No room for complacency
Financial and political chaos were widely predicted if the UK voted for ‘Brexit’, yet all is calm. While we remain unconcerned about the risk of a meaningful economic contraction in the short term, there are several risks to the UK and global economies.
Investors should be prepared for periods of volatility in the months and years before Brexit becomes a reality.
We are now three months into a post-referendum world – not post-Brexit, as some people have slipped into thinking.
The becalmed state of the UK economy is analogous to the ‘phoney war’ in 1939-40. This could continue until there is clarification on the terms of the UK’s exit from the EU and, potentially, the single market. This could take two to three years, although there are likely to be bursts of volatility along the way.
As a result of the uncertainty, economic growth may slow, but we do not anticipate a recession. The latest survey-based leading indicators of economic activity appear to confirm this and are well above levels associated with recession. Consumer confidence and manufacturing and services order books point to a period of stagnation similar to that experienced by the UK in 2011-12 when the eurozone crisis was in full flux; they do not point to a contraction.
Meanwhile, the Bank of England (BoE) has unleashed a level of monetary stimulus appropriate for a serious deterioration in forward-looking data. We question the efficacy of purchasing an additional £60bn of gilts by creating new reserve money, given that interest rates are so low and the yield curve is so flat. Also, given that most investors still holding gilts are probably doing so for regulatory reasons, it seems unlikely that they will sell and buy riskier assets. Nevertheless, the magnitude of the stimulus – and the commitment to ease even more at the November meeting – is likely to bolster economic confidence, which in turn will benefit asset prices.
There, but for the dollar, go I
Headline UK returns since the Brexit vote will have pleasantly surprised many investors. However, having the correct mix of investments – as well as picking the right industry sectors and stocks – has been crucial.
The weakness of sterling has largely determined whether investors have done well over the past three months. If, ahead of the referendum, a portfolio was positioned to take advantage of sterling weakness – particularly against the dollar – it will have performed strongly. Being overweight in US assets and overseas-earning FTSE 100 companies created a windfall in sterling terms, especially for the consumer defensive, pharmaceutical and beverage sectors.
However, a portfolio focused on domestically facing mid-caps would have experienced a much bumpier ride. Travel and leisure and retail stocks, for example, fell sharply as investors feared that a Brexit shock would hit consumer spending just as import costs increased. While these sectors have mostly recovered their ground, they are well behind the market in relative terms.
Many of the post-referendum winners already traded on above-average price/earnings multiples. If growth does slow down, companies that are more reliant on the business cycle to increase revenue will begin to struggle, which is why they trade at lower multiples. Paying a premium for more dependable growth in a low-return world is likely to continue as a dominant investment theme. But it raises questions about how much highly-valued stocks raise a portfolio’s risk profile and how much risk should be tolerated in exchange for high-single-digit returns. There are no simple answers, especially when ‘risk-free’ assets (gilts) are bumping against negative yields. Many of these sovereign bonds are trading above their face value, which will erode capital at redemption.
In the current Alice in Wonderland environment, investors are likely to chase returns from companies that can generate cash to reinvest in their businesses and/or grow their dividends. Globally, this is an ever-shrinking group of companies that are likely to see their valuations stretched further. Obviously this is very uncomfortable for investors. It is crucial, therefore, to maintain a well-diversified portfolio that offers liquidity even in times of stress. Investors must be able to ride out the volatility we may see in equity markets, while also owning a selection of assets that are uncorrelated with equities which can dampen portfolio falls.
‘Fog in Channel – Europe cut off’
Much has been said about the issues that the UK will face after Brexit, but few commentators have looked through the other end of the telescope to determine how the EU will cope without the UK. Although only 8% of German exports go to the UK, many of these exports could be subject to high tariffs outside of the single market, so our departure will hurt it economically. Moreover, it will also lose an ally in the tug of war between the fiscally-sound, pro-free trade north and the shakier south.
The European Central Bank and continental politicians are wrestling with a sclerotic banking system, creaking under the weight of bad loans. Banks are struggling to lend more to the real economy, effectively diluting monetary policy and inhibiting growth. But then, demand for credit is not exactly strong.
There is an overriding need for a consolidation of continental banks, especially in Italy, and a growing realisation that the pain cannot be deferred forever. Most recently, rumours have been swirling around Deutsche Bank. The once-champion European challenger to the American financial titans may need a major write-down of its loan book, just as the US Department of Justice pursues a $14bn fine for mis-selling subprime mortgage-backed securities. The bank’s market-cap is just $16.7bn.
Sluggish European economies will continue to struggle, even before the uncertainty of Brexit. Meanwhile, hard policy decisions continue to be kicked down the road.
Further east, the Japanese stock market continues to be extremely volatile. Investors are disillusioned by the government’s unsuccessful attempts to stimulate the economy and rekindle inflation. Despite this disappointing backdrop, major changes to corporate governance continue to roll on, which should not be underestimated. More companies are addressing the historically poor returns their investors have received. This cultural change should make them more attractive to both local and overseas investors. It is imperative that this represents a sea change in corporate attitudes and not just fleeting fancy. Meanwhile, the Bank of Japan almost doubled its purchases of equity exchange-traded funds (index trackers) during the quarter, which should lend support to Japanese stocks.
Recalibrating the scales
Before the referendum, we estimated that a vote to leave the EU would lower the sterling trade-weighted (or ‘effective’) exchange rate by 7.5-12.5% once the immediate volatility had subsided. At the time of writing, the effective exchange rate is 12.5% below the average level recorded in the week of the referendum. Ordinarily, we do not make short-term exchange rate forecasts, but these were extraordinary times. Our estimate was based on a range of assumptions about how a vote to leave might alter interest rate expectations in the UK relative to those overseas. It also included an analysis of the sensitivity of the sterling exchange rate to Brexit news flow and financial risk aversion in the 12 months running up to the referendum. Without such a disruptive event, forecasts are usually far harder to make with any confidence.
Exchange rates are impacted by longer term, structural dynamics, cyclical dynamics imparted by the business cycle, as well as more transitory, technical factors. These influences can pull a currency in different directions at once, making exchange rate forecasting prone to large and sometimes enduring margins of error. That said, in the rare instances when the short-, medium- and long-term factors all point in the same direction, investors should take note. At present, long-run analysis (such as purchasing power parity or our own behavioural equilibrium exchange rate framework), medium-term business cycle indicators (such as real interest rate expectations) and technical positioning (such as speculative short positioning) all suggest that sterling is oversold, particularly versus the dollar, but also against the euro and yen. This could continue for a while, but the balance of evidence suggests that sterling could strengthen significantly in time.
An emerging dawn
Both the coincident data available for July and the leading economic indicators suggest that GDP growth for emerging economies will improve in the third quarter, after six years of near-continuous deceleration. Although one quarter doesn’t make a trend, this is a significant signal.
Emerging market debt and equities tend to outperform when the gap between the growth rates of developing nations and those of advanced economies start to widen.
Emerging Asia is better placed than Latin America, and consumption trends there continue to strengthen since hitting a trough a year ago. South American equities have rallied sharply, but earnings momentum remains poor and valuations are far from attractive. With former Brazilian president Dilma Rousseff’s impeachment underway and interim leader Michel Temer being investigated by the ‘Lava Jato’ anti-corruption campaign, political uncertainty remains sky high.
The outlook for Mexico also remains uncertain. It is one of the few emerging economies that has a worse current account balance now than during the 2013 ‘taper tantrum’. President Enrique Pena Nieto’s reformist agenda has supported equity market performance until now, but with his popularity plunging due to several scandals and populist contenders snapping at his heels, there is a risk that he makes a U-turn. Previous falls in the peso look set to push headline inflation above the Banco de Mexico’s 3% target, so monetary policy is likely to tighten.
The new president
With fewer than 35 days to go before the US presidential election, Donald Trump has closed the gap on Hillary Clinton and is now ahead in several swing states. We are paying close attention to the insidious creep of protectionism as politicians in the US and elsewhere opportunistically harness the anger of citizens who feel disenfranchised. We believe that protectionism – shielding your country’s industry from foreign competition – and the prospect of a ‘beggar-thy-neighbour’ global trade war is one of the biggest risks to investment returns over the next decade. And it’s not getting nearly enough attention.
Protectionism may offer short-term relief to a small group, such as workers in a particular industry, but it will only raise living costs for the great majority and slow economic growth. This won’t help those struggling to make ends meet. The risk is highest if Mr Trump becomes president, but we wouldn’t discount the risk if the Democrats were to make a clean sweep of the White House, Senate and House of Representatives. This might give Mrs Clinton the opportunity to court popularity from disillusioned Democrats with a programme of labour laws that would be costly for US companies.
Over the long term, shareholder returns are tied to economic growth. As populations age and investment slows, productivity will drive economic growth in the 21st century. However, protectionism reduces productivity by discouraging competition. It also diverts labour and investment into less-efficient industries, preventing resources from flowing to the most productive areas. The good news is that equity investors are still demanding a large equity risk premium in return for investing into the US market, which provides some cushion against political risk.
Nonetheless, while the economic backdrop remains benign, there is a risk that the wave of populist phenomena, such as the UK referendum result, continues to confound reasonable and well-founded expectations. Investors have been warned...