United Kingdom stocks are underperforming the Eurozone markets as the nation faces the double challenges of an upsurge in virus infections and time running out in the deadlocked negotiations with the EU on Brexit.
Over the past three months through September 24, the iShares MSCI United Kingdom ETF, EWU, lost 5.0% on a total return basis and is down 25.3% year-to-date, whereas the corresponding returns for iShares MSCI Eurozone ETF, EZU, are a slight gain of 0.5% the past three months and a loss of 5.37% YTD.
The United Kingdom has nearly 400,000 confirmed COVID-19 cases, and officials have observed that the actual number is probably considerably higher. A definite second wave of new cases began in early August, with the number of cases now doubling every seven days. Prime Minister Boris Johnson has recognized that the country has “reached a perilous turning point.” New and tightened restrictions on social gatherings and pub and restaurant hours and extended mandatory face-covering requirements for England were announced on September 22. Scotland went further, to ban most household visits. A threatened broader lockdown is being avoided, but persons who can work from home are now encouraged to do so. That recommendation reverses the previous government encouragement for workers to get back to their workplaces. The objective is to check the growth in new infections while avoiding the negative economic effects that would result from a lockdown.
There surely will be a significant impact on hospitality businesses, tourism, and airlines, affecting employment and consumer and business attitudes. The government indicated that the restrictions are likely to remain in effect for the next six months and threatened stricter measures if the infection surge continues. The opposition Labour Party leader Keir Starmer agreed that the measures are needed in view of the spurt in new cases, but he underlined the failure of the government to meet the demands for coronavirus testing and tracking. The Johnson government has also been criticized for locking down the economy later in March than did many European governments.
The Brexit negotiations also suffered a reversal when the UK government published the Internal Market Bill on September 9. This bill would overwrite parts of the Withdrawal Agreement, which is an international treaty. Such a unilateral overwriting would clearly be a breach of international law, a fact that the UK government acknowledges. The bill gives to British ministers the unilateral power to determine if goods moving from Great Britain to Northern Ireland are at risk of going to the Irish Republic. Under the Internal Market Bill the UK government would also have the unilateral power to decide whether to inform the EU about state aid that affects firms operating in Northern Ireland. This provision would open the possibility of UK public subsidies undercutting EU firms, a strong EU concern.
This bill faces strong opposition within the UK, including within the Conservative Party and among all living former prime ministers, because the government is brazenly admitting a willingness to breach international law, and in a way that risks undermining the Good Friday peace process. In the US, Biden, the White House, and congressional leaders have all indicated they would not back a free trade agreement with the UK if the Northern Ireland peace process is threatened. The government has had to modify the bill so that ministers would have to get the approval of the House of Commons before using the powers in the bill to override the Withdrawal Agreement. This modification permitted a positive first vote on the bill in Parliament.
The EU has given the UK an end-of-September deadline to abandon the Internal Market Bill, or the EU will take legal action. Johnson rejected that threat and set a mid-October deadline for a Brexit agreement to be struck. That deadline coincides with the EU’s October 15–16 summit. It is possible that the bill is a tactical ploy to ratchet up pressure on the EU; but, if so, the risk of miscalculation appears to be high. The provisions relating to the Irish border and maintaining Irish peace are central to the Withdrawal Agreement. Aside from this complication, the Brexit negotiations are deadlocked on the state-aid rules that the EU wants the UK to follow and on access to British fishing waters.
It is possible that a last-minute trade deal will be reached, as both sides will suffer economically if the UK exits the EU at year-end without an agreement. UK exports to the EU would become less competitive as the EU would impose tariffs and quotas and customs delays at the boarder are likely to be onerous. Reports indicate some positive developments in the latest negotiations. While the risk of a no-deal Brexit remains significant, the latest more optimistic rumors are affecting market sentiment.
The financial sector is adjusting to the possibility of a no-deal Brexit. For example, JPMorgan Chase has told about 200 of its staff in London to move to continental European cities – Paris, Frankfort, Milan, and Madrid. The bank is also moving assets worth some 200 billion euros to Frankfort, a move that will make it one of the largest banks in Germany. This move will be welcomed by the EU, which is seeking to boost its own underdeveloped capital markets and reduce its reliance on London. The British revealing a willingness to breach international law will further weaken the EU’s readiness to offer financial market access (equivalence) to the UK after Britain exits the EU. The EU Commission intends shortly to announce its plans to bring closer together Europe’s disparate markets, and those plans include steps to unify supervisory standards across Europe.
The recovery in the UK economy is slowing as COVID restrictions continue to be a headwind. Also, the scope for catch-up growth is now limited, since most previously closed firms have reopened. The flash HIS Market Composite Index for September fell to a three-month low at 55.7, while still indicating a positive rate of expansion. Both manufacturing and services registered weaker rates of expansion. There were numerous reports of a lack of consumer confidence and reports of COVID-related supply chain disruptions.
Job cuts continue, and the announced ending of the job furlough scheme looks very likely to see unemployment rise sharply. The government is seeking to offset to some extent the end of the furlough scheme on October 31 with a more limited and less generous Job Support Scheme that will extend for six months as part of a “winter economic plan”.
The economic recovery may well continue to slow down in the next few months and even further should COVID cases continue to rise sharply and lockdowns need to be re-imposed. The outlook for 2021 is highly uncertain. It is dependent on the outcome of the Brexit negotiations and even more on whether and when there is a successful widespread dissemination of a COVID-19 vaccine. Even under optimistic assumptions, UK GDP is still likely to be beneath pre-virus levels at the beginning of 2022, as will be the case for most economies.
Neither of the ETFs mentioned in this note are held in Cumberland Advisors investment accounts nor in the investments of the author.
Sources: Financial Times, OECD, Oxford Economics, Barclays Research, The Economist, Bloomberg, IHA Markit, etc.com
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