Market Comment 07/11/2016
Market Commentary - November 2016
During the three month period to the end of October, Sterling weakened still further following the surprise ‘Leave’ result in the UK’s European Union referendum in June and confirmation that the government was looking to trigger Article 50 before the end of March 2017.
Generally, UK listed companies with significant overseas earnings made good gains and those domestically focussed companies, whose share prices had fallen sharply at the tail end of June, rebounded as the near term economic outcome of the referendum has not been as bad as first feared. The FTSE All-Share Index returned 4.2% over the period. The fall in Sterling helped boost international equity returns for UK based investors. The FTSE World Ex UK Index returned 8.1% in sterling terms, although in local currency terms, the return was only + 0.1%.
The Emerging Market equity region performed strongly (the MSCI EM equity Index returned +3.9% in local currency terms and 13.2% in Sterling terms. US equities lagged in local market terms (S&P500 Index, -1.7% in local market terms), but US Dollar strength against Sterling ensured a strong return for Sterling based investors (S&P500 Index, +6.9% in Sterling terms).
Gilts performed poorly as prices retraced from new highs stimulated by the Bank of England relaunch of quantitative easing and its bond buying program (FTSE Gilts All Stocks Index, -3.6%). UK high yield corporate debt outperformed gilts (BAML £ HY Index, +2.6%) as investors sought income further up the risk curve.
The Brent crude oil price rose 13.8% to $48.3/barrel during the three month period to the end of October. OPEC surprised the market by announcing that it had been agreed to limit output and that details of the decision would be released following the next meeting.
The gold price fell 5.6% to $1316/oz during the three month period. This translated into a 2.3% gain for UK based investors due to Sterling weakness against the US Dollar.
Gilts performed poorly as prices retraced from new highs stimulated by the Bank of England relaunch of quantitative easing and its bond buying program
Teresa May announced, somewhat unexpectedly, at the Conservative party conference that Article 50 will be triggered before the end of March 2017. This establishes a clear timetable for negotiations and assuming everything goes according to her plan, the UK will leave the European Union at the end of March 2019.
Whilst we now have certainty over the timetable, we have no clarity over what the UK’s ‘deal’ with the EU post Brexit will look like, however with the control of migration at the centre of the Government’s Brexit commitment, it looks as though the country’s access to the European single market will come with conditions. Should an agreed settlement not be forthcoming, in the limited time available, then World Trade Organisation (WTO) tariffs will be applied from April 2019.
With the timetable now clarified, any suggestion that there may be a Brexit fudge seems limited and therefore companies weighing up investment decisions are unlikely to choose the UK over other European Union countries in the near term (unless there is direct UK government intervention), particularly if there is a threat that tariffs could be applied to exports in just two and a half years’ time. Furthermore, competition to attract financial services away from London will intensify.
Whilst we now have certainty over the timetable, we have no clarity over what the UK’s ‘deal’ with the EU post Brexit will look like
These outcomes of the Brexit ‘leave’ vote allied with increased imported inflation (due to a depreciating currency) will have a moderating influence on economic growth. The government is, therefore, right to flag that increased budget deficits are likely going forward, thus reducing the economy’s resilience to further external shocks.
Whilst this is a rather gloomy prognosis of the near term impacts on the UK’s economic growth, manufacturing (although small in proportion to the overall economy) is becoming more competitive as Sterling depreciates and activity should be well supported in the near term.
Thankfully, the composition of companies listed on the UK stock market is highly international in nature and, given Sterling currency weakness, sales and profits which are generated overseas are worth more in Sterling terms. This is resulting in upgrades to estimates for companies with sizeable international operations and is helping support the market.
The weakness in Sterling is a symptom of international investors’ concern over the outlook for the UK economy but it has been exacerbated by the nonsensical introduction of quantitative easing by the Bank of England. Quantitative easing increases the stock of money and therefore devalues the currency.
Currency devaluation works as an economic pressure valve by mitigating the day-to-day impact of an economic shock and increasing international competitiveness. However, if the devaluation is too great it can be detrimental as it also ensures that goods brought into the country will go up in price and consumers’ buying power will, all things being equal, be diminished. It is important that currency weakness doesn’t overshoot.
We, therefore, do not support the Bank of England’s renewed quantitative easing program and see it as further proof that central banks across the developed world are hooked on the provision of ‘cheap money’, despite the policy generating perverse outcomes which is throwing financial orthodoxies upside down. Several companies (let alone governments) have been able to issue debt on negative yields. This means that investors are happy to pay these organisations to hold their money for them.
Thankfully, the composition of companies listed on the UK stock market is highly international in nature and, given Sterling currency weakness, sales and profits which are generated overseas are worth more in Sterling terms.
We believe that the advent of extreme monetary policy (negative interest rates and quantitative easing) is justified should economic depression threaten (as per 2008/09), but is an unwise policy tool in all other circumstances. Indeed, we believe that it is hindering economic growth by failing to allow the economic cycle to take hold and flushing out unproductive, highly indebted companies from the system. By not doing this, productivity remains low and therefore economic growth potential remains low too.
Given that extreme monetary policy seems to be failing to stimulate robust economic growth, is there an alternative? The idea of implementing fiscal policy stimulus is gaining ground across developed markets and we would not be surprised to see developed economy governments’ utilise their cheap funding costs to accelerate fiscal spending. This is a credible response so long as it is done incrementally and not in a ‘big bang’ as per Japan and China.
Our portfolios have numerous investments which will profit from such a change in policy. Both within our direct UK equity portfolios (where we have holdings which will benefit from increased infrastructure spend) and within our funds (where we hold investments in collectives which provide either equity or debt funding to infrastructure projects).
We also believe there is a risk that the consensus is incorrect in its belief that inflation will remain dead and buried in western, developed economies. Whether it is imported inflation in the UK, accelerating wage rises in the US or an increase in the oil price, there is scope for inflation to surprise on the upside in many developed economies next year. This could have negative impacts on the value of long dated government bonds and so called ‘bond proxy’ equities whose share prices have benefited from the belief that inflation will not return in the foreseeable future.
We also believe there is a risk that the consensus is incorrect in its belief that inflation will remain dead and buried in western, developed economies.
Again, we have invested to safeguard portfolios from the possibility of rising inflation via our holdings in strategic bond funds, absolute return funds, inflation linked government bonds, gold and several investment trusts (such as infrastructure and real estate) where the returns on many of their underlying investments have a link to the inflation rate. Furthermore, our direct UK equity portfolios are underweight in those sectors where ‘bond proxy’ equities tend to reside, namely consumer staples and utilities.
By ensuring portfolios are well diversified and challenging received wisdom, we believe we are well placed to achieve our investment objective which is to protect and enhance our clients’ real wealth over time.
Chief Investment Officer