InvestmentUpdate

29 December 2020

Brexit deal brings some clarity, but not without costs A free trade agreement with the EU avoids damaging tariffs, but other barriers remain

In summary companies less sensitive to Brexit practices. That’s important because − After nearly five years of sharing our and UK economic growth. medicinal and pharmaceutical goods are Brexit analysis with you, we finally the third largest category of UK exports, have some clarity. The UK will Non-tariff barriers to trade with the second largest trade surplus leave the (EU) The trade deal avoids the imposition of among categories of goods. However, with a free trade agreement (FTA) tariffs. This is good news. In the short- other sectors are not so fortunate. The in goods once the transition period run the imposition of tariffs would add agricultural sector faces many new ends on 31st December. an additional level of disruption and checks, such as vet certification, leaving − With the backing of the Labour would likely further delay productivity- British farmers facing more barriers whip, it is highly likely to pass the enhancing business investment as firms than New Zealand’s. Non-tariff barriers UK’s parliament. Approval from EU adapt to the new regime. Our favoured to exporting electric cars get a six-year member states was provided from economic research teams, such as those reprieve, but other consumer products the EU ambassadors on 28 at Citi, Oxford Economics or Capital will face significant red tape right away. December and we don’t expect any Economics, concluded that “No Deal” The UK has said that it won’t impose subsequent objections before the would have seen 0.5-2.0 percentage the new customs regime on imports official signing on 30 December. points less GDP growth by the end of from the EU until at least 1 July 2021, to − Policy uncertainty, in and of itself, is 2022 relative to what it might be under the trade deal. allow firms to acclimatise. The EU has negative for economic growth, and said that it will impose full checks from in this sense any news is positive. Over the long-term, however, non-tariff day one, which may mean that the UK’s But even an FTA imparts barriers (NTBs) are likely to exert by far exports to the EU are disrupted by more significant short-term economic the greater cost and, broadly speaking, than its imports from the EU. costs (and most likely long-term the trade deal doesn’t negate these, too), and it’s unfortunately still an despite what Mr Johnson tried to claim Of course, it has been known for some item in a list of reasons why the UK in his press conference. The Bank of time that NTBs are going up. As has the may emerge from the COVID- England expected around 80% of the near unanimous verdict of economists recession as an economic laggard. total reduction in trade as a result of “no (a rarity!) that the effects will be − Moreover, the fog of uncertainty is deal” to be attributed to NTBs. Others negative for UK growth. As investors we yet to disperse over the UK’s estimated upwards of 90%. The Cabinet focus on what risks may not already be outsized services trade. Talks are Office recently estimated the cost to UK compensated for by today’s prices. scheduled to begin in 2021 on companies of filling out customs The successful resolution to the trade several important ‘mini-deals’ declarations alone, for example, could talks makes us more hopeful that we covering, for example, cross-border come to £7bn. Various non-tariff will see use of trade facilitation financial services, the transfer of barriers affect trade in services too, to measures to cut down some – though by data between the UK and the EU, which tariffs wouldn’t have applied. no means all – of the burden of NTBs. or the portability of accreditation in That’s concerning because for several other professional services. decades UK growth has been founded The deal references a set of − Our analysis suggests that UK- upon its comparative advantage in arrangements whereby firms that focused equities and the pound are financial and business services. demonstrate consistent quality already priced for a particularly assurance on customs matters can be adverse scenario. Valuation gaps Few sectors escape NTBs such as checks designated “Authorised Economic with comparable assets overseas at customs on compliance with rules of Operators” who benefit from the fast- may begin to close, but not entirely, origin, labelling laws, and so on. An tracking of consignments and fewer as there are a number of non-Brexit annex on medicinal products sets out an physical and documentary factors at work. Broadly speaking, agreement on mutual recognition of examinations. It sets out clear we continue to favour global inspections and manufacturing

InvetmentUpdate: Brexit deal

procedures in a five page technical test. UK and EU financial institutions trading partners to make up trade appendix, and this is a good sign. currently follow the same rules, rules foregone with EU over the next decade. that tend to be decided by supranational Geopolitical dynamics have changed bodies such as the G20’s Financial since the referendum, and trade deals Risks to trade in services remain Stability Board or the Basel Committee, with both the US and China are The trade resolution also makes us and the most zealous aspects of recent arguably mutually exclusive now. The more hopeful about crucial negotiations have been proposed UK-China relationship was also on cross-border financial services, by the UK not the EU (e.g. the ring damaged by the decision to ban digital and data transfer rights between fencing of retail banking from Huawei’s kit from the UK’s 5G network. the UK and the EU, or the portability of investment banking, the bank levy, and accreditation to conduct accounting the ban on inducements). Investment and public policy services due to take place in 2021. It is Broadly speaking, the costs of Brexit can encouraging to see that the deal The UK’s pre-eminent financial services be broken down into three: (i) short- contains an agreement to permit industry is about far more than London term disruption; (ii) productivity and lawyers to provide cross-border as a convenient gateway into the EU. It capital losses as changes shake services. British politicians have pointed is the agglomeration of three centuries themselves out in the market; (iii) long- to the framework that the deal provides of global financial activity, supported by run costs associated with being a more for establishing mutual recognition of world-leading professional services in closed economy. professional qualifications. But the EU’s accountancy and law, safeguarded by deal with Canada also contained such a the British legal system and made The links between trade and framework and yet no recognition accessible by the English language and a productivity - via competition, market negotiations have been successful. convenient time zone. The economic size, specialization, cross-border benefits to locating here will not be investment and technological transfer - In short, risk and uncertainty remain. erased if the UK breaks ties with the EU, are well known, and we won’t repeat The UK runs a large trade deficit in and the sector is highly unlikely to them. The drag on productivity from goods that is paid for mostly by its large collapse. However, if the UK failed to Brexit could be eclipsed by a publicly trade surplus in services, which is negotiate a substantial agreement on backed wave of digitalisation, green almost entirely in financial and other continued access, it is difficult not to energy infrastructure (increasingly professional and technical services. envisage a gradual loss of financial important for competitiveness as we business and investment, particularly move into a world where carbon border The UK will leave the EU’s passporting given that legal and regulatory experts taxes are likely), as well as initiatives to regime that permits financial have been emphatic since before the raise productivity outside of the South institutions in one EU country to referendum that the EU intends to East. Overall public investment has operate in any other member state clamp down on the extra-territorial been lower than in other leading without any extra authorisation. The UK provision of financial services. economies in recent years, and has already legislated for a temporary investment in digital infrastructure still passporting regime that allows EU firms Some financial service chiefs have lags investment in transport, energy and to continue to operate in the UK while warned that even with equivalence, utilities, which in turn lags the best- the process of obtaining full some business will have to move. performing advanced countries. authorisation is worked out. The EU has Passporting lasted for as long as you not reciprocated, and UK firms have were in the EU, but equivalence can be Public investment and support for transferred their EU clients to EU withdrawn at a moment’s notice. private business investment has been subsidiaries to minimise the disruption. There’s form here. In 2019, Switzerland noticeably absent in UK fiscal policy Thankfully, a series of special had its market’s equivalence during the pandemic, in contrast with arrangements has minimised any risks withdrawn. the EU’s Recovery Fund, for example. to financial stability for the foreseeable But it was pleasing to hear it featuring future, according to the latest Non-EU trade deals: blue, yonder so prominently at the recent assessment in the Bank of England’s As an EU member the UK had 40 trade Conservative Party conference. Financial Stability Report. deals; 29 have been replicated, but they Moreover, November’s Spending cover less than 10% of UK trade. A new Review maintained ambitious plans for Next year, the EU will assess whether or deal was signed with Japan, but the public net investment, greatly not to grant UK firms “equivalence” government expects it to add a mere increasing from £42 billion in 2019 to status – a de facto, albeit impermanent 0.07% to GDP over the long run. an average of £73 billion in the years financial passport. There is a nominal 31 Distance matters in trade, and academic between 2023 and 2026, targeting March deadline, but this is not set in trade research is clear that the UK is digital and transport infrastructure and stone. We think the UK should pass the likely just too far away from other regional “levelling-up” (see our

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InvetmentUpdate: Brexit deal

InvestmentUpdate for more In short, with the second lowest debt Indeed, the UK is on track to have one information). burden among the G7 economies, of the worst outcomes this year out of structurally low interest rates and its the 42 developed and developing The continued uncertainty around trade own currency, UK public finances are countries that we monitor. One reason facilitation, and the portability of data, sustainable. Indeed, more money can be for this is the UK has suffered the financial services and professional borrowed to invest in projects that will fourth-worst health outcome (behind accreditations will likely continue to grow the future tax base. Discretionary only Belgium, Spain and Italy). That hold back business investment. As will fiscal spending in the Eurozone will raises the relative risk of more stringent the need to divert resources to remain significantly expansionary in restrictions, which could last into 2021. navigating and complying with the new 2021. The US is likely to follow suit. Using our bottom-up model of the UK regime. Between the referendum and Despite higher debt burdens, economy, we estimate that November’s the beginning of this year, UK business government borrowing costs in these national lockdown, and December’s Tier investment did not grow, compared to regions have stayed extremely low. We 4 restrictions will leave UK GDP 13% average growth of 10% in the other G7 are relieved that the UK Chancellor has below the pre-COVID high water mark. economies. shelved plans to prematurely withdraw In contrast Germany will be around support. Of course, this needs to occur 5.5% below and the US 3.5%. Academic research concludes that the at some stage, but getting the timing vote to leave has also cost billions of wrong could leave lasting scars. The UK has a larger consumer services pounds in lost foreign direct investment sector than most other countries, and (FDI), which is particularly important We expect monetary policy to support therefore is more sensitive to COVID for the long-run productivity gains on the economy should growth start to restrictions. Similarly, out of 22 which business profits depend. Despite falter. Even if Brexit were to constrain advanced economies it ranks third for its underrepresentation in the UK stock supply more than demand, we believe the proportion of its GDP produced in market, software technology is an that the disinflationary legacy of the its cities. Key sectors were already ailing important sector for FDI, often COVID-crisis (in other words a before the pandemic, and there’s accounting for the greatest number of protracted period of precautionary evidence to suggest the UK may have a FDI projects in a calendar year. saving) will keep inflation in check in greater share of so-called “zombie” Business services is often the second 2021. For more explanation, please see companies (unprofitable enterprises most important sector on this basis. our recent update on inflation and the propped up by extremely cheap Future inward investment is therefore policy response to COVID here. financing). The private sector is more also contingent on the result of those indebted than many countries too, negotiations slated for 2021. In another recent update we explained which increases fragility and limits the why we expect negative interest rates to bounce-back. To be clear, we do not expect FDI to be used only as a last resort. We have collapse without them. There are many questioned Bank of England Governor UK firms’ employment intentions are reasons why international companies Andrew Bailey and his colleagues at notably weaker than average according invest in the UK that have little to do roundtables and conferences, and the to international surveys. And a Europe- with unfettered access to the EU’s single Bank is still not confident that they are wide survey of unemployment market. But it is imperative that a feasible, effective or appropriate. It is expectations shows UK households are concerted public policy effort is made to certainly not ruling them out and has more fearful, which correlates with a ensure that the UK remains an asked financial firms to report on their lower propensity to spend. While attractive place to invest for the long ability to accommodate them surveys of other countries’ business term, and that a decade of stagnant operationally. But we would expect the investment intentions improved in the productivity and low rates of firm Bank to further expand its quantitative third quarter, in the UK they remain formation are put behind it. Although easing ( purchase) programmes stuck at the lowest level since the survey these are global problems, they appear a and targeted financing of bank lending began in 1997 – substantially worse little more chronic in the UK compared in the first instance should the economy than during the financial crisis even. to some of its peers. need it. The trade deal should help employment and investment bounce back, but we Fiscal and monetary policy Will the UK emerge a laggard? still expect the UK economy to Government debt is frequently Unfortunately the potential disruption underperform many peers. misunderstood, even by some from NTBs adds to an already long list economists. As we explained in our of reasons why the UK may lag other To be clear, our pessimism about the recent InvestmentUpdate, we are not major economies as the world emerges UK economy over the next year or so is concerned about this year’s from the COVID recession. purely an analytical judgement. In no extraordinary increase. way do we presume to judge whether

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InvetmentUpdate: Brexit deal

Brexit is right or wrong for the UK in ones, such as the IMF’s external balance before it started its protracted period of terms of its many juridical, social and framework, or our preferred proprietary underperformance relative to the rest of political facets. framework, which looks at relative the world. However, in time overseas prices, relative productivity and relative investors returning to UK assets could The weight of a pound savings. The latter suggests that the more than offset this mechanical effect. Although the pound has rallied pound has been trading around a value substantially against the dollar this consistent with an almost unthinkably There are other non-Brexit reasons why year, it has done little since the Brexit dire long-run scenario. we expect the valuation gap to remain deal was announced. On a trade- wide for the time being. Historically the weighted basis, the pound is still 10% UK has offered a high – and high- below where it was on the eve of 2016’s quality – dividend yield, but as we have referendum. UK equity implications questioned for some time (and has been A basket of UK-listed companies that proven this year), that is less the case We expect the pound to continue to derive over 70% of their sales from the today. The UK also has outsized appreciate, but both global and local UK has underperformed the main UK exposure to financial companies and oil cyclical factors may still hold it back equity benchmark (FTSE 100) by 15% and gas, whose profits are held back by over the next year. Ordinarily, the since the vote to leave. While they have bigger structural forces. The exposure to pound is a highly cyclical currency performed in line with each other so far resource extraction may have driven versus the dollar or the euro – it falls in 2020, the successful conclusion of the some underperformance as investors when global investor sentiment falls trade talks removes some major formally build environmental, social more broadly. That’s mainly because the challenges to UK growth and therefore and governance (ESG) factors into their dollar accounts for c.60% of reserve improves the prospects of this basket. selection processes. This year, a greater assets, the euro c.22.5% and the pound weighting in sectors badly affected by just 5%. It’s therefore not a major safe But the FTSE 100 itself has the pandemic compared with Europe haven, and it is also tied to a lot of underperformed the MSCI World equity and the US has further detracted from financial activity that moves with the benchmark over the last five years. This relative performance too. business cycle. The pound could be held year it ranks 22nd out of the 25 down if severe COVID restrictions developed market indices we monitor. A global antidote to UK gloom unnerve global investor sentiment over Since the vote to leave, the gap between Of course, companies listed in the UK the winter. valuation multiples, such as price-to- earn between 70-80% of their collective book value, in the UK and overseas has earnings overseas. There are many for Thinking locally, if negotiations go widened to a degree not seen since the which Brexit is ‘more bark than bite’ poorly next year, a loss of service sector 1970s, when the UK had to ask the IMF and offer good long-term investment access may require the pound to remain for a bailout. Surveys of institutional opportunities. We are becoming more cheap to facilitate a reallocation of investors have suggested global fund optimistic about global activity, while resources to the less competitive managers have been avoiding British acknowledging short-term cyclical risks manufacturing sector. The many non- companies. We expect some of this still to navigate this winter. The Brexit reasons why the UK is a laggard valuation gap will start to close, but by approval of COVID vaccines has in the COVID recovery could also hold no means all of it. changed the risk-reward profile of back the pound. equities in 2021 too. Given everything A rising pound is a mechanical we have discussed in this note, we On a range of long-term valuations headwind for the multinational believe a global mindset is needed to frameworks – the only time horizon for companies that dominate the FTSE 100. participate in this recovery, and UK which we believe currency forecasts can Revenues earned overseas in foreign domestic names could continue to lag. be made with any assuredness – the currencies are worth less when pound appears undervalued against translated back into sterling (all other For more of our latest analysis, please most major currencies. That’s the case if things being equal). Indeed, the FTSE see our Brexit hub. we look at simple frameworks, such as 100 initially rose on news of the vote to purchasing-power parity, very complex leave because of the fall in the pound,

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