Rules of engagement (Archived)

Is the UK likely to become more isolated in 2017 and what will this mean for its economic growth? The renegotiation of its trading relationship with the rest of Europe will be a central focus for the year ahead, with uncertainty likely to continue. Here, UK equity manager Christopher Metcalfe discusses what may be in store, highlighting areas of concern and the sectors that may hold opportunities.

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UK dividends remain attractive and may even see a surge of investor interest in the coming year as greater certainty surrounding Brexit emerges and continued sterling weakness boosts UK company dividends. Some of the biggest dividend payers in the UK are overseas currency earners, which is also helpful for investors.

We believe we are still in a deflationary environment and do not expect this to change in the medium term. As a result, we think equity income is likely to remain attractive with c3.7% yield on the FTSE All-Share Index looking attractive when compared to UK Gilt yields.

We remain cautious on UK growth for the year ahead but much will depend on how Brexit is implemented – which way will it go? It could come down to the default World Trade Organisation trade rules or a Canadian-style relationship, whereby the UK would receive preferential access to the EU single market and most trade tariffs could be eliminated.

Greater clarity may come in 2017 if Prime Minister Theresa May is able to keep to her proposed schedule for triggering Article 50 – legal challenges not withstanding. However, even once the accession has begun it will likely take more than two years for any trade relationship with Europe to be negotiated.

The Peterson Institute for International Economics (PIIE) released a study of how long the US took to agree 20 bilateral trade deals: the average negotiation period was 1.5 years, and 3.5 years to get to the implementation stage. At the more conservative end of the spectrum, it has taken Canada seven years (so far) to strike its agreement with the EU, according to the World Economic Forum.

In the meantime, how will UK-domiciled companies respond? We think it is too early to see if companies will enter into their own trading negotiations with other countries. That said, the global nature of many UK-listed firms should stand them in good stead, irrespective of the UK’s ongoing relationship with Europe.

Growing global debt

The growing global debt burden is another cause for concern – particularly the speed of debt accumulation in China. A possible consequence  of the latter for the UK is the impact on the mining and banking sectors. The luxury goods sector could also suffer if the Chinese consumer becomes more sensitive to increasing debt levels.

The UK financial services sector is also under pressure, which we do not see alleviating anytime soon. Post-Brexit there are huge uncertainties concerning the 'passporting' of products and services, an EU practice that has enabled London to become a leading financial centre.

However, we would temper the doomsayers on this point: financial services are a key UK offering and we question if companies are really going to relocate. Irrespective of our membership in the EU, London remains a highly skilled area for financial services, with the breadth of language skills, real estate and infrastructure to support it, few cities can compete.

Do other European cities even have the space such companies need? Are the banks really willing to soak up the costs involved in such a relocation when they have increasing regulatory requirements for robust capital ratios?

On the other hand, there are the positive effects Brexit may have on the manufacturing sector. Sterling has depreciated significantly against a basket of world currencies since the June 2016 vote and some companies have seen the benefits of this – both from a translation point of view and a transaction one.

Manufacturers could see a 10-15% earnings upgrade in the coming months simply as a result of the currency effect making their goods more competitive.

Yes, large ticket items such as cars have seen a drop off in sales in recent months. However, retail, particularly online, has remained strong.

UK equity income investors could also see the upside of ongoing sterling weakness. Some 40% of UK dividends are declared in dollars, so a sharp, sustainable depreciation in sterling boosts dividend payments for UK investors. As a result, the Q2 Capita Dividend Monitor, updated for Brexit, expects underlying dividends in 2016 to be up 0.5% due to the exchange rate boost versus an expected decline of 1.7% pre-Brexit. It is the diversity of the UK market’s earnings and significant dollar exposure which caused the FTSE All-Share to reach record highs post the EU referendum.

With respect to dividend growth we believe it still looks stable and while it may slow as 2017 progresses, distributions still look robust.

Another benefit of lower sterling may be an increase in M&A activity. The £24bn bid for the UK’s ARM Holdings by Japanese company SoftBank boosted global M&A activity in the third quarter and marked the third largest deal in 2016 (as of September), according to Deologic.

There are other aspects to watch in the coming months. Job vacancies were falling in the autumn of 2016 but we will need to keep a close eye on such data as 2017 progresses. We expect capex to falter as the Brexit negotiations reverberate through the year.

As a result, we remain less than sanguine about UK retailers and instead think dollar earners and multi-national firms will maintain more stable revenue streams against this backdrop.

Fiscal spending

Fiscal spending is likely to grow in the year ahead with greater indications on how it will be allocated expected. Housing could benefit but we believe there may be more attractive ways to play the infrastructure story, such as cement companies or infrastructure consultants.

In this environment, we believe UK dividends will remain an attractive area for investors regardless of the political theatre that might surround Brexit. Investors may have to start looking through the short-term noise to 2020 before we see any clear impact – positive or negative.

What to watch in 2017

  • UK interest rates and fiscal spending plans.
  • Scottish independence again?
  • Sterling fluctuations and the impact on consumer spending.

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