Investment Newsletter May 2017
What political risk? We have spent a lot of time recently pondering political risk, and the potential effect on investment portfolios.
Mike Deverell
From Brexit to Trump, French presidential elections and now another UK general election, it seems that the world has become particularly uncertain recently. However, whilst we have to be mindful of such risks and try and work out what might happen to our investments in any given scenario, we also have to be conscious of not giving politics too much weight in decision making.
Investment Manager
For example, the US election and the EU Referendum both had only two realistic outcomes. These were two cases where the outcome could have a significant impact on the future direction of the relevant country, where the polls were extremely close and the result highly unpredictable.
However, even those investors who did correctly predict these results and adapted their portfolios accordingly have often been caught out. For example, many people thought the UK stockmarket would fall if the Leave side won the referendum, and global stocks could be hit if Trump was elected. That turned out to be the opposite of what actually happened. Those who correctly predicted the political outcome were often unable to predict the market reaction. These things can be complicated and there are always several different factors influencing markets at any one time. In addition, one asset class can often have a knock-on effect on another. For example, after Brexit the pound fell sharply which many people had correctly anticipated. This led to a rising FTSE 100 index given that many of those companies make their profits overseas, and have been helped by a weaker currency. Fewer people anticipated this effect.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter May 2017
In fact, much of the time markets have actually seemed to care very little about political uncertainty. Chart 1 shows the relationship between global economic policy uncertainty and market volatility (as measured by the “Vix” index). Generally, market volatility increases as political uncertainty increases.
However, this has not been the case recently. This may be a sign of complacency, or simply a change in the way markets function affecting volatility measurements. Either way, volatility is currently extremely low.
Volatility index
Uncertainty index
Chart 1:
Jan 2014
July 2014
Jan 2015
July 2015
Jan 2016
July 2016
March 2017
Sources: BlackRock Investment Institute, Baker Bloom and Davis Economic Policy Uncertainty Index and Thomson Reuters, March 2017 Notes: The economic policy uncertainty index measures policy-related economic uncertainty based on newspaper coverage of related terms. The CBOE Volatility Index, or VIX, is a measure of the implied volatility of S&P 500 Index options
UK general election
So what of the UK general election? We are certainly not in the business of predicting the outcome, even if the polls currently point to a strong Conservative majority. Given this, the market reaction to the announcement was perhaps surprisingly sharp, taking into account it looks likely that the same people will be in power as now. This was particularly true in the currency markets, where the pound had been trading at around $1.25 against the US dollar and immediately leapt to around $1.30. Given the relationship between the FTSE 100 and the pound mentioned earlier, the FTSE fell sharply, closing down around 2.5% on the day the election was announced. Again, this reaction was perhaps slightly counterintuitive, where one might have thought that uncertainty could have led to a weaker pound.
One theory as to why this happened is that, if Theresa May were to increase her majority, this could increase the chances of a “softer” Brexit. Mrs May campaigned for Remain (though she doesn’t seem to like being reminded of it), and many believe she would like to see a longer transitional period and greater links to the EU than some in her own party. The government majority currently stands at just 15 seats and within the Conservative party around 40 or so MPs are thought to be in the so-called “Hard Brexit” camp. Given the slim majority, those hardline Eurosceptics can have a significant influence on negotiations. If Mrs May increases her majority by the projected 50 or so MPs, that could potentially reduce the influence of this group. Of course, if the noises from Brussels are to be believed we might not have any choice over this
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter May 2017
anyway. The EU seem to be signalling a hard Brexit or nothing! Whether or not any of this is true, what we saw following the announcement was a typical reaction to recent political events. A very short lived, sharp move,
Fundamentals
If markets don’t really seem to care about politics, what do they care about? Over the long term it’s the basic fundamentals of each asset class that make the difference. How cheap or expensive are markets relative to the underlying profits of the companies? Are those profits going up or down?
following which markets forget all about it and move on! In fact, over the past couple of weeks the FTSE has climbed to new highs despite the stronger pound, with the relationship between sterling and the market somewhat breaking down of late.
It is worth remembering that, on average, we get a 10%+ drop in markets every year, regardless of whether the market ends the year up or down. Given the ongoing geo-political uncertainty, including things we haven’t yet mentioned such as North Korea, or Trump vs the FBI, there remains a significant chance of a market correction even if markets are currently ignoring such risks.
For now, we continue to believe that stockmarkets look expensive relative to history as they trade at high multiples of earnings. However, on the positive side we are finally starting to see profits begin to grow again, after several years of flat earnings. In our view this is necessary to justify the current market levels rather than an indicator that they can go much higher, however it is welcome nevertheless. For the time being we remain cautious, but this earnings growth does strengthen our belief that a pullback in markets would be a good buying opportunity.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter May 2017
General Economic Overview The global economy continues to expand, although there are tentative signs that this growth is slowing, particularly in China. This is one reason why commodity prices, including oil, have weakened of late. The pound has rallied after the election announcement, but it still remains significantly down on this time last year. This has fed into inflation which has reached 2.7% this month (CPI). Despite this, we do not expect the Bank of England to put rates up in any meaningful way for some time. However, we expect the US Federal Reserve will increase rates again in June. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Our score is unchanged from last month as we continue to believe that many equity markets are fully or over-valued. In relative terms, our valuation indicators point to better value in markets like Asia including Japan.
-5
Fixed Interest The score is unchanged from last month. We continue to hold some index-linked gilts given the higher inflation picture but otherwise we prefer corporate bonds. We are generally positioned towards bonds which have low sensitivity to interest rate movements.
-3
Commercial Property The current growth in the UK economy would indicate very little capital appreciation in commercial property. However, rental yields remain ok. Brexit raises particular issues for the London office market and we are therefore avoiding this part of the market.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-3 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and neutral property. We are roughly neutral equity and also have with additional holdings in defined returns and alternative equity.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent Equilibrium’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.