"Britain can be cancelled, top EU lawyer says" so read a headline on the CNN website. It certainly feels like it. A divided nation, a crippled Government and a Leader of the Opposition who transparently covets investors' hard earned savings. The nation is crying out for strong leadership but few of our current crop of politicians come close and Parliament merely mirrors the divisions across the nation. As the old joke advises, you really don't want to start from here. It is perhaps not a surprise therefore that this has been the worst year for UK financial markets since the Great Recession in 2008 and the FTSE 100 is back down to a level first seen in 1999. Thankfully, we have positioned our portfolios with limited exposure to equities, particularly in the UK and this has helped provide some insulation for our portfolios.
Perversely, the principal cause of the markets' woes was not UK related but more global in nature and, in particular, American. Stock markets began to feel the chill draft of the US 10 year Treasury bond topping 3.2% in late September, triggering the global market correction that began in October. At the time, it appeared to be a replay of February's valuation recalibration in response to a higher discount rate. However, many weeks later, nerves have yet to settle despite Treasury prices rallying; the 10 year note is now yielding below 2.9%. Unlike in February, the hitherto market leaders have been pummelled and the ecommerce giants seem have lost their air of invincibility. This is despite Q3 earnings leaping by 24% and President Trump's tax cuts accounting for only part of this bounty.
Despite the largesse of Trump's $1.5trn stimulative package, the growth impetus is already waning. Coupled with lacklustre progress in Europe and Japan, evidence is amassing that the developed nations are in, and have been in for some time, a new economic paradigm. Indebtedness continues to swell and is well above the levels seen just before the financial crisis. The baby boomers are becoming greyer and entering a retirement which promises to be long and expensive. It is little wonder that those who have missed out on, or, who are on the negative side of this ledger, are leaping onto populist band wagons.
The debt burden has left economies acutely sensitive to monetary policy. Merely turning off the monetary spigots in Europe has been enough to quell growth. In Japan, continued extreme QE action seems no more effective than performing CPR on a zombie. The proposed increase in GST must now be in doubt. Trump desires to reinvigorate the US growth engine and he has built a pyre of discarded regulation in an attempt to reform the supply side. This bonfire may end up with horrific consequences for the atmosphere. Even here, merely lifting interest rates from an 'accommodative' state is having a marked impact.
This moderates the need for aggressive policy action and we are growing more confident that we will be stuck with low interest rates for many years. We can't be sure that the inflation risks created by full employment have gone away entirely but the recent data is comforting, particularly as energy prices reverse. Low interest rates mean low discount rates, but do not negate the need for a hefty risk premium to reflect the dangers of excessive leverage within the system.
The surge in EPS and falling stock prices has resulted in an almighty derating of the US market. According to Credit Suisse, it has been the 3rd greatest derating since 1976 (the other 2 occurred in 2002 and 2008). Market direction of course is driven by the 12-18 month outlook and the optimism here is waning. Forecasts have been nudged lower but analysts are still looking for a chunky 9% gain in EPS next year, which sounds aggressive in an economy which will grow say 5% over the same period. However, the 2018 share buyback bonanza has reduced the share count by 3% suggesting 8-10% EPS might be possible. However, the surprise extent of the economic growth shortfall is likely to lead to operational issues for businesses and we suspect that earnings disappointments will be far more prevalent than positive surprises next year.
Turning to the UK, Theresa May seems to have achieved the impossible in uniting Parliament. Both Brexiteers and Remainers have railed against her compromise solution, and this now appears dead in the water (though oddly with Labour now 4% ahead in the polls, perhaps not quite deceased). The two extreme options, a second referendum or a Hard Brexit remain on the table, though some sort of compromise solution based around the European Economic Agreement (i.e. Norway) is still a possibility. Rees-Mogg accurately described this option as 'vassalage' but given the leadership credentials of Westminster MPs, perhaps this doesn't sound so bad?
The outcome of this is impossible to predict, and even if we did know the Brexit outcome, it is very difficult to determine how the market will respond. This makes the UK market virtually uninvestable and our call to move into passives late last year has proved to be justified. The main exposure to the UK market in our MPS portfolios is through the iShares All Share tracker which is below the 30th percentile of the peer group. However, equally pleasingly, the two active funds we retained are both in the top decile for the year.
Our instincts tell us that value is now emerging and we should consider deploying some of our cash overweight. However, the correction probably hasn't finished and even if it has, markets are unlikely to shoot ahead. After all it took them time to reflect our concerns about the US/China tensions, Brexit and Trump. It is increasingly looking like Brexit won't be resolved ahead of March, and could drag on well beyond then. This may leave us with the opportunity to pick up stocks at cheaper prices than are currently on offer, especially if there are further downgrades to earnings next year as we fear. This means that there are no changes to our asset allocation grid, although we are poised to make adjustments outside of our formal quarterly meetings.
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