Clients will know that our aim has been, and will continue to be, the creation and ongoing management of diversified investment portfolios incorporating a range of asset classes. Between them, we believe that they provide a sensible balance between risk and opportunity, delivered to clients on an individually tailored basis reflecting their requirements. Since the EU referendum, this policy has ensured that, for most clients, less volatility has so far been delivered than might have been expected.
More specifically, the cautious elements of portfolios have held their value well while our approach to equity investment, incorporating a significant element of overseas focus (either directly or via UK funds with a focus on large international companies that just happen to be based here) ensures that, in considerable measure, too much purely UK focused risk is limited.
On this basis, we see no reason to make major adjustment to portfolios at this time.
A point that has been made by a number of commentators is that Brexit concerns may trigger a global slowdown in economic activity, adding to pressures that already exist. We thought it might be helpful to try to put this into some context, drawing upon figures for 2015 drawn up by the IMF. The following table illustrates the importance globally of the three main economic power blocks and of the next most significant individual countries. It also shows how activity is divided within the EU, in so far as the three major EU economies are concerned:
Percentages of Global GDP for 2015 in perspective:
Within the EU element, the ‘big three’ are, as a percentage of global GDP, as follows:
The UK accounts for 17.6% of the EU total.
In terms of overall scale, the UK lags behind Japan and Germany and with approximately 4% of global GDP it is not vastly significant. However, in the context of the EU (in which the UK may well remain for at least two years under Article 50 rules), it clearly matters rather more. We conclude that if there were to be a significant recession in the UK then there will be a knock-on effect across Europe, particularly among the smaller, often weaker, economies. We also conclude that, at a global level, modest recession in the UK, while damaging sentiment, will not in itself cause major disruption. In our view, these are important points to bear in mind when considering the investment outlook.
Turning now to the UK outlook, there is a substantial political vacuum which appears unlikely to be resolved until September but that of course is simply the first step as at some point EU negotiations will begin in earnest and may drag on for an extended period. The EU does of course account for approaching half of the UK’s exports so that this is a matter of material consequence.
The other half of UK exports are despatched worldwide. In fairly short order, the UK will have no established trading relationships with the rest of the globe: although some may be established quickly, we are concerned that the UK will be seen as a ‘sitting duck’, constrained by time to make trade agreements speedily. If we are right, then there may be a material slowdown in UK trade in both goods and, vitally, in services. Furthermore, if future trade deals are concluded with others on less favourable terms than exist under the EU umbrella, long lasting damage may be done. We conclude that ongoing economic uncertainty and possible long term issues are likely to cost the UK more than will be saved if and when the net payments to the EU cease.
If in due course we are shown to be correct in these views then the best likely outcome for the UK economy over the next few years is stagnation which, if Sterling should continue to depreciate, could transform into ‘stagflation’ or indeed recession, continuing for some while as the economy and households adjust to lower real incomes and lower living standards. Both monetary and fiscal policy will, however, provide shock absorbing mechanisms by way of offsets: there is evidence of these being introduced already.
Our post referendum equity investment strategy
There are a number of points to make here, firstly starting with the UK market.
As we have often said, many companies that are FTSE 100 constituents derive the bulk of their turnover and profits from their activities overseas. While these companies are not immune from development at home, they are substantially independent of them and given that those profits are earned in foreign currency, the sterling value of them increases when sterling declines in value as it has, sharply, since the referendum.
Companies that are more UK facing (for example the high street banks, house builders and companies in the UK service sector such as ITV and Whitbread) have seen substantial share price falls as they stand to lose from domestic slowdown and from sterling’s depreciation particularly if pressure for rising wages builds as a result of inflation. As it happens, while there are some such companies in the 100 share index, there are many more in the FTSE 250 index and among smaller companies generally. It is our view that the scale of share price falls in these sectors lends added strength to the possibility of UK slowdown (the stock market is a generally good leading economic indicator) but equally it may be that falling share prices in these areas have been somewhat overdone.
We conclude on the UK by noting that larger company funds may well have an edge over their smaller company focused competitors in the short and medium term. For mid and smaller company funds, on the other hand, we could see the emergence of a buying opportunity for the long term investor relatively quickly as valuations may have fallen too fast.
Global equities are arguably in a different place. After some Brexit inspired falls, we consider that value is to be found in North America, Japan (despite the latter’s strong currency) and in many emerging markets, the latter arguably for higher risk and long term investors. For European companies, the outlook is more tainted by Brexit trade deal issues and our view is to underweight Europe until matters are clearer.
Our view is that commercial property values in the UK will be knocked back as, for a period at least, turnover in commercial properties will decline with buyer’s potentially remaining on the side-lines. Fear of this has already had an impact as the cash reserves of many leading UK commercial property funds have been exhausted by investors withdrawing monies from them. As a consequence, a number have suspended dealings by investors wishing to sell holdings until the picture becomes clearer. We do not know how long this may take and nor do we know the extent to which unit prices, based of course on asset value, will be affected.
What we can however say is that the UK property funds that we have selected are invested in good quality commercial buildings with high tenancy rates and attractive yields. While in the short term, suspension of dealing in funds is unsettling, we do believe that the underlying property portfolios are very sound. In the meanwhile, investors in global property funds are substantially unaffected.
Fixed interest investment
We believe that the pendulum has swung in favour of fixed interest and index linked investment since the referendum.
Unless Sterling totally collapses (to, say, around parity with the dollar, an unlikely extreme) it appears that interest rates will stay low in the UK, and may even fall further. This is of course not a sign of strength: rather, it is one of self-imposed (by the voters) uncertainty. We may yet see UK interest rates slipping into negative territory as is the case in, for example, Germany and Japan, but for the UK the reason for this is simply to try to stop stagnation turning into deep and prolonged recession. Indeed, there is talk of more quantitative easing and other radical measures to keep the economy ticking over via the process of pumping money into it. We will learn more on these matters as summer moves into autumn, when the thinking of the Office for Budget Responsibility is reflected in the Chancellor’s autumn statement. At this stage it is encouraging to note that the latest Gilt issue has been well received by the market, including in particular by overseas buyers. Perhaps some feel that Sterling’s fall has been overdone.
Inflation linked fixed interest investment, which has quietly proved its worth over the last seven years or so (despite low inflation) may once again come into its own as a consequence of the pound’s depreciation which has the effect of pushing up import costs. This is already beginning to be felt at the petrol pumps and has the potential to find its way into consumer staples, notably food prices (some 40% of the UK’s food is imported), quite quickly.
In summary, we see fixed interest markets remaining stable for longer than we had previously anticipated, there is a very real prospect of more QE to limit recessionary pressures and while inflation is likely to move higher, we see the prospect of sharply rising interest rates to protect the currency and to control inflation as being a remote possibility.
We do not believe that there will be an economic dividend to be reaped from Brexit, at least for some years: rather, our view is that over the next few years an economic slowdown will produce a net cost to the UK. We hope to be proved wrong.
However, investors should bear in mind that markets, and particularly equity markets, are driven by more than movements in a country’s GDP. If as seems likely, UK GDP slows or shrinks while our future trading arrangements remain uncertain, and while this may have an impact on some sectors, it will be at least in part ameliorated by monetary and fiscal changes while more outward looking sectors may be substantially unaffected. It is worth remembering that attractively priced investment opportunities often appear in times of greatest uncertainty.