Alex Scott, Deputy Chief Investment Officer.
29 March 2017.

Markets continue to be caught between the economic backdrop and political events although now, for the first time in years, we appear to have a synchronised upturn developing in all of the world’s major economies.

Ordinarily, this would be a clear positive, supporting the outlook for corporate earnings and encouraging yet more confidence in the markets. This in turn feeds through to yet more economic growth and fuels further stock gains. It enables us to favour equities over bonds, which is comfortable territory for our portfolios in particular. However, while current equity market valuations might raise some concerns and suggest we adopt a degree of caution, they are not necessarily stretched enough to justify any dramatic, near-term unease. Meanwhile, there are equity pockets, such as Japan, where valuations are not as overextended and so offer up good opportunities for our portfolios to benefit in a rising rate environment. As we have written before, it’s the political uncertainty that investors must continue to contend with.

In the UK, there’s the distinct possibility of a cliff-edge hard Brexit undermining Sterling still further and knocking long term confidence in the British economy. The timeline that’s been published for the first month of the Brexit negotiations sees a lot of EU activity without any involvement from the UK, which could lead to the scenario in which Sterling’s exchange rate with the US reaches new lows – some fear as low as US$1.10 to a Pound.

In the US, investors remain understandably uncertain about any likely fiscal and trade policy as the new administration finds its feet. With the decision to kick the healthcare bill into touch, the floor is now free to debate other topics including Trump’s much vaunted fiscal stimulus. Here though we must be cautious about any potential upside in the markets. The healthcare bill has taught us how difficult it can be to get any legislation passed into law. The increasingly angry splits in the Republican Party are apparently at a time when Trump should still be on his honeymoon, and augers badly for his ability to deliver on his campaign promises.

Also, the lack of a reduction in the healthcare costs of the country means that Trump has a lot less money to pump into infrastructure projects and tax cuts. His approval ratings among Republican voters remain high…for now…but those numbers could suffer if it becomes clear that Trump isn’t able to “Make America Great Again”. The election cycle begins again in 2018 with mid-terms. Republicans could attempt to distance themselves from Trump to ensure their own re-election.

Meanwhile in Europe, there’s still the possibility of a Le Pen victory in the forthcoming French election. While admittedly it is not our most likely scenario, she is expected to get through the first vote on 23 April and, as we have noted before, 2016 saw the pollsters get things wrong: their predictions for the 7 May vote may prove equally so. This would reopen existential questions for the Eurozone. Le Pen is promising a renegotiation of France’s Eurozone integration and a referendum to either accept those new terms or leave the single currency. She also wants to introduce a new Franc – effectively devaluing the currency – to reindustrialise France. Her ‘France First’ rhetoric is very much à la Trump.

“In the UK, there’s the distinct possibility of a cliff edge hard Brexit undermining Sterling still further and knocking long term confidence in the British economy.”

Le Pen’s main competition is the much more market friendly Macron, who is promising structural reform – including a proposal to tackle France’s 35-hour working week – and a fiscal injection to boost sluggish economic growth. Our question centres on whether his new political party will win many seats in the June French legislative election – and actually enable him to carry out any of his promises.

Germany’s elections are a little further ahead in September, but Merkel has already indicated this may be her toughest election yet. However, while Schulz certainly injected vigour into his SPD party, he failed to encourage many voters in Saarland to put their trust in him – in fact the swing was against him. However, Saarland is a tiny state and Schulz himself was not running – although no one was in any doubt that any SPD vote was for him – so it may yet be too soon to write him off.

Either of these two events could put a serious spoke in the Brexit wheel of negotiations. The EU is keen to go into the negotiations with a united front. They have vetoed any trade talks until the divorce settlement is agreed – this will enable them to quieten some of the internal debate about how Britain’s contributions will be divided up in the future, and enable them to preserve promised incentives that in turn keep some of the more wayward members quiet.

There could also be a relatively quick deal for EU citizens living in the UK and the UK citizens residing across the EU, which the EU would like to get done to keep Spain and Eastern Europe on side. Scotland’s demands for a fresh independence debate also provide Brussels with a card to play against the UK. The UK though has a card to play with Eastern Europe for any military and intelligence support, given that the US has put paid to its NATO cheque.

We continue to look into our options for alternative investments and will add to the circa 20% weighting we have in those assets as our due diligence process allows. We have also put some money into US Treasuries – moving back to an overweight. We believe that the market has already priced in the anticipated three Fed rate hikes for 2017, which suggests that there is some room for disappointment. Their continued role as a safe haven has given us courage to follow our convictions.

Meanwhile, the balancing act between political risks and equity investments continues. So we have moved some money out of European equities, despite the decent economic story backing them, until some of the potential political upsets clear from view. However, we remain marginally overweight so it would not be too difficult to add to these positions again at a later date.

With US equity valuations becoming more stretched, we have also taken the decision to move to an underweight here in favour of Japan (equities and Yen) and Emerging Markets (both local currency debt and equities). India remains a favoured market given the strength of its domestic story and its limited vulnerability to Trump trade rhetoric. Although that bombast may also fade away. On the campaign trail Trump labelled China as a currency manipulator, but since taking office he’s been rather quiet on this. April sees the release of the US Treasury’s latest currency report, and may allow the administration to step away from this label, and allow political uncertainty to fade here. This in turn would help Emerging Market equities given China, as well as South Korea and Taiwan make up over half of the Index.