Between vast, fiscal support packages to tackle the Covid dilemma, and playing Brexit chicken with the Withdrawal Agreement stand-off, the actions of the UK Government present investors with both a plethora of macroeconomic risks and corresponding opportunities.
Speaking to the Investment Observer, RBC Wealth Management‘s Head of Investment Strategy, Frédérique Carrier, tells us about the challenges Brexit and Covid pose, and how the erratic and audacious conduct of the UK Government creates some highly foreseeable openings.
Boris Brexit brinkmanship and hopes of an FTA
On Brexit brinkmanship and the potential of reneging on the Withdrawal Agreement (WA), Ms Carrier said that the Internal Market Bill would effectively negate much of the WA, with two main digressions being on state aid and the Northern Ireland issue.
On the former, the UK Government has now decided it wants an unhindered ability to dole out subsidies to companies and industries, something that would have been constrained under the terms of the current WA. On the latter, ignoring the Northern Ireland protocol would mean ditching the Good Friday Agreement, which prevents a hard border with the rest of Ireland.
This second issue is the area of greatest contention, with former Prime Ministers fearing that the UK would join the likes of Russia, in the ranks of countries with a reputation for ignoring international law (which, at present, seems pretty fitting, given our love for accommodating Russian hijinks). Further, and more concerning from the perspective of investors, is that US politicians, Nancy Pelosi and Joe Biden, have both said they would be unlikely to approve a US-UK free trade agreement (FTA) if the Good Friday Agreement is breached.
This is a major thorn in the UK’s side. With the alternative US FTA being a big bargaining chip to show the EU that we aren’t desperate, and the alternative to a US Deomcrat-led deal being the one likely to be offered by the Republicans, which, putting the NHS on the table, would rightly be political suicide for the Prime Minister daring enough to play that hand.
According to Ms Carrier, however, there is still a chance of there being at least a rudimentary FTA (covering goods) with the EU. Indeed, the EU would prefer there being one and the UK authorities should, if possible, avoid additional economic shocks, given present weaknesses courtesy of the Covid situation.
Ms Carrier stated that: “While a rudimentary FTA is still possible in theory, we continue to assign a probability of just over 50 percent to the UK leaving the EU without a significant economic arrangement on December 31. Time is quickly running out, and the prospect of a no-deal Brexit seems to inspire less fear in the EU than it did in the past, given the bloc’s recent creation of its ambitious fiscal stimulus package.”
Covid costs for the economy and public purse
Also, while the UK might have somewhat bounced back from its 22% year-on-year Q2 contraction, the likelihood of further restrictions down the road has led RBC Capital Markets to stand by its prediction of a nine percent contraction in the UK economy during 2020 – with this fall being far steeper than that anticipated for the economies of the UK’s US and Canadian cousins, expected to slide by 3.5% and 6% respectively.
Similarly, in light of the recent but more sparing fiscal support packages, Ms Carrier says that the Bank of England is now on high alert. Between ‘less generous’ emergency Government support, additional restrictions taking effect and the prospect of a No-Deal Brexit, she expects that the UK economy is likely to require additional support in the coming months.
To this end, the bank has already reiterated that negative interest rates are on the table, and are now examining how they might be brought into effect most impactfully. Between now and then – and seemingly, in perpetuity – it is highly likely the central bank will focus on quantitative easing, and corresponding gilts, with the potential for interest rates to be cut to zero percent thereafter.
What do investment strategists suggest?
Speaking on the RBC Wealth Management view on the ongoing macroeconomic and political madness, Ms Carrier said on UK Government bonds:
“For now, with a 6- to 12-month view, we would be Underweight UK sovereign debt. We expect gilt yields to grind higher over time as the effects of much higher government spending and accommodative monetary policy play out. Sterling investment-grade corporate credit provides relatively more compelling valuations, though we would be very selective given the double challenge of the pandemic and Brexit.”
Then, on the battered and bruised sterling, she added that further retreats could be likely if the currency’s optimistic pricing in of the current situation doesn’t materialise:
“The prospect of negative rates, the recent resurgence of COVID-19 infections, and news of the government’s intention to negate the Withdrawal Agreement led the pound to retrace some of its recent gains against the U.S. dollar and the euro, falling five percent against the former so far in September. We believe trade negotiation headlines will be the most prominent driver of sterling in coming weeks. With risks asymmetric to the downside, we have a cautious outlook for the currency. The pound’s buoyancy so far this year suggests it is pricing in a 60 percent likelihood of a trade deal being signed, so it would likely retreat should this not materialise.”
And finally, on stocks and the UK markets, she rather inevitably predicts more hard times are to come:
“As for equities, valuations are undoubtedly attractive, with the FTSE All-Share Index close to where it stood following the 2016 Brexit referendum. But with the COVID-19 crisis far from being under control and a hard Brexit possible, we continue to believe there are better opportunities elsewhere and maintain our Underweight recommendation. We would focus on UK companies that are well positioned to benefit from long-term structural growth tailwinds or that have internal levers to grow, rather than on those whose prospects are tied to the macroeconomic environment.”