After a difficult start to the year for equity markets across the globe, the latter half of the first quarter brought a broad-based recovery. 
Looking ahead to the second quarter, many of the same questions remain regarding global growth, interest rates and stimulus programmes. However, domestic and international politics will also have more of a bearing.
The UK referendum on 23 June will present UK voters with the choice of leaving or staying in the European Union. This will undoubtedly dominate discussion in the UK and Europe, and potentially further afield as well.
Currently, the polls say the result is too close to call whilst the betting exchanges (which have more accurately predicted voting outcomes recently), suggest there is a preference to stay in the European Union.
Using the 2014 Scottish referendum of independence as a template, we can expect more risk deriving from the uncertainty which would follow a vote to leave the European Union to be reflected in equity market valuations as we draw closer to the referendum date itself.
Currency markets have already started to reflect the heightened risk premium associated with sterling, with the pound falling sharply (3.3 per cent) against the US dollar in the wake of London Mayor Boris Johnson’s announcement that he would be supporting the campaign to leave the EU.
Performance of sterling versus the US dollar over 1yr
Source: FE Analytics
The sterling has now reached lows which have been seen only a handful of times in the past 30 years.
Up until the June referendum, we expect domestically-orientated stocks in sectors like housebuilders and property to remain under pressure, as international investors delay decisions until there is greater clarity.
On the other hand, international earners (such as tobacco companies) are likely to relatively outperform; any weakness in UK domestic demand is likely to be negligible in terms of their overall business, but earnings would be flattered by favourable exchange rate when translated back into a weaker sterling.
Overall economic management could also be affected depending on the outcome of the vote, and the Bank of England will have to keep a watchful eye on demand and the level of interest rates. Clearly, uncertainty will increase into the referendum, producing volatility in share prices that will probably continue for an extended period if voters choose to leave the EU.
Perhaps related to the referendum debate and the commensurate movement in sterling, the large cap FTSE 100 Index has been outperforming over the year to date relative to the UK’s mid-cap companies, a reversal of the pattern seen for many years.
Performance of indices in 2016
Source: FE Analytics
The overseas nature of earnings, which is significant throughout the UK market, is even more prevalent at the upper end of the market cap spectrum.
We expect this trend to continue, especially if the recent rally in commodities continues. The oil price has appreciated to around $40 a barrel and, whilst this remains very subdued compared to the highs of $115 a barrel in the summer of 2014, it is underpinning oil company share prices whilst still supporting customer spending power
Cheap oil has been painful for some sectors in developed economies, but this has been counteracted by the benefits reaped by consumers.
Low oil prices have kept inflation close to zero, acting as an effective tax cut for many. Even as the benefits of a lower oil price annualise out and, potentially, food prices stop falling, inflation in the UK is only expected to rise gradually over the next couple of years, especially if the slightly slower output of Q4 2015 continues.
The Bank of England only expects inflation to reach its 2 per cent target in two years.
With this in mind, the Bank’s Monetary Policy Committee once again voted to keep rates at their record low of 0.5 per cent, where they have been for seven years. This decision comes amid worries about global growth and uncertainty ahead of the forthcoming EU referendum.
A first rate rise this year now seems unlikely, and the scale of increases beyond have been downgraded.
In the US, the short-term data, which had been troubling the market, has been supplanted by data that is more supportive of growth. For example, February 2016 non-farm payrolls grew at 242,000 ahead of the forecast of 195,000.
However, wages dropped, with average hourly earnings declining 0.1 percent from January; the first monthly drop in more than a year. Annualised wage growth has held just above 2 per cent since the expansion started in mid-2009 and continues to do so.
With the future direction and timing of interest rate moves so uncertain, we have seen commentators swing wildly from expecting a number of rate increases this year, to none. Without data which is both decisive and directional, the market has a tendency to anchor off the latest piece of news.
This can lead to over analysis of small changes in data, extrapolating it too far into the future, and failing to allow for some degree of volatility in data points around the pattern or trend. Stepping back from the short-term noise, broader economic data and comments from the US Federal Reserve seem to suggest there is potential for one or two interest rate increases over the balance of the year.
US politics will also have a bearing on world markets as we move closer to the presidential election in November 2016.
The leading candidates, currently Hilary Clinton and Donald Trump, will no doubt be issuing more policy statements which may have an impact both geopolitically and at a sector and company level. For example, we have already seen the pharmaceutical sector come under pressure regarding price increases for vital drugs. Other sectors may well follow suit.
Global mergers and acquisitions (M&A) activity is at its highest year-to-date level since 2009 and the UK has been the leading nation for finance-targeted M&A so far in 2016, according to Dealogic. Between 1 January and 14 March this year, the volume of reported M&A has been £39.6 billion, up 29 per cent on the figure recorded in the same period last year. This surge in consolidation over new issues is a response to low growth and cheap borrowings.
The acquisition of BG Group by Royal Dutch Shell has already completed and, as we move through the year Anheuser-Busch nBev should complete its purchase of SABMiller, and Shire’s of Baxalta.
Meanwhile, there may be counterbids for the London Stock Exchange.
In terms of dividend payments, expected growth has declined to low single digits, but remains supported by the currency impact on those that pay in US dollars such as HSBC, BP and AstraZeneca.
Without this help growth could actually be zero, if not negative. However, behind this average is a bifurcation in the market between those with the financial robustness and cash flows to pay dividends, even special dividends, such as Lloyds Banking Group, ITV and Prudential, and those that are cutting them, such as the large mining companies.
Even within some industries there is a spread; in the same week we had Barclays cutting its future dividend and Lloyds announcing a special dividend, admittedly coming back from a low base.
The next three months will bring uncertainty and volatility in the UK and Continental European stock markets as we approach the UK referendum on EU membership.
Performance of indices over 1yr
Source: FE Analytics
Accordingly, we continue to be more cautious on UK domestic sectors, such as housebuilders, particularly those with a London bias which have historically benefitted from oversea buying, whilst favouring some of the larger companies with international earnings.
However, short-term concerns will provide investment opportunities across the whole market, both domestic and international, as valuations move away from fundamentals and make UK investments attractive whatever the outcome of the vote.
Alan Custis is head of UK equities at Lazard Asset Management and runs four funds at the group, including the Lazard UK Omega and Lazard Multicap UK Income funds. All the views expressed above are his own and shouldn’t be taken as investment advice.