Predictably Unpredictable

So, we have another newsletter to write, and yet again it is political surprises that are front and centre of our thoughts.  This time, the “shock” news is that we are all going back to the ballot box for the third time in a little over two years.  For those of us north of the border we have also had an independence referendum and Scottish parliamentary elections on top of this, all in the space of less than three years.  Election fatigue is certainly kicking in in Chez Nimmo.

To the lay investor, the weakness of equity markets last week – where the FTSE100 delivered its worst weekly return since the week of the EU referendum last year – might have given the impression that political shenanigans were once again the root cause of economic and financial instability.  In fact, recent weakness has had much more to do with a general “risk off” phase in financial markets as evidence starts to mount that US economic growth is pausing for breath, and the peculiarity of strengthening Sterling actually being a negative for the valuation of the country’s largest companies.  Indeed, that modest strengthening of the currency was a result of a generally positive response to the prospects of the Conservative Party having a much more commanding majority on the 9th of June.  In our view, the perception of upside from a market standpoint probably comes from three possible outcomes.  The most likely is that a commanding majority in the House of Commons leads to a much less chaotic exit from the EU than could have been the case if Mrs May had to placate equally the hardline Eurosceptic and Europhile remainer camps within her own party to ensure she could pass any subsequent legislation.  With a thumping majority she will be in a much stronger position to play hard ball when necessary with the EU, and will not feel the pressure of an impending election in 2020.

A second, but less likely, source of upside for markets is that politicians have mis-judged the “will of the people”, and by making this election essentially a referendum on Brexit it fosters a huge surge in support for the Liberal Democrats, that when combined with the Europhile wing of the Conservative Party ensures that Brexit is as soft as possible, and the UK retains unfettered access to the single market.

Lastly, with a slightly longer term perspective, any material retrenchment in support for the SNP north of the border may be seen as a rejection by Scots of Holyrood’s plans for another independence referendum, thereby moderating the subsequent risk that the UK’s exit from Europe is the catalyst for the break up of the union of the crowns itself.

Notwithstanding all of this, the mood of markets last week was resoundingly business as usual.  We have seen the early birds in those companies who will make first quarter trading statements, and the mood is predominantly consistent with that which prevailed during the annual results reporting season, which fostered continued upgrades to earnings and dividend forecasts.  By and large, the world seems to be trundling along just fine.

However, one should not be complacent about where future returns are made.  If Sterling strengthens further, its takes material pressure off the future input costs of the country’s retailers and other importers – who had already been preparing for the worst.  By contrast, those companies who have benefitted from the tailwind of translating overseas profits back into more Pounds Sterling for the last year, will suddenly have to start taking the red pen to forecasts.  That the former category of companies is amongst the market’s most cheaply valued and the latter amongst the most expensive could make that adjustment painful for the unprepared.

A recent meeting with the finance director of Next was instructive in understanding the mindset of some retailers and other consumer businesses at the moment.  Current planning involves “armageddon” scenarios of many years of significant declines in sales, no relief from currency moves and increases in wage rates that continually add to the company’s costs, but are not significant enough to engender any kind of consumer boom.  In our experience, once a company’s management team starts to face its demons in this manner, it is normally pretty close to as bad as it is going to get.  By contrast, its share price is still suggesting it is still going to get worse from here.  Next is perhaps the perfect example of the risk and reward paradigm characterising the UK equity market at this time.  A very high quality business that is deeply unloved, but will offer huge upside if historic trends reassert themselves.  But is it’s a fairly sizeable “if”.

Active equity investment in the UK has had a fairly bad rap over the last couple of years.  There is an undeniable bias to small and mid caps in the active segment of the UK equity space, and a pronounced (but less so) bias to domestic earnings as a consequence.  As these factors have worked against active management in the short term, so the attraction of “cheap beta” through passives has increased.  Yet, the idea of a “passive” investment in our mind is an oxymoron.  The performance of large companies that drove returns of stock market indices to outperformance of active managers was a function of two factors.  Firstly, their heavy weighting of overseas earnings were suddenly more valuable to Sterling based investors, and, by and large, they were pretty cheap to start with.  To allocate money to passives from here is an “active” decision to invest more money in these areas that are now neither cheap, nor benefiting from currency tailwind.  That may well still be the right thing to do, but it is not a particularly passive, or low risk, decision.

We are not necessarily saying that a full rotation into domestic small and mid caps is, by extension, a no brainer.  It is not.  What we are saying is that as financial markets become increasingly immune to “political shocks”, the periods of extended “risk off” or “risk on” will diminish.  As will big thematic swings driven by currencies, or fixed interest markets.  What will replace it is the micro economic test of how you position your business to meet the prevailing industrial or commercial opportunities, and how much an investor is willing to pay for the stream of cash flows that come from it.

Across a number of geographies, political events will dominate our TV screens and news feeds for the foreseeable future.  Short of Jeremy Corbyn becoming the next prime minister, equity investors look increasingly set to shrug their shoulders and get on with the day job.