Theresa May has laid out her plans for a soft Brexit. Yet despite all the high-profile resignations and dramatic headlines, it’s just business as usual for investors, says John Stepek.
It’s been a busy week in politics. At the weekend, Theresa May dragged her cabinet off to Chequers in an attempt to get them all to back one single Brexit plan, which will form the starting point for the next stage of negotiations with the European Union (EU). For a brief moment it seemed she had managed to harness them all, Brexiteers and Remainers alike, into backing her approach. Then the resignations began. Brexit Secretary David Davis quit, along with his deputy, Steve Baker. Foreign Secretary Boris Johnson then decided he had to go too. In short, the planned Brexit is not “hard” enough for them.
This should not come as a huge surprise. The prime minister’s decision to hold a snap general election in 2017 might have seemed a good idea at the time, but a catastrophic campaign left her with an even weaker position in the House of Commons than before.
As William Hague puts it in The Daily Telegraph, even if May was keen on the idea of a more confrontational, “take it or leave it” approach, the “Commons as currently constituted does not support the harder forms of Brexit”. Instead, a broad outline of the Chequers plan (the White Paper on the topic had not yet been issued at the time of writing) suggests that the starting point for a deal is roughly as follows, according to Pantheon Macroeconomics.
Firstly, the UK will follow the EU’s single market rules for goods. Britain would – Norway-style – technically be able to block any new EU rules that it didn’t like, but the potential consequences (the imposition of a “hard” Irish border) would more than likely prevent this. Equally, if Britain wants to trade with the EU then it would have to follow the rules anyway, so this isn’t necessarily a disaster. Secondly, goods from non-EU countries that enter the UK on their way to the EU will have EU tariffs imposed on them. The UK would be free to set a lower tariff if these goods end up remaining in Britain. Finally, the UK would end freedom of movement, but also develop a “mobility framework” to allow EU citizens to live and work in the UK, and vice versa. In short, things remain – in the near term at least – fairly similar to the way they are now.
So what happens now?
The headlines were immediately filled with talk of mass rebellion and the 1922 Committee (which oversees the election of Conservative party leaders). But in reality, this seems unlikely. This is the world of politics, of course, which is even less rational than that of financial markets. So anything could happen. But from a practical point of view, however frustrated some members of the party may feel, as Matthew Partridge points out, the Conservatives still have the same basic problem that has plagued them all through this process – if not May, then who? A radical Brexiteer such as Jacob Rees-Mogg would divide the party; a Remain-leaning candidate such as Ruth Davidson would do the same. So if they do force a leadership election, then they are almost certain to end up with another compromise candidate, who would be faced with exactly the same set of problems. In the meantime, none of this messing around would endear them to the electorate, which is a huge risk – Jeremy Corbyn’s popularity may appear to have peaked for now, but he also looked like a surefire loser ahead of last year’s election, and we know what happened then.
And of course, another leadership election would mean no progress on discussions with the EU, which in turn would increase the odds of no deal at all.
One contingent of the party and the electorate would be happy with that, but it’s a small one. So while a challenge is not out of the question by any means (never underestimate a politician’s ego), given the number of serious drawbacks, it seems unlikely. The fact that the pound initially slid after Johnson’s resignation, but then rallied, suggests that markets have tentatively decided the same thing – there is not much alternative to May, for now.
A bigger risk lies with the EU itself. May has clearly spent a lot of political capital to get this deal this far. She’s been drinking in the last-chance saloon for a long time, but the bell for last orders rang a long time ago, and they’re starting to stack the bar stools and sweep up the sawdust around her. If the EU stonewalls on this deal – one that even the most ardent Brexit-haters in the media are describing as a genuine effort at compromise – then it’s hard to see what she can do. Outright rejection would not only make her position untenable, but it would also probably give her an excuse that she might secretly welcome to resign her position with her pride intact. So, again, while you can’t control for ego and mishaps, this outcome seems unlikely. German Chancellor Angela Merkel has been positive in a lukewarm way, while the EU’s chief negotiator Michel Barnier noted that “after 12 months… we have agreed on 80% of the negotiations”, reports The Guardian.
A market-friendly outcome
None of this is to say that discussions won’t fall apart at a later stage, or that the government won’t face another, more serious crisis. But in short, although it’s messy, it’s also still business as usual. As we’ve said here at MoneyWeek for a long time (both before and after the Brexit vote), the most likely outcome of a vote to leave the EU was always going to be something along the lines of what is now described as a “soft” Brexit – one that maintains our trade links with the EU while making it very clear that we’ve stepped off the “ever-closer union” train (which, incidentally, should then make it a lot easier for those EU nations that truly desire ever-closer union to pursue this path without us getting in the way).
This is also the most market-friendly of all the possible outcomes. It results in the least upheaval and it’s pretty clear from the movement of the pound that for now markets like the idea of a “softer” Brexit and worry more about a “harder” one. That’s because one option involves a lot more interim uncertainty than the other. Indeed, Anatole Kaletsky of Gavekal goes as far as to say that “the time to start buying cheap British assets may have come”, given that “what is now almost certain is that Britain will not leave the EU in some kind of disorderly crisis without any kind of agreement on a new relationship”. He reckons that now would be a good time to go “long” the pound.
How cheap are British assets?
Given how despised the UK is by global fund managers at the moment (according to Bank of America Merrill Lynch, global managers spent most of the start of this year extremely “underweight” UK equities and that is only starting to change now), it’s easy to imagine that the market must be dirt cheap. That’s not the case. As John Kingham notes on his UK Value Investor website, on a Cape basis), the FTSE 100 index of British large-caps is trading at roughly its long-term average level. In other words, it’s not cheap, but relative to other markets it’s reasonable value, and it’s also offering a pretty attractive dividend yield of more than 3.5%. It’s a slightly different story for the mid-cap FTSE 250. It has hugely outperformed the FTSE 100 since the financial crisis. Historically, says Kingham, it’s traded on a higher average Cape than the FTSE 100 (20 versus 16) and today it looks “slightly expensive”, on a Cape of around 24. In short, the UK isn’t at “screaming bargain” levels, but then almost nothing in global markets is right now.
Given the broader risks to the world – such as a trade war, a China slowdown, or just a general wilting under the pressure of tighter monetary policy – we would recommend having a higher-than-average level of cash sitting in your investment portfolio. However, we also suspect that now might be a good time to consider rebalancing your portfolio in order to top up your investments in the UK. Things could get worse (see the paragraph below), but equally we seem to be edging towards clarity on Brexit, and that will make UK assets appear more attractive.
You could simply buy a cheap UK tracker fund. Alternatively, a contrarian option is Alastair Mundy’s Temple Bar (LSE: TMPL) investment trust, which aims to buy “out-of-favour stocks which have been over-sold”. Partly as a result of Brexit “the portfolio has certainly taken on a more UK-centric feel in the last 12 months”. UK-listed stocks account for about 80% of the portfolio, with around 54% invested in FTSE 100 firms, and about a fifth of the portfolio in total invested in the UK banking sector. The trust trades on a discount to net asset value of around 6% and offers a dividend yield of more than 3%.
Stay diversified in case of surprises
There are, as we have mentioned, risks to this outcome, and it would be wise to plan for those contingencies. One scenario is that May is replaced as party leader by a hard Brexiteer. Another is that the EU and the UK reach a point where they can’t agree and any sort of deal is called off. Yet another is that we end up with another general election, and this time Corbyn wins.
The good news is that in all of those cases, the initial market impact is fairly similar – a weaker pound, partly because of rising political uncertainty and partly because fears over growth would probably result in the Bank of England raising interest rates more slowly (if at all). Clearly, the longer-term impact would depend on a number of variables, but we can plan for those if and when the situation arises. For now, you don’t have to take much action – while you may want to boost your allocation to cheap UK stocks somewhat, you should certainly hang on to your overseas investments, and also hang on to your gold (it’s denominated in US dollars, but more importantly, it’s also good to have in a financial emergency). In other words, maintain a healthily diversified portfolio. Like we said, business as usual.