Do you feel lucky?

10 Aug 2017

Chris Darbyshire, Chief Investment Officer

It took stockmarkets about a fortnight to overcome the shock of Brexit. It took them about two hours to overcome the shock of Trump. Since then, stockmarket volatility has fallen to all-time lows, suggesting that investors are actually more confident than ever before.

To be fair, company profits have recently demonstrated strong growth and this has been enough to convince investors to pile in. Company profits, though, do not predict the future. Moreover, you might expect investors to have learned in 2007 that stockmarkets are most risky when they are least volatile.

Brexit and Trump are profoundly worrying, potentially destabilising, events. The Leave vote did not triumph solely because British people wanted a "bonfire of the regulations" and a glorious world of unfettered trade outside the EU. It triumphed because optimistic free marketers were joined by a cohort of angry, disaffected voters seeking to turn away from free trade and globalisation. If it’s becoming apparent that the former vision cannot be achieved without significant risk (see below), it’s absolutely certain that a Brexit that appeases the latter would hurt the British economy. Corbyn’s recent statement in support of a Brexit outside the European Single Market and Customs Union should have given even the most ardent free-traders pause for thought: here was a hard-left Labour leader embracing a ‘Hard’ Brexit! We expect Labour to soften its stance over time, but the comment highlights how much Brexit is driven by ideology rather than reasoned discourse. Stockmarkets are most risky when they are least volatile.

Unfortunately, that applies to both extremes of the Brexit debate. Furthermore, the government is in disarray on the issue: there is little unanimity on what is right or even feasible, and the Prime Minister has yet to confess to the British electorate the true risk, cost and complexity of the process. This process is going to be messy.

Rarely do entire nations shoot themselves in the foot but, with the extraordinary absence of circumspection surrounding the entire Brexit process, plus the many egos and political careers on the line, it cannot be written off. These are risks that we have never encountered before. We don’t mind taking a risk when it can be adequately priced in, but this is not the case with Brexit. One of our research providers recently compiled an index of genuinely local UK companies (the ‘ASR UK Domestic 100’).

The requirement for inclusion in the index was that companies must derive at least 80% of their revenues from the UK, which enables us to look at the valuations of companies that are more directly exposed to Brexit risks (see chart).

Price-Earnings Valuations of the ASR UK Domestic 100

Source: Absolute Strategy Research

We find that UK companies are still trading at Price-Earnings (‘P/E’) valuations well above the averages of the past seven years. The stockmarket is implicitly pricing in little Brexit risk.

Of course, the stockmarket may be right. But the impact of Brexit, though insignificant at first, has begun to gather pace. The continuation of normal growth in the aftermath of the referendum now appears to have been largely funded by consumers taking on more debt, as the Bank of England cut rates to 0.25%. More recently consumption has faltered, most likely because consumers have been hit by higher inflation following the Pound’s devaluation. Moreover, British industry has finally spoken out about Brexit. The farming, automotive, aerospace, investment banking, legal, shipping and air transport industries have all recently warned against the government’s strategy and the risks of a cliff-edge. Investment banks have been the first to announce actual staff transfers to Frankfurt, Paris and Dublin. We hope, of course, that Brexit plays out well – but ‘hope’ is not an acceptable investment strategy.

As if this isn’t enough excitement, consider the other, unique risk that applies to British investors. Unlike other global investors, we have been the lucky recipients of a massive decline in our home currency. This has boosted the value of investments denominated in foreign currencies. Moreover, as most large ‘British’ companies are actually globally-diversified multi-nationals, British investors received a double benefit as the value of overseas assets owned by those companies took off in Sterling-terms and the UK stockmarket rocketed up! Foreign assets proved to be a powerful hedge against the uncertainty created by the EU Referendum; so powerful, in fact, that many investors are probably wondering what all the fuss is about.

Consequently, if Brexit turns out to be a damp squib (economically speaking), and Sterling returns to its pre-referendum value, British investors holding globally-diversified portfolios face substantial losses. First, they are exposed to a substantial decline in the value of their foreign investments. Secondly, this decline would be accompanied by a similar decline in the value of shares in British-domiciled companies with overseas assets.

In addition to the usual portfolio risks that investors run, therefore, British investors uniquely have two other risks: Brexit and currency risk. Consider what might happen to a standard British portfolio if all three risks were to converge. Imagine, for instance, that economic data began to point to a global economic slowdown (perhaps of the kind threatened in early 2016). The usual market correction would ensue, perhaps exacerbated by an eruption in volatility from its current low levels. This is scary enough. But there would also be additional weakness centred on British assets as investors priced in the extra risk of Brexit in a recessionary environment. Given this scenario, it’s not inconceivable that the government would change direction on Brexit. It might announce a softer strategy or even a second referendum. Sterling might jump up on this news (or even on the expectation of it), hurting portfolios even further. Finally, those UK companies with overseas holdings that had been so beneficial in Sterling’s descent would then hurt portfolios on the way back up. Such an Armageddon-scenario might have a small probability of occurrence, but it would do vast and long-lasting damage to British investors: for a typical portfolio, the impact of a ‘normal’ correction might be doubled due to additional Brexit-related risks.In addition to the usual portfolio risks that investors run, British investors uniquely have two other risks: Brexit and currency risk.

Our philosophy, which is to reliably deliver our target returns over the long term, prompts us to avoid such outcomes even if it means sacrificing some upside. We long since dropped our UK allocations to the minimum and will maintain them there until we feel more confident about Brexit outcomes. In order to assess our UK economic exposure accurately, we must make a distinction between companies that are listed in the UK (on the London Stock Exchange) and where their trading actually takes place. The former is always a much greater share of portfolios than the latter. When we analyse our current holdings, looking at the specific companies held and estimating how many of their revenues are actually derived from the UK, we find that less than 5% of assets in the Balanced portfolios are economically exposed to the UK. Our biggest exposure is in the Adventurous portfolios but, even here, the figure is less than 6%. Finally, we have also sought to protect against an unexpected rise in Sterling relative to foreign currencies through buying call options on the Pound-Dollar exchange rate.

What might be the catalyst for such market shocks? The obvious culprit is the end of unconventional monetary policy, now being signalled by some central banks. We are only half-way through the grand experiment of Quantitative Easing, and must now disentangle ourselves from a policy that has massively reduced debtors’ payments while simultaneously inflating the portfolio values of creditors. It’s hard to exaggerate how important monetary policy was in stabilising the economic environment, post-Credit Crunch. The monetary backdrop will now necessarily become one of increasing ‘instability’, albeit from a very low base, as companies and consumers learn again how to stand on their own two feet. This puts enormous pressure on economic growth to plug the gap in confidence that will open up.

But today’s environment is also characterised by political risk – specifically the desire to enact policies based on ideology rather than sound economics. Brexit is one example; President Trump is another. The Trump administration, initially a beacon of optimism for investors, is increasingly looking like the lights of an oncoming train. Fortunately, so little legislation has been enacted that there will be little economic damage. Unfortunately, there is little economic upside.

Meanwhile, key geopolitical and trade relationships are souring. President Trump seems destined to leave a trail of wreckage through longstanding diplomatic policies and relationships. This would arguably be manageable by an able team of advisers, but the context is worrying. Stockmarkets, being focused on company profits and guidance, tend to ignore geopolitical risks until they are slapped in the face by them. We can’t know specifically what such a surprise might look like, but we think the chances of significant geopolitical fallout are high and getting higher. Researchers at the US Federal Reserve Bank recently compiled a geopolitical risk index (‘GPR’) based on analysis of global media stories: their work suggests that current geopolitical risk levels are at levels seen only every few decades or so (see chart). Combine volatile geopolitical risk with a volatile President and the result, at some point, could be toxic.

Geopolitical Risk Index (GPR)

Source: Caldara, Dario and Matteo Iacoviello, "Measuring Geopolitical Risk," working paper, Board of Governors of the Federal Reserve Board, 2017

Next up in the US domestic political agenda, meanwhile, is the negotiation over the Debt Ceiling. This is the subject that led, in 2011, to a downgrading of US government debt by ratings agencies and a stockmarket swoon. Trump wants to win at any cost. He was able to ‘bribe’ his way to power with a string of empty, unfunded commitments to tax cuts, infrastructure spending, the Wall on the Mexican border, and so on. Now that he’s in power, he has the opportunity to literally ‘buy’ his way to re-election. Not surprisingly, he wants the Debt Ceiling raised without any strings attached. This is toxic to many in the Republican Party and we expect another spectacle worthy of Cirque Du Soleil.

The investigations surrounding the Trump administration’s relationship with Russia will rumble on and on. We worry that, if the investigators dig deep enough, they will inevitably find something touching Trump or his inner circle; whether it be Russia-related wrongdoing or some other kind. Even if this does not lead to legal action in the short term, that risk won’t go away. President Trump has alienated powers that will pursue him to the bitter end. This raises the stakes considerably: as the investigation digs deeper, Trump will be more and more incentivised to find distractions and to maintain the privileges of the presidency. Desperate acts are not out of the question.
We are more concerned with ensuring that we can sustain returns over the longer term, so we shouldn’t just ignore unpriced threats.

Stockmarkets may be right: perhaps economic growth is now robust enough to withstand a great deal of political shenanigans. In fact, we would not disagree with the view that everything will most likely be fine. But investors have had a great run recently, despite the potential headwinds of Brexit and Trump, and our philosophy is not to push the whole team over the half-way line when we are already winning two-nil. We are more concerned with ensuring that we can sustain returns over the longer term, so we shouldn’t just ignore unpriced threats and go for the hat-trick. Moreover, when we actively consider what those less-favourable scenarios could look like, and estimate the probability of their occurrence, it takes the gloss off expected short term equity returns.

While things will most likely turn out OK, the risks around that central scenario are elevated in new and strange ways. Frankly, no one has any idea if there will be any monetary, political or geopolitical fallout, what kind of fallout might occur, or how big and long-lasting its impact might be. Our seatbelts are fastened.

On most risk measures our portfolios are currently close to their lower bounds. In addition to maintaining little UK economic exposure, we currently have relatively little exposure to risky assets generally. As at 31 July 2017, equity holdings are about nine percentage points below their strategic allocation (i.e. their long-run ‘neutral’ setting). For example, in our Balanced risk profiles we hold 39% of assets in equities versus a strategic allocation of 48%. Where we have retained equity risk it is skewed towards Europe and Asia – two regions whose economic cycles have lagged those in the US and UK. More recently, political risk in Europe has eased, though it is not negligible. We believe these holdings can generate significant upside in the event of another market rally, while the overall risk position would withstand a market shock relatively well.

Our bond holdings are also below their long-run, strategic allocations as we anticipate the unwinding of unconventional monetary policy. In particular, allocations to government and other high-quality issuers are slightly above half their strategic reference weights: 14% in Balanced portfolios, for example, versus 26% in the strategic allocation. The difference is partly absorbed by holdings of Emerging Market bonds, which are largely a play on Emerging Market currencies; these currencies generate relatively high yields and still have significant rebound potential following the period of US Dollar strength in 2014.

Within the portfolios, the allocation to ‘Other assets’, which includes alternatives, is increasingly filling in for stock and bond-market risk. As a result, this allocation has increased to double its strategic weight. Holdings of gold are significant (7% of assets in Balanced). Gold is a volatile asset but largely uncorrelated with the major risk classes, and we believe it will react favourably to any eruption in geopolitical or US domestic political risk. Various alternative investments are also designed to offset market downside, including some outright hedges on the US stock and interest rate markets.


Visit our literature section for a full breakdown of our fund holdings.

The value of investments can go down as well as up and you may get back less than you invested originally.

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The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.
The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.

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