Attitudes towards UK smaller company equities are at times governed by attitudes to, or perceptions of, the UK economy. This has been a more discernible pattern in investor behaviour since the EU referendum with sterling acting as the barometer of those attitudes. In general, investors have been pleasantly surprised by the resilience of the UK economy. The weaker currency, a more accommodating monetary and fiscal policy framework, and a confident consumer mood delighted with the referendum result (especially in the regions) meant that the UK left 2016 with greater momentum than it started.
With that we entered 2017 with a wider appreciation of the UK smaller company opportunity set mirrored by an assertive Conservative government confident enough to call a snap general election. We ourselves had talked, unusually, to the prospect of greater certainty running into an election! Not for the first time in the last year polling did not follow the expected path and over the summer the ramifications of a hung parliament have begun to test investor confidence in the UK. A nascent prevailing wisdom has been emerging that a messy Brexit process will weigh on an economy that is slowing and increase the burden on a consumer who has seen discretionary income squeezed by some inflationary pressures. All of which, once again, has been reflected in a weak currency and some waning investor appetite for UK companies with a domestic label.
This view is not universal and there are some alternative perspectives that don’t get the same airtime from a domestic press preoccupied with the Brexit agenda.
Firstly, global growth has been better than expected generally. For the first time since 2007 all members of the OECD are growing at the same time. US data has been good but it is the strength of European economic data that has surprised most investors particularly in France, Germany & Spain. In addition, the electoral results in France produced a reassuring vote for change, not overhaul. In our view, it is this more positive image of Europe that dictates the strength of the euro, and a favourable perception of the European economy and equities, rather than (or as much as) Brexit negativity determining the weakness of sterling. In relative terms a growing but slowing UK has slipped from the top of the developed world economics leaderboard.
Secondly, it has been an unusually active summer for smaller companies raising capital. There have been some notable and quite hotly contested IPOs. A number of established companies have also made significant investments with the support of additional capital from existing and new shareholders. That support for both new listings and existing companies, whether offering dividend yield or investment for growth, is an important indicator of market health and investor appetite to support smaller company corporate development.
What is the current status of the Brexit process?
The market’s expectations here have been shifting with the Government already taking a more accommodating stance towards Europe post-election. The summer has witnessed a rapid proliferation of position papers on both sides of the Channel. The new clear thread that has emerged on the UK’s part is acceptance of the need for a transition period through which the status quo is preserved as far as possible. It had not been our view that a hard Brexit was ever a likely outcome, just a negotiating stance. The irony, therefore, is that a softer approach will probably lead to a less favourable deal. From a market perspective however, the ‘fat tail risk’ of a disorderly exit has been reduced.
As negotiations stall on the size of the divorce bill and the order of negotiations themselves, it is increasingly clear that the current timetable is unrealistic. Fund managers receive a lot of 'incoming' on the Brexit question from investors but Vince Cable's suggestion that we may never actually get around to leaving highlights not only the protracted nature of the process but, importantly in our opinion, that other events will be more significant in the meantime.
So what else is on a fund manager's mind?
Bond yields over the summer have been drifting lower. Reflationary expectations appear to be receding, which, in the short term, can have implications for sector leadership within equities. Expectations of interest rate rises have been pushed out which is no doubt helping mitigate the increasingly idiosyncratic & provocative pronouncements of the US president, amongst others in relation to North Korea, climate change, and domestic political personalities. The more important factor here for global markets is how much domestic reform Trump will actually implement.
We may also see a new term enter the investment vernacular in the coming months ‘Quantitative Tightening’ or “QT”. The Fed, Bank of England and the ECB continue to express their desire to reduce central bank asset purchase schemes. This would suggest the re-rating of equities by falling bond yields is complete and so too the unusually high correlation of returns between asset classes across the globe fostered by the weight of ETF and passive money. This fund manager’s conversation with clients points to a more discriminating investment approach slowly taking hold. Investors are increasingly accepting of the limits of an unfettered globalization. With that their focus is shifting and the search for value with supportive fundamentals is being reflected in the greater appreciation of small over large, local over global, and longer holding periods for returns to mature.
To finish, has anyone noticed that actuaries are revising their expectations regarding how long we all live? We are starting to see pension fund liabilities revised down. Yes, they have been overestimating how long we are expected to live. Now there is some food for asset allocation thought.
This article was written by Adam McConkey, Portfolio Manager at Lombard Odier Asset Management.
