UK update for Q4 2018

Hugh Gimber |06-Feb-2019

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Brexit news is dominating headlines and UK markets, making it challenging for investors to look past the country’s scheduled March 29 exit date from the European Union. Yet global forces will also play a big part in determining portfolio outcomes next year.

Our investment themes for 2019 — slowing global growth, the US Federal Reserve gradually tightening policy towards neutral, and the need for a barbell approach to risk-taking — all apply to UK investors, with a volatile political backdrop at home presenting further challenges.

Growth slowdown, but not
economic contraction

Global growth is set to slow in 2019, as the US economy enters into the latter stages of the cycle. We anticipate any slowdown in Chinese growth should be mild, with policymakers willing to use fiscal and monetary stimulus to prevent a hard landing. We see a low probability of the global economy entering a recession next year, yet rising fears of an economic downturn are a key risk for markets.

UK growth moderated gradually through 2018 from last year, supported by strength in consumer spending. Yet business investment has kept falling, not helped by the uncertain economic outlook. And the support the UK economy has received from strong external demand over the past couple of years may continue to wane in 2019, with economic growth of key trading partners around the globe set to cool.

Corporate earnings growth is also set to moderate globally, partly due to a higher hurdle versus 2018, when US corporate tax cuts provided a big boost to earnings across the Atlantic.

In the UK, analysts expect companies to increase earnings by 7% on average in 2019, Thomson Reuters data show. These are still robust levels but below both UK earnings in 2018 and expectations of most other major regions in 2019.

Rates en route to normal

We see the path for the US Fed as another key driver of global markets in the year ahead. As the central bank approaches neutral – the interest rate that neither stimulates nor restricts growth – we expect US policymakers to become more cautious and pause their pace of quarterly rate hikes. This should ease some of the pressure we have seen on global asset valuations.

In the UK, we believe the Bank of England (BoE) will remain on hold pending further clarity on Brexit. Assuming a no-deal scenario is avoided, we expect markets to price in further tightening, with one hike in 2019 and another in 2020 most likely at this stage, in our view.

Geopolitics will maintain their grip on markets next year, although we enter 2019 with many risks better reflected in asset prices than a year ago. Several country-specific emerging market (EM) concerns are receding, but we have grown more worried about Europe over the medium-term.

Crunch time looms for Brexit

The UK parliament remained deadlocked in mid-December, making the odds of Prime Minister Theresa May’s deal passing in its existing form very low. A change of path is likely necessary, but it is unclear which direction this might take. A second referendum may be required to break the deadlock, although May appears to be hoping fears of a new referendum or a disruptive no-deal scenario may be enough to win support for some amended version of her withdrawal deal closer to the final hour.

Many potential paths for UK politics require significant time to play out, likely compelling an extension of Article 50. We believe the European Council would only be open to an extension if it paves the way for a “soft Brexit” or an outright cancellation of Brexit. We still assign a low probability for a “no-deal” Brexit as we expect the UK parliament would ultimately vote against it, although the valuation of sterling appears to reflect significant fears of a disruptive exit. There is also a growing possibility that an election may be required in order to break the impasse in Parliament, a prospect which may also be depressing sterling.

Building resilience with the barbell

Growth should reassert itself as the key driver of financial asset returns in 2019, making a repeat of 2018’s unusual combination of negative returns across bonds and equities less likely. UK investors looking to balance risk and reward may consider a barbell approach: government bonds to add ballast, alongside high-conviction allocations to assets with the most compelling risk/return prospects, such as quality and EM equities.

Brexit negotiation brinkmanship is likely to keep UK assets volatile, and we see sterling serving as the main barometer of sentiment. Smooth passage to a transition period would allow the Bank of England to resume gradually raising rates, ultimately lifting the currency and pushing gilt yields higher. If the prospects of a Labour government were to rise, we expect upward pressure on longer-dated UK gilts given the prospect of looser fiscal policy. We could also see domestic earnings under pressure because of investor fears of potentially higher taxes.

We maintain a broad preference for companies with international earnings in UK equities. Yet we are starting to find more opportunities in domestically focused companies with robust business models that are potentially positioned to benefit from technological disruption. Strong fundamentals in this space have been overwhelmed by negative sentiment stemming from Brexit, we believe. Within credit, we are cautious on financials given their sensitivity to Brexit risks while clarity on the future relationship between the UK and the EU remains absent. In real estate markets, we take an up-in-quality stance, focusing on prime locations as we see these assets as more resilient during a period of elevated risks.

Hugh Gimber
Mulit-Asset Strategist, BlackRock Investment Institute

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