Brexit in-limbo aside, sentiment is improving
12 April 2019
Even though our prediction that Brexit would neither happen on 29 March nor 12 April has turned into reality, there seems little point in celebrating. Yes, the immediate threat of a cycle-ending shock event to the pan-European economy has been averted. However, the economic drag brought to the economy by this extension of uncertainty – continued deferment of business investment and potentially unnecessary worst-case preparations – has also simply been extended for six months. For the time being we are grateful that level-headedness has prevailed. This should help the UK economy to participate fully in the anticipated recovery of global trade volumes over the coming months – following the 2018 slump. On the other hand, the only way – or so it currently seems – to prevent the proponents of a ‘dirty break’ from the EU seizing power, may well lead to political instability as well. A confirmatory second referendum or a general election appears inevitable in order to break the deadlock in a parliament which of late is far less reflective of party politics and far more representative of a highly divided UK public.
For the time being we observe that capital markets in the end fully shared our expectation of a Brexit extension, and the recent rise in the value of £-Sterling against the €-Euro and the US$ reflected the rising probability of such an event, rather than a crash Brexit. When EU leaders emerged with their agreement to the Brexit extension there was virtually no currency movement. For our investment positioning this means that we are satisfied that holding on to a neutral exposure to UK investments was the prudent course of action.
Looking beyond the UK, the picture of where capital markets may be heading has become slightly more optimistic but is still full of regional uncertainty.
The end-of-cycle doom-mongers in the market have become less vocal as the typical late cycle conditions (overheating economic activity, restrictive monetary policy signals from central banks) have reversed over the past 12 months. The global economic slowdown of 2018 is still in full swing but is now clearly just that – a slow-down in growth and not a recessionary growth contraction. In the recent past such conditions have persuaded investors to take a longer-term perspective on corporate earnings growth and look beyond one or two quarters of low or even negative growth, so as not to miss the upswing.
This leads to the situation (for many, hard to comprehend) of rising stock markets against the backdrop of poor corporate results. Following the (once again) impressive rebound of global stock markets since the beginning of the year (after overly pessimistic economic outlook views had led to excessive stock market losses in Q4/18), it is not unreasonable to expect that stock markets will continue to grind higher, although not with the same vehemence as during the Q1 recovery. Should stock markets get ahead of themselves and display signs of unwarranted exuberance as they did back in January 2018, then a resurgence of volatility is very likely, as investors bank their returns and anxiety re-emerges over valuation levels.
At a regional level the outlook is more complicated. The US stock markets have been the most vibrant during this entire episode and are once again more highly valued then their longer-term historical average. All other stock markets offer valuation levels below their long running averages and thus seemingly have more upside potential. It can be argued that the US market enjoys the higher valuation advantage for at least two reasons, namely it is overweight with global technology leaders who can command higher profit margins than most other sectors, and the region still runs at higher domestic growth levels.
On the other hand, the US has not yet experienced the slow down which the rest of the world has gone through. This is because US demand was artificially elevated by Donald Trump’s late-cycle fiscal stimulus of corporate tax cuts and governmental deficit spending, which is now waning. Europe on the other hand has suffered from investor withdrawal due to its high dependency on global trade and – of late – the Brexit headwinds. As both of these factors are now abating, Europe’s stock markets should have a considerably greater upside potential given their lower starting point.
There are always risks to our various outlook scenarios and we are therefore constantly monitoring the data flow for confirmatory or contradictory indicators. The Q1 corporate earnings results season that has just started will provide us with valuable insights into the resilience of the corporate sector, and the management outlook statements will provide us with valuable micro-economic insights about their collective future expectations and sentiment.