FTSE 100: 7423.68 ▲ 6.44 (0.09%)
As prime minister Theresa May kick-starts two years of negotiations with the European Union over the UK's exit with the triggering of Article 50, investors are gearing up for uncertainty ahead.
Markets responded sharply to the Brexit vote in June, with the pound tumbling and the FTSE 100, after an initial fall, rallying strongly, with much of its momentum driven by a weakened sterling.
But only now will the real negotiations take place, with the future shape of the UK's relationship with the European Union forged. The outcome could range from an agreement giving the UK effective access to the single market, or no deal at all, with the UK falling back on more punitive World Trade Organisation (WTO) rules in its trade dealings.
'A huge amount depends on the type of agreement that can be reached,' said Stephen Macklow-Smith, manager of the JPMorgan European (JETI) investment trust. 'The bottom line is that if no deal is possible, that will have a negative impact on growth in the UK and the European Union.'
Azad Zangana, senior European economist at Schroders, said the prospect of negotiations collapsing with no deal was 'a real concern'. 'The odds of a hard Brexit are sufficiently high to worry,' he said.
'Moving onto WTO rules would impose much higher tariffs than would otherwise be the case on goods,' he said. 'It wouldn't cover services at all, so the difficulty of exporting services would become much, much greater.'
While the pound has continued to trade around 15% lower against the dollar since the Brexit vote, investors are not yet pricing in the risk of negotiations collapsing, according to Viraj Patel, foreign exchange strategist at ING.
'Current sterling levels are not in our view pricing in the tail risk of a "cliff edge" Brexit,' he said. 'The clock is ticking once Article 50 is triggered and any initial political stalemate - or anything that pushes us closer to the proverbial cliff-edge - could tip the pound over.'
Patel said negotiations were 'likely to be tricky and fairly inconclusive' in their early stages, meaning the pound could be set for volatility.
'The pound will have to bear the brunt of this lack of political clarity,' he said. 'There's nothing stopping the pound trading with a 5% uncertainty premium at certain points over the next three to six months.'
Further falls in the pound could exacerbate the pick-up in inflation, which is expected to lead to a squeeze on consumer spending.
Household spending has proved the backbone of the UK economy's resilient response to the Brexit vote, surpassing the expectations of most economists.
But with the rise in inflation now having an impact on household disposable incomes, which were rising by 5% at the start of 2016 but were flat by the end of the year, that consumer confidence could start to falter, argued Zangana.
'Inflation has continued to rise and is currently at 2.3%. We forecast it to increase by up to 3.5% by the middle of this year, which implies disposable income will shrink further in the coming quarters, and should cause households to either reduce their spending or savings,' he said.
'As it happens, households have been reducing their savings for some time and the savings rate is as low as it was during the financial crisis. There’s very limited scope for households to cut back savings further to prop up consumption. We expect a slowdown in consumption and therefore gross domestic product growth through this year.'
That could spell more bad news for the domestic-focused UK stocks that were worst hit by the Brexit vote. 'For sectors that are more domestically exposed, we would be concerned,' said Schroders chief economist Keith Wade. 'That would probably lead you to be more concerned about the small cap end of the market.'
'We remain more positive than consensus on economic prospects in 2017 as unemployment remains low, wage inflation is picking up and we believe that inflation will peak at around 3% this summer before falling back,' he said.
'The net result is that we think the UK consumer will see a slowdown in discretionary income growth, rather than a sharp squeeze. At the same time, banks remain willing to provide credit to the economy and the fiscal deficit has surprised positively, leaving the Chancellor with some leeway to spend more if the economy slows during the negotiations on Brexit.'
That could translate into a brighter outlook for the pound, which despite the uncertainties over Brexit and a possible second Scottish independence referendum, may be able to draw on support from other sources.
'We can see many reasons why the currency could strengthen from here,' said Legget. 'The trade deficit is falling; growth is surprising positively; the budget deficit is better than expected; foreign direct investment is holding up.'
Guy Foster, head of research at Brewin Dolphin, agreed. 'The degree of negativity surrounding the UK pound has been excessive,' he said.
'Better economic performance, or a more constructive resolution of the negotiations, would enable it to recover. This would be good for UK equities relative to their overseas peers, for retailers and for real estate. It would enable smaller businesses, which tend to be domestically focused, to outperform larger companies who have benefited from the fall in the pound inflating their overseas sales.'
But while Legget may be more bullish than some on the prospects for the UK, he sounded a note of caution on the fate of domestic-focused stocks.
'We remain of the view that UK domestically-focused stocks are unlikely to re-rate materially until the outcome of the Brexit negotiations becomes clear,' he said.
'On this basis the portfolio’s domestic holdings are concentrated in stocks with growing earnings, trading on low multiples and offering a reasonable yield.' Most of Legget's domestic exposure is to house builders, banks and insurers.
Should investors be looking for more reassurance on UK stocks, they can get them from valuations, argued Steven Andrew multi-asset fund manager at M&G.
'When we look at how the UK and European markets are currently priced, current market expectations are still anchored in a pretty bleak place from a fundamental perspective, so we see more upside risk than downside,' he said.
'Equity markets have recently delivered strong returns but unlike the US and other parts of the world this has not been the result of a re-rating. Profits have grown faster than prices, meaning that many sectors have actually got “cheaper” while going up.'
Andrew argued that a focus on fundamentals, rather than an attempt to forecast the outcome of Brexit negotiations, was likely to prove more rewarding for investors.
'The negotiations around the withdrawal of the UK from the European Union have the potential to be the most significant structural change to the UK's economy in a generation,' he said.
'Then again, the economic impact might be so small, we may not even notice. The degree of clarity around these issues is very likely to stay murky for some years yet, so rushing to judgement either way – from an investor's perspective – is not a good idea.'