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UK stocks cheap regardless of Brexit outcome

Emma Wall  |  11 Dec 2018Text size  Decrease  Increase  |  
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The House of Commons was due to vote on the Brexit deal UK Prime Minister Theresa May had negotiated with European Union on Tuesday 11 December 11 at 7pm, but this has now been delayed.

The proposed deal leaves the UK in close allegiance with the EU until at least 2020, during which time the UK would no longer be a member of the Union but be subject to many of the rules and regulations. The transition period buys politicians time to negotiate a final deal and avoids a cliff-edge Brexit, but critics argue the UK would be surrendering control to the EU.

Media forecasts predicted the deal was unlikely to be passed in parliament whenever MPs get to vote on it, with both main political parties split on the best Brexit outcome.

But the UK is due to leave the European Union on Friday 29 March, 2019 – regardless of whether a deal has been struck with the remaining 27 member states. There are broadly five options on the table: four Brexit scenarios as modelled by the Bank of England earlier this month and a fifth option – to stay in the EU as a result of a second public referendum.

Forecasts vary widely

The Bank of England has mapped four likely scenarios for the outcome of Brexit:

  • a deal which leaves the UK in a close relationship with the European Union
  • a deal resulting in a less close relationship between the two
  • a no-deal Brexit with disruptive outcomes
  • and the fourth most damaging to the economy: a no-deal disorderly Brexit

We would add a fifth scenario to this modelling:

  • a second referendum resulting in a Remain vote. We assign a 30 per cent probability of a worst case, disorderly, no-deal Brexit

Opinion is divided as to which is the most likely of these scenarios. Bank of England Governor Mark Carney has stated that the worst-case scenario, a "no deal disorderly" Brexit is not the most likely outcome. This scenario forecasts the following outcomes:

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The best-case Bank of England scenario of a close-relationship "soft" Brexit also seems unlikely, due to the time constraints.

Bank of England U.K. GDP Forecast Under Varying Brexit Scenarios

While many Remainers both public and political are in favour of a "People's Vote", a second referendum may not be logistically feasible. It requires an act of parliament with the backing of the majority of MPs – a cross-party initiative which could result in further resignations leaving both main political parties weakened. Neither party wishes to do this with a general election in the offing.

The Electoral Commission also requires six months between announcing a referendum and the vote itself, taking us past the Brexit deadline of 29 March as triggered by Article 50. An extension to this deadline is possible but it requires approval by all 28 EU member states.

The odds currently imply a 40-50 per cent probability that an agreement not will be reached by the 29 March deadline – meaning there will either be a no-deal hard Brexit or an extension of Article 50 or a withdrawal of Article 50.

Morningstar assigns a 30 per cent probability of a disorderly exit from the EU without a deal, a conservative estimate given "no deal" is in no one's interest, including the EU and even the hardest Brexiteers.

No mass exodus from UK equities despite fears

Despite this uncertainty, and the headlines suggesting otherwise, there has been no mass exodus from UK equity funds, according to Morningstar Direct data. In the context of equity funds benefiting from net inflows of €177.5 billion from 1 June 2016 to the end of October 2018, UK equities experienced €16.7 billion net outflows, the lion's share of these from the UK Equity Income category.

Morningstar fund analyst Pete Brunt says that while the trend away from UK equities is clear, it is important to note that these figures have been exacerbated by fund specific issues on a small number of the biggest funds in the category that led to significant redemptions from a loss of investor confidence.

LF Woodford Equity Income, Invesco Income, Invesco High Income, Invesco Strategic Income, which all experienced dramatic and extended periods of underperformance from 2016, lost €24.8 billion over the period.

"Factoring these four funds out of the equation, the picture is less clear about the extent of the negative sentiment towards UK equities, with investors arguably being more opportunistic in their allocations," says Brunt.

"Looking at the UK Mid-Cap Equity and UK Small-Cap Equity categories, we see that while both experienced sizeable net outflows in 2016, they experienced net inflows in 2017 and 2018 to the end of October, resulting in net inflows for each category in aggregate over the entire period.

"Given that small and mid-caps typically exhibit a greater exposure to domestic revenues, it is fair to say that these categories give a good indication of sentiment towards the UK. This suggests that while investors took flight upon the initial fallout of the referendum, they were not afraid to subsequently increase exposure to the domestic economy."

Fund managers are taking positions reflecting their Brexit views, however – with some avoiding domestic focused stocks, and others exploiting the value opportunities created by the uncertainty.

Morningstar equity analysts expect smaller UK-centric firms that compose much of the FTSE 250 are likely to feel the brunt of a Brexit-triggered economic downturn. Among the larger stocks, banks, autos, supermarkets and aerospace stocks are most vulnerable.

Consumer stocks with a strong competitive advantage are most immune to a worst-case scenario Brexit – stocks such as Unilever, Nestle and Danone.

What should you do?

"Brexit is difficult to analyse because of the indirect and tenuous connections it has on investment fundamentals," says Morningstar Investment Management's Dan Kemp.

"We therefore believe that when investors depart from long-term, fundamentally sound investment analysis, they can drift dangerously into speculation. The first thing to acknowledge about the fundamentals is that the UK economy is not the UK equity market. We do not need to predict the UK economy to know what might happen to UK stocks. The UK is unloved, reasonably cheap, and fundamentally healthy."

Given that political circumstances are so difficult to predict, Kemp recommends putting them to one side and focusing on valuation instead. And remember, investment is not about what happens in the next few days, weeks or even months, but over the next years and decades.

However, volatility can be your friend by offering quality assets at cheaper prices than previously available. UK assets appear in the main to be undervalued, especially compared to other developed market equities. We find UK equities to be somewhere between 30 per cent to 45 per cent cheaper than the US market on a combination of valuation metrics.

Asset quality in the UK has a long history of durability, and Kemp says his team sees no evidence of change. He concludes: "Leverage is under control and below pre-crisis levels. Plus, it is one of the least crowded trades in the marketplace."

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