UK outperformance despite Covid and Brexit

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So far this year, global stock markets have fallen. The MSCI ACWI All Country Index is down 5.91% since the start of the year on February 18. International markets outside the United States are also down, but to a lesser extent. The international MSCI ACWI ex US index is down 1.87% since the start of the year. In Europe, the Eurozone MSCI EMU Index is also down, down 4.36% year-to-date. Now is the time to look for markets that continue to capture investors’ attention, with economies emerging strongly from the late-2021 downturn. This note focuses on one such economy and market, the UK. The MSCI UK index is up 3.27% since the start of the year. Over the past 12 months ending Feb. 18, this index is up 15.61%, about three times the 5.45% gain over the past 12 months for the MSCI ACWI Index for all countries. The latest available data on the UK economy is strongly positive, with one exception – intensifying cost pressures. Just-released UK PMI flash data for February indicates the private sector is accelerating at the fastest pace since June 2021, following the disruption caused by the fast-spreading Omicron variant of Covid towards the end of the year. It is impressive that private sector output has increased for 12 consecutive months. The services sector rebounded to an eight-month high with a strong recovery in consumer spending on travel, leisure and entertainment. Keep in mind that services account for over 81% of the UK economy’s output, as measured by GDP. While the flash PMI for manufacturing remained at the January level, this masked growth in manufacturing output which was the strongest since last July, an increase in new incoming orders and strong business optimism. Production has now returned to its pre-Covid level. This recovery follows one of the largest production declines among advanced economies, of more than 9% in 2020.

The negative news on inflation in the PMI report calls for caution. Input prices are rising at the second fastest rate since the index began in 1998. The CPI averaged 4.9% in the fourth quarter of 2021. A peak CPI rate of around 7.5 % should be reached in April, then moderate slowly. For the year 2022, the average CPI could approach 6%. The deterioration of the situation in Ukraine could well add to inflationary pressures. This cost outlook suggests that consumers will face lower real incomes. Another headwind will likely come from a more aggressive monetary policy, with rising interest rates, as the Bank of England seeks to counter high inflation. Fiscal policy should also tighten.

Despite these concerns, UK businesses are optimistic, as noted by the PMI report. Their investment intentions appear to be becoming more robust, partly reflecting a solid financial situation for most, including significant excess cash and a tax incentive to use that cash for capital spending. We were among those who feared that the UK’s exit from the European Union and its single market (Brexit) would harm the UK economy and have a negative effect on business investment. It is still too early to quantify all the effects of Brexit and dissociate them from the effects of the pandemic. Indeed, trade relations between the UK and the EU remain on hold and difficult negotiations continue. We remain convinced that the uncertainty surrounding the long run-up to Brexit and the continued uncertainty due to many important unresolved issues have already had a negative effect on investment, while increasing costs and reducing GDP. The fact that Brexit has not been in the news lately may suggest to some that it is of less and less concern. However, the costs for businesses are obvious. We will continue to monitor developments in the Brexit negotiations and the implications for our UK positions in our international and global equity ETF portfolios.

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Sources: Financial Times, Oxford Economics, Goldman Sachs Research, HIS Markit, ETF.com

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