Winter 2016 Market Review - A Year of Surprises
2016 was a strong year for the UK stockmarket, despite some tumultuous events along the way. Indeed, the year started badly for equity investors as tumbling commodity prices and fear of a China-led global slowdown drove the FTSE 100 index down to a three year low of 5530 by mid-February. In the event it was a classic example of how quickly market perceptions can change as a rebound in commodity prices and more constructive commentary on China quickly saw the market recover its poise.
As the mid-point of the year approached, markets began to focus on the UK’s EU membership referendum. The Brexit vote on 23 June was a genuine shock for markets given investors had been confident of a narrow win for the “Remain” camp. However, a sharp drop in equities on the day of the result was promptly followed by a strong upward surge that saw the FTSE 100 reach an all-time high of just over 7100 during October. The main driver of this strength was sterling weakness, which is generally positive for the UK stockmarket given that it is dominated by international companies that derive a large proportion of their revenues from overseas – and a weakening pound meant these overseas revenues were translating into ever-higher sterling earnings.
After the shock of Brexit, investors approached the US election on 8 November with a degree of trepidation and the FTSE 100 briefly retreated to 6700 during the run-up. In the event, consensus opinion that Hillary Clinton would win was again wrong. In addition, the market’s reaction to the shock of a Trump victory was likewise surprising to many. Following an extremely brief bout of broad-based weakness, equity investors quickly chose to embrace the positive aspects of a Trump presidency, pushing the FTSE 100 back up to all-time highs by the end of the year.
Trumpflation
Donald Trump’s policies, as far as they are known, are considerably more inflationary compared to Hilary Clinton’s. Specifically, he is keen to provide a fiscal spending boost to US growth through a focus on infrastructure investment and tax cuts. A Trump presidency does of course bring with it a number of significant risks. However, in the short-term, investors have bought into the positive concept of “Trumpflation”, whereby fiscal policy is expected to supercharge the US economy and nurture global reflation (think rising nominal growth, wages and inflation). As such, there has been a marked re-pricing of certain assets within markets as investors start to shift away from what had become a fairly entrenched consensus; that we are in a prolonged period of anaemic global growth amid fears of deflation. First, money has flowed out of government bond markets - an asset class which typically performs well when expectations of economic growth and inflation are low – as investors start to question the “lower for longer” era of ultra low bond yields and interest rates. Second, the concept of global reflation has driven a rotation within equities – away from the businesses that fare well in a low growth, low inflation environment (e.g. ultility and consumer goods companies) and towards the likes of financial and resource businesses that are clear beneficiaries of higher interest rates and inflation respectively. So whilst the market as a whole is at all-time highs, it has been the hitherto unfashionable sectors that have powered the rally.
Trump policy, if implemented, could also prompt a global shift in focus from monetary policy (how a central bank influences a nation’s economy via the likes of interest rate changes or quantitative easing) to fiscal policy (how a government influences a nation’s economy via the likes of spending and tax rate adjustments). Indeed, more and more of the world’s central banks are concluding that the effectiveness of monetary stimulus may be waning – with greater fiscal stimulus needed to truly jumpstart growth.
Risks
Political and policy risks abound. There is uncertainty about Donald Trump’s agenda, its implementation and timing. On the one hand fiscal spending and tax cuts should indeed be supportive of growth in the short term, but on the other hand increasing the US’s already large $19trn debt burden could have nasty side effects. Furthermore, whilst Trump’s inflammatory rhetoric may simply have been a tool to get him into the White House, his policies on trade and security remain question marks – enforcement of trade barriers and a protectionist agenda would be viewed negatively by markets, as would any insensitive diplomacy that sparks international disputes.
Closer to home, the UK has vowed to trigger its exit from the EU by the end of March, starting two year negotiations that will determine how much economic activity may be disrupted. Upcoming French and German elections will further test Europe’s cohesion amid a forest fire of populism around the world that is challenging the established political economic order and the principle of globalisation. There are also ongoing concerns surrounding global debt levels and China’s growth profile. However, as we have said before, it is important to remember that long term investing is all about taking advantage of uncertainty. In this light, the presence of a long list of things to worry about is no bad thing – indeed, it is these very risks that should keep equities priced attractively enough to deliver good long-term returns.
Outlook and Approach
Our long-term expectation continues to be that the innovation-driven global economy will deliver GDP growth for the foreseeable future, despite occasional hiccups. It is too early to call an end to deflationary pressures, but with central bankers keenly aware of the debt overhang that persists, they will likely remain very cautious about raising interest rates too much or too quickly. We therefore remain of the opinion that the ultimate path for the global economy is one where some inflation is a necessary outcome and equity markets move higher over time. Having said this, it is worth repeating that we naturally become a little more cautious after periods of strong performance. Our short-term enthusiasm is also dampened by the fact that the UK market is now approaching the upper end of its long-term valuation range at a time when a multitude of political and economic risks lurk on the horizon.
Our approach to navigating ever-present uncertainties and the occasional market shock will remain the same and we are pleased this has served our portfolios well during a year of testing circumstances. In particular, by managing equity portfolios that are widely diversified by company, sector and country, we have (and will be) prepared for uncertainty. Our aim is not to outperform the market in any one short period, but to construct robust portfolios that deliver attractive long term real returns after costs. For example, during a period such as the last quarter within which the financial and resource companies performed very strongly, it is difficult (and indeed not particularly desirable from a risk perspective) to outperform the index. This is because these sectors make up a large proportion of the FTSE 100 and to outperform the index when they do well would usually require an unbalanced portfolio that is heavily skewed to these sectors – an approach that we judge to be risky, as it requires the luck needed to second-guess the market correctly.
In the fixed return part of our portfolios we have for some time been prepared for a rise in inflation and interest rate expectations through a preference for index-linked and short dated securities over conventional long bonds. Pleasingly, this has seen us well-positioned during a period within which consensus opinion has started to shift in this direction. Conventional bonds have been in a 35-year bull market and do not, in our opinion, offer any chance of positive real returns for long term investors at current prices.
To conclude, we finish with two observations that jump out from the events of this year.
The economy is not the same as the stockmarket. There is an overlap, but it is far less deep than most people think/assume. The domestic macroeconomics of the UK has very little to do with the collection of international businesses the make up the UK stockmarket.
It is better to prepare for and subsequently take advantage of uncertainty than attempt to predict it. It is virtually the job of the stockmarket to be surprising and unpredictable. We have long accepted that attempting to predict its short-term direction is a fool’s game. The problem does not just lie in the fact that macro events are difficult or even impossible to predict. To invest successfully on this basis you would not only have to predict future events accurately but would also have to know what the market was expecting and how it would react. Our preference is not to predict the unpredictable but to remain fully invested for the long term.
Investment Management - NW Brown & Company Limited
For more updates: http://www.nwbrown.co.uk/news/