By Paul Harwood, Chief Investment Officer.
Most forecasts are looking at 2018 as being “more of the same”, following the pattern of 2017. On current evidence, these are reasonable assumptions but it is important to be aware of what might happen and to be ready to identify early signs of change.
A good starting point is the US. Here, the Federal Reserve is currently predicting three 0.25% increases in interest rates this year. Underlying economic growth is around 2.5% and with further stimulus from mildly accelerating global growth and probable US tax cuts, the basis for such interest rate changes looks well founded. Whilst investors may accept these rate forecasts, US and international bond markets are not fully adjusted to this prospect with yields remaining stubbornly low. This is a function of global financial liquidity brought about by nearly a decade of quantitative easing. Should central banks unwind these programmes, then bond yields would rise. A substantial increase in bond yields would be an early indicator for subsequent equity market weakness.
The economic picture both in Europe and Asia is strong and we continue to favour these regions in our mandates with global exposure. Consensus growth forecasts are 2.5% and 3.5% respectively. Neither excessive growth nor inflation seem likely to undermine economic policy in the regions, though the European Central Bank has indicated that it will curtail its quantitative easing programme in 2018. Probably, the principal risk lies in a pronounced Chinese slowdown. Rio Tinto (the mining giant) has hinted at lower expected Chinese metal demand during the first half of 2018, but recent high demand for coal and gas in China seems to contradict this. Clearly, Chinese economic performance has important implications for all the major world economies.
UK growth slipped marginally to about 1.8% in 2017 after 1.9% in 2016. However, accelerating growth in the US, Europe and Asia makes this a relatively poor outcome. Sterling’s weakness post Brexit led to a small decline in consumer spending power and business investment was held back by the surrounding uncertainty. 2018 should witness steadier real incomes and the inevitably delayed benefit from sterling weakness on UK competitiveness. Manufacturing industry forward indicators are showing good strength and the much larger services sector held up well in the final quarter of 2017. Consequently, there are solid reasons to expect overall UK growth to stabilise in 2018, especially given the favourable European backdrop.
UK Equity Investment Outlook
The economic background for UK equities is probably better than consensus expectations. However, the impact of politics on the exchange rate and sector strategy will be equally important. There is a risk that, if the Brexit ‘process’ goes badly, the Conservative government will be blamed despite the democratic vote to leave. The passage of time also favours Labour since at the next general election (2022 at the latest) a high proportion of the voting population will not have experienced the impact of essentially socialist politics on economic performance and general welfare. Hopefully, this will not damage investor sentiment in the near term.
Our UK portfolios feature a particularly strong position in companies and industries that generate a significant proportion of their earnings overseas and are exposed to growing international demand. In the short run, sterling’s partial recovery against the US$ will negate some of this benefit, though there are now offsetting tax reductions on US profits. Businesses with a more European focus still have a major exchange rate benefit and for exporters, the margin and volume uplift from sterling weakness has yet to be fully captured. More generally, slower growth in the UK relative to the US and Europe together with the UK’s persistent Balance of Payments current account deficit, ‘Brexit’ negotiations and longer term political risk all seem likely to cause further sterling weakness over the medium term.
Although underlying demand may now have stabilised, we expect many consumer facing businesses will continue to see increasing competition. This is particularly true in retailing but internet based competition is also directly or indirectly affecting some leisure based industries. A focus on clear winners in all consumer sectors will be key. So called ‘recovery stocks’ may prove illusory if business models cannot adapt.
With the threat to profitability in the utility sectors, investors may re-evaluate businesses (typically in the support services area) which share the same low cyclicality and continuity. Some such companies were overlooked in 2017 in the search for growth and overseas earnings.
We are expecting an improvement in banking profitability in 2018 as interest rates edge higher and Personal Protection Insurance claims start to decline. We are nervous about longer term competitive challenges through new competition but current valuations still seem unduly cautious.
Shares in the energy and metals sectors have had strong performances through 2016/17. With the global economic recovery likely to continue for some time and with commodity supply and demand in better balance, there would seem further potential. We are also anticipating dividends to be somewhat ahead of market expectation.
We have some exposure to science and technology based businesses though this was reduced during 2017. Very high valuations and companies with a narrow range of activities can show volatile share price performance.
More generally, good investment performance in 2018 will require diligence. There have been a number of profit warnings during the latter part of 2017 and share price reactions have been severe. That pattern is expected to be repeated in 2018. Low quality businesses with aggressive accounting must be avoided.
We do not consider the UK stock market overvalued given the favourable economic background and growth potential in many equity market sectors. Low long term bond yields reinforce this view. We argued last year that poor bond market performance could be a positive for equities causing a repositioning of investment portfolios. This still looks a valid observation provided global liquidity conditions stay favourable.