It is perhaps no wonder that economics is often referred to as being ‘the dismal science’. While the phrase first appeared around 170 years ago, in a very different context, it continues to have a certain resonance today. Perhaps the principal difficulty with economics is that, while science is generally considered to deliver relatively precise outcomes, economics does anything but. The very best economic modelling systems employed by central banks produce results that can be thrown way off course by the development of an unexpected factor or the appearance of a particular piece of news.
In the UK, just over a year ago, the opinion polls suggested that voters would elect to remain in the EU while this Spring, similar opinion polls were suggesting a certain, well almost certain, resounding victory for Mrs May’s Conservatives. President Trump’s election in the US also defied earlier opinion polls. Economic and financial market thinking based on those apparent certainties turned out to be nonsense.
Since Trump’s presidency began, few pre-election economic promises have become anywhere near realities. Nonetheless, Wall Street has continued to power ahead, not so much because of those promises: rather, company profits have for the most part been strong and there have been no major economic shocks. The Federal Reserve appears content to raise interest rates gradually and does not appear likely to reverse quantitative easing in any great rush.
In the UK, the Brexit vote led to an immediate devaluation of Sterling which had previously not been on the cards. The Base Rate was halved (albeit from very low levels) and equity markets, particularly for companies with significant overseas earnings, have powered ahead while low interest rates have underpinned the fixed interest sector. The UK’s modest manufacturing base has been able to take some advantage from the lower currency to boost exports a little.
But then there is the negative side. Devaluation increases the import costs of everything. Therefore what manufacturing gains on the one hand it loses on the other because raw materials and many component parts are imported at higher cost. Inflation has outstripped real wage growth so that households are poorer and anyone holding excess cash in bank accounts, or in Cash ISAs for example, has lost money in purchasing power terms.
In recent weeks, Sterling has recovered a little against the Dollar, very much because of the Dollar’s weakness resulting from President Trump’s difficulties, rather than because of any fundamental recovery in Sterling, while it is perhaps ironic that growth within the rest of the EU is improving, so Eurozone unemployment is falling and the Euro has strengthened. Among other things, trips to Europe are increasingly expensive.
The Outlook
After the shocks and surprises of the last 12 months, can there be more? Well of course the answer is yes and because they are shocks and surprises, they can be difficult to see coming.
Starting with the US, which remains the world’s largest economy, we continue to see prospects for growth and, barring shocks, we expect the Dollar to strengthen over the next year. There are risks attached to this, but we believe that the US remains a worthwhile opportunity for equity investment with the Federal Reserve continuing to behave cautiously on interest rates. The latest US employment figures were in our view sufficiently robust to warrant one more interest rate increase later this year, while two more would constitute a shock and push the Dollar higher.
The Eurozone continues to recover: we believe that this will continue but buying into Eurozone investments has become more expensive given the strength of the currency. At long last, problems with southern European banks appear to be in hand while their northern counterparts have recapitalised and a strong banking system is of course a vital ingredient for a strong economy. Should the Euro continue to appreciate, Germany’s competitive export position will begin to be eroded and their high manufacturing costs (including high labour costs as the trained workforce ages) may begin to count against it. However, the Eurozone recovery still has to reach more deeply into the weaker economies and as this happens, worthwhile opportunities appear probable and the Euro may strengthen further.
The Far East, which includes many of the emerging markets, is of course another giant economic area. We note with interest that construction activity in China is increasing and this has led to an inevitable rise in Chinese imports of raw materials, good news for mining companies. What is not so good news for China is the level of debt, although the asset base appears to make that manageable. Perhaps more fundamentally there is a serious shortage of labour in China as the result of long term enforced low birth rates and a lack of immigration. Over time, we believe that the Chinese economy will begin to mirror that of its smaller neighbour, Japan, where labour shortages are endemic. Efficient Chinese exporters hold potential through use of technology and as labour costs remain relatively low for now, while individuals in China will benefit from increasing spending power as wages pick up in the future.
We continue with China for a moment longer because from next year, mainland China shares, previously restricted to Chinese ownership, become available internationally and enter the MSCI emerging market indices. Because the Chinese stock market is so large, this will inevitably have a significant influence on those managing Asian assets, so that funds in this sector will almost certainly have to increase their Chinese weighting, altering the makeup of their portfolios and perhaps adding to volatility. In the round though, Asia continues to offer worthwhile potential. As for Japan, clearly a very developed market, the scarcity of labour is driving a significant trend towards further automation while temporary inexpensive foreign workers fill the gaps. Over time, we believe that this will help to propel Japanese markets higher.
Turning now to the UK, a key market for many of our clients but it is one that is relatively modest when measured against the power of North America, Europe and Asia. We remain concerned in respect of the outcome of the Brexit negotiations where, over the first year since the referendum very little that is tangible or positive appears to have been achieved. The UK’s FTSE 100 constituents enjoy substantial protection derived from their overseas earnings but the further one delves into smaller companies, the greater the risks of a disorderly Brexit appear to be for their businesses. This sector, and the wider economy, also faces further issues, namely a decline in investment in industrial and business capacity plus growing skills shortages. Should these continue, the long term impact will be felt on productivity, making already slowing growth harder to achieve. Following the general election, the UK is also not without political risk with its as yet untested minority government facing deeply difficult issues. Therefore, we are somewhat cautious on certain areas of the UK equity market, which is a change from where we were ahead of last Summer’s referendum.
As a general rule, we are also somewhat cautious on fixed interest markets, both in the UK and overseas, as the result of the gradually emerging trend towards higher interest rates. Fixed interest values move conversely to interest rates, so that modest increases in the latter will act as a headwind against the former. Should for any reason there be sharp upward interest rate shocks (likely should a Labour government with huge spending commitments be elected), those headwinds would have considerable force. We are minded to increasingly underweight fixed interest exposure within portfolios, this also applying to index linked holdings for those clients taking a relatively short term investment view.
Absolute Return investment is a concept that will be new to some clients. In essence, managers aim to achieve positive returns in all market circumstances over rolling periods. While not risk free, funds in this sector are used defensively and as such provide an alternative to fixed interest investment or, where a client may wish to reduce overall shorter term risk to an extent, as a hedge against some equity risk. Given the uncertainties facing the UK, such funds have a role to play in an increasing number of portfolios.
Summary
Very broadly, we continue to believe in the medium and longer term power of equity investment. As companies retain capital, and then reinvest it in their businesses for growth, a compounding effect takes place which is much enhanced for those who are in a position to reinvest dividends. While we are to an extent slanting exposure away from areas of the UK market, the basic equity argument remains in place and for all but short term and very cautious thinkers, this is where the bulk of portfolio investment will continue to be allocated.
Budget 2024