Deciphering the UK’s mixed signals

Alan Custis

Alan Custis

The recent flurry of high-profile profit warnings has added to the mixed signals emanating from the UK as investors attempt to discern whether cracks in the domestic economy are starting to show and what this might spell for UK equities.

A burst of earnings misses—which has included Provident Financial, WPP, Dixons Carphone, GKN, ConvaTec and Merlin Entertainments—has understandably drawn interest and heightened concerns about a deterioration of the UK economy amid the ongoing Brexit uncertainty. 

Understanding whether these negative surprises were idiosyncratic in nature or a manifestation of an overarching theme—such as slowing economic growth and a weaker UK consumer—is important to determine the course UK companies might plot in the months ahead.

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To cite the profit warnings as a harbinger for further disappointment for UK investors is, in our view, too simplistic as these companies are very different businesses with varied revenue streams and drivers. In addition, UK economic indicators remain mixed, further complicating the picture as trends in consumer spending and business investment have diverged. 

The UK’s economic growth has been patchy since the start of the year, which has meant that sectors and companies closely tied to its economic prospects have been exposed to a number of opposing factors, underscoring the importance of active stock selection. 

The direction of UK government bond prices suggests investors are expecting inflation to push higher, while UK equities, which have lagged global markets, appear to reflect concerns over slowing growth. 

This embodies the policy dilemma faced by the Bank of England (BoE). If it moves too aggressively when raising rates, it risks choking off economic growth, too softly and inflation could overshoot materially to the upside. 

Although many economists now expect a rate hike in the coming months—some believe this could occur as soon as November this year—we would argue that the BoE may find it difficult to justify raising rates amid the uncertainty over Brexit.

For more internationally exposed companies, we would point to the continued positive momentum in emerging markets as a supportive factor, while the commodities and mining sector could also offer a potential tailwind.

The oil and gas sector is influenced less by the UK interest rate cycle and developments around Brexit compared to other sectors, and is closely tied to global economic prospects where there are positive signs. The Organisation for Economic Co-operation and Development projects that the global economy will grow by 3.5 per cent this year and 3.7 per cent in 2018, with the upturn synchronised across most major economies.

The oil and gas industry has been through a pivotal period of self-help and adjustments. This could see the sector reduce debt organically and return to a healthy dividend cover as free cash flows have started to improve. 

Major oil companies are regaining competitiveness owing to the adjustments made, even during periods of prolonged oil price weakness. Global demand/supply dynamics have also been supportive for the sector.