The Centre Holds

Alex Scott, Deputy Chief Investment Officer.

11 May 2017.

Investor attention has been dominated by political risk for the best part of a year. Now, however we see signs that we might be passing the peak, which would allow investors to refocus a little on more natural territory, such as economics and corporate earnings.

European equities rallied strongly at the end of April as the first round of the French Presidential election revealed two key insights. First, the opinion polls were very close to the actual outcome and second, the far right Marine Le Pen could not expect to win the second round in early May. Confirmation of this with Macron’s strong win in the run-off removes, for now, a significant political risk for the Eurozone. Macron is strongly pro-EU, and has written in support of further Eurozone integration and debt burden-sharing. Le Pen meanwhile threatened to take France out of the Eurozone or to default on France’s Euro-denominated debt. The actual Front Nationale policy on the EU might have been confused or uncertain, but there is no doubt that a Le Pen win could have reignited market concerns about the integrity of the Eurozone, the sustainability of Euro countries’ debts and the outlook for the banking sector.

The absence of this negative is a positive in itself, removing a damaging ’tail risk’. Combine this with a brightening economic picture in the Eurozone, increasing business and consumer confidence, modest valuations and what seem to be the beginnings of a catch-up in corporate profits, and European equities could be real beneficiaries. Political risk hasn’t entirely gone away – parliamentary elections in France in June may clarify how much real reform Macron will be empowered to achieve. German elections in September will feature heavily in market commentaries, but it’s a contest between the pragmatic, mainstream, pro-EU centre-right and centre-left candidates, with the anti-immigration Alternative für Deutschland appearing to have lost significant support in recent state elections, Germany has limited scope to be a source of investor angst this year. There’s the possibility of an Italian lurch to the anarchic Five Star Movement which remains a threat for 2018 – but the coast looks relatively clear for now.

We can’t yet declare that markets have stopped looking at politics in the UK; far from it given the snap General Election on 8 June. But arguably markets are looking at politics from a slightly different viewpoint now. There is a strong consensus that we will see a large Conservative majority. This may change as the campaign unfolds, but as things stand we see a low probability of other scenarios. Domestic UK politics generally have quite limited ramifications for the headline UK stockmarket, which is dominated by global companies doing most of their business overseas. However, to the extent that this election affects the likely Brexit outcome and therefore the outlook for Sterling, it is still of major importance for investors.

We are sceptical that a large Conservative majority makes any real difference to the UK’s negotiating leverage in Europe. However, it does significantly increase the Prime Minister’s negotiating leverage within her own party and her ability to aim for her favoured flavour of Brexit. It does not, in our view, make it more likely that the EU will compromise on its negotiating priorities and bend to the UK’s wishes.

The election arguably does change some aspects of the negotiation however. it may be easier for May to agree to a transition period after 2019 given that she will no longer have to fight an election in 2020 when we are neither fully in nor out of the EU. This could push out the reckoning for the UK economy and shift currency markets’ attention away from the day-to-day gossip of Brexit negotiations. Furthermore, by strengthening her position within her party and within parliament, May looks less vulnerable to being diverted from her aims – either by the ultra-hard Brexiteers who would accept (or even welcome) a “no deal” situation (and potentially catastrophic implications for UK trade) or by an opposition who would seek a softer Brexit or even one that would try to reverse the Brexit process.

As we write before the release of the party manifestos, we still lack detail on exactly what May’s desired vision for the UK’s future trading relationship with the EU looks like, but it seems likely the aim is a hard Brexit, with limits to freedom of movement. This will mean constraints to the UK’s participation in the single market, for goods and especially services, with consequent risks to the UK’s current account, inward investment and Sterling. An election win makes this outcome more likely. The Pound rallied on news of the election – perhaps a counterintuitive move if this makes a hard Brexit more likely, but perhaps not if we take account of the lower risk of a chaotic no-deal exit or better prospects for transition arrangements, leaving markets to focus more on economics here too.

Some stress points are emerging for the UK economy – notably the increase in inflation above the rate of wage growth, and evidence that consumer spending is being supported by debt rather than incomes, but, for the time being, confidence is holding up reasonably well and the economy has not yet subsided enough to change the political course.

No-one could reasonably argue that political risk has gone away in the US; but perhaps the market is coming to terms with the limits as to what the Trump administration can actually achieve. Even with the Republican’s control of Congress, the constitutional, legal and procedural checks and balances have proved an obstacle to sweeping change. This may intensify if the administration pursues unpopular change to healthcare or if scandals around Russian involvement implicate President Trump more directly.

Markets have arguably downgraded and deferred their expectations for infrastructure spending and tax reform, but also they seem to feel less concerned that we will see significant and damaging anti-trade measures imposed by the White House. The good news is that reduced expectations for fiscal stimulus don’t matter too much for an economy that seems to be in a steady and resilient growth mode. While this is supporting a decent upswing in corporate earnings; the bad news is that equity valuations are quite demanding – not necessarily a sign of imminent trouble, but it is a deterrent to excess enthusiasm for that market.

Having profited in 2016 from holding a very high exposure to overseas currency, we increased allocations to Sterling through the second half of 2016 and moved overweight against our long-term strategic asset allocation – meaningfully so in most portfolios. We’ve diversified our overseas currency exposure away from its recent focus on the US Dollar to include more Euros, Yen and Emerging Market currencies. Our challenge is to balance conflicting demands – holding enough overseas currency to provide diversification into worldwide opportunities and to give valuable protection to portfolios at times of weakness for the Pound (as in 2016), but not so much overseas exposure so that the strength in Sterling detracts too much from returns. We hold much more Sterling now than last year, so the drag from Sterling strength now is much less than the benefit we gained last year, but we will need to remain flexible and prepared to move in either direction as the political and economic outlooks evolve.

We have added risk in Europe and Emerging Markets recently, but are running relatively modest levels of risk overall. Gold, US Treasury bonds, cash and alternative strategies play a role in most portfolios – these assets have been a modest drag on returns over the past couple of months, but we think they play a necessary role in managing overall risk. Market volatility has collapsed to unusually low levels. While we might bemoan the drag from portfolio protectors while such an environment persists, we’ll be grateful for them when we hit the next bump in the road.


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