pound Sterling moved higher in the run up to the election and peaked as results became known, before pulling back when Johnson then announced he would introduce legislation that would bar the U.K. from extending trade negotiations beyond the end of next year. Similarly, stocks in the FTSE 100 rallied significantly during the two trading days following the election, before giving back some gains and settling into a holding pattern.
Although the “Boris bounce" was short-lived, having a government which can finally make decisive decisions about Brexit, is a good thing for capital markets.
For markets, uncertainty is worse than bad news
In short, the outcome of Britain's general election is a good thing because it removed a considerable amount of uncertainty from the market. Uncertainty about the U.K.'s exit from the European Union has consistently weighed on investors' expectations since the referendum was first held back in June 2016.
In addition to Brexit, the two main parties in Britain were focused on very different fiscal plans. A Labour Party win would've increased overall spending in 2023-2024 from 37.8% to 43.2% of GDP. The Conservative's plan also focused on providing stimulus, but to a much lesser degree. (The difference between the two parties' planned expenditures was £80-billion per annum or 3.5% of GDP, not including the additional £32-million in annual spending planned for the Labour party's investment budget.) The Conservatives instead campaigned on the promise of certainty that the government would “get Brexit done" if elected.
A win for Jeremy Corbyn's Labour Party, on the other hand, would've been challenging for a number of reasons: The party's planned expenditures would likely result in an increase in government debt and corporate taxes. Corbyn's plans to nationalize select infrastructure companies and the promise that he would hold another referendum on Brexit were also deeply unpopular, particularly in business circles.
Tactically overweight U.K. stocks
That said, we believed share prices in the U.K. already reflected the potential for a negative electoral outcome. With that in mind, we introduced a modest overweight tactical allocation to British stocks in early December. We did this because we think the underperforming FTSE 100 was being partially held back by poor sentiment stemming from the upcoming election and ongoing uncertainty regarding Brexit. We believe the country was and is undervalued. The best possible outcome for this position was the election of a majority Conservative government that would help settle Brexit.
The near-term outlook for British equities is positive
To be sure, Boris Johnson's government has a great deal of work ahead before it can complete Brexit trade negotiations and effect a smooth transition. Still, we continue to believe there is further upside for British stocks over the next 12-18 months.
Going forward, we think any continued uncertainty will have a bigger impact on currency volatility than on equities. We've already witnessed some of this in action. It is also worth noting that the British economy hasn't deteriorated as quickly or as sharply as some expected. Real growth has slowed with the general slowdown in the global economy, but hasn't crashed in the way some economists predicted.
Although Johnson's plans to force the resolution of Brexit negotiations by the end of 2020 spooked markets mere days after the Prime Minister took office, we believe the move is likely a negotiating tactic to force the European Union to come to the table earlier. It does create uncertainty and near-term currency volatility, but it doesn't change our view on British stocks. We expect to see positive stock performance because a lot of uncertainty about the future has, for the most part, been quelled.
Ever since Brexit was announced in 2016, many institutional investors have maintained an underweight position in British equities. With this shift in fortunes, we expect many to begin unwinding their structural underweight positions—an effort which can take a few quarters. We expect this will be a positive thing for British equities as well.
More support could be on its way
Going forward we also expect the country's economy will be supported to some extent by additional healthcare and infrastructure spending by the new Conservative government. There is also still a bit of wiggle room for central bankers to provide monetary policy support.
Markets expect future interest rate cuts will support the economy—they're already reflected in the price of shares today—but we will be watching the Bank of England very closely. In particular, Bank of England governor, Mark Carney will be leaving the Bank at the end of January. It remains to be seen whether his replacement will lower rates further in an effort to ease some Brexit risks. This presents some downside risk for the Pound in 2020. Along with our expectation that volatility will remain high, it is one of the factors we've considered in maintaining a neutral position for the Pound Sterling.
Overall, it is our view that U.K. stocks are undervalued compared to their global peers. The country's stocks are well positioned to benefit from an upturn in economic growth.
For more information about U.K. equities, how they fit in your portfolio or your investments in general, please contact your MD Advisor*.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.