Last Thursday marked the summer edition of our periodic strategy meetings, where we invite our two resident “Wise Men” in for coffee, sticky buns and some insight into what is currently making the world tick. It was the first meeting since the Brexit shock, and the time that has elapsed since the 23rd June has allowed for a more considered discussion of the likely consequences and ramifications of the referendum. That said, whilst one may assume that the UK and its relationship with Europe dominated the discussion, in fact there were more than enough question marks over other parts of the global economy to foster an all-encompassing debate for equity investment.
On a prima facie basis, the discussion was fairly one dimensional – whilst recent estimates of global economic activity have seen broadly based downgrades to growth expectations across most major territories, it is only in the UK where the cut to 2017 expectations has been material. Brexit is expected to slow economic activity as investment and hiring decisions are delayed or cancelled until the trade landscape is clearer. The IMF has reduced UK 2017 GDP growth forecasts from 2.2% to 1.3% over the summer. The UK Treasury’s poll of economists suggests the impact will be even greater at growth of only 0.7% – a number that will be almost impossible to achieve without drifting into the technical definition of a recession, which is two consecutive quarters of negative growth. As a central case, it is difficult to take issue with this prognosis too much given the dearth of actual economic evidence so far.
However, much of this is now well known, and largely incorporated into the prices being paid and received for financial assets. So, of more interest to us in the discussion is where the surprises might come from. That is likely to drive where share prices go from here.
The first thing to say about forecasts of UK economic activity going forwards is that those made post Brexit (even by experienced and skilled economists) are dealing with a massively incomplete data set. Economic forecasts are hit or miss at the best of times; at times like this they have only a little more validity than sticking a wet finger in the air. The evidence we have seen so far suggests that short term concerns may be overdone, even if the longer term threats are just as relevant. By and large retailers and banks have reported no immediate change in spending patterns. Housebuilders saw a brief jump in cancellations for two weeks before previous trends re-asserted themselves, and most are still seeing year on year growth. Other areas of the construction market experienced delays in bigger projects starting, but there is anecdotal evidence that these are now starting to move again. The wider housing market is still robust, albeit that the London market is undoubtedly slowing from previously exuberant levels. In job prospects, the employment data we have seen covers only one week of post Brexit, but we have seen the claimant count figures for July, and these were marginally lower than the previous month, suggesting no knee jerk reaction on payrolls. Nominal wage growth has been stable at over 2% for a while now, and whilst Sterling induced inflation may erode some of the real terms benefit of wage growth, the corresponding cut in interest rates will benefit all borrowers on tracker mortgages, and most others on variable rate mortgages.
So, the consumer engine of the UK economy might be OK for a while yet. Investment is weak – but has been for some time, and probably has more to do with the outlook for Oil & Gas than Brexit fears. It is likely to be a while before the fall in Sterling benefits the trade balance in goods, but employment and inflation data coming out of the Restaurant and Hotel sectors suggests that tourism has enjoyed an immediate boost from the cheaper currency. All in all, the meeting felt that the balance of risks to the UK’s economic growth from here – relative to forecasts – was possibly on the upside.
By contrast, the meeting felt that the initial surge in share prices of businesses with overseas operations might not have fully incorporated the developing risks elsewhere. Growth in the United States appears to be still set fair, yet even here the decline in corporate profitability, reduced business investment and signs of a pick-up in average wage costs point to risks in domestic activity that are perhaps not reflected in equity markets hitting all-time highs. Allied to this, such a strong US Dollar will naturally rein back external demand.
In Europe, the Eurozone is struggling to maintain the monetary policy expansion it experienced through most of last year. Demand for credit has started to ease, despite credit conditions improving at the same time. Despite the ECB’s attempt to flood the market with liquidity, money supply growth is lack-lustre and recent evidence suggests that GDP will struggle to make significant headway as a consequence.
Yet it is in China where perhaps our greatest concerns reside. Secondary economic data remain at odds with headline official data that records an economy growing at more than 5% per annum. Chinese rail freight volumes are 5% lower year on year, and the China Electricity Council recently announced that electricity consumption in January-June was up just 1.3%; its lowest rate of growth for 30 years. All of this is set against a backdrop of rocketing private sector indebtedness and continued reduction of central bank foreign currency reserves to defend the value of the Yuan.
None of these concerns are enough to suggest that we need to run away and hide for the next three or four years, but where the risk to rebased growth expectations in the UK is on the upside, it is entirely possible that elsewhere a rebasing of growth expectations is required to address slower burning economic challenges.
These trends have also manifested themselves in earnings growth expectations and equity price valuations. Consensus forecasts expect FTSE100 companies to deliver almost 16% earnings growth in 2017, which is quite an ask based on historic trends. A big chunk of this is dependent on the recent decline in Sterling not reversing over the next 18months. Given the factors playing out overseas, that might not be quite the one way bet it seemed eight weeks ago. By contrast, the more domestically focused Mid 250 is forecast deliver a more modest 10% growth in profits; but again it is largely dependent on currency adjustments. There is little in the way of domestic profit growth factored in; which is reflected in UK domestic businesses trading at a substantial discount to their more international peers.
There is also the political angle to overlay on top of all this. The Germans, Americans and French will all change or re-elect their political regimes in the next 15 months. In all of these countries there is the risk of a sharp rise in nativism and protectionism. The Italian government could fall on the back of a failed referendum on the constitution. In the UK, the Conservatives could engineer an early general election in an attempt to decimate a deeply divided Labour party should Jeremy Corbyn be re-elected as leader.
So, there is more than enough to be worrying about. Yet, when placed against the context of what has gone before in the last 10 years, this is little more than “business as usual”. Indeed, that decade cautions us about trying to look too far into the future. Rather that we need to play things as they are more than trying to second guess the future.
Our meeting finished on a relatively bullish note (and I emphasise the relatively). The one off effects of Sterling’s slide on UK prices aside, the balance of risks to the global prices remains on the downside. As a consequence, monetary policy will remain accommodative virtually everywhere. On top of this, we perceive a marked shift in the political appetite for fiscal stimulus to replace monetary policy tools that are almost fully spent. Most obviously, this is apparent in the UK, where the new political regime has already binned Mr Osborne’s balanced budget targets. However, in the US, both presidential candidates are also making expansionary overtures. China still has the firepower to effect fiscal stimulus should the growth trajectory decline further. With governments able to borrow at ultra-low rates for long periods of time, the benefits of heavy government infrastructure investment in economies starved of private sector and public sector capital investment since the financial crisis could be very significant indeed.
The outlook for the next two years remains highly uncertain. But it is anything but unrelentingly bleak. Recent moves in government bond markets have taken them to the point that are almost exclusively of interest to those worried only about the return of a nominal sum of money at a specified point in the future. They are purely wealth preservation devices. For those seeking wealth creation, unquestionably more risk needs to be assumed, and short term volatility must be endured, but very many companies out there offer a mix of decent dividend payments, supported by cash generative and strongly financed businesses, with the potential to grind out returns across many economic scenarios. Most portfolios should have a little bit of that.