Britain’s exit from the European Union, passed by a June 2016 U.K. referendum, and formally begun in March 2017 by triggering the so-called article 50 of the Lisbon Treaty, is approaching the two-year deadline to define the new terms of a Britain/Europe relationship. While the lack of a deal could end Theresa May’s stint at Prime Minister, as well as cause significant disruptions to EU stocks, betting on a particular political result is not part of our investment strategy. Moreover, our global and international portfolio strategies select positions based on company-specific attributes which we expect to perform through a wide variety of economic and political outcomes.
Brexit includes not only trade but also defense collaboration, security, and border management conditions, including how to prevent a “hard border” between U.K.-controlled Northern Ireland and the Republic of Ireland, an EU member. Predictably, the intrigue surrounding this process and the lack of key agreements between these key economic centers adds volatility to the pound/euro/dollar exchange rate, as well as to the continent’s equities, which have already also been roiled quarter to date by U.S./China frictions and central bank tightening or prospective tightening moves. Although core points of the separation agreement have been approved by the EU side, gaining passage in the U.K. government appears to be a huge challenge. Prime Minister May is having to walk a tightrope trying to bring a largely adversarial parliament together with significant blocks of hardline Brexiteers and pro-EU members both expressing hostility towards the deal. The split accentuates regional differences with Wales, Scotland, and Northern Ireland overwhelmingly voting to stay in the EU in the 2016 referendum. Ironically, Prime Minister Theresa May, also the Conservative Party leader, will probably have to rely on Labour Party parliamentary support to gain passage. She also faces such severe criticism within her own party that a vote of “no-confidence” to unseat her has been floated by some Conservative MPs. Such is the frequent unpredictable and volatile nature of politics.
If the early December U.K. Parliament vote fails to pass the agreement, a new deal would need to be renegotiated, and/or a delayed exit negotiated which will require a new EU vote. Obviously, the markets would not look kindly on this lack of progress. Moreover, without passage the U.K. may leave the EU without any replacement agreement, meaning trade would revert to WTO terms. In this scenario, economists worry about harm to the U.K. economy, in particular. This includes reduced financial service access, slowed travel between the regions, and supply-chain disruptions resulting in inflationary pressures, and possibly even shortages of key products including industrial equipment and medicines. Moreover, in this scenario a U.K. recession seems highly likely, although the depth and duration remain uncertain. Some pessimistic estimates project a three-year recession for the U.K. While we believe some kind of deal is the most probable event given neither party will want to deal with the negative political fallout from a no-deal Brexit, the challenges remain significant, and a U.K. exit without new trade terms remains a significant risk.
Where does that leave us from an investment standpoint? First, we point out that while Brexit uncertainty has weakened U.K. growth, the economy has proven more resilient than the more pessimistic scenarios postulated after the referendum. We note historically low borrowing costs, solid household credit growth, low unemployment and rising employment since the referendum has continued to increased household spending. A weak pound has also improved the U.K.’s competitiveness in export markets. The economic diversity and labor flexibility of the U.K. suggests to us businesses and economic activity will continue in the U.K. regardless of the pathway taken regarding Brexit. Also, while the U.K. is important, the country represents just 5% of the MSCI All-Country World Index and 10% of this index excluding the U.S. Our allocation to the country in our Global portfolio strategy is lower than the benchmark and is near the 10% benchmark weight in our International portfolios. Importantly, most of these positions look very attractive from a valuation, yield, and long-term earnings growth perspective. Moreover, we invest based on company-specific investment attributes, not bets on political outcomes. We believe these companies can deliver solid earnings and pay attractive cash dividends in a variety of economic and political environments.