Britannia No Longer Rules for Investors

In Britain, a round of disappointing data and an inconclusive election have stoked investors’ concerns about the country and its divorce from the European Union.

The U.K. is fast becoming one of global investors’ least favorite places to put money.

This past week, domestically focused shares sold off after British retailers posted their slowest sales growth in almost four months for May. Meanwhile, data showed that accelerating inflation and slow wage growth are eroding spending power for the economy’s all-important consumer.

The FTSE 250 index of midsize British companies fell 2.1% Thursday, its worst day this year amid pressure from retailers. Though the index recovered Friday, fund managers said the stumble was a warning shot.

“I think U.K. equities are going to have a tough time over the next few years, specifically the retail side,” said Seema Shah, global investment strategist at Principal Global Investors, a manager of $620 billion in assets.

Meanwhile, money flowed out of U.K. funds for the eighth week in a row, figures from fund tracker EPFR Global showed Friday, with a net redemption of $563 million. A survey by Bank of America Merrill Lynch published earlier in the week showed that the U.K. remains the least popular market for European investors.

On Monday, the U.K. will begin negotiations to exit from the EU, a process many investors believe will be bad for its economy and which may have been complicated by Prime Minister Theresa May’s loss of her parliamentary majority in this month’s election.

To be sure, many economists predicted a recession in 2016 if Britons voted to leave the EU, and this hasn’t happened. Economic growth has since accelerated and business investment has remained resilient.

But the economy’s reliance on consumers spending almost all their earnings long predates Brexit and isn’t diminishing. Consumer spending is responsible for 65% of the U.K. economy against an average of 55% over the EU, according to the Organization for Economic Cooperation and Development. And British consumers are sitting on large debts, raising further questions about their continued ability to power the economy.

During the fourth quarter of last year, U.K. households saved only 3.3% of their income, the lowest proportion since official records started in 1963. And household debt compared to income, while still below where it was in 2008 before the financial crisis, is predicted to grow faster over the next five years than previously expected by the Office for Budget Responsibility, the U.K.’s independent fiscal watchdog.

That is hurting stocks reliant on the British consumer.  Measured in U.S. dollars, the FTSE Local U.K. index, which tracks U.K.-exposed shares, has fallen 14% since the Brexit referendum in June last year.

On Friday, sterling was trading at around $1.28, down 15% since the Brexit vote. This has made things worse for consumers, because higher import costs push up prices.

In May, inflation rose 2.7% from a year earlier, above the Bank of England’s 2% target, meaning workers’ purchasing power actually fell 0.6% in the three months to April.

“It’s hard to see the trend in retail sales improving soon,” said Samuel Tombs, economist at Pantheon Macroeconomics. “Retailers have not finished yet passing on higher import prices to consumers, wage growth looks set to remain depressed and banks are reporting that they intend to restrict the supply of unsecured credit.”

Because this kind of inflation isn’t driven by stronger growth or a tighter labor market, all these concerns could boost the market for British government debt, or gilts. Yields on 10-year gilts have fallen in recent months, after hitting a peak of 1.5% in January.

On Thursday, three out of the Bank of England’s eight rates setters voted to increase interest rates, surprising investors who expected a less hawkish stance. But yields edged up only a little and closed the week at 1.017%. Investors typically sell bonds when they believe there is a chance rates will rise. Bond yields move opposite to prices.

Jim Leaviss, a fund manager at M&G Investments, which manages £265 billion ($338 billion) in assets, said he believes investors have been buying gilts precisely because they have been anticipating U.K. consumers’ woes and the brake that would place on rate rises.

“You see it priced in because nobody expects the Bank of England to rase rates in the foreseeable future,” Mr. Leaviss said.

Jon Sindreu

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