Investment Outlook

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May 27, 2019

Investment Outlook

Tom Elliott

Market sentiment: Remaining uncertain. The U.S/ China trade war has become increasingly shrill and increasingly about technology, with Trump receiving bi-partisan support at home for his stance. This is contributing to fears that higher tariffs will slow growth in both countries, and to a rise in stock market volatility. In the U.K, the chances of a no deal Brexit has risen, putting pressure on sterling. Several contenders in the Conservative Party leadership race have followed Boris Johnston in openly contemplating no deal if future negotiations with the E.U do nothing to change May’s ill-fated Withdrawal Agreement. Populist politics continues to flourish: Modi has won his second presidential term in India on a manifesto of Hindu nationalism, which investors have welcomed by sending the local stock market to new highs, and in European Union Parliamentary elections are expected to see populist parties make significant gains. 

Global investors currently favour defensive assets, leading to rallies in core government bonds and sustained support for the dollar. The VIX index of implied volatility on the S&P500 stands at 15.8, down from a recent spike of 20.5 on May 13th, but well above levels seen in April. 

Trade war. The winner of the U.S/ China trade dispute will be the side that can play the longest game: Trump wants a deal before his re-election campaign starts, Xi Jining before weaker economic growth threatens civil unrest. Given China’s skill at playing geopolitical long games, the odds must be on Xi’s side. However, the economic risks are asymmetric, with China more vulnerable. 

The longer the dispute goes on, the greater the risks for long-term global growth as third-party countries become forced to attach themselves to the U.S or the Chinese camps and tech supply chains are disrupted. For instance, China last week threatened the U.K with unspecified consequences if it banned Huawei 5G technology on security grounds, while U.K-based ARM mobile phone chip designer can no longer supplying Huawei if it wants to continue to work with Android and Apple.  

The interesting FTSE 100. The underperformance of defensive sectors on global stock markets in recent years has resulted in some defensive-biased stock markets, such as the U.K blue-chip FTSE 100 index, looking very cheap by comparison with growth-orientated stock markets. The FTSE 100 has an attractive dividend yield of 4.5%, well above the 10 yr gilt yield of 1%, and trades on a relatively undemanding (by international standards) P/E ratio of 15.5. Around 75% of FTSE 100 company earnings come from abroad, meaning that if sterling weakens on a no deal Brexit, the value of their dollar, euro, and yen earnings will become worth more and support the share price. 

Furthermore, a more defensive tone on global financial markets is likely to favour value/ defensive stocks over growth stocks – benefiting the FTSE 100 that is long in energy, financials, consumer staples, tobacco etc. 

However, the high dividend yield on the FTSE 100 can be read a warning signal. It suggests that investors are sceptical of the long-term sustainability of corporate earnings, and of dividend payouts. Will this undermine the defensive characteristics of the index? Or will investors be willing to take some dividend cuts, and perhaps these are already priced in?

Brexit and the leadership contest. The ruling Conservative Party is seeking a new leader. Theresa May wasn’t very good. To appeal to the 120,000 membership base, the majority of whom want a no deal Brexit on 31st October, leadership candidates will be obliged to ‘sound tough’ on Brexit. This means being open to a no deal, which is a popular option with 70% of the membership. While Parliament has ruled out the government making no deal a policy, it can still happen through an absence of any Brexit deal being passed by Parliament on October 31st.

However, a no deal Brexit is a chimera. First, a new Prime Minister’s willingness to contemplate a no deal risks seeing further splits in the Conservative Party, and defections of the party’s M.Ps. The new Prime Minister would lose the narrow working majority that the government currently has in the House of Commons. A general election, which the Conservatives are currently likely to lose, would follow. A new Labour-led government is likely to prefer either a soft Brexit (with the membership of the customs union) or a second referendum.

Second, even if the U.K did leave without a deal on October 31st, the very next day the U.K government will be wanting to sign a trade agreement with the E.U. The E.U takes just under half Britain’s exports, and a trade agreement will be vital to avoid disruptions to supply chains to British companies. It will again have to debate within itself, and with its DUP allies and indeed the nation, how it can secure a favourable trade agreement with the E.U, while making its own trade deals with the U.S, India, etc, and at the same time keeping the Irish border open in the spirit of the Good Friday Agreement. 

Who will win the leadership contest? After Conservative M.Ps have whittled the list of prospective candidates down to just two names, I suspect two types will emerge and be offered to the membership. One will be an enthusiastic Brexiter who waves the flag and offers a no deal Brexit. But they will have limited support in the House of Commons to get the necessary E.U trade-related policies through after October 31st. The other will be a reluctant, cautious, Brexiter who can get a wider backing in the House of Commons, avoid a no deal, but whose lack of enthusiasm for the Brexit cause will ultimately be his/her downfall with the Conservative membership. Former foreign minister Boris Johnston, against the current minister for international development Rory Stewart, perhaps?

Sterling may weaken over the coming weeks, as leadership candidates ingratiate themselves with the Conservative Party membership’s enthusiasm for no deal.

A multi-asset portfolio for the long term. Many long term investors favour investing in a combination of global equities and bonds since the two asset classes have a relatively low correlation with each other and so offer diversification benefits. Below is an illustration of a typical 60% equities/ 40% bonds fund. The exact ratio of equities and bonds will reflect a client’s risk profile and investment horizon.

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