The UK economy, the fifth largest in the world and second in Europe after Germany, advanced at an estimated 2.2% pace last year and is expected to register a similar gain in 2016. This compares with the Eurozone economy’s 1.5% increase last year, with only a 1.7% advance likely this year – and maybe less if the bank situation worsens. Yet the performance of the UK equity market was identical to that of the Eurozone over the past six months, with the main UK total market ETF, the iShares MSCI United Kingdom ETF, (N:EWU), down by 21.37% through February 9, compared with a decline of 21.12% for the iShares MSCI EMU ETF, (N:EZU). This note discusses some of the headwinds holding back UK equities despite relatively favorable economic conditions.
Solid Data
Purchasing Managers’ Index readings for January indicate a slight upturn in the pace of UK economic activity in January. Manufacturing output was at its highest since June 2014. This contrasts with today’s release on industrial production for December, a decline of 1.1% from November. Growth in the dominant services sector remains steady. The main driver of economic growth continues to be domestic demand. Consumer spending power is improving, with consumer price inflation close to zero and wages strengthening as labor markets tighten. The outlook for capital spending also remains positive, with firms continuing to have strong financial conditions. So far, exports have yet to gain from the depreciation of the British pound, down some 7% versus the US dollar over the past six months. Positive effects do seem likely going forward, although businesses continue to complain that the currency is still too strong.
Recently there have been indications of some weakening in both consumer confidence and business sentiment. The global sell-off in equity markets in the current quarter, the concerns about prospects for China and emerging markets, and the lowering of economic forecasts for Europe and most other countries must be affecting UK consumer and business sentiment. The uncertainty about the global outlook and the retreat from risk is one important factor depressing UK stocks. Bear in mind that that the international sales exposure for firms in the FTSE 100 is 78%, strongly suggesting that the global outlook is a dominant force in this market.
Another headwind for UK stocks has been continued earnings declines that have pushed the FTSE 100 down to the same level as in 1998 -- despite the relatively strong economy. The earnings weakness in the oil and gas plus basic resources sectors -- 17.3% of the FTSE 100 -- is likely to continue this year; and the outlooks for the banks (11.2%), insurance (6.2%) and other financial services (1.6%) also are problematic. An earnings catch-up this year looks unlikely.
Depressing Referendum
In considering how different factors affect the UK equity market, it is also important to bear in mind that non-UK investors own more than half of this market, which is the largest in Europe, almost twice the size of the German market. So the UK market is driven both by global developments and by the investment allocation decisions of international investors. The uncertainty created by British Prime Minister David Cameron’s commitment to holding a national referendum later this year or early next year on whether the UK should remain a part of the European Union (EU) is probably another factor currently depressing both UK equities and the currency. Investors do not like uncertainty, particularly when one of the possible outcomes -- UK departure from the EU, or “Brexit” -- could have profound effects that would not be clear for some time. The protracted period of uncertainty would affect the EU as well as the UK.
Cameron has been negotiating with the EU on a draft agreement, reached February 2, that seeks to redefine some aspects of the British relationship with the EU in order to strengthen domestic support for remaining in the EU. The agreement includes, most importantly, curbs on welfare for migrants and a brake keeping the UK from forming an “ever closer union” with the EU. There are also some safeguards for the city of London. A Brussels summit on Feb. 18–19 is expected to approve this agreement. The Brexit referendum now looks likely to be held on June 23.
Best Guess
We do not know how the nation will vote. Our base-case guess at this stage is that the UK will not, in the end, leave the EU, despite current polls giving a lead to the “out” camp. All mainstream parties are campaigning to stay in as are the main business and trade union organizations. The uncertainty leading up to the June vote will likely continue be a heavy weight on UK equities and the currency. Should the vote confirm our expectation that the UK will remain in the EU, both stocks and the currency would probably get a positive bounce in a relief rally, whereas a negative result would likely have the opposite effect: a steep and protracted decline. Some may see a trading opportunity in the period before the referendum. We, however, are hesitant, both because of the potential cost of our being wrong about the vote’s outcome and because of the other factors noted above that constitute headwinds for UK equities. We want to see an improvement in the outlook for the global economy and for the UK resources sector before adding to our currently small UK positions in our International and Global Portfolios.
Bill Witherell, Chief Global Economist.