Spring 2017 Market Review - What a difference a year makes

During the first quarter of last year the FTSE 100 hit a low of approximately 5600 amid tumbling commodity prices and fear of a China-led global slowdown. At the time we circulated a note to clients explaining our view that stock markets were incorrectly anticipating a major global slowdown and that equity valuations were looking attractive. Whilst being correct that the world economy would avoid going into recession, no one could have predicted that the FTSE 100 would today be some 30% higher, having navigated the surprise of both the Brexit vote and the election of Donald Trump as US President.

Political change

Looking forward, it seems likely that 2017 will be a year of considerable uncertainty and change. The Brexit vote and US presidential election are clear examples of a global shift from the existing liberal establishment towards more populist politics. Companies and investors alike are having to cope with a range of uncertainties regarding the policies of President Trump, the implementation of Brexit, and the results of upcoming elections in France and Germany. If the trend towards populism continues, we will have to get used to less predictable and more idiosyncratic leadership in a large part of the developed world.

So far, investors have interpreted the resurgence of populism favourably as it brings with it an immediate prospect of reflation (think rising economic growth, wages and inflation) through tax cuts and increases in government spending. As a result, most developed equity markets are standing at, or close to, all-time highs. However, we cannot ignore that populism also brings with it a greater likelihood of protectionism, conflict, greater budget deficits and capital controls; all things that are not so supportive of financial assets.

Brexit

Any discussion of political change must also cover the divisive topic of Brexit. Theresa May has duly signed and delivered the UK’s Article 50 letter, thereby starting the two-year countdown to exit, and we expect this to mark the start of intense political, public and media focus on the negotiating process with the EU. Unfortunately, the negotiations can be expected to be anything but easy; not least because the chief negotiators (David Davis for Britain and Michel Barnier for the EU) appear to have conflicting objectives. On the one hand, Davis wants a smooth process so that companies in Britain do not panic and take flight; but Barnier’s instructions are to make Brexit look worse than membership and he knows that the more uncertainty there is, the more companies will be tempted to move to the EU and the weaker Britain’s hand becomes as the two-year clock ticks down. The first item on the agenda is the cost of departure. Jean-Claude Juncker, European Commission President, estimates the UK owes about €60bn from past financial commitments – a figure that British ministers describe as absurd. Months of negotiation may be wasted on this before the important issues of immigration and market access are even touched on. It is hoped that the economic interests of all parties will eventually outweigh the political squabbling and allow a future relationship that benefits both the UK and the remaining 27 EU nations; however, a persuasive case can be made for a less favourable end result. In the first instance, it is unlikely that any meaningful progress will be made ahead of the pivotal French presidential elections on 7th May.

Where does all this leave financial markets?

In the short term our enthusiasm for equities is dampened by the fact that the UK market is trading towards the upper end of its long-term valuation range at a time when a multitude of political and economic risks lurk on the horizon. However, it is worth repeating that we are not believers in materially changing the asset allocation of a fully invested portfolio without a significant change in a client’s circumstances. Investors who do this are attempting to double guess when equity “bull” and “bear” markets will start and end. We do not believe that this is possible. Investors who make a habit of jumping in and out of the stock market based on valuation will typically underperform over the long term as trading costs, bad timing, and loss of income from being out of the market eat into returns.

Over time, the natural global growth that comes from rising populations, innovation, new products and productivity improvements should ensure that equities continue to deliver attractive real returns through the cycle – despite the occasional hiccup. The best policy for long-term investors is therefore to hold equities through both good and bad times. Both bull and bear markets are unpredictable, except with hindsight. Equity markets can rise very significantly for an extended period and highly valued equity markets can become cheaper with rising earnings, not just falling share prices. For this reason our asset allocation strategy changes little. At times like the present we tend to allow cash to accumulate, but this is more a function of the absence of attractive investments to buy rather than a compelling belief that markets are about to fall.

With the market having established new all-time highs, it is also worth repeating that this is not necessarily a bad omen. This is because the widely quoted and tracked indices such as the FTSE 100 are not particularly useful guides. First, they are not adjusted for inflation – whilst the FTSE 100 is trading close to its nominal high, for example, it is some way below its inflation-adjusted peak. Second, they are capital-only indices that do not include the impact of income – the dominant driver of long-term returns. The Barclays Equity Gilt Study, for example, shows that a ￡100 investment in UK equities in 1899 would have grown, in nominal terms, to ￡14,597 by the end of 2014 without reinvesting income. However, with dividends reinvested over this period the value grows to ￡2,240,727. In short, it is difficult to overestimate the importance of income to long-term returns. In this context, it is interesting to note that UK equities do not look expensive on a relative basis as they presently offer significantly more attractive yields compared to cash and bonds.

Strategy

Our emphasis remains on quality, value and diversification within equity markets. We feel that this leaves us well prepared for a wide variety of eventualities. If a Trump tweet or Brexit development suddenly causes a particular sector to suffer disproportionately compared to expectations, for example, it will matter little in the context of long-term returns from a well-constructed equity portfolio that is diversified by company, sector and country. In the fixed return part of portfolios we remain firmly tilted towards short duration and index-linked securities as it seems inevitable that at some point over the coming years, interest rates and inflation will rise significantly from their currently depressed levels. We concede that there are good reasons why interest rates may well be kept low for a while longer, but it is better to act early than after the event. As for cash, we are typically allowing it to accumulate until clearer value opportunities arise – although our exact approach does vary as per each client’s particular mandate.

Kraft Heinz & Unilever

We conclude with some commentary on Unilever, which saw off a $143 billion (￡115 billion) takeover approach from US-based Kraft Heinz and its private equity partner 3G Capital last month.

Overall, we are pleased that Unilever has retained its independence as it is an example of a strong, well-managed company with an enviable portfolio of brands that should enable it to continue to grow whilst maintaining attractive margins. In particular, it is investing in new business categories and retail channels to secure sustainable growth in the years ahead. This is in stark contrast to 3G Capital’s preferred approach, which focusses more on urging its companies to strip out costs and boost short-term returns – potentially to the detriment of long-term business health. Management did not emerge from the bid unscathed, though, and announced a strategic review to ‘accelerate delivery of value for the benefit of our shareholders’. From our perspective as long-term investors we are always keen to ensure that such reviews do not end up favouring near-sighted strategies.

NW Brown Investment Management