2017 Outlook – UK and Fixed Interest
UK equities have continued to be robust relative to other markets, in spite of the Brexit overhang. Given the well-publicised overseas earnings of the UK equity market, investors have preferred to overlook domestic issues. Furthermore, the more positive than expected economic performance of the UK has encouraged mid and small cap investors and has led to a rebound in domestic cyclicals. There is clearly the potential for the negotiations over the next two years to reveal a real risk to the UK that would lead to tangible impacts on many constituents of the UK market. On the other hand the valuation of the market as a whole remains relatively attractive against the US.
The performance of the UK market has been helped significantly by the improvement in the oil and mining sectors, which make up a large segment of the index. Forward earnings of these companies have therefore contributed significantly in the “earnings growth” of the index as a whole. Likewise, the weakness of sterling has continued to flatter company/index earnings growth, which are due to come through later this year. Growth beyond is likely to be more determine by macro developments, however, there remains a high correlation between sterling value and index returns. The constant currency earnings growth of FTSE 100 companies was negative last year.
From a valuation perspective the UK market is not significantly overrated, although it also does not look cheap. Given the pace and series of index highs seen there is a significant risk of a technical correction and a possibility for earnings/economic disappointment. Furthermore, the UK should rightfully trade at a discount to counterparts given the level of political risk.
The UK economy has continued to be resilient following the referendum vote. Consumer spending has driven growth and employment has continued to increase. While the unemployment rate is low at 4.7%, wage growth continues to be muted and is now beginning to be eroded by faster inflation. It is therefore likely that consumer spending growth will begin to slow. Some of this reduction in activity has been picked up by accelerating manufacturing growth. A cheaper currency has led to a rapid increase in orders, however, there are concerns that this may be short lived. The cost of raw materials has likewise increased sharply and will filter through to end products over time.
The improvement in domestic production has generated a welcome reduction in the level of the UK current account. This has been running at worryingly high levels and is a further justification for the weakening of Sterling. The slowing of consumption and continued resurgence of manufacturing should continue to drive an improvement, however, this may be short lived. Any persistent weakness in the current account will continue to put downward pressure on the currency. However, as shown in the graph below, sterling is now at an attractive discount when compared to the dollar although political pressure will continue to depress the currency.
Fixed income has been relatively flat over the quarter. Yields in the US rose rapidly following the election of Donald Trump, the more positive economic data and subsequent interest rate rises. Many other markets have also experienced a similar change. Under a more solid economic platform credit has demanded a lower spread over gilts. There is clearly potential for this to widen from its current level, if there is a deterioration of economic conditions.
It is generally assumed that the world is now entering an interest rate rising cycle, originating from the US. However, the pace of this is debatable. The Federal Reserve has been very accommodative of concerns that the market has and if there is a change in sentiment by investors (for whatever reason) it is likely that the rate of increases will reduce.
In the UK, it is becoming more likely that the Bank of England will move rates back to 0.5%. However, the chance of them going above this level are slim with the cloud of Brexit negotiations. Shorter term inflation may well give confidence to the members to raise rates during the next three months. A rate rise will have a small impact on yields and will likely strengthen the sterling, although again only marginally.
It is now highly likely that the ECB will taper its asset purchase programme in the not too distant future. Inflation and employment in the Eurozone are now much healthier and the potential damage that negative deposit rates and bond yields are having may become unnecessary. Importantly, the Eurozone yield curve has steepened as a result of higher future inflation expectations. This should help banks improve profitability and increase lending, supporting economic growth going forward.
We still prefer the credit/strategic bond funds over sovereigns given the relative returns on offer and the continuing very low yield on gilts. Short duration bond funds have been a good way of giving portfolios the stability they need from the fixed income allocation as well as an acceptable level of return.
The graph above shows the current relative yield curves for the major government bond markets.