European equities
04 Dec 2018 | By Dan Nickols

Fundamentals intact

Putting Brexit to one side, the prevailing market backdrop suggests UK small cap investors still have plenty to be positive about, says Dan Nickols.

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There’s no escaping it – the “B” word and 29 March 2019 loom large for all investors in the UK. But the broader economic and market backdrop against which the UK’s departure occurs is arguably of much more significance when it comes to investing in UK companies in 2019.

While the UK’s imminent departure from the European project is finally having something of a dampening effect on both investment and the consumer, such an effect is largely the result of near-term uncertainty.

Real GDP growth in the UK has been impacted by the fall in the exchange rate since the EU referendum but has remained around 1.5%. Consumption, which accounts for around 60% of UK GDP, has been constrained by the squeeze on real incomes, but this has latterly turned positive. Meanwhile, the employment picture is strong; unemployment sits at 25-year lows while the labour force participation rate sits above its historic average.

Global growth, while arguably less synchronised now than was the case at the start of 2018, is still robust by historical standards. At the same time, there is little evidence to suggest policymakers around the world are behind the curve. While trade wars represent an unhelpful development, they are likely to marginally slow, rather than fundamentally undermine global economic expansion. It remains, all in all, a pretty benign backdrop.


At the time of writing, with the UK’s exit from the EU fast approaching, a wide range of outcomes still remains possible.

Sterling is the transmission mechanism to both the consumer and investment worlds and could bounce a long way in the event of clear resolution. Such an outcome would boost those domestically focused areas of the market which are currently trading at depressed multiples. In terms of sterling’s reaction to the potential outcomes, a disorderly Brexit – no trading agreement with the EU – could prompt the pound to dip below the US$1.20 mark. Conversely, a comprehensive and clear resolution could see sterling hit the heights of US$1.50.

But our central expectation is for a fudge within which the need to make the most contentious decisions is deferred, possibly for a number of years. While this could be expected to give rise to a rally in both sterling (to, say, US$1.35) and UK domestically exposed cyclicals, fundamental uncertainties are likely to persist and these could be expected to constrain the extent of any such rally.


In this broad scenario, we feel that our current positioning – held since December 2016 – of roughly 50% domestically focused/50% internationally focused businesses remains appropriate.

The indices against which we operate generate between 40-50% of their revenues from international markets, so we continue to be overweight in the international space – taking the view that overseas markets are likely to offer a more benign environment for growth than the UK domestic economy. Along with a muted environment for discretionary spending, key UK consumer discretionary sectors – notably retail and travel and leisure – are currently also being affected by profound structural headwinds including the shift to online and year-over-year increases in the minimum wage, which make it incrementally more difficult for such companies to grow their profits.

From a thematic perspective, we continue to be overweight to “structural growth” companies, as we judge that they are likely to continue to deliver to earnings expectations at the very least. We do not feel that the market volatility seen towards the end of 2018 marks the start of a fundamental shift in market leadership – rather, we view this as a healthy and necessary correction.

Clearly, a more extreme Brexit outcome would mean we have work to do, but in our central case we expect portfolios to continue to deliver earnings growth well above that of our benchmarks.


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