Review of the past quarter
The second quarter of 2016 saw a short-lived recovery in commodity markets, with oil prices briefly touching the US$50-a-barrel mark. Weak growth and economic uncertainty, however, slayed market sentiment.
Anticipation of the UK’s referendum on European membership kept investors in apprehensive mood throughout the period, increasing volatility in equities markets and prolonging the rally in global bond markets.
Meanwhile, the rival party campaigns for the US Presidential election contributed to a global rush for investing in safe-haven assets, as the chasm in views on trade, international participation and domestic politics has only grown, without a matching confidence in the party candidates’ qualities. The much anticipated rise in the Federal Reserve’s deposit rate did not come about amid precautionary signs on US economic health.
In Europe, the European Central Bank (ECB) started another round of its stimulus measures in June by buying out banks’ debts in an effort to further its quantitative easing programme. Stimulus measures have not been very successful in the Far East, where China’s growth is still subdued and uncertain. The third quarter of the year, however, has been made unpredictable by Britain’s referendum vote for leaving the European Union, which sent global markets into a jitter and placed a number of questions at the doorstep of the governments.The actuarial view:
The situation in the UK has not altered greatly in recent months. The same problems of anaemic growth abroad, combined with slowing economic growth and resolutely low wage growth at home provide many obstacles. This is before we factor in the recent uncertainty caused by Brexit. A combination of low rates and steady equities has served to lower expectations and the consensus now seems to be rates rises could still be many years away.
The one positive is emerging markets, where both forecasts and therefore prospects have improved. Yet the rise is small and there remain significant obstacles and obvious risks, as has been eloquently proven by Brazil in recent weeks. Bonds have continued to do well, but the question has to be asked: what prospects does this asset class have?
The expectation is that rate must go up; yet both Germany and Japan have gone negative on terms as long as ten years. All this suggests that there are other possibilities, and that moves need neither be quick or soon; yet over the long-term prospects are poor. For this reason, movements have been small with a slight reduction in bond allocation in favour of cash and an increase in emerging markets.What to look for in Q3
Bank of England (BoE) Monetary Policy Committee Meetings: The next meetings are scheduled for 14 July, 4 August and 15 September. The BoE has refrained from making any changes to interest rates, which remain at 0.5 per cent. It has warned that Brexit could trigger a technical recession, which will require a further cut in interest rates. An inflation shock, however, is likely in the short term, which would call for an increase in rates for stabilising purposes.
Federal Reserve Meetings: The next meetings are scheduled for 26-27 July and 20-21 September. The Fed has scheduled further tax hikes for this year, but none have been implemented so far over considerations of weak US employment data. Any decision in the next quarter will be contingent upon the fallout over Brexit and any economic contraction resulting from an EU crisis.
Governing Council of the ECB: The next meetings will be held on 21 July and 8 September. The ECB’s decisions are unpredictable at this moment in time, given the unclear consequences of Britain’s vote for leaving the European Union. The immediate effects of weakening the euro suggest, however, that a more generous quantitative easing (QE) policy may be on the agenda, along with talks to stabilise the eurozone amid market shocks.Asset class scenarios
Most Likely: UK equities will face a summer of uncertainty, as the country waits for a new Prime Minister to negotiate how to extricate from the EU. Given that a majority of FTSE 100 revenues are derived overseas, as well as the incremental effect from weaker sterling, it seems unlikely that there will be significant earnings hit. Larger caps and defensive stocks should be more resilient in choppy markets. We believe that the prospects for domestically focused UK businesses are clearly the bleakest of all.
Worst Case: It is now more reasonable to assume that the UK will quickly enter a period of economic recession, which is a negative to equity markets. In the coming months, there may be delays to consumer
spending, companies’ recruitment and foreign direct investments. There is a real danger that the negative sentiment could feed on itself to create a substantial market correction.
Best Case: UK equities have been weak this year in the run-up to the referendum so some of the negativity is already ‘priced-in’. Any positive news can therefore trigger a market rally. Restarting the programme of
quantitative easing looks like a possibility. Another positive for UK equities could be a jump in inflation, as a direct result of the decline in sterling.
Most Likely: The UK referendum result has amplified an already volatile political backdrop, with news surrounding general elections across Europe and the US likely to further destabilise markets. Add central
bank actions to this, as interest rate signals by the US Federal Reserve drive speculation, and international equity markets are likely to be in for a turbulent ride, despite few significant macroeconomic developments.
Worst Case: A successful negotiation of a Brexit for the UK could actually be a substantial negative for equities, particularly Europe. Further fracturing of the EU via subsequent membership referendums, could
easily see equities suffer as investor risk-aversion builds. A combination of these known risks alongside a surprise shock event may create the conditions for a perfect storm.
Best Case: An ideal scenario would be based upon a failure of disruptions materialising; global economic growth has been fairly robust across both developed and emerging markets. Although there are signs of overheating or slowing in areas, governments could take advantage of record low borrowing costs and provide stimulus, helping to smooth slumps in economic activity and supporting markets.
EMERGING MARKET EQUITY
Most Likely: Investors are likely to continue to favour the US dollar in the short term, which will be negative for most emerging market economies, particularly net commodity importers. However, we believe there is
valuation support for emerging markets after a torrid number of years, which should limit any losses, and once calm returns to markets the region could do well as the cycle turns.
Worst Case: China has kept GDP growth high with huge levels of credit creation. If China falters and suffers an economic shock as a result it would severely hurt those emerging markets, which are part of supply
chains with the country or major trading partners. Similarly, any global recession would hit the emerging markets hard as a demand slowdown from the developed world could be disastrous.
Best Case: Emerging markets will do well if the global economy shrugs off Brexit fears, relieving the pressure on their currencies. Stable or rising commodities would be a net positive. A fast-growing US economy with a weaker US dollar would be the ideal recipe. Political stability has increased this year and more of the same would help.
Most Likely: Following Brexit, cash returns continue to remain below levels that are considered satisfactory, as they sit barely above the inflation rate. Given the likely volatility that lies ahead in both equity and fixed income markets, cash should still provide safe haven status.
Worst Case: The next interest rate move is not a rise, but rather a cut, as the likelihood of falling rates surges higher. As the price of oil continues to recover, returns across bond and equity markets should improve, which not only lowers the relative return on cash, but also erodes the real return as inflation picks up.
Best Case: A scenario featuring shrinking global growth, rising interest rates and falling commodity prices could see simultaneous declines in both equity and fixed income markets. In relative terms, it would imply
that the neutral positioning of cash would outperform.
Most Likely: Low growth and inflation prospects favour low yields, and the chances of a rate rise are minimal, with a higher chance of a cut. The Brexit vote will also increase the appeal of government bonds. We expect more weakness in lower-quality credit as fears of a recession have increased; however, our core expectation is not for a recession. Emerging market debt may struggle as the US dollar strengthens.
Worst Case: We believe that UK debt will still be seen as a safe haven. The worst realistic case for bonds is that inflation spikes higher, which reduces real returns for bondholders. A significant fall in the pound versus the US dollar and euro in particular could cause this.
Best Case: For government bonds the best-case scenario is the worst for the economy. If political negotiations are inamicable, this could increase concerns of political disintegration in Europe and push core bond yields lower. For corporate bonds, the best case would be if there was little reaction by companies to the vote and they expect business to continue as normal and profit margins would be preserved.
Most Likely: Expect market volatility in UK real estate as market participants will likely react to any piece of news coming out, relevant or not, and others will delay investment decision until the negotiations with the EU are clearer. Currency volatility is also on the menu and will contribute to the uncertainty freezing decisions. However, longer-term fundamentals remain unchanged. Investors who can should remain invested.
Worst Case: The UK economy goes into recession, transaction volumes shrink and properties are marked down. Inflation surges, triggering a rate rise. Funding costs are higher, slowing down activity even further. That said, there are factors indicating that the slump would be constrained in the medium term and a contagious fear outside the UK seems unlikely.
Best Case: Inflation is contained and the BoE cuts interest rate or reintroduces QE, which supports yielding assets such as property. It lowers funding costs for investors, limiting a slowdown in real estate activity. Supply remains tight in many segments of the market, supporting prices. The drawdown experienced by property equity is recovered quickly. Real estate conserves its attractiveness in a low growth world.
Lovewell Blake Financial Planning Limited is a firm of independent financial advisers authorised and regulated by the Financial Conduct Authority.