Spring Investment Outlook
In late January, we published our market outlook for 2016, in which we said we expected stock markets to make progress after a weak start to the year. Our view was that the recent unsettling news from China shouldn’t derail economic growth in the developed world and markets would recover. Share prices rallied initially, but fell further in February as nervousness returned; the markets’ fears became manifold. Some investors raised concerns of a recession in the US and others pointed to heavy forced selling of shares by sovereign wealth funds in countries with reduced oil revenues. Meanwhile the banking sector became a focus; Deutsche Bank was rumoured to be having difficulty with its capital structure, regulatory fines continued to exceed expectations and profits appeared to be threatened in countries with negative interest rates.
Having reflected on these risks, investors appear to have concluded that their fears were unjustified and markets have subsequently been on a gently rising trend. The S&P 500 and FTSE 100 indices are now close to the levels at which they started the year; though Japanese and European indices remain lower in local currency terms, a decline in the value of sterling means that UK investors have been somewhat protected. While stock market declines were making the headlines in the early weeks of the year, the fall in the pound has not received the same attention; the trade-weighted value of sterling is now c.6% lower than it was at the start of the year, compared to the c.1% decline in the FTSE 100 index.
We believe there are two reasons sterling has fallen. First, the Bank of England has reduced its inflation forecasts; this means that UK interest rates are unlikely to rise in 2016, thereby reducing the attractiveness of sterling assets. Second, the date of the UK’s referendum on EU membership was announced for 23 June 2016; uncertainty around this issue led to the precautionary selling of sterling, as investors priced in the risk of Brexit. Our January note outlined our expectations for the vote; we thought negotiations between the UK Government and EU might drag on but the electorate would support the status quo and vote to stay in.
It turned out the Prime Minister had prepared the ground better than we had expected, and a prompt agreement was reached. While we retain our view that UK voters are likely to see Brexit as being too extreme, it would be reassuring to have some credible opinion polls to test this judgement. Meanwhile the betting markets are indicating that there is a c.65% probability the UK votes to remain in the EU. This expectation makes sense to us – we don’t believe that the UK is an isolationist nation and it would be remarkable if voters took the opposite stance to the country’s political leadership.
Nonetheless, we need to confront the impact of a possible Brexit. Forecasts of the economic implications are varied; some studies conclude that EU budgetary and regulatory savings would boost the UK economy while others find that higher trading tariffs would outweigh these benefits. What seems clear, however, is that negotiating the terms of Brexit could overwhelm the UK’s political infrastructure. It is unlikely that any EU state or institution would make Brexit easy for the UK, not least to discourage other potential countries from following suit. New trade arrangements would need to be established worldwide and the UK would have to pass legislation for many areas of the financial services industry which are currently addressed by EU regulations alone. If agreement could be reached, it would then require ratification in many European National Parliaments (including all seven Belgian Parliamentary Chambers!) and there must be a possibility that one country’s parliament throws a spanner in the works as the process draws towards a conclusion. The worst case outcome would be that the UK could fall back on its World Trade Organisation (“WTO”) membership to set trade tariffs. However, under these circumstances, some finessing of obligations would be required, which would require separate negotiations with each of the 161 members of the WTO.
The prospect of a long period of uncertainty as the details of Brexit were negotiated would most likely lead to yet further weakness in sterling. This could lead to lower gilt prices (and higher borrowing costs for the UK government) but is not necessarily bad news for the UK stock market; about 70% of the revenues of companies listed on the London Stock Exchange are generated overseas and these would be worth more if sterling declines. Hopefully the elections to be held on 5 May 2016 may give us a clearer insight into the likely outcome of the referendum; the London mayoral contest is being fought between an “EU Stay” Labour and an “EU Leave” Conservative candidate and the Scottish Parliamentary election is likely to involve Brexit issues.
In the medium and long term the prospects for financial markets will be dictated by economic fundamentals rather than politics and we currently retain our view that global growth should be supported by the resilience of the US economy and the benefits of stimulatory measures in Europe, China and Japan. We are therefore recommending long term investors remain fully invested in markets - providing they maintain portfolio diversification appropriate for their tolerance for risk. We are retaining a positive stance towards company shares, with a particular focus on smaller companies, which should continue their long-term record of outperformance in most markets. We are recommending that portfolios have good geographic diversification – which serves to mitigate Brexit risk - and we continue to recommend a heavy allocation to UK commercial real estate, where attractive yields and rental growth should continue to deliver stable returns, particularly in funds with a low exposure to London, where the market appears overheated, and most vulnerable to the removal of overseas investment.
You will have no doubt received numerous updates on the UK’s Spring 2016 Budget. Please click here if you would like to see our own summary and comments on the matters we believe most likely to affect our clients.
To discuss this note, or any other matter, please contact Nick Fletcher on 020 3696 6801, or any member of the London Wall Partners investment team on 020 3696 6805.
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