What will drive UK equities this year?
2016 – stranger things have happened
UK equity investors had no shortage of things to worry about in 2016. This time last year, the market was fretting about the Chinese economy while subsequent months saw rising concerns about the UK’s European referendum and the US presidential election.
In the event, the Chinese hard landing did not transpire but the worst fears of the prevailing consensus did indeed come to pass with the Brexit vote and the election of Donald Trump, both of which had been deemed to be low-probability, market-negative events.
As dreaded as these outcomes had been to most observers, the market’s response was far more phlegmatic. From the close of the UK polls on 23 June 2016, the FTSE All-Share Index rose over 11% to year-end while the comparable figure for UK equities since election day in the United States was up 4%.
Markets’ reaction to the repudiation of Italian Prime Minister Matteo Renzi’s reform plans in the December referendum was similarly relaxed, with UK equities rising 6% from then until New Year.
For 2016 as a whole, the FTSE All-Share made a healthy total return in sterling terms of just under 17%. We will seek to explain why the UK market reacted to these events the way it did and then assess how Brexit, President Trump and events in Europe and China could affect the fortunes of UK equities in 2017.
Past performance is not a guide to future performance and may not be repeated.
Brexit – breaking up is hard to do
The FTSE All-Share’s intra-day low on the day of the referendum result was some 4% lower than the close on polling day. That it rallied 11% from this point to the end of 2016 was largely a function of weaker sterling, an influence particularly positive for the blue chip FTSE 100 index.
For the more domestically-orientated FTSE 250 index, its recovery was driven by the realisation that the UK economy was resilient and that any negative impact from the execution of Brexit would be longer dated than the fears prevalent among bleary eyed observers early on 24 June.
As to how things play out, we believe Theresa May will trigger Article 50 by the end of March 2017, on the assumption that it is voted through by the House of Lords. In market terms this is already well discounted and the notification itself is therefore unlikely to have an impact on UK equities. In contrast, the two years of negotiations which follow Article 50 will have a much greater influence on UK companies and markets.
The prime minster’s 12-point plan foreshadows a departure from the single market, given her insistence on control of borders and the end of the European Court of Justice’s jurisdiction. It would appear that investors have not yet priced this in. In this sense, the tone of the EU’s response to Britain’s serving of notice will be important. Given that it will be an opening salvo in a protracted process of negotiations, it is unlikely to be dovish or particularly positive for UK equities.
As the bargaining continues, we expect to see recurring bouts of market volatility as investors respond to, and anticipate, evolving negotiating positions.
In terms of sector implications, retail will be particularly susceptible to the EU exit process and indeed sterling weakness following the Brexit vote is already beginning to affect companies’ margins through rising raw material costs.
The UK consumer’s spending power will also be vulnerable to imported inflation, thereby affecting households’ real income at a time when the savings ratio is already low.
On the other side of the coin, however, recent data from the ONS and the NIESR demonstrate the beneficial effect on exports of a weaker pound. As sterling fluctuates over the next two years, so too will the share price performance of the consumer and industrial sectors. It should be noted that the influences on sterling will also include global factors, not just Brexit-related drivers.
The fortunes of other sectors will come in and out of focus too. The issue of passporting rights will influence financial services stocks, while the mechanics of customs arrangements will be very relevant to industrial companies with cross-border just-in-time supply arrangements. Should the UK’s eventual trading terms fall under World Trade Organisation (WTO) rules, there will clearly be major implications for supply chains.
In the meantime, we believe that the ebbs and flows of the negotiating process should throw up valuation anomalies in a number of stocks as investors attempt to identify and calibrate the implications for individual companies. Our bottom-up stock-picking approach should serve us well as we look to exploit these mispriced opportunities when they emerge.
@POTUS – defining Trumponomics
The conventional wisdom prior to the election was that a victory for Donald Trump would be bad for equity markets. Instead, the expected “Trump dump” turned into a “Trump bump” as markets moved quickly to price in a consensus that the economy would benefit from the reflationary1 bias of the new administration.
In terms of the market implications of the new president, our sense is that President Trump will govern as a transactional, “CEO-president”. This will lead to some unpredictability and increased idiosyncratic risks for investors, particularly since his policy positions are also more nuanced than those of most previous presidents. He will not be immune, however, to the normal constraints of congressional votes, time and money in furthering his legislative programme.
Trump’s commitment to deregulation is highly market and economy friendly and it is also actionable through executive orders without congressional approval. These, alongside the appointment of reform-minded officials, will lead to a reduction of red tape and lighter enforcement across a range of areas including financial services, energy, communications and employment.
Tax reform looks like a key legislative priority for Trump and congressional Republicans but the path to law will not be straightforward given the legislative complexities of process, scope and policy. The overall direction of travel is nonetheless clear, albeit investors seem some way from fully discounting the positive effect of lower tax rates and potentially higher capital allowances.
From an investment perspective, we feel sure that many stock and sector opportunities will emerge while the tax reform process plays out and expectations evolve, particularly on such matters as a potential border adjustment tax.
Healthcare reform is another priority but it will be complicated and time consuming. Congress has already started the ball rolling for repeal of Obamacare but replacement will be a far more challenging task given numerous cost and coverage issues. We would therefore be mindful of the risks to “big pharma” from any deterioration in pricing.
Repeal of the Dodd-Frank framework of financial regulation is unlikely any time soon given other priorities, but, as Trump’s initial executive order on the matter demonstrates, a relaxation of regulation and enforcement is highly likely and would encourage greater lending activity. On this basis, generally low valuations for banks should provide a favourable basis for continued outperformance despite the sector’s recent rally.
Domestic energy production will be stimulated by Trump and should help deliver energy independence, investment, jobs, lower pump prices and increased US industrial competitiveness. This increased activity is a potential depressant for the price of oil and is a counterweight to the price-supportive impact of OPEC’s supply cuts.
Elsewhere, however, there will be legislative and financial limits to Trump’s ability to deliver on his infrastructure promises and some building and construction stocks now look vulnerable after outperformance.
On defence, Trump is committed to increased spending but the budget is in place already. Many defence stocks have performed well and look potentially vulnerable, particularly if Trump continues to talk about programme costs and reimbursement as he did recently on the F35 project.
Perhaps the biggest anxiety for markets is the protectionist tone of Trump’s comments on trade, with his inauguration address emphasising his belief in “buy American and hire American”. Trade frictions are inevitable but Trump also sees himself as a believer in free markets.
Protectionist trade wars remain a tail risk not priced into markets, but on balance we feel that Trump will be pragmatic enough to avoid greater hostilities.
Eurozone – studying politics and economics
That markets took the Italian referendum result in their stride was largely a function of the fact that uncertainty had been removed. This was particularly pronounced in the case of Italian equities which had already been weak but rallied nearly 18% in the fourth quarter of 2016 because the bad news associated with a Renzi defeat was already priced in.
Other contributory factors included an accommodative European Central Bank monetary stance, supportive regional lead indicators and a positive outlook for corporate earnings.
Past performance is not a guide to future performance and may not be repeated.
Looking at the year ahead, our economics team is constructive on the eurozone given stronger business investment, faster consumption growth and greater trade activity. There is also evidence that the fundamentals of labour markets are improving.
It would be unwise to ignore the potential impact of elections in France, the Netherlands and Germany in 2017. However, our current sense is that the relatively benign conditions in the eurozone are by implication supportive for the UK economy and UK equities as an asset class.
China – finely balanced
The pronounced fears about China in early 2016 are no longer weighing on investors. This is somewhat disconcerting in the sense that this might represent a degree of complacency about the country. Growth of 6.7% for 2016 was a respectable clip in Chinese terms but the main driver appears to have been government investment.
This does not support the narrative of a rebalancing economy, while the growth in credit in excess of GDP is a concern for the long term sustainability of growth.
In the shorter term, we expect a modest slowdown in the economy with limited changes in terms of policy direction. The trading relationship with the US will be a focus for markets, as will the related fortunes of the Chinese currency, on which subject Candidate Trump famously called China a currency manipulator.
On the trade front, protectionism and tit-for-tat tariff hostilities would be damaging for both China and the US and, as discussed above, markets are rightly vigilant. The focus of markets will therefore be on the extent to which Trump will be a pragmatist, as well as on the restraint or otherwise which the Chinese apply to any retaliating actions.
As for currency, the chart below shows that China has been using its reserves to support the renminbi. This is consistent with a conciliatory approach by President Xi, while his recent visit to the World Economic Forum annual meeting in Davos suggests that he is looking to operate within traditional global structures.
In terms of UK equities, the mining sector and the Far Eastern banks are the most sensitive to Chinese developments with the former benefiting from Beijing’s recent investment stimulus and from the closure of polluting low-grade domestic steel mills. Both of these sectors have performed well recently and we are mindful that valuations have also increased.
What is the impact for UK investors?
As discussed above, UK equities will be influenced in 2017 by many of the same issues prominent in 2016, namely Brexit, Donald Trump, the eurozone and China.
It is important, however, to put these into a wider macroeconomic context. To this extent, a strengthening global economy supports the “narrative” which emerged in 2016 of a normalisation of government bond yields, inflation, growth and monetary policy. Trump’s reflationary agenda has boosted market trends already in place while a recovering eurozone and a still-resilient China can be viewed through the same prism.
We have already looked at a number of the risks facing the global economy but in market terms the growing maturity of the economic cycle - particularly in the US, UK and China - will in time become a headwind as global monetary policy moves to a tightening bias. Indeed, an increasing desire among governments to “pump-prime” through infrastructure spending certainly brings with it end-of-cycle hazards.
With the VIX Index of volatility at all-time lows, investors are in “glass half full” mood and therefore vulnerable to any rude awakenings. This could come from a perception of policy error with Janet Yellen, the Federal Reserve Chair, herself pointing out recently that “waiting too long to remove accommodation would be unwise”.
That being said, we think UK equities currently offer reasonable value on a prospective 2018 price-to-earnings2 multiple of 13.5x. The dividend yield is 4.2% with dividend growth averaging 7% in each of the next two years.
In terms of stock selection, our investment approach continues to be bottom up. We look for mispriced opportunities in individual stocks where we can identify an inflection point to deliver timely valuation upside.
To the extent, however, that we have an overall bias, it is in favour of those parts of the market such as banks and construction which should benefit from the global reflationary forces we have considered above.
Stocks and sectors mentioned are for illustrative purposes only and not a recommendation to buy or sell.
Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
1. Reflation is a fiscal or monetary policy designed to expand a country's output, seeking to bring the economy back up to the long-term trend after periods of stagnation or contraction.↩
2. The price-to-earnings ratio (or P/E ratio) is a ratio for valuing a company that measures its current share price relative to its per-share earnings.↩
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