We enter 2017 with some important new factors to consider. The economic variables are more complex and they are compounded by political considerations. Additionally, equity valuation must reflect on local and global bond markets which are in flux.
The UK economy expanded by just over 2% in 2016, driven largely by consumer expenditure which may have grown by close to 5%, implying reduced savings/higher borrowings. This seems unlikely to continue into 2017 as the Brexit induced fall in sterling is expected to push inflation towards 3%, suggesting (at best) no growth in real wages. Indeed, employment over the past three months has levelled out so wage growth may struggle to maintain its current 2.5% per annum pace.
The Bank of England has indicated it is prepared to overlook a temporary rise in inflation above its target 2% CPI rate. If we have seen the end of sterling weakness and commodity prices (especially oil) level out, then interest rates may move only marginally higher in 2017. There remains a risk, however, that rising US interest rates, together with the consequences of the UK’s persistent 5% current account deficit in the balance of payments, will cause further problems for the UK exchange rate.
The broader picture internationally is more positive. President Trump’s apparent plan to stimulate growth through fiscal measures could well work, at least in the short term, with the US being a relatively closed economy. Most of the Pacific economies are showing better trends going in to 2017. China may have achieved steadier growth of around 6% but public and private sector debt expansion has been excessive. It will be interesting to see if China can avoid the associated downturns which such conditions created in Japan in the 1990’s and in the west post 2008/9!
In Europe, monetary growth is accelerating from a low base which is producing improving trends in Germany and Spain. France and Italy look more problematic.
Looking at the political situation, the important developments will concern Brexit and “Populism”. Brexit has the capacity to derail the above assumptions. Uncertainty has already slowed capital investment. Even public sector projects are being delayed despite the government’s pledge to do more. Exports and imports will be affected by Brexit negotiations though the risks here may have been overstated. Exchange rate movements are more important and have been positive for the UK through 2016. There is a big risk to the UK financial services industry as a result of Brexit. The importance is compounded by the high proportion of UK taxation flowing directly and indirectly from this sector. On a negative note, there is a suggestion that some of these financial services are being commoditised such that their profitability may be in secular decline in any case.
Both Brexit and Trump’s US election victory are examples of the reaction of electorates to frustration over centralised political power and the consequences of globalisation for developed economy wages in many industries. How far this leads to changes in taxation and corporate governance is, as yet, unknown. Hopefully, we are some distance from global trade restrictions but Trump has certainly raised the issue.
As always, there are positive and negative influences on equity markets. Most of these apply to all the principal western equity markets.
The big positive is the fading attraction of bond markets. UK equities marginally outperformed ten year government securities in 2016 and the relative trend towards the year end was highly positive. It would take only a minor change in investment allocation towards equities to reinforce current strength. Provided bond markets remain sanguine about inflation trends, the precipitous decline in bonds which would undermine equities should be avoided.
We might also speculate on the cosy assumption that bond market investments for pension funds are a natural hedge for real liabilities. This may come under pressure as pension fund trustees (amongst other investors) witness declining bond market valuations.
Even with the above tailwind, there are other risks for UK equities to contend with. The current “bull” phase has now lasted almost seven years. The FTSE All Share Index has risen 110% from the low of March 2009; although it is just 10% higher than the July 2007 peak. Valuations relative to earnings look high but are distorted by low current profits in banking, energy and mining industries. Without this distortion, valuations look close to long term averages; the All Share Index yield of 3.5% being mid-range for the last 40 years. Given the UK ten year gilt yield is just 1.6%, this makes equities relatively highly attractive. A further positive is likely dividend growth of 8-10% in 2017, mostly due to past sterling weakness against the US Dollar. We are also seeing an upturn in corporate bid activity throughout the stock market. Technological change and industry consolidation are big drivers of takeovers and the UK stock market is at a reasonable level for the typical 40% share price premium to be attractive for both buyers and sellers of businesses.
Sector choice will again be key in 2017. 2016 witnessed a major recovery in the depressed energy, mining and banking sectors together with an emphasis on “safe” international consumer focused multinationals. Given that these areas represent all of the top 10 constituents of the All Share Index and around 60% of the entire stock market, it is not surprising that most stock-pickers and almost all small cap managers underperformed. 2017 should be different. Small cap valuations are relatively low against their larger brethren and against past averages. Analysts have been slow to adjust profit forecasts for the smaller companies yet many are set to gain the same exchange rate advantage that has been factored in to larger company valuations. For UK Businesses with a domestic focus, gains could also be significant where the bulk of competition is foreign based. In the almost wholesale downgrading of prospects for UK business, this latter factor has been largely ignored.
Of course, the obvious risks of higher input costs (labour, materials and services) with flat volumes and a difficult pricing environment are the typical model for both economic and investment analysis. Our task is to ensure we have the businesses which can avoid this damaging scenario, especially where the stock market assumes they cannot.