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Outlook brightens for UK PLC, but Brexit will bite soon

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By Jon Hay
13 Dec 2019

There are fundamental reasons for UK assets to be revalued upwards, analysts believe. The powerful majority achieved by Boris Johnson's Conservatives tilts the UK towards a Trump-like market-friendly, fiscally generous patch. But the reality of Brexit cannot be ignored for long.

"We have gone from a situation where all we can see is risks, to suddenly three or four of the five are positive, and you just have one risk to worry about," said Kallum Pickering, senior economist at Berenberg in London. "The hard Brexit risk is the single biggest risk to the UK economic outlook. It will probably weigh on hiring and business investment next year, even as the rest of the economy improves."

Pickering said analysing the UK outlook was about netting off positive and negative effects, but he is convinced the positive are dominant. Berenberg has lowered its forecast for the UK's long term trend growth from 2.1% to 1.7%, because Brexit is now virtually certain to go ahead. But it has raised its prediction for 2020 to 1.8%, and for 2021 to 2.1%.

That will be driven by catch-up growth as the economy overshoots in recovery, after a period of underperformance.

"The removal of no deal Brexit is only one part of the story when it comes to why the economy may improve," said Pickering. "I'm expecting Johnson to throw lots of money at the economy, Trump-style, which will lift medium term spending and demand. And the flip side is a decisive loss for Jeremy Corbyn: voters rejected his far left vision for the UK, which had panicked markets and for some people was as big a risk as Brexit. The risk that the UK could really go left seems to be contained."

Utilities are first in line to benefit, since Corbyn had pledged to nationalise the electricity, water and rail industries, as well as Royal Mail and parts of British Telecommunications.

Severn Trent, Centrica and SSE shares all rose more than 8% on Friday, while United Utilities and BT climbed more than 6%. They were outdone by many other consumer-focused businesses powered by the expected lift to UK growth. Three housebuilders, Taylor Wimpey, Barratt Developments and Berkeley Group, all rose 14%, while EasyJet climbed nearly 8%.

“It’s clear that the trade deal with the EU is going to be the focus at some stage, but for Q1 and Q2 we expect a rally,” said Philippe Bradshaw, head of European syndicate at NatWest Markets in Amsterdam. “We expect UK GDP to grow 1.3% next year and for sterling to improve further versus main currencies.”

Both Berenberg's and RBS's forecasts are above the analysts' consensus, but they are not high growth figures in absolute terms. 

"If we get into the second half of next year and the markets really start to worry about the risk of a hard Brexit, we would become much less optimistic, but the optimism and improved sentiment reflected in financial markets now will soon show up in business and consumer sentiment, and so in spending, helped by fiscal stimulus," Pickering said.

Johnson's big majority will give him political space to shape his government and implement his domestic agenda.

The election result, said Andrew Milligan, head of global strategy at Aberdeen Standard Investments in Edinburgh, "opens the door to the Conservative government becoming more One Nation, moving more towards the centre". 

Having won seats from Labour — and already referred in a speech to Labour voters having "lent" the Tories their votes — Johnson would be likely, Milligan argued, to want his government's first budget, planned for February or March, to include "rather more fiscal spending, especially aimed at some of those northern and western seats, in areas like health, education, infrastructure".

Early indications will come from whom Johnson picks for his Cabinet. Rumours are that Michael Gove might be put in charge of negotiations with Brussels. 

If Sajid Javid is reappointed chancellor of the exchequer, that might be a sign that the government intends to remain fiscally conservative — but as Milligan put it: "If you are the prime minister, with that size of majority, if you wish more people to be moved around, now is the time to do it. Or if it is the same people, they can be told: 'your KPIs are going to be A, B and C, understood?' If not, there will be a queue of willing volunteers waiting outside the door."

The tone of speeches from leading Conservative politicians in the coming weeks would be important, he said, for clues as to the government's domestic agenda and how confident it felt, but it would be the first Budget that would reveal the actual money behind the government's promises — an important moment for domestic-facing UK stocks.

But the present euphoria for UK credit and equities may soon come up against ugly reality, as after Brexit, expected to take place on January 31, the UK will have to move very quickly into tough negotiations with the EU over their future trading relationship. 

As the EU trade deal gets negotiated, “It will depend which Boris we see,” Bradshaw said.

The big question analysts foresee is how Johnson handles the trade negotiations, which he has promised to finish by the end of 2020. His large majority could free him from pressure from the far right of his party, enabling him to seek a closer relationship with Europe.

Equally, however, it might embolden him to play hard ball with the EU, which could again mean brinkmanship and threatening to leave the Transition Arrangement without a trade deal.

"Some degree of uncertainty is likely to persist over the next year, as the next phase of the negotiations kicks off, over both the content and also the timing," said Paul Hollingsworth, senior European economist and head of UK economics at BNP Paribas in London. "After all, Boris Johnson’s deal points to quite a hard version of Brexit, while he has ruled out an extension of the transition period."

He added: "There will be more certainty that he can deliver his chosen form of Brexit, but uncertainty about exactly what that will look like."

No one knows which way Johnson will go, or whether, having chosen a path, he will stick to it. He has given no clues to his intentions.

"Boris will say 'I've achieved our exit, now it's for others to sort out the detail'," said Milligan. "He's not a details man. 

"Not a single expert has said it will be possible to achieve a trade deal by the end of 2020," he added. "Does he bite the bullet straight away in the spring and say 'Well of course what we want is an even more comprehensive agreement than we've been talking about before, and that will take more time' [and ask the EU for an extension]?"

Alternatively, Johnson might go for a very unambitious trade deal, to make it as easy as possible to agree.

A crucial point will be the EU's deadline of July 1, after which the UK will no longer be able to seek an extension to its transitional trading arrangement. If that moment passes, the UK will then be in a six month countdown to leaving the Transition Arrangement at the end of 2020, even if it has not concluded any agreement to replace it. 

Some observers are sanguine that the Brexit angst of the past three years will become calmer now. 


"Once we get an orderly Brexit and it comes to UK-EU negotiations, I think the world will look greyer and more nuanced," said Pickering. 

A hard Brexit was still possible, he emphasised, but he added: "It seems unlikely, given that at the end of January the UK and EU would have achieved something very difficult over the last three years, that they would allow a technical hard Brexit without some kind of political fudge or half compromise."

With the Conservatives riding high politically, they ought to be able to get an extra year on the Transition Agreement, or strike a new temporary agreement as a bridge, or agree with the EU to implement on January 1, 2021, the parts of the trading relationship that they had agreed on, while continuing to work on the rest. A version of this technique was used for the EU-Canada trade deal.

Between obtaining a completed trade deal in one year and leaving with no deal on WTO terms, there was, Pickering said: "a huge grey area in between, where reality has to fit".

However, these very complex negotations will have to be filtered into public and market consciousness through a political class and media that will tend to dramatise them as a conflict, as well as exaggerating the potential benefits of a trade deal with the US, which would in reality be much slimmer than those from the EU relationship, and would conflict with them.

"The only thing I think we can say with certainty is that the final detail on the final sector is going to be agreed several years from now," said Milligan. "There will be very complicated discussions about a whole range of sectors, whether cross-border trade, data protection — a lot of issues are very complex. We have to assume we will still be discussing them right through the life of this government."

In the coming months and perhaps years, these talks are likely to lead to continual episodes of market disruption, with sterling, for example, remaining volatile. At present it looks set to bounce up and down in a $1.30 to $1.40 range.

But in the long term, optimists believe there will be a gradual rapprochement between the UK and Europe.

"I don't think what we would look to [at the end of the Brexit talks] is an endgame for all future relations between the UK and EU," said Pickering. "What comes at the end is a low water mark, a baseline from which to build a more comprehensive future relationship. The UK is the second largest economy in Europe, and if the demographic projections are right, it could be the largest by 2060. On foreign policy the UK matters a lot. The idea that the UK and EU could coordinate foreign policy through some very standard free trade agreement — I don't see how that can work. Eventually we will see the relationship develop more fully over time."


By Jon Hay
13 Dec 2019