UK Prime Minister Boris Johnson has started negotiating an alternate withdrawal agreement with Europe, with little success thus far, as expected.
UK Prime Minister Boris Johnson has started negotiating an alternate withdrawal agreement with Europe, with little success thus far, as expected. The standoff between Parliament—with a majority opposed to a disorderly Brexit—and a government willing to accept this outcome is likely to further intensify.
The opposition and some Tories are discussing a vote of no confidence, which seems achievable by the numbers. However, they will need to agree on timing, a course of action after the vote (referendum or general elections), and the choice of who should lead the coalition. In contrast, Brexiters argue that there would still be enough time to make Brexit happen even in the event of a no-confidence vote, given the time it takes to prepare for a general election. All in all, while Parliament still has means to resist a no-deal scenario, odds for a hard Brexit have risen. While we might still be far from the end of the Brexit saga, the direction towards which forces are leaning might become more apparent when they reach the crossroads October 31.
In the meantime, uncertainty is steadily taking its toll on business confidence and capex, with strong implications for sectors and companies most exposed to domestic weakness or upheaval in foreign trade relationships. Main equity indices were resilient year-to-date thanks to the demise of the pound. However, there was a strong divergence in sector returns. Telecom, Banks, Utilities, Energy, Materials, and Real Estate underperformed. In contrast, Healthcare, Consumer Staples, Tech, and Industrials outperformed.
The fate of Brexit remains the dominant UK equities driver, tracked by the gap between stocks with the most exposure to the domestic market and those exposed to foreign markets and supported by a falling GBP. Yet, several signs suggest UK equities are making more room for stock picking.
First, unlike prior episodes of Brexit stress, stock as well as sector pairwise correlations remain low, pointing to a wider set of market drivers.
Second, quantitative factors focused on UK stocks remain reasonably decorrelated from Brexit trends. Moreover, they showed limited volatility. While confirming that Brexit is not the sole driver, this also provides opportunities for relative stock pickers.
Third, we observe more fundamental pricing across UK equities. When isolating the share of stock returns that can be explained by markets, the portion derived from sector or company specific trends has risen steadily this year. This stands in contrast with prior phases of Brexit stress when stock moves were largely driven by broad markets.
Fourth, an alternate way to assess fundamental pricing is to focus on the earnings season, measuring how prices respond to changes in company fundamentals. We find that the relationship tightened in the majority of cases, reflecting a greater focus on micro developments.
Fifth, Base Metals, Energy and Financials, largely dependent on foreign markets and therefore sensitive to Brexit, account for nearly half of the FTSE 100 weightings. Greater sector and business diversity exists among mid and small caps, where UK stock pickers tend to operate.
Sixth, UK stocks have become increasingly cheap and under-owned after months of outflows. Importantly, we find that Brexit risk is reasonably factored, as reflected by the tight correlation between Domestic vs Foreign focused companies to GBP (a reliable proxy for Brexit). More BoE easing, fiscal expansion, and high dividend yield would also mitigate the market impact were a no-deal scenario to become a reality.
Last, UK focused managers remain cautious with limited directional exposure. Moreover, the pairwise correlation of the returns from our basket of UK focused L/S Equity strategies declined this year while dispersion soared. This is a sign that the opportunities and themes exploited are diverging.
While Brexit remains an obvious hurdle for UK stock pickers, a widening set of drivers, greater focus on micro developments and cheap valuation might soon make the strategy attractive again.