Before I move on to a discussion of global investment markets and our current asset allocation policy, it is worthwhile to outline what we should expect in the next six months up to the Article 50 departure date of 29th March 2019, and most importantly what we are doing for portfolios, and particularly how we can protect GBP based investors.
The UK and the EU are working on two documents that will set up an orderly departure of the UK from the EU as the Article 50 period ends. The first is the “Withdrawal Treaty” which will create binding commitments under international law, containing its own procedures for dispute resolution. The second is very much a political declaration on the framework of the future relationship, which will not have the same legal status.
According to sources, 80% of the first document has been agreed including EU/UK citizens’ rights, the financial settlement, and how any transition period will work.
The key areas still to be agreed include:
- The Irish border backstop
- The governance of the treaty in case of any dispute
- The ability to extend the transition period if negotiations have not been completed without the need to get agreement from all national parliaments in the EU 27
- Whether there is a link between the negotiated settlement and any future trade agreement
There are a series of summits at monthly intervals during the autumn that should increase the focus and intensity of the negotiations, and our central case is that we will see a negotiated Withdrawal Agreement in November.
What is becoming clear is that the political declaration, which was previously expected – when David Davies was minister of the Department for Exiting the European Union – to be a very comprehensive document is now more likely to be a very high-level and much shorter document. It will set some broad parameters for future arrangements, which will be negotiated during the transition phase.
The negotiations with the EU are one thing, but perhaps the bigger hurdle is to get the agreement through the House of Commons, given the various leave and remain factions that make up both the main political parties.
The key question for us is how this could affect asset prices and what action should we take? Foreign exchange markets in the short term are extremely sensitive to Brexit news – the spectre of a “no-deal” or a hard Brexit tends to lead to a weaker pound against all currencies, including the euro and the dollar. This has been one of the factors in our decision to prefer non-sterling equities for some time.
The pound was very weak over the summer, falling very briefly from around 1.43 to below 1.28 to the US dollar. We continue to hold index-linked gilts that would outperform in the event of a hard Brexit. There may also be an opportunity to switch from large cap oriented funds to buy small and mid cap exposure at attractive valuations as the dust settles.
We consider economics, valuation, sentiment and risk to formulate our asset allocation policy. Turning to the global economy, the outlook remains reasonably positive, although Janet does note that growth is now less synchronised given the relative slowdown of non-US economies compared to the US economy, which continues to be enhanced by the Trump tax cuts and the fiscal boost.
Although there have been signs of a tighter labour market and stronger wage growth, core inflation has not risen very rapidly or alarmingly in the US. Interest rates should continue to rise, albeit gently, as monetary conditions continue to normalise.
In terms of valuation, global markets have de-rated from the extended price earnings multiples seen in the first quarter of 2018. In the US, a higher equity market has been more than offset by extremely strong earnings growth.
In the rest of the world we are seeing less strong (but still positive) earnings growth combined with lower equity markets, producing lower valuations.
As far as sentiment is concerned, the euphoria that symptomised stock markets at the beginning of the year has clearly been replaced by more balanced positioning among market participants and less consensus on the outlook, which makes for a healthier investment environment.
There are certain asset classes that could be described as being attractive but unloved – for example, emerging market debt was added to portfolios earlier in the summer, while the US dollar currently appears to be a little bit too popular.
There are very few instances of a bear market occurring, while the global economy is still growing, hence the biggest risk to the current environment being signs of a clear economic weakness. We are watching very vigilantly, but it still seems set fair through 2019. Commentators are more concerned about the outlook for 2020.
Other dangers: trade disputes and the tighter monetary policy
The two other major risks to the global economy are a protracted and expensive trade war that impacts consumer and business sentiment and capital investment, and a deterioration in liquidity conditions through a combination of higher interest rates and a reversal of quantitative easing.
So, where does this leave our portfolio positioning? Despite the correction in valuations and sentiment over the past few months, markets cannot truly be described as cheap, and as a consequence we are broadly more neutral in our allocation towards equities.
We are continuing to move portfolios towards a more global asset allocation and have reduced the home bias in both our GBP and EUR denominated portfolios.
We continue to hold inflation-linked securities especially in the GBP portfolios, although as bond markets normalise and yields rise, we have been looking to improve the credit quality of our portfolios. In US dollar portfolios, we have included conventional government bond holdings after many years of absence.