The United Kingdom and European Union have been engaged in months of detailed negotiations on the separation of the United Kingdom from the EU. The EU insists on agreeing to terms before discussing future trading relationships — an important issue for both sides. For obvious economic reasons, the United Kingdom has been concerned about a cliff-edge “hard” Brexit. This refers to the potential consequences of the United Kingdom exiting the EU without a formal withdrawal agreement on March 30, 2019.
In an effort to avoid this cliff-edge departure, the United Kingdom has agreed in principle to pay an exit bill covering ongoing obligations from its EU membership. In addition, it has agreed to abide by EU laws and regulations during a post-Brexit transition period, despite not having the right to vote on or influence these regulations.
In return, EU member leaders provisionally approved a transition period that provides additional time to clarify the terms of any future relationship, and for companies and households to plan accordingly. Some risk remains in the finalizing of this agreement, notably the future of the border dividing Ireland, an issue that is both unresolved and politically contentious.
The current state of the U.K. economy
Although many investors braced for a recession in the immediate aftermath of the Brexit vote, it did not materialize for a few reasons. First, the British pound sterling materially declined, making U.K. exports more competitive and the United Kingdom a more attractive tourist destination. Also, the Bank of England cut interest rates, providing significant liquidity to the economy through the banking system.
However, in terms of economic performance, we have witnessed a marked difference in the United Kingdom relative to the EU and the rest of the world. The U.K. economy has slowed compared with its pre-referendum growth rate, driven by a few trends. One is reduced household purchasing power, as wages have not kept pace with inflation brought on by the decline in sterling. Also, corporate and consumer confidence and investment have been impaired due to uncertainties surrounding Brexit.
Approaching U.K. equities with caution
The outlook for the U.K. economy remains challenged, in our view, both in absolute terms and relative to other regions. Central government debt remains high, limiting fiscal flexibility, and the Bank of England is likely to raise interest rates, given the inflationary pressure building in the economy. While aggregate figures remain resilient, evidence is emerging of distress in consumer-facing sectors. For example, we have witnessed some high-profile bankruptcies in the retail and leisure sectors.
Politics remains a key variable due to the slim majority of the Conservative Government, internal divisions within that party, and growing support for the left-wing Labour Party, with its policies of higher taxation and re-nationalization. We believe, from a longer-term perspective, value is emerging selectively across the U.K. equity universe. However, in our portfolios, we continue to maintain underweight exposure to the United Kingdom. Within our UK holdings, we favor high-quality exporters, which benefit from the depreciation of the pound.
