Tales of the Unexpected

There have been several occasions over the last three years where we have hesitated to put our thoughts down on paper for posterity because of the risk that events would very quickly render those words irrelevant, or even absurd. Concluding on a cogent “world view” can be difficult at the best of times, but the UK’s tumultuous political landscape since the decision to leave the European Union has made forming such a view that will stand scrutiny for more than a couple of days very challenging indeed.

With this in mind, the start of campaigning in the UK’s third General Election in five years offers a brief period of respite to take stock of the situation. A huge amount of hot air will be expended over the next five weeks, but on the ground very little is likely to change. It also coincides with a slightly quieter period in stock market reporting; some non-calendar year end companies will have interim or final results, but many businesses will be silent on trading until the end of the current calendar year and into 2020. That is, of course, unless trading has materially deviated from market expectations and a clarification statement is required. It is an appropriate vantage point from which to take stock.

As a reminder, we came out of the summer months more cautious about the underlying economic backdrop than we had been for some time. Specifically, we felt that the US economic cycle was edging ever closer to rolling over, and that traditional policy levers (in both monetary and fiscal policy) did not have the capacity to arrest a decline in economic activity. Furthermore, we felt that the slowdown in global trade and industrial activity that has persisted through the second half of the year would make it difficult for a number of internationally facing businesses to hit profit expectations for the full year. As a result, we took out a number of our more cyclically exposed investments from client portfolios and replaced them with businesses where we believed there was greater certainty in the delivery of revenues and profits.

Since that time some of the initial fears over the rate of slowdown in global economic activity have eased. The US Treasury yield curve is upward slopping once again, having temporarily inverted over the summer months, providing some relief to chart watchers that history was not about to repeat itself. All of this was helped by a much more dovish tone from the US Federal Reserve, which has cut the Fed Funds rate three times since the summer. Specifically, in the US the underlying economic data has shown some resilience with job creation remaining robust and Q3 GDP growth coming in slightly ahead of expectations. In Europe, both the UK and German economies have (very narrowly in the case of Germany) avoided slipping into technical recession with modest growth in the third quarter.

However, all of this data is largely backward looking, and it is our job as fund managers to look forward. Feedback from companies suggest no real improvement in underlying trading conditions, with certain investee companies suggesting that US manufacturing and construction are close to absolute falls in levels of activity. Further, virtually all industrial companies updating the market on current trading in the last month have referred to “challenging conditions” or variants thereof in their commentary.

That said, it is also fair to report that the substantial majority have also tended to report that trading and profitability in calendar year 2019 will be in line with current market expectations. In response, the market has generally rewarded these statements with higher share prices; partly out of relief, and partly – it would appear – as a result of many active managers being caught relatively short of this exposure over the last quarter of the year.

A similar theme tends to play out in UK domestic exposure. We believe that many UK equity investors remain significantly underweight in domestically focused businesses, and any sign of a resolution to the current Brexit paralysis leads to a short-term squeeze in share prices as investors cover their positions.

Which leads us to the question of where we go from here, and with our UK perspective inevitably pondering whether the impending General Election will give us a path to a clearer future.

It seems perfectly logical to us that the best short-term outcome for the UK economy and its equity market is an election that delivers a convincing Conservative majority in parliament. We have never believed that Brexit would do anything but damage the UK’s economic interests, but increasingly we have come to the view best espoused by Philip Collins in The Times that the short-term economic damage done by Brexit will be repaired more quickly than the political damage done by not Brexiting. However, with a large majority Boris Johnson would not be held hostage by the “Spartan” (was there ever a more ironic moniker?) fringe of his party, which would pave the way for some kind of sensible future trading agreement with the EU. It is worth remembering that Boris Johnson is not an ideological Brexiteer. Brexit has simply been a flag of convenience to sail under whilst he furthers his political ambitions.

Under such a scenario, Sterling and domestic UK equities would undoubtedly rebound. It is also likely that business investment would increase and some positive momentum would be reignited in the jobs market. Against a backdrop of loosening fiscal policy, the economic outlook would improve for some time. Yet, whether we Brexit or not, the UK economy is fundamentally tied to events elsewhere. The US economy remains far closer to the end of the current cycle than the beginning, and has fewer policy tools at its disposal to halt the decline when it comes. The Chinese economy has heroically sustained its 6% GDP growth target over the last few years, but the signs are there that this trick is increasingly hard to pull off. Political and social disruption in Hong Kong will weight further on activity. European growth is likely to stay moribund until economies with fiscal capacity start to loosen the purse strings.

So, for internationally facing businesses, things may stay challenging for some time yet. Markets have been reassured by recent trading statements that suggest 2019’s profit numbers are intact. What we don’t really know is how much of that has been sustained by a short term reining in of costs to compensate for slower revenues. If this is the case, it is a strategy that can work for short periods of time, such as leading up to the calendar year end. It won’t be able to compensate over a full financial year.

Summing up, our views have not changed significantly over the last three months. We see clear upside in UK domestic earnings as and when the political landscape stabilises. We are not so foolhardy, however, to ignore the fact that the General Election could return yet another hung parliament with potentially even less prospect of the compromises needed to resolve this crisis. For this reason we won’t throw all our eggs in that particular basket. We hold a diverse and multifaceted portfolio, which has been repositioned slightly over the Autumn to emphasise resilience in the face of economic uncertainty.

We now have to sit and wait and see what the next chapter in this extraordinary tale has in store for us.