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Long/Short Investments in L/S Equity: Valuation and Ideas,

​UK Economy Likely to Underperform Technical Forecasts

Since the UK’s referendum to leave the EU, its economy has actually performed quite well, with consumption spending carrying on where it left off, house prices remaining strong, unemployment continuing to shrink, and stock markets bouncing well off the initial post-referendum lows.

The UK economy increased 0.5% quarter-over-quarter, or 2.0% annually if calculated in the same fashion as the US. Exports have benefited from the drop in the British pound, as they’ve become comparatively cheaper to the trading partners. Consumption hasn’t been affected and business investment, while taking a hit, hasn’t deteriorated to the levels anticipated.

With that said, inflation is expected to increase as the currency drop makes imports comparatively more expensive, as corporations typically pass off much of the cost to consumers. A PricewaterhouseCoopers-CBI survey showed financial firms are mired in the lowest overall sentiment since 2009. Commercial development activity also fell for the four months after the referendum before picking up in September. Any hit to investment due to an uncertain political and economic atmosphere will work to lag productivity and hurt growth.

Technical Picture

Since the official end to the recession in Q3 2009, US growth, on an annualized basis has been virtually equal to that of UK growth – 2.06% in the US versus 1.99% for the UK.

For these forecasts I use an ARIMA model, which combines autoregressive and moving average models, with a chance to correct for differencing issues with an “integration” component. I forecasted UK GDP in the same fashion as US GDP although the UK Office of National Statistics does not report it in that way.

Based on the autocorrelation function (ACF) and partial autocorrelation function (PACF) we see one spike on the first lag of the PACF (which dictates how many AR terms to add) and geometric decay on the ACF, which normally indicates no use for an MA term. Therefore, it’s best to go with an ARIMA (1,0,0) model.

I forecasted out the next four quarters only, as ARIMA models tend to converge quickly to their intended level. Forecasting for the long-term is almost impossible regardless.

The point forecasts (or mean expectations) come out in the 2.1%-2.4% range, denoting some slight seasonality in the data.

In terms of a purely technical forecast, this is about what one would expect, given Brexit has really had no tangible impact on the data thus far. The BOE initially forecasted a 2.7% annual growth rate for 2017 and 2.3% for 2018. These, in the wake of the referendum result, were brought down to 0.8% and 1.8%, respectively. Overall, this model predicts about a 67% chance of a negative growth reading in any of the next four quarters.