Outlook 2017: UK equities (business cycle)
We remain in the slowdown phase of an extended business cycle, but the unexpected events of 2016 have prompted us to take a slightly more balanced view of the end of this cycle.
- We believe that we have seen the peak in real growth rates and corporate profit margins, but may find ourselves in another late-cycle upswing
- It seems that an era dominated by ultra-loose monetary policy may finally be drawing towards a close
- This has important implications for overall portfolio positioning and also, of course, for the valuation of individual companies
A very eventful year
After a torrid start to 2016, UK equities recovered, delivering double-digit returns as deflationary1 fears eased and US interest rates stayed low. While economic activity had been slowing from mid 2015, the stabilisation in commodity and industrial input prices, helped by aggressive pump priming in China heralded an important and welcome pick up in nominal growth in 2016.
Even the two major political surprises of the period – the Brexit vote and Donald Trump’s election victory – failed to derail equity market progress. The year will, of course, be remembered for these historic events of June and November respectively. But it was also a surprise for many investors that UK large caps (FTSE 100) led the market higher, miners and oils outperforming the wider market, leaving the mid and small-cap sections trailing in their wake.
For UK investors, 2016 was first and foremost about the UK’s decision to leave the European Union, and this helped to cement the market’s focus on overseas earners, both cyclicals2 (oils) and, at least initially, defensives (tobacco). Despite some further monetary easing from the Bank of England, the uncertain outlook for UK business investment and economic growth weighed on many domestically-orientated sectors in 2016, including travel & leisure, housebuilders and real estate. Meanwhile, internationally-focused companies continued to rally as investors discounted the beneficial impact of sterling weakness on their overseas earnings.
Lots of noise, but a change in the investment rhythm
As we explained in last year’s outlook, we are in the slowdown phase of an extended business cycle, but the unexpected events since have prompted us to take a slightly more balanced view of the end of this cycle. We still believe that we have seen the peak in real growth rates and corporate profit margins, but we may find ourselves in another late-cycle upswing. Alongside this, 2016 has seen a significant back up in sovereign bond yields from ultra low levels, reflecting the changing investment landscape.
The revival in commodity prices has started to overcome the underlying deflationary trends of demographics and technology change. This has been supported by the recent “agreement” among both OPEC and some non-OPEC oil suppliers to reduce production. While these "shock" events dominated, and will continue to dominate all the news headlines, we sense that there is an underlying shift in the dominant investment paradigm.
Low interest rates, quantitative easing and falling bond yields have driven equities (and other asset classes) from 2008, with only brief spurts of economic expansion at the regional level. It has been a long time coming but we have already seen the signs that the world’s economic policymakers will pursue a more balanced mix between fiscal and monetary support, where they can. It seems that an era dominated by ultra-loose monetary policy may finally be drawing towards a close. This has important implications for overall portfolio positioning and also, of course, for the valuation of individual companies.
Wage inflation has already accelerated, putting pressure on corporate profit margins, which have now probably passed their peak for this cycle. Low interest rates have been used effectively by many developed market corporates, especially to boost return of capital, at the expense of investment. In a rising yield environment, this boost to returns will start to wane and eventually higher levels of corporate borrowing will take its toll.
While the Federal Reserve (Fed) has indicated it is prepared to tolerate higher inflation, even in the core measure3 , a more aggressive Fed tightening cycle and strong US dollar will be the most likely cause of the next recession. An unscheduled move up in bond yields, that unnerves equity investors could be another trigger.
Our concerns for corporate profits are consistent with the slowdown phase of this extended business cycle. The cycle is extended because of prolonged and aggressive monetary policy measures following the financial crisis and recession of 2007/08, but remains very much alive and kicking. While 2016’s shift in economic policy emphasis alters the investment landscape, we still believe a balanced portfolio is most suitable at such a late stage in the cycle.
State of the nation
Growth, Growth Defensives and to a lesser extent Value Defensives (see ‘The seven style groupings of the Business Cycle equity team’, below) have been the dominant performance category since mid 2014, driven by fears of deflation and falling bond yields. However, we sense that this dominance has and will continue to be challenged and we will need to see a more significant de-rating before we move aggressively overweight. Although we are late in the business cycle and have therefore retained a balanced portfolio, we recognise that the best stock opportunities are likely to be found in businesses that have been out of favour over the last few years.
Financials, including banks, are an area where we continue to find opportunities as we feel these could offer the best combination of attractive valuations and potential for earnings to further improve. We think the recent performance pick-up has taken out the extreme oversold conditions post-Brexit, and that the valuation gap has closed from extreme to very attractive. With this in mind, if financial stocks are to continue to outperform we need to see an improvement in the fundamentals: specifically rising bond yields feeding through into a recovery in profit margins.
Commodity Cyclicals have been in recovery mode since early 2016 and we expect them to remain positive early into 2017 as balance sheets are repaired and nominal growth picks up. Within the remaining cyclical style groupings, Industrials are currently better placed with end prices rising again and a strong element of restructuring in many areas, particularly where capital investment plans are starting to recover. The most interesting, but challenged grouping is Consumer Cyclicals, which have seen a 10-15% de-rating since June. We are not bullish on the outlook for UK real wages as domestic inflation lurches upward, but many stocks in the group carry a massive risk premium, which could provide an opportunity if demand remains robust.
1. Describes a situation where there is a persistent fall in the general price of goods and services.↩
2. A cyclical sector is one whose value is directly related to the economic or business cycle. By contrast, the value of a defensive sector tends to fluctuate less over the cycle.↩
3. A measure of inflation that excludes volatile components such as food and energy prices.↩