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Rathbones: Five key themes investors can’t ignore

26 October 2016

The firm’s Strategic Asset Allocation Committee explains the fundamental themes shaping its portfolios as we head into 2016's fourth quarter.

By Lauren Mason,

Senior reporter, FE Trustnet

Rich valuations in infrastructure, the triggering of Article 50 and the valuation of sterling are among some of the themes shaping Rathbone’s investment strategy as we head into this year’s final quarter.

In its latest quarterly investment outlook, the firm explains that a “phoney war” is being fought against the potentially negative impacts of Brexit, pointing out that it will take several years to fully sever ties with the European Union.

It also explains that while a Trump victory in the US election is likely to cause high levels of economic uncertainty, a Clinton win could also bruise commodity sectors given her anti-fracking stance.

This year has been a particularly challenging one for active investors. Markets kicked off 2016 with a disappointing performance due to China growth fears and plummeting commodity prices.

Performance of indices in 2016

 

Source: FE Analytics

The middle of February then saw a sudden rebound as the oil price crept up and the Federal Reserve released dovish statements, suggesting dollar strength was unlikely to be as pronounced as many investors feared.

Markets then achieved surprisingly strong returns after the UK’s EU referendum result was announced, with many international and global-facing companies rallying off the back of weak sterling.

Now though, with monetary policy pushing asset prices to historic highs and significant geopolitical uncertainty on the horizon, it could be argued that the fourth quarter could bring even further challenges to investors.

In the below article, Rathbone’s Strategic Asset Allocation Committee talks through five key themes that will have the greatest impact on portfolios during this year’s final three months.

 

The impending Brexit

The committee points out that the EU referendum result has had minimal impact on the UK other than sterling weakness and the change of prime minister.

“The FTSE 100 recovered quickly and even the FTSE 250 has regained its pre-vote levels, confounding the warnings from a range of experts. However, performance has diverged between companies with substantial overseas earnings and those which are more domestically-exposed,” it explained.

Performance of indices in 2016

 

Source: FE Analytics

“Brexit will take several years to come to fruition. During this time, economic growth may slow because of uncertainty, but we do not expect a recession.

“So far, leading economic indicators confirm this. However, this period could be difficult, with politically-driven volatility shaping the investment landscape.”

The team also says fiscal stimulus policy is likely to be announced by chancellor Philip Hammond in November’s Autumn statement in a bid to boost the economy.

It also notes that the Bank of England has relaunched its QE programme and reduced interest rates to 0.25 per cent, also supporting economic growth. 


The US election

Often billed as one of the most controversial presidential elections to-date, Rathbone’s Strategic Asset Allocation Committee says the result could change market behaviour, despite the fact political events tend to have a limited impact.

“The key issue for investors is the potential for the US to impose trade tariffs. Conditions are ripe for protectionism to have broader appeal regardless of the result, although Donald Trump appears to represent a more extreme risk,” it said.

“Such a new trade policy would lower our forecasts for the long-term returns from US equities because protectionism inhibits productivity growth.”

The committee believes a Trump victory will predominantly hurt sectors which are more sensitive to economic uncertainty and that the US business cycle will correlate with a high proportion of earnings from China.

It adds that Hillary Clinton’s anti-fracking stance could also hurt commodities and lead to lower oil prices if there were to be a Democrat victory. It says that expensive labour laws could also be imposed on the sector.

 

 

The behaviour of sterling

Given the fall in sterling immediately after the EU referendum result and its further deprecation over recent months, the committee says the increased likelihood of a ‘hard Brexit’ is not doing the currency any favours. 

Performance of currency vs US dollar in 2016

 

Source: FE Analytics

“Global investors see significant risks ahead for the UK economy and therefore sterling, and are very negative on the short-term outlook for the currency,” it explained.

“Our research shows that currencies have an equilibrium exchange rate from which they can deviate substantially, and for considerable periods, but to which they gravitate again over the long term.

“Measured against all major developed market exchange rates, our analysis suggests sterling is substantially undervalued and is likely to appreciate over the next few years.”

In the meantime, though, the Rathbone team says geopolitical uncertainty will continue to peddle currency market volatility, with the US, French and German elections all occurring over the next few months.

“Even if the UK is shut out of the single market, which would affect the equilibrium rate, sterling still appears undervalued,” it added. 

 

Emerging market debt

The team believes emerging market debt looks particularly attractive at the moment, given that traditionally ‘safe’ fixed income assets are offering yields at historic lows.

“In an environment of low rates and depressed bond yields across the developed world, investors have regained their appetite for emerging markets [EMs], which offer exposure to higher rates of economic activity than the developed world,” it continued.


“EM debt looks attractive across various valuation measures. Although there are more risks attached to investing in EMs, we believe the potential returns on offer are now sufficient to compensate investors.

“Our long-term positive outlook for EMs is based on demographics and the huge potential for economic and financial services growth.”

The committee says the high yield is compensating for risks such as an increased slowdown in China’s economy, wider geopolitical volatility and significant Fed rate hikes.

Given these factors, as well as the fact emerging markets are not a homogenous group, it plans to access this area of the market through specialist active fund managers. 

 

The high valuation of infrastructure funds

Given ultra-loose monetary policy and the subsequent hunt for yield, the committee warns asset prices have rocketed in income-paying areas of the market such as infrastructure.

It says many infrastructure trusts are now trading on significant premiums and questions whether they deserve to be trading on such high valuations.

Performance of index in 2016

 

Source: FE Analytics

The team said: “Although the cash flows on private finance initiative (PFI) vehicles are government-backed, there is a lack of clarity over how they would perform in a rising rate environment.

“Inflation is also important because it affects cash flows. Those with the ability to set prices are best placed to generate returns.

“With governments around the world considering fiscal stimulus, infrastructure is likely to provide long-term investment opportunities. However, for closed-end funds, we recommend waiting until valuations improve.” 

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