Alex Scott, Deputy Chief Investment Officer
Last month, we focused this commentary on our currency positioning: we prepared portfolios for the possibility of Sterling strength as the government position on Brexit is forced to soften – compelled by markets, by the economy, by shifting public opinion and by political constraints, in particular the broadening realisation that the UK faces a trade-off. Leaving the single market and customs union of the EU almost certainly means a significant amount of disruption to trade, slower growth and risks for jobs and inflation. This is the most probable political constraint: a party leading the country to a damaging Hard Brexit is unlikely to be rewarded by the electorate at the next time of asking, when the reality of the economic risks of this policy have hit home.
As a result, we see a significant probability of public opinion converging on softer forms of Brexit, ones that prioritise trade, jobs and growth over immigration controls, while mainstream politicians are forced to alter course accordingly. However, even in the event of a sudden and complete U-turn on Brexit policy, some damage has probably been done to the UK’s economic prospects and its reputation as a place to do business. While it’s unlikely that the Pound would quickly recover its levels of last summer, we would see a softening policy stance by the government and a greater focus on the economy as generally helpful for Sterling. All else equal, a strong Pound hurts portfolio returns, as the value of overseas assets falls in Sterling terms.
It’s unlikely to be a smooth process: complex international negotiations, strained domestic politics, a softening UK economy and divided views on interest rates at the Bank of England exert different pressures on the Pound. So it’s reasonable to expect the currency to be caught in the crosswinds. Indeed, it would not be a major surprise to see weaker economic data undermine Sterling again before driving a more decisive shift in public and political opinion towards a softer Brexit. This creates an asymmetry, in our view: the worse it gets, the more likely that policy changes in favour of soft Brexit and a Sterling rebound. We believe this is a risk worth protecting against: moves we’d taken to increase Sterling allocations over recent months have helped protect portfolios against the rise in the Pound and, particularly, the fall in the US Dollar over the last few weeks.
Looking more broadly across markets, it’s not controversial to suggest that most financial assets are looking expensive – the product, perhaps, of a long economic recovery and the distorting effects of Quantitative Easing (QE). Higher than average valuations today, across many equity and bond markets, suggest lower than average returns in future. However, unfortunately, while that observation may hold true over the long term, valuations are not a reliable tool for short term forecasting. Assets may look expensive today, but they may stay expensive for a long time, and become even more expensive: the experience of bond markets over recent years demonstrates this beyond doubt. Clearly, valuations alone are not enough to justify a more cautious stance.
Meanwhile, there are other reasons to tread a little cautiously in markets right now, and not just because of expensive valuations. Central banks are striking a more hawkish tone: the European Central Bank is seemingly looking to take another step towards ending QE; the US Federal Reserve is still expected to raise rates again this year; and the Bank of England’s Monetary Policy Committee surprised investors by edging closer to a rate hike. This seems unexpected in the UK, given persistent Brexit uncertainty, but central bankers in the US and Europe may well be right that their economies have recovered enough to wind down Financial Crisis-era monetary policy. However, even if their economies can tolerate a change, it’s less clear whether markets can stomach it without some indigestion.
Market expectations point to steady or even accelerating economic growth in some economies, with inflation remaining relatively muted. On the face of it, that’s an enticing combination. However, we have some concerns over this optimistic assessment: to some extent, economists’ hopes rely on an anticipated fiscal stimulus (especially in the US) which looks likely to be smaller and later than previously hoped, as Trump’s White House struggles to progress infrastructure spending plans and tax reform.
More immediately, we are concerned that recent economic data releases appear to be surprising to the downside, lagging bullish expectations – again, perhaps particularly in the US. Lead indicators and surveys of business and consumer confidence are holding up far better than ‘hard data’ economic releases. This divergence seems unsustainable: either the hard data has to pick up to match surveys and lead indicators or if hard data continues to lag expectations we would expect optimism about the future to erode too. This is not at all to suggest that we are approaching the end of the cycle and an imminent downturn – on the contrary, we suspect steady, if unspectacular, growth over the next year or so is the most likely scenario. However, we are somewhat concerned that markets – and equities in particular – could be taking too rosy a view, perhaps setting the scene for a healthy correction. While investor sentiment became excessively and irrationally bearish eighteen months ago, with markets pricing in a recession that never materialised, it may now be leaning a little too far in the optimistic direction.
Furthermore, political risk has not gone away, despite the apparent crumbling of the anti-establishment nationalists in Europe over the past six months. We are wary of over-emphasising geopolitical concerns for investors not least as there is always risk in geopolitics. And yet they rarely pose more than a transient concern for markets, simply because it’s quite unusual for global geopolitical threats to have a sustained, meaningful effect on the major developed economies. Today is probably no different, but with markets that are on demanding valuations, there’s no margin for complacency here. North Korea is a key focus – markets are currently quite sanguine (the South Korean equity index is within inches of all-time highs), but it’s possible that US efforts to step up economic, diplomatic and military pressures could unsettle investor nerves at some point. Gold is a potential hedge for geopolitical risk but, other than a brief surge in Jan-Feb this year, the price of gold has been drifting lower for a year and now stands nearly 9% lower than levels seen in mid-2016 (in US Dollar terms). We are, however, comfortable taking the risk that gold drifts lower given the potential protection it could provide in a tougher environment.
Volatility has been incredibly low this year after two years where volatility may have felt higher, but was in fact broadly in line with the average of the last 20 years. Over this period, the MSCI World Index has moved in either direction by more than 1% on average a little over 50 days a year. So far in 2017, we’ve only seen two days when global equities moved by more than 1%, by some distance the lowest reading in the last 20 years. Periods of low volatility can persist for some time, but it seems unlikely that markets can remain quite as calm as this forever. Indeed, calm markets can often sow the seeds of their own demise since low volatility may embolden investors into riskier behaviour. We believe that it’s more prudent to assume that volatility will return to more normal levels at some point, and to prepare for such an outcome.
There are rarely if ever ‘open and shut cases’ in markets. There are positives to be sure as well as causes for concern. We are talking about an environment where the risk of a tradable equity market correction is higher, and not a re-run of 2008. The global economy is still growing and we may yet be several years away from the end of the cycle and the next recession. Equity markets across the world look set to report a synchronised pick up in profits this year – the first time since 2010 when no major region has been stuttering on profitability – but expectations have risen to match. To assume that upswing continues means baking in a fair degree of optimism into current equity prices. There may be room for disappointment against these rosy forecasts.
For investors, there is always a balance to be struck between offence and defence, but we feel the current environment demands a stronger than usual focus on downside risk. We could be wrong – or we might be too early in calling this. Markets may be right to be optimistic about a continued strong economic upswing and corporate earnings could still surge higher. Even if not, we know that stockmarket valuations can defy gravity for a long time.
It is perfectly possible that the risk factors we are wary of are not strong enough catalysts to force a correction. If that’s the case (as it’s been for periods in the first half of 2017, when we have been gradually becoming more cautious), it’s not a bad outcome, more a case of missed opportunities. While we would still expect portfolios to make money, they would lag any flying markets and other funds that may be more aggressively positioned.
On the other hand, if we are right that the environment could become more challenging, we should be relatively well-placed to weather a storm. This is not to say that portfolios wouldn’t fall at all: they would. Our increased positioning across a broad range of defensive assets – including gold, US Treasuries, index puts and specific alternative strategies – is intended to mitigate market impact in a more challenging environment, but cannot eliminate it altogether. And it allows the portfolio some flexibility to buy favoured assets from a position of relative strength if we do see asset prices fall – in bonds, equities or both. Time will tell whether our degree of caution is warranted, but we see enough to push us to a wary stance for now.
