The UK and EU finally managed to agree on a trade deal. As had become habitual in this game of brinkmanship, the agreement came close to the deadline, meaning there was a mad rush to ratify it before the end of the year.
The ability to negotiate a deal was one of the key risk factors for the final quarter of 2020, so the fact that it has been resolved should be viewed as a positive for risk assets. That said, the fairly muted reaction from the GBP – the broad trade-weighted index initially bounced but has failed to break to new highs – suggests that the market was broadly positioned for a deal.
UK equity markets are higher but, globally, equity performance has also been driven by the signing into law of the US stimulus package, making it hard to determine a specific Brexit effect. This muted market reaction may be in part due to the time of the year, with trading possibly limited to market participants neutralising existing positions rather than initiating fresh ones, but it may also be that its financial impact is unclear.
A deal is better than no deal, but there are some material costs that exporting businesses will now be forced to bear in the form of proving compliance with EU regulations. Perhaps the biggest issue with the deal is the lack of any clarity around access for financial services providers to the EU single market. Equivalence has not been granted – which is odd from a practical standpoint given the UK is currently fully aligned – but will be looked at by March 2021. Most of the large banks and asset managers should have made provisions to run operations out of the EU, limiting the disruption, but it is still likely to add to costs and this may ultimately prove prohibitive for smaller financial companies.
From that perspective, while the deal and the rising tide of equities should support investment grade credit, limiting exposure to financials may be wise. In this context, an all maturity index such as the Bloomberg Barclays Sterling Corporate Bond Index, where financials constitute around a third of the index, is better positioned than shorter options such as the Bloomberg Barclays 0-5 Year Sterling Corporate Bond Index, which is closer to 50%. There will be some risks around this, given its longer duration (8.7 years versus 2.5 years) although the longer index provides compensation in the form of a higher running yield (an additional 55bp) and a more attractive spread to gilts (+25bp).
In the government bond space, gilts have not moved very far. Again, this could be indicative of positioning at this time of year or the fact that a deal was already largely in the price. Overall, it is hard to view recent developments as positive for gilts for a few reasons:
Even though a post-Christmas/New Year surge in infections looks likely, markets have so far shown their ability to look through near-term issues and focus on the better economic backdrop that may persist for most of 2021. The State Street Global Advisors forecast for UK growth is an impressive 7.9% for 2021. While this may prove a little over-optimistic given the lockdown now in place, it appears unlikely that the BoE will cut rates into negative territory with growth running at its fastest pace since the 1980s. Yet the money markets continue to price an eventual cut (the SONIA forwards price around a 50% probability of a 25bp cut by end Q1 2022). The market is likely to gradually price out the probability of a cut, which creates a bearish backdrop for gilts.
To some degree yields may be held down by the BoE’s ongoing programme of purchases. The MPC agreed a further £150 billion of gilt purchases at the November meeting but this has been insufficient to stem the rise in yields with the 2-30Y curve slope around 35bp steeper than it was in May.
So for gilt investors, limiting duration risk looks appropriate. To put it in context, the yield to worst on the Bloomberg Barclays UK Gilt 1-5 Index is -10bp while on the Bloomberg Barclays Sterling Gilt Index it is 35bp. This 45bp yield differential would appear to favour the all gilts index but there is a substantial difference in duration with the shorter index at 2.9 years while the longer one is 13.3 years. This difference in the price sensitivity of the index to moves in yields suggests that a yield shift in the curve of as little as 5bp would wipe out the carry advantages from the longer index.
Institutional investors are heavily underweight in UK equities, with this being the most unloved developed market since the Brexit referendum in 2016. Take away the uncertainty and potential disruption, as the Brexit deal has done, and the region looks interesting as a value and recovery play.
Compared with other developed markets (i.e. the MSCI World Index), UK equities (i.e. the FTSE All-Share Index) appear cheap on common measures of earnings, EBITDA and book value; for example, the prospective P/E for UK equities is 15.1x versus 20.8x for MSCI World, a discount of more than 25%.
Over the last few years, an important source of income for the UK economy, namely oil and gas companies operating in the North Sea and worldwide, has suffered from low oil prices. This damage may now be assuaged, with mobility expected to improve as COVID-19 vaccines are rolled out.
Nevertheless, much larger weights in the UK stock market are now found in consumer staples (including leading global food and beverage brands) and financials (operations for banks and financial services companies will need to evolve, as mentioned above, but the shares seem extremely cheap and financial conditions are sound).
In terms of accessing the market, the FTSE All-Share offers comprehensive, diversified exposure across UK businesses, earning just over 50% of their revenue overseas, according to FTSE Russell. This index of small, mid and large cap companies outperformed FTSE 100 last year and consistently over the long term (since the inception of FTSE 100 in 1984, FTSE All-Share has outperformed by 0.8% p.a.). Given the smaller size component, this relative outperformance could continue following long-term trends and has less reliance on the direction of sterling for exporters than the FTSE 100 index.
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