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Article 50: M&G view

Steven Andrew, M&G Multi-asset Manager, provides his outlook for the UK economy ahead of Article 50 being triggered:

“The negotiations around the withdrawal of the UK from the European Union have the potential to be the most significant structural change to the UK’s economy in a generation. Then again, the economic impact might be so small, we may not even notice. The degree of clarity around these issues is very likely to stay murky for some years yet, so rushing to judgement either way – from an investor’s perspective – is not a good idea.

“Going into the UK’s EU Referendum last June, there were great prognostications of doom. The data shows that that simply has not happened and not much has changed economically since the vote to leave. We have had a labour market that has continued to grow, the unemployment rate is close to 40 year lows, while average earnings growth of households actually accelerated in the second half of the year. Therefore at this stage, there really is not any tangible evidence that there has been a meaningful response from the underlying economy.”

Political risk cannot be ignored – but its importance should not be overstated

“Historically there have been many political movements which have had a lasting impression on markets over the long term. Events such as the fall of the Berlin Wall and the establishment of the Euro as a single currency represented substantial shifts in the underlying regime driving economies and markets. Politics is crucial and it is durable. It is very important and will never go away. However that does not mean that the market should be ebbing and flowing and listening to every utterance, whether it is going to be a hard or a soft Brexit, and what the probabilities of those things are going forward. It is more important to get into the underlying value of these assets and see what is truly driving things.

“The market likes to have its attention pulled here and there, and the past 12 months has been a good example of political noise muddying the water. When evaluating political risk, investors need to focus on two things: does this change the underlying value of my investment? Then crucially, how much can I try and deeply understand about this more than the market can? As interesting and important as many of these topics are, investors need to be careful that they are not straying into the grounds of forecasting asset prices or what is happening in politics because we simply do not know.”

Upside risks as markets remain pessimistic on fundamentals

“When evaluating asset prices investors need to assess what the market currently believes and what the risks are, and where the potential surprises could come from. If we know one thing about the future, it’s that it’ll be surprising in some way. However, when we look at how the UK and European markets are currently priced, current market expectations are still anchored in a pretty bleak place from a fundamental perspective, so we see more upside risk than downside.

“Equity markets have recently delivered strong returns (again showing that even if you forecast events correctly, the price response may be something else entirely) but unlike the US and other parts of the world this has not been the result of a re-rating.

“Profits have grown faster than prices, meaning that many sectors have actually got “cheaper” while going up. The extent of this will be driven by the rebound in commodity prices and Sterling declines, but the table below shows that even for the more domestically focused FTSE All Share the trend is relatively broad-based.”

“There are a lot of metrics that investors can use to evaluate the strength of underlying economies, but wage growth data will be key for demonstrating future growth in the UK and Eurozone. If wages start to grow faster, the Central Banks have already told us they will come in and raise interest rates. That will be a bit of a jolt to people’s expectations. Everyone is expecting slow and steady and the market has not really priced for an upside there. This is the key point of vulnerability from a policy perspective and should be a good indicator as to where interest rates are going.”

“It is hard to believe that anybody knows how Brexit negotiations will resolve themselves, or how the world will look when they finally do. Rather than construct our own ‘outlook’ to compete in the game of forecasts, the more useful observation from an investor’s standpoint is to identify the scope for surprise. Both economic forecasts and asset prices imply a more gloomy view about the UK than was initially the case even immediately after the vote, despite a factual improvement in fundamentals. This should be encouraging for investors; when markets suggest more weight is being given to forecast than facts it often means the scope for surprise is higher than normal.

“However, the impact of Brexit will be very real. Suggesting the environment will resemble the facts as they stand today is just as much of a “forecast” as a pessimistic view on these impacts. Investors need to assess the sentiment of markets and whether, given the range of possible outcomes, asset pricing suggests such a degree of pessimism that they will be well rewarded if outcomes are less bad than expected, or even positive. In our view there are signs of this pessimism, but it is not extreme. We need to expect that attention on Brexit will wax and wane in the coming years and be prepared to respond as it does rather than getting caught up in the noise.”