History is littered with examples of heavy stock market corrections being triggered by unexpected events, but over the past 12 months the conventional wisdom that markets ‘hate uncertainty’ has been turned on its head.
Three big events – the EU referendum vote, US presidential election and our own snap election – all had surprising outcomes and wrong-footed the majority of investors. But, while there are greater levels of uncertainty in the air, markets have taken all three results in their stride.
The key reason is down to the relationship between the pound and the wider FTSE 100 stock market. When the pound falls it is negative for holidaymakers going abroad and consumer spending generally (as prices of imports rise), but most of the FTSE 100 companies welcome the move, as their exports are made considerably more competitive by weaker sterling, thus boosting earnings.
We have sought the views of various respected fund managers to assess whether the eight-year bull run for equity markets still has legs.
Reasons be to be positive….
The Conservatives’ failure to secure an outright majority means a ‘hard’ Brexit has become less likely. This is a positive as far as markets are concerned, because it lessens the risk of unpredictability that would come in the event of Britain leaving the single market or even quitting the EU without a deal being put in place.
Under a milder version of Brexit, access to the single market will likely be retained in return for some sort of trade-off – possibly some element of free movement.
Andrew Bell, chief executive of the Witan investment trust, adds: ‘A softer line may be taken in the Brexit negotiations, since playing hardball in Europe with only a tiny and vulnerable House of Commons margin will lack credibility.
'The UK would have had more leverage if the EU negotiators were not able to game our domestic politics because of the close balance in the House of Commons. A stronger mandate was requested by May in May and declined by popular will in June.’
As well as having less sway at the Brexit negotiating table, the government will also find it harder to get tax rising or spending cuts approved. This will likely lead to looser fiscal policy, another positive as far as markets are concerned, according to respected investor Neil Woodford. ‘Theresa May does not have the mandate that she had hoped for; that, in my view, will mean that the new administration will embrace a looser fiscal strategy going forward – borrowing more and spending more,’ he says.
‘Overall, this will be positive from the perspective of UK economic growth. I would also expect, for example, the cap on public sector pay to change, as part of this fiscally stimulative agenda.’
But Bell points out that the most important tailwind of all is that the pound is likely to remain weak for some time, which in turn will continue to benefit UK stocks with overseas earnings. ‘With the UK running a sizeable external deficit and on the threshold of renegotiating its trading relations with its largest trading partners, a weak pound seemed on the cards whatever the election result,’ he adds.
In contrast, though, more domestically focused businesses will not welcome a lower-for-longer pound scenario. According to Steve Davies, manager of the Jupiter UK Growth fund, a year on from the Brexit vote this has left its mark in terms of valuations. ‘UK domestic stocks appear very cheap and are already pricing in a difficult backdrop. Global multinationals (for example, consumer staples stocks), on the other hand, are trading at very rich valuations,’ he says.
This valuation gap, however, is bound to close at some point, which is why investors, including Woodford, are optimistic the eight-year long bull run for UK equities has further to run.
But there are risks on the horizon….
There are however, some reasons to be fearful that a market correction could play out in the coming months. Inflation is on the rise and consumer spending on the decline. Mark Burgess, chief investment officer at Columbia Threadneedle, notes that while the UK economy has on the whole been resilient since last year’s Brexit vote, cracks are now starting to emerge.
‘We’ve seen a definite softening more recently. UK consumer confidence appears to be running out of road and we are likely to see further weakening of the UK economy, which will hit over-leveraged households,’ he says.
Other commentators are concerned, including Azad Zangana, senior European economist at Schroders. Zangana expects a pullback in household spending and business investment, which he says will exacerbate the slowdown currently being experienced.
He adds that the fall in the pound has been smaller than expected given the hung parliament. But he is also of the opinion that lower sterling will push up inflation a little further than previously forecast, which will have a small negative effect on household spending.
‘As for Brexit, serious damage has been done to the UK’s negotiating position. Without a strong mandate, Europe can ignore the UK’s demands. Even the UK’s threat to pull out of negotiations will now appear hollow and lacking the support of the British public,’ says Zangana.
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