Getting ready for a no-deal Brexit

We continue to prefer US over EU/UK equities on superior economic fundamentals and the breadth of companies that ride secular growth trends.
Chief Investment Office02 Sep 2019
Photo credit: AFP Photo

What happened?

Suspension of UK Parliament. With just a few weeks left till the UK leaves the European Union (EU), the newly-elected UK prime minister Boris Johnson has added an unexpected and controversial move to the Brexit saga – to suspend parliament.

The Brexit referendum has already claimed the tenures of two prime ministers. Pressure on Boris Johnson is mounting as 31 October, which marks both Brexit as well as the day Jean-Claude Juncker and Mario Draghi relinquish their roles as Presidents of the European Commission and the European Central Bank respectively, draws closer.The suspension will start on September 11 and the Parliament will be reopened on October 14 by a Queen’s speech, marking the longest suspension since 1945. Ironically, there are only two weeks standing in between the reopening and the last day to strike a deal.Up to now, UK corporate earnings have been helped two main factors: a weakening GBP and overseas income. The top-13 listed entities derive some 70% of their revenues from outside of UK/EU.

To date, UK corporate earnings have been supported by two main factors: a weakening GBP and increasing overseas income. The top-13 listed entities derive some 70% of their revenue from beyond the UK and EU.

At the going rate, a no-deal Brexit seems to be the default outcome – the EU and its 27 members have remained adamant about the UK leaving the trade bloc since the Referendum began in 2016. This could prove crippling to corporate earnings, household income, and the domestic economy which is already skirting near recession. A mismanaged situation could well see shortages in food, medical, and gasoline supplies; disruptions to seaports, airports, as well as cross border trades; and more importantly, further deteriorations to the already fragile pound.

What does this mean?

As detailed in CIO Insights 3Q19 and an earlier CIO Perspectives, we have been cautious on the UK situation since the start of the year.

We believe there will be further downside to the UK and EU:

  1. The prolonged feet-dragging of Brexit and the closing in of the 31 October deadline will further depress economic growth (Figure 3).
  2. UK prime minister Boris Johnson should think twice if he hopes domestic consumption will step in and rescue the situation (Figure 4).
  3. UK equities have vastly underperformed their US counterpart since Brexit began (Figure 5).
  4. Faced with trade tensions which are fast closing in on its exports and plagued with intensifying domestic issues, Eurozone overall is not looking good. In Italy, the formation of a new coalition between the opposing 5-Star Movement and Democratic Party may not offer the best solution, let alone the run-away budget deficit and high government debt holding stubbornly at 132% to its gross domestic product (Figure 6).

What should you do?

We have been constructive on US equities while staying cautious on the EU and UK since 3Q18. We further reiterated our stance at the start of 2019. Despite the huge gap of under-performance that has resulted in valuations that are at a steep discount to the US, we stay Underweight on EU/UK equities.

The much-anticipated potential reduction in the European Central Bank’s deposit facility announcement rate (now at -0.4%) is unlikely to help much in spurring the region’s growth. In addition, unlike the US market, we do not see the same breadth of companies that can ride the global secular growth trends of cloud computing and e-Commerce in the EU and UK.

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