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Article 50: What can we know?

The negotiations around the withdrawal of the UK from the European Union have the potential to be the most significant structural change to the UK’s economy in a generation.  Then again, the economic impact might be so small, we may not even notice.

The degree of clarity around these issues is very likely to stay murky for some years yet, so rushing to judgement either way – from an investor’s perspective – is not a good idea.

It feels uncomfortable to admit this. Many professional investors pay lip-service to the idea that forecasting most variables is almost impossible… before immediately outlining their current economic outlook. This is because it is embarrassing to say that you “don’t know” when: a) you are paid to make investment decisions and b) everyone seems to have such a strong view.

However, successful investing is not the same thing as predicting outcomes (other than in the ultimate return on asset price); it is about assessing the compensation being offered for the range of possible outcomes and judging whether this compensation seems appropriate.

So, how can we think about Article 50 and Brexit? Part 1: The Economy

We do know that the UK economy has been stronger than expected of late.

We also know that economists and market participants seem to be partially ignoring this. The below shows the median GDP forecast of economists and practitioners compiled by Bloomberg.  Having started 2016 forecasting growth in 2017 to be around 2% (the orange line), economists revised down their expectations to around 0.5% immediately after the Brexit vote.

Since then, the better than expected data have prompted an upward revision in expectations for 2017 to a more ‘normal’ level. When it comes to 2018 GDP however, expectations are actually lower than they were immediately after the vote.

It is reasonable to argue that, because Brexit will not be triggered for at least two years, it is appropriate to look through recent strong data. But this was not the view being put forward as many were sharply revising 2017 forecasts. Our preferred explanation is that economists are human beings, subject to the same biases as the rest of us.

So, how can we think about Article 50 and Brexit? Part 2: Gilts

Laughing at economists’ forecasts is a popular pastime but is only useful insofar as it prevents us falling into the same trap. For investment decisions, the above is only interesting if we can spot similar possible biases in asset prices.

And to some extent we can. Economic surprise indicators do not tell us about the absolute strength of the economy; recent positive surprises in the UK are simply a function of the very same depressed expectations that are illustrated in figure 2, but other data is meaningful in this regard. The chart below shows UK wage growth alongside core inflation.

At just 2.5%, average wages growth still seems somewhat below where the MPC would like to see it before making itself unpopular by lifting rates.  But the unemployment rate is close to 40 year lows and households’ earnings did spend the six months after the referendum vote accelerating.  With the uncertainties of the initial Brexit reaction fading, and core inflation having turned upward, the MPC could easily, and happily, justify raising rates in the near term once the all-important wages box has been ticked.

You may expect this uncertainty to be reflected in higher Gilt yields, but yields on two year gilts are below where they were immediately post-Brexit.

This dynamic has also been partially reflected at the long end of the curve of late, where UK long dated Gilts yields have fallen while US, Japanese, and German counterparts have been flat. The market does not believe the UK will be increasing rates any time soon and it is this assessment which has driven Gilt yields rather than factually strong recent data (or indeed that the possibility of a weaker Sterling associated with Brexit could prompt shorter term inflation).

So, how can we think about Article 50 and Brexit? Part 3: UK stocks

The deep skepticism about recent strength in data because of Brexit’s shadow is also evident in UK stocks. Equity markets have recently delivered strong returns (again showing that even if you forecast events correctly, the price response may be something else entirely) but unlike the US and other parts of the world this has not been the result of a re-rating.

Profits have grown faster than prices, meaning that many sectors have actually got “cheaper” while going up. The extent of this will be driven by the rebound in commodity prices and Sterling declines, but the table below shows that even for the more domestically focused FTSE All Share the trend is relatively broad-based.

Despite all the gloom about the prospects for the UK economy, listed UK corporates have recently delivered the strongest year on year profits growth since the recovery from the financial crisis in 2010. That many areas of the market have de-rated in the environment is not unusual in recoveries from earnings shocks but is also indicative of how views on Brexit impacts are being given more weight than the information we have at hand.

Conclusions

It is hard to believe that anybody knows how Brexit negotiations will resolve themselves, or how the world will look when they finally do. Rather than construct our own ‘outlook’ to compete in the game of forecasts, the more useful observation from an investor’s standpoint is to identify the scope for surprise.  Both economic forecasts and asset prices imply a more gloomy view about the UK than was initially the case even immediately after the vote, despite a factual improvement in fundamentals. This should be encouraging for investors; when markets suggest more weight is being given to forecast than facts it often means the scope for surprise is higher than normal.

However, the impact of Brexit will be very real. Suggesting the environment will resemble the facts as they stand today is just as much of a “forecast” as a pessimistic view on these impacts. Investors need to assess the sentiment of markets and whether, given the range of possible outcomes, asset pricing suggests such a degree of pessimism that they will be well rewarded if outcomes are less bad than expected, or even positive. In our view there are signs of this pessimism, but it is not extreme. We need to expect that attention on Brexit will wax and wane in the coming years and be prepared to respond as it does rather than getting caught up in the noise.