Chris Darbyshire, Chief Investment Officer
Can political uncertainty become so elevated that it affects a country’s economy? We are about to find out. British businesses, already dealing with the coming departure from the EU, must now also try to anticipate what domestic government policy will look like at that time. And it might look very different. With the electorate rapidly drifting to the left it is increasingly likely that, following the next general election, the UK will have left a free-trade agreement with its biggest trading partner and will also have an anti-trade, hard-left Labour government in place.
The Labour leadership’s failure to endorse membership of the European Union has been one of the surprises of the past 18 months. More recently, the Labour Party has conspicuously failed even to endorse membership of the European Single Market. Criticised by the right for constraining Britain’s commercial potential, the EU is actually too commercially-orientated for an old Labour policy mix. The European Single Market is, after all, concerned with opening up national markets to cross-border competition. Labour wants to nationalise key industries. The EU seeks to impose market discipline on recalcitrant national governments. Labour wants to govern markets. You might not like the speed at which Europe moves, or the way in which it makes progress, but at least its direction of travel is to encourage business and trade. Come 2022, Britain could be firmly in reverse gear.
The flavour of Brexit is still the great unknown. Will it be hard, soft or a transitional fudge? Will it satisfy the hard-core Brexiteers or favour the status quo? Time is running out. Risks are increasing, and more risk is exactly what the government does not need right now. Ideally the government would attempt a cross-party approach, sharing the risk of failure with the opposition. But Labour would rightly be averse to participating in what is already looking like a procedural shambles. The Conservative government must, at some point, pick its poison – it must prioritise between its own right wing and economic stability.
Meanwhile, the British economy is wobbling. Economic growth slowed significantly in the first few months of the year and recent data suggests this was not a blip. Industrial output appears to be slacking despite the boost to exports from the weaker Pound. House price appreciation is losing speed despite the substantial stimulus engineered by the Bank of England following the EU Referendum.
Consumers are still spending but that’s increasingly funded by borrowing (see chart), and their ability to support the economy will inevitably be eroded by the rapid rise in inflation. Voters are fickle and will change their minds on the major issues of the day when their economic wellbeing is threatened. The prospects for the government are grim indeed if the public comes to associate Brexit with economic harm.
The case for holding British investments in the short term is weak, and we have maintained our portfolio policy of minimising exposure to UK assets, whether they be stocks or bonds. Previously we had found plenty of investment opportunities abroad, but our view has now changed, mainly due to potential weakness in the US stockmarket.
Like the UK, the US is in the throes of a political maelstrom that could have broader consequences. Trump is at war with many factions – not just his enemies in Congress and the Senate (who include both moderate and extreme Republicans, as well as Democrats) – but with leading civil servants, entire government departments and, rumour has it, senior members of his own administration. He is severely constrained by the Washington infrastructure, by judicial processes and by civil society. At best his administration will simply fail to enact significant legislation – a mere matter of broken promises.
The president, however, still sets the tone for America’s interaction with the world. The international perception of American values and prestige is being undermined as a result of Trump’s excessive posturing for his domestic constituents. Where does this end? Without material policy successes at home, Trump will be more likely to jeopardise longstanding, diplomatic relations abroad in order to score a victory. God forbid he should need a major distraction.
Meanwhile, former allies are being variously bullied, insulted or merely embarrassed. Trump’s abuse of London’s mayor following the London Bridge terrorist attack achieved all three of these. This works both ways: anti-Trump rhetoric has become a useful tactic for politicians abroad, who can inspire domestic support by invoking fear of the US (it’s hard to believe that these words now apply to American allies as well as its enemies).
You would think that prudence among investors would be appropriate, given the bizarre nature of the presidency. But US consumer and business confidence is sky-high (see chart) and the US stockmarket continues to trade at ever-richer valuations. Moreover, falling volatility in the stockmarket implies a complacency which is at odds with the political environment. Admittedly, political risks are longer term in nature than pure economic risks. It takes time for bad politics to feed through into poor policies, which then take time to impact the economy.
Meanwhile, investors can occupy themselves with the prospect of bumper profits growth among US companies. Except, even here, we see potential weakness. The sky-high confidence is not matched by sky-high growth. In fact, expectations for more rapid US economic growth have dimmed since the election. Given the US economy isn’t growing any faster than average, company profits as a whole will struggle to accelerate to this degree. Put it all together and we think there’s now a good argument for sitting on the sidelines.
The economic outlook is still relatively robust in Europe and Asia, where economic data is holding up better relative to expectations. Moreover, those markets do not suffer from heady valuations. However, our enthusiasm is tempered by the knowledge that other stockmarkets rarely hold up when the US stockmarket is wobbling.
Over the past five years, most of our portfolios have comfortably exceeded their expected return targets. Some of that outperformance has been due to the surprising ebullience of stockmarkets over the last 12 months. From here, we expect things to get a bit more difficult, and would like a better entry point in order to be more confident of continuing to deliver to those expectations.
This piece is taken from the 3rd quarter update from 7IM. For more information, please click to download the document for either our funds or our model portfolios.
