Recession risk remains heightened though the odds of one forming have dropped as the economic data shows signs of stabilising. The consumer is holding up and index of Leading Economic Indicators may be about to turn up as base effects kick in. PMIs remain soft, particularly in manufacturing but at least trajectory is less worrying. The yield curve has normalised but this provides no comfort – it always has done ahead of a US recession, which has typically lagged an inversion trough by12-18months. We can only wait with fingers crossed.
Markets have surged higher this year, led by the US, despite the evaporation of hopes of any profits growth. Valuations have become notably more expensive as a result. More positively, Trump has announced a ‘phase one’ trade deal with China. According to Trump this deal is “phenomenal” and “amazing for all” although the details released so far are very sketchy. Given Trump’s record, we take this to mean that it is nothing but window dressing and an excuse to call a truce during the run up to the election. Anything else will be a bonus.
Despite climbs in stockmarkets this year, equity risk premia remain juicy. Valuations remain pricy compared to history, but this is no surprise given the unprecedented low bond yields. Determining our tactical positioning under these conditions is difficult as the past provides no guidance. One of the few tools left in policy makers box is fiscal spending, yet budgets are already well into deficit in developed economies with the principal exception of Germany. We can do little more than make educated guesses as to what might happen. On balance we think caution in equity positioning remains appropriate despite the slight improvement in the economic outlook.
The UK electorate was left with a miserable set of options: a Shadow Cabinet offering a Marx & Spenders manifesto, or a continuation of the Shallow Cabinet with a questionable record of competence and probity. Brexit seems to have been the critical swing factor. However, for the first time in over a decade we have a government that has a free hand politically and some room for fiscal spending. We are no fans of the UK economy as it faces a number of structural issues such as the feeble levels of productivity growth and a sizeable trade deficit. Nor is a trade agreement with the EU a done deal and we expect further delivery pains over the coming 12 months.
The election result has lifted both the price of sterling and the UK stockmarket but in the context of the market’s performance since the referendum, this is a blip. To illustrate, over the last four years, the FTSE All Share Index is up 45%, whereas the US S&P 500 index is up 90%. We have been correct to underweight UK assets since the referendum and it is time to reduce our underweight which has started to become significant in places. We suspect that many international asset allocators will lift their stance on the UK market from uninvestable to merely undesirable in their New Year deliberations and the money which has flooded out of the market should reverse. Flows are most likely at first to be directed passively into indices. This suggests we too should for the moment go passive, especially as we deal with year-end liquidity issues. There will be upsets to come for markets and we do not envisage a completely smooth run in finalising Brexit. Ultimately, we dismiss outright the idea of a hard Brexit, which would spell the end of the Union as the now Catholic majority in Northern Ireland and the strong SNP in Scotland would surely demand. However, a market wobble would provide us with a grand opportunity to switch from passives to active UK funds orientated towards cheap domestics.
We considered trimming our modest overweights in Japan or GEM to finance the move. Instead we have elected to go underweight US. The US market always appears expensive, but looking at the top ten companies in the S&P 500 only JP Morgan is trading below 20x; Amazon is on 77x (admittedly cheap to its history). Even the mature tech companies such as Apple and Microsoft are on 22x and 30x respectively. Frankly, we have no idea what the correct valuations for these businesses are but what has contented us in the past is that these types of assets simply don’t exist elsewhere in the world. What we do know is that the Democrats will be sorely tempted to lift corporation taxes if they win the Presidential elections in November. This could take 10% off prices and alone is good justification to take some profits.
We also discussed property and we are very thankful to be out of it. The FT100 retail focused Intu Properties has fallen 70% this year, and other property companies are trading on large discounts. UK direct property funds are beginning to gate and we think that worse is to come. With business rates where they are, rental incomes from some retail properties will fall to zero and it will take years to bring supply back in balance with demand. Many ‘primary’ retail properties will begin to feel decidedly secondary and could end up as tertiary. We should investigate how much retail constitutes in the main property indices. At its peak this exceeded 60%.
Within our matrix we are reducing US equities to ‘avoid’ but have not lifted UK equities to ‘neutral’. Our portfolios will remain underweight UK though less so than before, largely to finance our underweight equity stance and desire to hold specialist international strategies.
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